Money in Banking Final Exam

Chairman Bernanke (2006-2014):

Background in academia and focused his decisions on analytics; Focus on Board's staff forecasts and greater use of model simulations; Encouraged a more informal discussion at the FOMC by having members raise their hands to speak and waits the end to make his recommendations; Famous for being a clear speaker and strong advocate of more transparency

Chairman Greenspan (1987-2006):

Background in economic consulting and advocate of laissez-faire capitalism; "Maestro" of forecasting because of his ability to "immerse" himself in data; Exercised extensive control of the formal discussion at the FOMC by making his recommendations and then asking members to agree/disagree on them; Famous for being obscure in his hearings and opposed more transparency.

Federal Reserve Act of 1913

- Elaborate system of checks and balances - Decentralized

Resistance to establishment of a central bank

- Fear of centralized power - Distrust of moneyed interests

No lender of last resort

- Nationwide bank panics on a regular basis - Panic of 1907 so severe that the public was convinced a central bank was needed

The writers of the Federal Reserve Act wanted to diffuse power along regional lines. This has resulted in the evolution of the Federal Reserve System to include the following entities:

- The Federal Reserve banks - The Board of Governors of the Federal Reserve System - The Federal Open Market Committee (FOMC) - The Federal Advisory Council - Roughly 2,500 member commercial banks

Arguments in favor of an explicit inflation target:

1. It would draw attention to what the Fed can actually achieve in practice. 2. It would provide an anchor for inflationary expectations. 3. It would promote accountability.

Monetary Policy Tools and the Federal Funds Rate

1. Open market operations 2. Discount policy 3. Reserve requirements

The Goals of Monetary Policy

1. Price stability 2. High employment 3. OutputStability 4. Stability of financial markets and institutions 5. Interest rate stability 6. Foreign-exchange market stability

Arguments against an inflation target:

1. Rigid numerical targets for inflation diminish flexibility to address other goals 2. Reliance on uncertain forecasts of future inflation can create problems. 3. The goal of transparency could be achieved without explicit inflation target.

Federal Reserve Bank

A district bank of the Federal Reserve system. Division of the United States into 12 Federal Reserve districts.

Inflation Targeting

Before the financial crisis, there was significant interest in using inflation targeting as a framework for monetary policy. With inflation targeting, a central bank publically sets an explicit target for the inflation rate over a period of time. In 2010, the Fed announced that it would attempt to maintain an average inflation rate of 2% per year.

Fixed Exchange Rates under Bretton Woods

Central bank interventions in the foreign exchange market maintained the fixed exchange rates of the Bretton Woods system. A central bank can maintain a fixed exchange rate as long as it is able and willing to buy and sell the amounts of its own currency that are necessary for exchange rate stabilization. A country has its ability to buy its own currency (to raise its value relative to the dollar) limited by the country's stock of international reserves. When a country's stock of international reserves was exhausted, the central bank would have to implement restrictive economic policies (e.g., increasing interest rates) to reduce the trade deficit, or abandon the exchange rate policy.

The Federal Funds Market

Demand for Reserves: determined the banking system: 1. To meet their legal obligations to hold required reserves; 2. If they wish to hold excess reserves to meet their short-term liquidity needs. Supply of Reserves: controlled by the Fed.

Discount policy

Discount policy is the policy tool of setting the discount rate and the terms of discount lending. Discount window is the means by which the Fed makes discount loans to banks. This serves as the channel for meeting the liquidity needs of banks.

High Employment

High employment, or a low unemployment rate, is another key monetary policy goal. Unemployment reduces output and causes financial and personal distress. In the long run, the natural rate of unemployment is estimated to be between 5% and 6%. This is given by the sum of frictional and structural unemployment. The tools of monetary policy are ineffective in reducing these types of long-run unemployment, but the Fed attempts to reduce cyclical unemployment associated with short-run business cycle recessions.

Open Market Operations

In 1935, Congress established the FOMC to guide open market operations. An open market purchase of Treasury securities causes their prices to increase, and so their yield to decrease. As the monetary base increases, the money supply will expand. An open market purchase is an expansionary policy because it reduces interest rates. An open market sale has the opposite effects, and so it is called a contractionary policy.

What Happened to the Link between Money and Prices?

In the United States, the money supply has grown more rapidly during decades when the inflation rate has been relatively high. Prior to 1980, strong evidence supports the link between money and prices in the short run of a year or two. The economists who argued this point most forcefully were known as monetarists, notably Nobel laureate Milton Friedman. Under Paul Volcker, the Fed shifted its policy to emphasize nonborrowed reserves as a policy instrument. This episode of "The Great Monetarist Experiment" produced mixed results.

Foreign-Exchange Market Stability

In the global economy, stability in the foreign-exchange value of the dollar is an important monetary policy goal of the Fed. A stable dollar simplifies planning for commercial and financial transactions. Fluctuations in the dollar's value change the international competitiveness of U.S. industry: an appreciation of the dollar makes U.S. goods more expensive abroad, reducing exports.

Quantitative easing

Is the central bank policy that attempts to stimulate the economy by buying long-term securities. During 2009 and early 2010, the Fed bought more than $1.7 trillion in mortgage-backed securities and longer-term Treasury securities. In November 2010, the Fed announced a second round of quantitative easing (QE2), which involved buying $600 billion in long-term Treasury securities. In September 2011, the Fed announced its policy of Operation Twist, which involved buying $400 billion of long-term securities (lowering long-term interest rates) while selling $400 billion of short-term securities (raising short-term interest rates). In September 2012, the Fed announced a third round of quantitative easing (QE3) that focused on purchases of mortgage-back securities and ended in October 2014.

Interest Rate Stability

Like fluctuations in price levels, fluctuations in interest rates make planning and investment decisions difficult for households and firms. The Fed's goal of interest rate stability is motivated by political pressure and a desire for a stable financial environment. Sharp interest rate fluctuations cause problems for financial institutions. So, stabilizing interest rates can help to stabilize the financial system.

Dynamic open market operations are intended to change monetary policy as directed by the FOMC.

Likely to be conducted as outright purchases and sales of Treasury securities to primary dealers

Money Supply

Monetary Base x Money Multiplier

Monetary base (or high-powered money) is the sum of bank reserves and currency in circulation.

Monetary base = Currency in circulation + Reserves. The money multiplier links the monetary base to the money supply. When the money multiplier is stable, the Fed can control the money supply by controlling the monetary base. There is a close connection between the monetary base and the Fed's balance sheet.

Defensive open market operations are intended to offset temporary fluctuations in the demand or supply for reserves, not to carry out changes in monetary policy.

Much more common, and are conducted through repurchase agreements. A similar action is changing Federal Reserve float, which increases if there is a delay in check clearing after a snowstorm

Open market operations

Open market operations are the Fed's purchases and sales of securities, usually U.S. Treasury securities, in financial markets.

Price Stability

Problems caused by inflation: • Inflation makes prices less useful as signals for resource allocation because uncertain future prices complicate decisions households and firms have to make about savings and investment. • Inflation can also arbitrarily redistribute income. • Hyperinflation (inflation in the hundreds or thousands of percent per year) can severely damage an economy's productive capacity.

Reserve requirements

Reserve requirement is the regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the Fed.

Creation of the Federal Reserve System

Resistance to establishment of a central bank No lender of last resort Federal Reserve Act of 1913

Discount Policy

Since 1980, all depository institutions have had access to the discount window. Each Federal Reserve Bank maintains its own discount window, although all Reserve Banks charge the same discount rate.

Changes in the Discount Rate

Since 2003, the Fed has kept the discount rate higher than the target for the federal funds rate. So, the discount rate is a penalty rate, as banks pay a penalty by borrowing from the Fed rather than from other banks. Most changes in the discount rate will not affect the federal funds rate.

Output Stability

Stable economic growth is based on a stable business environment that allows firms and households to plan accurately and encourages long-term investment. With high unemployment, businesses have unused productive capacity and are much less likely to invest in capital improvements.

Using Operating Targets to Meet Goals

Targets are variables that the Fed can influence directly and that help achieve monetary policy goals. Traditionally, the Fed has relied on two types of targets: • policy instruments or operating targets • intermediate targets

Implementing Open Market Operations

The FOMC issues a policy directive to the Federal Reserve System's account manager, who is a vice president of the Federal Reserve Bank of New York. The Open Market Trading Desk is linked electronically through the Trading Room Automated Processing System (TRAPS) to about 20 primary dealers. Each morning, the trading desk notifies the primary dealers of the size of the open market purchase or sale and asks them to submit offers to buy or sell Treasury securities.

How the Fed Changes the Monetary Base

The Fed changes the monetary base by changing the levels of its assets by buying and selling Treasury securities or making discount loans to banks.

Monetary Targeting and Monetary Policy

The Fed often faces trade-offs in attempting to reach its goals, particularly the goals of high employment and low inflation. To spur employment, the Fed could lower the target for the federal funds rate, which increase the money supply, potentially increasing the inflation rate in the longer run. The tools of monetary policy don't allow the Fed to have direct control over real output or the price level.

Changes in the Required Reserve Ratio

The Fed rarely changes the required reserve ratio. The last change took place in April 1992, when the required reserve ratio were reduced from 12% to 10%.

political business cycle

The Fed would try to lower interest rates to stimulate economic activity before an election to earn favor with the incumbent party running for reelection.

Open Market Operations Versus Other Policy Tools

The benefits of open market operations include: Precision: the Fed can change the money supply by the desired amount; Flexibility: the Fed can easily switch from buying to selling securities; Predictability: the Fed can predict the change in money supply (multiplier). Discount loans depend in part on the willingness of banks to request the loans and so are not as completely under the Fed's control. The Fed can implement its open market operations with no administrative delays. Changing the discount rate or reserve requirements requires lengthier deliberation.

Arguments for Fed Independence

The main argument for Fed independence is that monetary policy is too important and technical to be determined by politicians. • Because of the frequency of elections, politicians may be shortsighted, concerned with short-term benefits without regard for potential long-term costs. • Accommodation: complete control of the Fed by elected officials increases the influence of political business cycles on the money supply.

The Choice between Targeting Reserves and Targeting the Federal Funds Rate

The main policy instruments have been reserve aggregates and the federal funds rate. The Fed has used three criteria when evaluating potential variables for policy instruments: 1. Measurable: The variable must be measurable in a short time frame to overcome information lags. Both reserve aggregates and the federal funds rate are easily measurable. 2. Controllable: Open market operations can keep both variables close to whatever target the Fed selects. 3. Predictable: The complexity of the impact that a change in either reserves or the federal funds rate has on economic goals compromises predictability.

The Federal Reserve's Balance Sheet and the Monetary Base

The model of how the money supply is determined includes three actors: 1. The Federal Reserve: responsible for controlling the money supply and regulating the banking system. 2. The banking system: creates the checking accounts that are a major component of M1. 3. The nonbank public (all households and firms): decides the form in which they wish to hold money (e.g., currency vs. checking deposits).

Explaining the Explosion in the Monetary Base

The monetary base increased sharply in the fall of 2008 and stayed at high levels through 2012. This happens whenever the Fed purchases assets of any kind, the monetary base increases. Most of the increase occurred because of an increase in the bank reserves component, not the currency in circulation component. Typically, when the monetary base increases, the Fed purchases Treasury Securities, but the Fed's holdings of Treasury securities actually fell. Innovative Policy Measures: As the Fed began to purchase assets connected with Bear Stearns and AIG, the asset side of its balance sheet expanded, and so did the monetary base.

The Simple Deposit Multiplier

The money multiplier helps us understand the factors that determine the money supply. The money multiplier is determined by the actions of three actors in the economy: the Fed, the nonbank public, and banks.

Did the Gold Standard Make the Great Depression Worse?

To remain on the gold standard, central banks often had to take actions that contracted production and employment rather than expanding it. For example, the Fed attempted to stem gold outflows by raising the discount rate and making financial investments in the United States more attractive to foreign investors. Higher interest rates were the opposite of the lower interest rates needed to stimulate domestic spending. The devastating economic performance of the countries that stayed on the gold standard the longest is the key reason that policymakers did not attempt to bring back the gold standard.

Arguments against Fed Independence

Undemocratic: elected officials should make public policy. The public could hold elected officials responsible for perceived monetary policy problems. • Lack of coordination: monetary policy could be coordinated and integrated with government taxing and spending policies. • Unsuccessful: the Fed failed to assist the banking system during the economic contraction of the early 1930s. Also, Fed policies were too inflationary in the 1960s and 1970s. Finally, the Fed ignored the housing market bubble in the early 2000s and then moved too slowly to contain its effects in 2006.

Stability of Financial Markets and Institutions

When financial markets and institutions are not efficient in matching savers and borrowers, the economy loses resources. The stability of financial markets and institutions makes possible the efficient matching of savers and borrowers. The Fed responded vigorously to the financial crisis that began in 2007, but it initially underestimated its severity and was unable to avoid the deep recession of 2007-2009. The severity of the 2007-2009 recession has made financial stability a more important Fed policy goal.

Speculative Attacks in the Bretton Woods System

When investors believe that a government was unable to maintain its exchange rate, they can profit by selling a weak currency or buying a strong currency. These actions, known as speculative attacks, could force a devaluation of the currency. Speculative attacks can produce international financial crises. Devaluations are forced by speculative attacks when a central bank is unable to defend the exchange rate, as in England's 1967 crisis.

Did the Gold Standard Make the Great Depression Worse?

When the Great Depression began in 1929, governments came under pressure to abandon the gold standard. By the late 1930s, the gold standard had collapsed.

Bank reserves

are bank deposits with the Fed plus vault cash. Reserves = Bank deposits with the Fed + Vault cash. Reserve deposits are assets for banks and liabilities for the Fed. Why? Banks can request that the Fed repay the deposits on demand with Federal Reserve Notes. Reserves = Required reserves + Excess reserves.

International reserves

are central bank assets that are denominated in a foreign currency and used in international transactions. If the Fed wants the value of the dollar to fall, it can increase the supply of dollars by buying foreign assets. Such transactions affect not only the value of the dollar but also the domestic monetary base.

Capital controls

are government-imposed restrictions on foreign investors buying domestic assets or on domestic investors buying foreign assets. Capital controls have significant problems: •Government corruption is often a result of investors having to receive permission from the government to exchange domestic currency for foreign currency. •Multinational firms will have difficulty returning any profits they earn to their home countries if they can't exchange domestic currency for foreign currency. •In practice, individuals and firms resort to a black market where currency traders are willing to illegally exchange domestic currency for foreign currency.

Excess reserves

are reserves that banks hold above those the Fed requires to hold.

Required reserves

are reserves that the Fed requires banks to hold.

Open market operations

are the Fed's purchases and sales of securities, usually U.S. Treasury securities, in financial markets. • Open market purchase is the Fed's purchase of securities. • Open market sale is the Fed's sale of securities. Open market operations are carried out electronically with primary dealers by the Fed's trading desk. In 2012, there were 21 primary dealers (commercial banks, investment banks, and securities dealers).

Primary credit

consists of discount loans available to healthy banks experiencing temporary liquidity problems.

Secondary credit

consists of discount loans to banks that are not eligible for primary credit because they have inadequate capital.

Seasonal credit

consists of discount loans to smaller banks in areas where agriculture or tourism is important.

Foreign exchange market intervention

is a deliberate action by a central bank to influence the exchange rate.

Gold standard

is a fixed exchange rate system under which currencies of participating countries are convertible into an agreed-upon amount of gold.

Discount loan

is a loan made by the Fed to a commercial bank. Discount loans alter bank reserves. An increase in discount loans affects both sides of the Fed's balance sheet: •$1 million of discount loans increases bank reserves and the monetary base by $1 million

International Monetary Fund (IMF)

is a multinational organization established by the Bretton Woods agreement to administer a system of fixed exchange rates. It also serves as a lender of last resort to countries Headquartered in Washington, DC, this multinational organization grew from 29 member countries in 1945 to 188 in 2012. The IMF no longer attempts to foster fixed exchange rates, but its activities as an international lender of last resort have grown.

Exchange-rate regime

is a system for adjusting exchange rates and flows of goods and capital among countries.

Fixed exchange rate system

is a system in which exchange rates are set at levels determined and maintained by governments.

Public interest view

is a theory of central bank decision making that holds that officials act in the best interest of the public. The Fed seeks to achieve economic goals that are in the public interest (e.g., price stability, high employment and economic growth). Does the evidence support the public interest view of the Fed? Some economists argue that it doesn't appear to with regard to price stability (e.g., persistent inflation since World War II). Other economists argue otherwise. There are similar debates over the Fed's contributions to the stability of other economic indicators.

Principal-agent view

is a theory of central bank decision making that holds that officials maximize their personal well-being rather than that of the general public. • This view predicts that the Fed acts to increase its power, influence, and prestige as an organization, subject to constraints placed by principals (the president and Congress). • The principal-agent view also suggests that the Fed would fight to maintain its autonomy. Indeed the Fed has frequently resisted congressional attempts to control its budget and lobbied against reductions in its independence. • According to the principal-agent view, the Fed could manage monetary policy to assist the reelection efforts of presidential incumbents who are unlikely to limit its power.

Vault cash

is currency held by banks. Currency in circulation = Currency outstanding - Vault cash.

Currency in circulation

is paper money and coins held by the nonbank public.

Multiple deposit creation

is part of the money supply process in which an increase in bank reserves results in rounds of bank loans and creation of checkable deposits. • As a result, an increase in the money supply is a multiple of the initial increase in reserves.

Federal funds rate

is the interest rate that banks charge each other on very short-term loans. The target for the federal funds rate is set at FOMC meetings, but it is then determined by the demand and supply for reserves in the federal funds market.

Discount rate

is the interest rate the Fed charges on discount loans. The discount rate differs from most interest rates because it is set by the Fed, whereas most interest rates are determined by demand and supply in financial markets. The monetary base (B) includes: the nonborrowed monetary base (Bnon) and borrowed reserves (BR) (same as discount loans). B=Bnon +BR. The Fed has control over the nonborrowed monetary base.

Devaluation

is the lowering of the official value of a country's currency relative to other currencies. A country whose currency was undervalued relative to the dollar could revalue its currency.

Required reserve ratio

is the percentage of checkable deposits that the Fed specifies that banks must hold as reserves.

Revaluation

is the raising of the official value of a country's currency relative to other currencies. In practice, countries didn't often pursue devaluations or revaluations. Governments changed their exchange rates only in response to severe imbalances in the foreign exchange market.

Simple deposit multiplier

is the ratio of the amount of deposits created by banks to the amount of new reserves.

An unsterilized foreign exchange intervention

occurs when a central bank allows the monetary base to respond to the sale or purchase of domestic currency in the foreign exchange market.

sterilized foreign exchange intervention

occurs when a foreign exchange intervention is accompanied by offsetting domestic open market operations, so that the monetary base is unchanged. Because the monetary base is unaffected, domestic interest rates will not change. So, the demand curve and supply curve for dollars in exchange for yen will not be affected, and the exchange rate will not change. To be effective, central bank interventions that are intended to change the exchange rate need to be unsterilized.

Bretton Woods

system is an exchange rate system under which countries pledged to buy and sell their currencies at fixed rates against the dollar (and the United States pledged to convert dollars into gold if foreign central banks requested it to). By fixing their exchange rates against the dollar, these countries were fixing the exchange rates among their currencies as well. Because central banks used dollar assets and gold as international reserves, the dollar was known as the international reserve currency. The Bretton Woods system lasted from 1945 until 1971. The United States agreed to convert U.S. dollars into gold at a price of $35 per ounce.

Board of Governors

the governing board of the Federal Reserve System, consisting of seven members appointed by the president of the United States. • The Board of Governors is headquartered in Washington, DC. • Members are confirmed by U.S. Senate, and serve 14-year, nonrenewable terms. The terms are staggered so it is unlikely that one U.S. president will be able to appoint a full Board of Governors. • The president chooses one member of the Board of Governors to serve as chairman. Chairmen serve four-year terms and may be reappointed. • Board members are professional economists from business, government, and academia.

Roles of The Board of Governors:

• Administers monetary policy: determines reserve requirements and sets the discount rate charged on loans to banks • Influences the setting of guidelines for open market operations • Informally influences national and international economic policy decisions • Advises the president and testifies before Congress on economic matters • Exercises administrative controls over individual Federal Reserve banks

Inflation Targeting

• Central banks in Canada, Finland, New Zealand, Sweden, and the United Kingdom have official inflation targets, as does the European Central Bank. • The U.S. Fed has only an informal inflation target. • By setting a target for inflation, the central bank can be held accountable.

Functions of District Banks:

• Clear checks • Issue new currency • Withdraw damaged currency from circulation • Administer and make discount loans to banks in their districts • Evaluate proposed mergers and applications for banks in their districts • Examine bank holding companies and state-chartered member banks • Collect data on local business conditions and conduct research

The Federal Open Market Committee

• Consists of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, the presidents of four other Federal Reserve banks, and the Chairman of the Board of Governors who chairs it. The Chairman sets the agenda for meetings, speaks and votes first about monetary policy and then negotiates with Congress and the President. • Meets eight times a year in Washington D.C. A public announcement about the outcome of the meeting is given by the Chairman after each meeting. • Directs open market operations by issuing directives to the trading desk at the Federal Reserve Bank of New York and outlines different scenarios for monetary policy actions, based on teal and beige book.

Member Banks

• Currently, only about 16% of state banks and about one-third of all banks are members of the Federal Reserve System. • Historically, state banks often chose not to join because they saw membership as costly. Banks could also avoid the Fed's reserve requirements. • The opportunity cost of being a member of the Fed increased during the 1960s and 1970s as nominal interest rates rose, and fewer state banks elected to become or remain members. • The Fed argued that declining bank membership eroded its ability to control the money supply and urged Congress to compel all commercial banks to join the Federal Reserve System. • Congress has not yet legislated such a requirement, but in 1980 required that all banks maintain reserve deposits with the Fed on the same terms.

Power and Authority within the Fed

• During its first 20 years, the decentralized District Bank system could not adequately respond to national economic and financial disturbances. • Centralization: The Banking Acts of 1933 and 1935 gave the Board of Governors a majority of seats (7 of 12) on the FOMC. • Independence: The secretary of the Treasury and the comptroller of the currency were also removed from the Board of Governors. • Informal power structure within the Fed: more concentrated than the formal power structure. The Fed chairman is the most powerful in the system. • Clear distinction between ownership and control: Member banks own shares of stock, but this ownership confers none of the rights that are typically granted to shareholders of private corporations.

Who owns the Federal Reserve banks?

• Quasi-public institution owned by private commercial banks in the district that are members of the Fed system. • When banks join the Federal Reserve System, they are required to buy stock in their District Bank. So, the member banks own the District Bank. • Nine directors appoint the president of the bank; subject to approval by Board of Governors. • The directors represent the interests of three groups: 1. Banks, who elect three bankers (Class A directors); 2. Businesses, who elect three leaders (Class B directors); 3. The general public, represented by three Class C directors.

The Speculative Attack on the Deutsche Mark and the Collapse of Bretton Woods

• The Bundesbank was trying to maintain a low inflation rate. • The German deutsche mark was undervalued against the dollar. • On May 5, 1971, the Bundesbank purchased more than 1 billion U.S. dollars, but halted its intervention later that day for the fear that continued increases in the monetary base would spark inflation. • The mark began to float against the dollar, with its value being determined solely by the forces of demand and supply in the foreign exchange market.

Functions continued..

• The Federal Reserve District Banks engage in monetary policy both directly (by making discount loans) and indirectly (through membership on Federal Reserve committees). • In recent decades, the discount rate has been set by the Board of Governors in Washington, DC, not by the District Banks. • The District Banks also influence policy through their representatives on the FOMC and on the Federal Advisory Council, a consultative body composed of district bankers.

End the Fed?

• The U.S. Constitution does not explicitly give the federal government the authority to establish a central bank. • The standard argument in favor of the constitutionality of the Fed is that Article 1, Section 8 of the U.S. Constitution states that Congress has the power "To coin money [and] regulate the value thereof. . ." Congress delegated this power to the Federal Reserve under the Federal Reserve Act. • Modern arguments against the Fed have been mostly based on whether an independent central bank is the best means of carrying out monetary policy. • Given the Fed's power and the fact that its officials are unelected, its role will remain a subject of debate among economists and policymakers.

Central Bank Independence Outside the United States

• The degree of central bank independence varies greatly from country to country. • In the United States, board members serve longer terms than in other countries, implying greater independence. In other countries, the head of the central bank serves a longer term, implying somewhat less political control. • An independent central bank is free to pursue its goals without direct interference from government officials and legislators. • An independent central bank can more freely focus on keeping inflation low.

The Trend Toward Greater Independence

• The most independent central banks had the lowest average rates of inflation during the 1970s and 1980s. • The Bank of England (founded in 1694) is one of the world's oldest central banks, obtained the power to set interest rates independently in 1997. • The Bank of Canada has generally controlled monetary policy, while the government has the final responsibility for it. • The Bank of Japan Law, in force since April 1998, gives the Policy Board more autonomy to pursue price stability.

The Special Role of the Federal Reserve Bank of New York

• When the Fed was created, district banks were intended to have much more independence than they have today. • There was agreement about six cities: Boston, Chicago, New York, Philadelphia, St. Louis, and San Francisco. • New York Fed's prominent role: 1. Its district contains many of the largest commercial banks in the US; 2.It houses the open market desk, which conducts open market operations; 3. Its president is member of the Bank for International Settlements; 4. Its president is the only permanent voting member of the FOMC.

Drawbacks of the Gold Standard

• With fixed exchange rates, countries had little control over their domestic monetary policies: gold flows from international trade caused changes in monetary base. In the 1890s, gold rushes in Alaska and in South Africa increased price levels around the world. Under the gold standard, periods of unexpected and pronounced deflation caused recessions.

The German Central Bank (Bundesbank)

•Experimented with monetary targets in the late 1970s to combat inflation. •Used an aggregate called central bank money (M3). •Succeeded in maintaining its target ranges for M3 growth in the early 1980s. •After reunification, differences between West and East German currencies brought inflationary pressures. •The success of German monetary policy lies in the clear communication of the central bank's focus on controlling inflation more than on monetary targeting. •Had an informal inflation target since 1975. In 1999, the inflation goal was 2%. •Relinquished its control of monetary policy to the European Central Bank after introduction of the euro in 2002.

The Fed faces a trade-off:

•It can choose a reserve aggregate for its policy instrument, or it can choose the federal funds rate, but it cannot choose both. •Using reserves as the Fed's policy instrument will cause the federal funds rate to fluctuate in response to changes in the demand for reserves •Using the federal funds rate as the policy instrument will cause the level of reserves to fluctuate in response to changes in the demand for reserves. The federal funds rate has been the Fed's policy instrument for the past 30 years.

Policy Instruments, or Operating Targets

•Policy instruments are variables that the Fed controls directly and they are closely related to intermediate targets. •Examples of policy instruments are the federal funds rate and nonborrowed reserves.

The European System of Central Banks

•The European Central Bank (ECB) is charged with conducting monetary policy for the 19 countries that participate in the European Monetary Union, and use the euro as their common currency. •In operation since 1999, the bank was modeled after the German Bundesbank, with price stability as its primary goal. The ECB is the most independent central bank in the world. Its charter cannot by changed by legislation; only by revision of the Maastricht Treaty. •Clear mandate to emphasize price stability by defining an inflation range 0 - 2%. •Struggled to forge a monetary policy appropriate to the very different needs of the member countries during the financial crisis and its aftermath: Countries such as Greece, Spain, and Ireland urged that the ECB follow a more expansionary policy, while countries such as Germany that had fared better were reluctant to see the ECB abandon its inflation target.

The Fed also faces timing difficulties:

•The information lag refers to the Fed's inability to observe instantaneously changes in economic variables. •The impact lag is the time that is required for monetary policy changes to affect output, employment, or inflation. One possible solution to those timing problems is for the Fed to use targets to meet its goals.

Intermediate Targets

•Typically either monetary aggregates or interest rates •The Fed can use an intermediate target to achieve a goal outside of its direct control better than it would if it had focused solely on the goal. •Can also provide helpful feedback about the Fed's policy actions. •After 1993, the Fed no longer announces targets for M1 and M2.