EC1008: Chapter 14 questions and answers

Why was the Federal Reserve System set up with twelve regional Federal Reserve banks rather than one central bank, as in other countries?

Because of traditional American hostility to a central bank and centralized authority, the system of 12 regional banks was set up to diffuse power along regional lines.

Why could eliminating the central bank's independence lead to a more pronounced political business cycle?

Curtailing the central bank's independence and subjecting it to more political pressures will impart an inflationary bias to monetary policy. Without independence, the central bank will respond to short-run problems that will result an expansionary monetary policy and a political business cycle.

"The theory of bureaucratic behavior indicates that the Fed never operates in the public interest." Is this statement true, false, or uncertain? Explain your answer.

False. Maximizing one's welfare does not rule out altruism. Operating in the public interest is clearly one objective of the Fed. The theory of bureaucratic behavior merely points out that other objectives, such as maximizing power, also influence Fed decision making.

"The independence of the Fed leaves it completely unaccountable for its actions." Is this statement true, false, or uncertain? Explain your answer.

False. The Fed is still subject to political pressure, because Congress can pass legislation limiting the Fed's power. If the Fed is performing badly, Congress can make the Fed accountable by passing legislation that the Fed does not like.

"The independence of the central bank has meant that it takes the long view and not the short view." Is this statement true, false, or uncertain? Explain your answer.

It is uncertain. Although independence may help the Fed take the long view, because its personnel are not directly affected by the outcome of the next election, the Fed can still be influenced by political pressure. In addition, the lack of Fed accountability because of its independence may make the Fed more irresponsible. Thus it is not absolutely clear that the Fed is more farsighted as a result of its independence.

What are the main difficulties encountered by the newly established central banks in transition economies?

Prior the 1990, most of the transition nations possessed one state-owned bank that had the dual roles of a commercial bank and a central bank, while a few others already possessed a separate central bank that dominate the operations of other state-owned banks. Also the banking sector had huge debt portfolio owned by the inefficient public sector firms besides the problems of inflation, balance of payments and devaluation .After 1989 and 1991, central bank are separated from commercial banks and gradually central bank independence has been implemented.

Do you think that the fourteen-year nonrenewable terms for governors effectively insulate the Board of Governors from political pressure?

The 14-year terms do not completely insulate the governors from political influence. The governors know that their bureaucratic power can be reined in by congressional legislation and so must still curry favor with both Congress and the president. Moreover, in order to gain additional power to regulate the financial system, the governors need the support of Congress and the president to pass favorable legislation.

Which entities in the Federal Reserve System control the discount rate? Reserve requirements? Open market operations?

The Board of Governors sets reserve requirements and the discount rate; the FOMC directs open market operations. In practice however, the FOMC helps make decisions about reserve requirements and the discount rate. The decision making process at the EMU takes place at three levels; the Governing Council, the Executive Board and the General Council. The Governing Council is the decision maker and formulates monetary policy for the Euro area. The Executive Board ensures the day to day implementation of monetary policy through giving detailed instructions to all NCBs in accordance with the decisions of the Governing Council.

While the Fed promotes secrecy by not releasing the minutes of the FOMC meetings to Congress or the public immediately, the ECB holds a press conference after each of its meetings. Discuss the pros and cons of each of these policies.

The FED simply releases a statement about the setting of the monetary policy instruments. The ECB goes further by having a press conference in which the president and vice president of the ECB take questions from the news media. The theory of bureaucratic behavior suggests that one factor driving central banks' behavior may attempt to increase their power and prestige. Holding such a press conference as soon as the meeting over, can be tricky because it requires the president and vice president to be quick on their feet in dealing with the press. If they cannot manage, it might be understood as the loss of power and the weakness of the decisions. On the other hand, the central bank should act in the public interest, having press conference may refer as the transparency and accountability.

The Fed is the most independent of all U.S. government agencies. What is the main difference between it and other government agencies that explains the Fed's greater independence?

The Fed is more independent because its substantial revenue from securities and discount loans allows it to control its own budget.

In what ways can the regional Federal Reserve Banks influence the conduct of monetary policy?

The Federal Reserve Banks influence the conduct of monetary policy through their administration of the discount facilities at each bank and by having five of their presidents' sit on the FOMC, the main policymaking arm of the Fed.

What political realities might explain why the Federal Reserve Act of 1913 placed two Federal Reserve Banks in Missouri?

The placement of two banks in the Midwest farm belt might have been engineered to placate farmers, an important voting bloc in the early twentieth century.

What is the primary tool that Congress uses to exercise some control over the Fed?

The primary tool that the Congress uses to exercise some control is the threat that it will acquire greater control over the Fed's finances and budget.

Compare the structure and independence of the Federal Reserve System and the European System of Central Banks.

The structure of the European System of Central Banks (ECSB) is similar to that of the Federal Reserve: the National Central Banks (NCBs) have a similar role to the Federal Reserve Banks and the Executive Board is similar to the board of Governors. The Governing Council has a similar role to the FOMC, and its voting members include the presidents of the NCBs and the Executive Board members, just as the FOMC has as its voting members Federal Reserve Bank presidents and members of the Board of Governors. There are some differences however. First, the budgets of the Federal Reserve Banks are controlled by the Board of Governors, while the NCBs control their own budgets and the budget of the ECB in Frankfurt. Second, the monetary operations of the Eurosystem are conducted by the NCBs in each country, so monetary operations are not centralized as they are in the Federal Reserve System. Third, in contrast to the Fed, the ECB is not involved in supervision and regulation of financial institutions. The ECSB is more independent than the Fed because its charter can only be changed by revision of the Maastricht Treaty, a very difficult process because all signatories to the treaty must agree to accept any proposed change, while the Fed's charter can be changed by legislation which is much easier to do. On the other hand, the goal for the ECSB is more clearly specified than it is for the Fed because the Maastricht Treaty states that the overriding long-run goal of the ECSB is price stability, although it doesn't specify exactly what "price stability" means.

In the 1960s and 1970s, the Federal Reserve System lost member banks at a rapid rate. How can the theory of bureaucratic behavior explain the Fed's campaign for legislation to require all commercial banks to become members? Was the Fed successful in this campaign?

The theory of bureaucratic behavior indicates that the Fed will want to acquire as much power as possible by requiring all banks to become members. Although the Fed did not succeed in obtaining legislation requiring all banks to become members of the system, it was successful in getting Congress to legislate extension of many of the regulations that were previously imposed solely on member banks (for instance, reserve requirements) to all other depository institutions. Thus the Fed was successful in extending its power.

Explain why eleven states of the EU have opted not to adopt the euro as their domestic currency.

There are benefits to having one currency in a market as large as the European Union .i.e. some costs (average cost of currency conversion for travelers and transaction costs), exchange-rate uncertainty on trade and investment decrease. But there are also problems when the business cycles are unsynchronized and labor is relatively immobile. The U.K., Denmark and Norway chose not to be in the euro zone, whereas the countries becoming members in 2004 and 2007 have scheduled to adopt euro as their domestic currency.

"The Federal Reserve System resembles the U.S. Constitution in that it was designed with many checks and balances." Discuss.

True. Like the U.S. Constitution, the Federal Reserve System, originally established by the Federal Reserve Act, has many checks and balances and is a peculiarly American institution. The ability of the twelve regional banks to affect discount policy was viewed as a check on the centralized power of the Board of Governors, just as states' rights are a check on the centralized power of the federal government. The provision that there be three types of directors (A, B, and C) representing different groups (professional bankers, business people, and the public) was again intended to prevent any group from dominating the Fed. The Fed's independence from the federal government and the setting up of the Federal Reserve banks as incorporated institutions were further intended to restrict government power over the banking industry.

What are the reasons that compel some developing nations to adopt currency unions?

Very poor and small developing countries adopt the currency of larger "anchor" countries because they do not possess a domestic currency. The national central bank cannot carry out monetary policy due to large decline in the value of domestic currency. For example, Ecuador discarded its national currency and adopted the US dollar in 2000.