FIN 515: Financial Markets & Institutions - Ch. 9 Q&As

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

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

The Fed is the most independent of all US government agencies. What is the main differences between it and other government agencies that explains the Fed's great independence?

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

Why was the Federal Reserve System set up with 12 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 might eliminating the Fed's independence lead to a more pronounced political business cycle?

Eliminating the Fed's independence might make it more shortsighted and subject to political influence. Thus, when political gains could be achieved by expansionary policy before an election, the Fed might be more likely to engage in this activity. As a result, more pronounced political business cycles might result.

People in general welcome actions that promote transparency, and in particular when they involve public or quasi-public institutions. Can you think of a reason why a more transparent communication strategy might be detrimental to the Fed's objectives?

From a Central Bank's perspective, it might not be beneficial to be that explicit about its policies. When a Central Banks explicitly conveys the idea that a particular policy will be followed, it is at the same time tying its hands. This happens because the policy announcement becomes a commitment, and failure to honor that compromise would hurt its trustworthiness, a key element in monetary policy.

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

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 12 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, businesspeople, and the public) was again intended to prevent any group from dominating the Fed. The Fed's independence of 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 fundamental differences between the styles of Greenspan and Bernanke and Yellen as chairs of the Fed? Do you think that the recent trend toward increased use of formal econometric analysis when making decisions about monetary policy is a good idea or not?

One of the most important differences between the styles of Greenspan and Bernanke and Yellen arise from the fact that the two latter spent most of early part of their careers in academia. These years of formal education and research gave Bernanke and Yellen the sense that formal (theoretical and empirical) analysis is very important both to the understanding of current economic conditions and to forecast future movements in relevant macroeconomic variables. Based on that idea, the Fed has recently moved to increase the importance assigned to more formal methods of forecasting, like models that simulate the effect of an increase/decrease of short term interest rates. Time will tell if this is a better approach than the one followed by Alan Greenspan, who relied much more on his beliefs.

Do you think that the 14-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.

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.

The Fed promotes secrecy by not releasing the minutes of the FOMC meetings to congress or the public immediately. Discuss the pros and cons of this policy.

The argument for not releasing the FOMC directives immediately is that it keeps Congress off the Fed's back, thus enabling the Fed to pursue an independent monetary policy that is less subject to inflation and political business cycles. The argument for releasing the directive immediately is that it would make the Fed more accountable.

How would you argue in favor of the current trend toward central banks' independence?

The most important argument in favor of the trend towards central bank independence is the growing body of theoretical and empirical evidence that suggests that more independent central banks are able to get better results (in general, lower inflation rates) than less independent central banks. However, this movement towards more independence is resisted in some countries, precisely because it insulates the conduct of monetary policy from politics.

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 (ESCB) has many similarities to that of the Federal Reserve System. The ESCB has an Executive Board that is similar to the Board of Governors of the Federal Reserve System, a governing council that has a similar function to that of the Fed's FOMC, and the ESCB has national central banks just as the Fed has regional Federal Reserve Banks. There are differences between the ESCB and the Fed. First, the budgets of the Federal Reserve Banks are controlled by the Board of Governors, whereas the National Central Banks control their own budgets and the budget of the ECB in Frankfurt. The ECB in the Euro system therefore has less power than does the Board of Governors in the Federal Reserve System. Second, the monetary operations of the Euro system are conducted by the National Central Banks in each country, so monetary operations are not centralized as they are in the Federal Reserve System. Third, in contrast to the Federal Reserve, the ECB is not involved in supervision and regulation of financial institutions; these tasks are left to the individual countries in the European Monetary Union.

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

The threat that Congress will acquire greater control over the Fed's finances and budget.

William does not feel comfortable with the current level of the Fed's Independence. Put yourself in William's shoes and state an argument against the current level of the Fed's independence.

William might feel that people in charge of the design and conduct of monetary policy were not elected by the general public, and so are not sufficiently accountable to the public. Although the Executive and Legislative branches of the U.S. government participate in the appointment process of members of the Board of Governors, presidents of the Federal Reserve Banks are elected by member banks of each district.