Central Banks, the Fed, and Monetary Policy

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Central Banks, the Fed, and Monetary Policy

• Professor Wayne Carroll
• Department of Economics
• University of Wisconsin-Eau Claire
• carrolwd_at_uwec.edu
• Slides available at www.uwec.edu/carrolwd

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Central Banks
Bank of Japan
Bank of England
Peoples Bank of China
Federal Reserve System
European Central Bank
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Central Banks

• Good sources
• Bank for International Settlements website
• http//www.bis.org/
• Links to central bank websites
• http//www.bis.org/cbanks.htm

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The Federal Reserve System

• The Fed
• Central bank for the U.S.
• Roles
• Conducts monetary policy (controls the nations
  money supply)
• One of the agencies that regulates the banking
  system
• lender of last resort
• Facilitates payments (issues currency, clears
  checks)

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The Federal Reserve System

• The Fed is directed by
• Board of Governors
• 7 members appointed by the President and approved
  by Congress
• Federal Open Market Committee (FOMC)
• 12 members, including the Board of Governors and
  five other Fed officials
• Chair serves as chairman of both committees

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The Federal Reserve System

• Alan Greenspan Chair, 1987 - 2006

• Ben Bernanke
• Chair, 2006 - ?

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The Federal Reserve System

• The Board of Governors meets in Washington, D.C.
• The Fed includes 12 regional Federal Reserve
  Banks

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Some Federal Reserve Banks
Minneapolis Fed
New York Fed
Atlanta Fed
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Some Federal Reserve Banks
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The Feds Balance Sheet(billions of dollars, as
of December 20, 2006)
Liabilities Federal Reserve notes
775.9 outstanding Bank deposits (reserves)
16.5 U.S. Treasury deposit 5.4 Other
liabilities 40.7 Capital Surplus
30.4 Total 868.9
Assets U.S. government securities 811.1 Discount
loans 0.2 Gold and SDR accounts 13.2 Other
Federal Reserve assets 44.4 Total 868.9
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The Fed and the U.S. Government

• The Fed was created to be very independent.
• Not really part of the federal government
• Not directed or controlled by the President,
  Congress, or any government agency
• Fed decisions are made by the Board of Governors
  and other Fed officials
• The President and members of Congress respect
  the Feds independence.

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The Fed and the U.S. Government

• Factors that make the Fed more independent
• Not funded by Congress
• Members of the Board of Governors have long
  (14-year) terms
• Factors that make the Fed less independent
• The Fed was created by Congress, so Congress can
  pass legislation that changes the Feds
  structure, procedures, or policies
• The President appoints members of the Board of
  Governors, and they are approved by Congress

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Central Bank Independence

• Economists and policy makers believe that its
  important for a central bank to be independent
  from the government.
• Many countries have granted more independence to
  their central banks in the last fifteen years.

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Central Bank Independence

• Why is an independent central bank better?
• An independent central bank is more likely to
  follow low-inflation policies.
• Evidence suggests that in the long run a central
  bank can only control the rate of inflation (not
  the economic growth rate).
• The government tends to push for policies that
  promote faster economic growth in the short run.
  If the central bank is independent, it can say
  No.

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Central Bank Independence and Inflation Early
Evidence
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Central Bank Independence and Inflation Recent
Evidence
Charles T. Carlstrom and Timothy S. Fuerst,
Central Bank Independence The Key to Price
Stability? Federal Reserve Bank of Cleveland,
September 1, 2006.
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Macroeconomic Goals of the Fed

• According to the U.S. Congress, the Fed should
  seek to promote effectively the goals of maximum
  employment, stable prices, and moderate long-term
  interest rates.
• These goals are often in conflict.
• The Fed must choose the best balance.

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The Feds Monetary Policy Tools

• Monetary policy refers to changes in the
  nations money supply brought about by the Fed.
• Monetary policy tools are actions the Fed can
  take to alter the money supply.
• Open-Market Operations the Feds purchases and
  sales of government bonds for its own portfolio.

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Open-Market Operations

• An open-market purchase causes the nations money
  supply to increase.

bonds
Public
The Fed

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Open-Market Operations

• Open-market operations take place on the open
  market, not through transactions with the U.S.
  Treasury or directly with banks.
• Controlled by the Federal Open-Market Committee
  (FOMC).
• The FOMC meets every six weeks to consider policy
  changes.

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Federal Funds Rate Target

• The FOMC formulates its monetary policy in terms
  of a target level for the federal funds rate.

federal funds rate the interest rate banks
charge each other when they borrow and lend
reserves.
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Federal Funds Rate Target

• Banks set the federal funds rate, but the Fed
  uses open-market operations to control it.
• Open-market purchase
• The Fed buys government bonds.
• Sellers of the bonds deposit the funds in banks,
  so bank reserves increase.
• Banks have more reserves, so they choose to set
  the federal funds rate lower.
• Similarly, an open-market sale tends to raise the
  federal funds rate.

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Federal Funds Rate Target

• So the Fed sets a target level for the federal
  funds rate, and then uses open-market operations
  to hit the target.
• A lower target
• The Fed buys more bonds, and makes the money
  supply increase more.
• This tends to make the economy grow faster in the
  short run.
• Therefore the Fed reduces the federal funds rate
  target in a recession.

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Federal Funds Rate Target

• A higher target
• The Fed buys fewer bonds (or sells some of its
  bonds), so the money supply increases slowly (or
  falls).
• This tends to slow the economy in the short run.
• The Fed uses this policy when it wants to fight
  inflation.

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Federal Funds Rate Since 1990

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Federal Funds Rate Since 1990

recessions
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The Feds Monetary Policy

• During a recession the Fed
• Reduces the federal funds target rate
• Makes the money supply grow faster
• Makes the economy grow faster in the short run
• After a recession the Fed
• Raises the federal funds rate to prevent an
  increase in the inflation rate
• Makes the money supply grow more slowly
• Slows the nations economic growth in the short
  run

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Monetary Policy Strategy

• Any central banks monetary policy aims at a
  nominal anchor target.
• Choices
• Exchange rate
• Inflation rate
• Money supply
• Targeting a nominal anchor keeps the central bank
  focused on low inflation in the long run.

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Exchange-Rate Targeting

• The central bank fixes the value of its currency
  to the dollar (or some other major currency).
• The central bank gives up its independent
  monetary policy powers.
• Two interesting options
• Currency board (as in Hong Kong)
• Dollarization (as in Ecuador)

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Inflation Targeting

• The central bank
• announces a target range for the inflation rate
  (perhaps 1 to 2)
• commits itself to following a monetary policy
  that hits the target
• Inflation targeting makes it easier for the
  central bank to follow a low-inflation policy in
  the long run.

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The Feds Monetary Policy Strategy

• The Fed uses an implicit nominal anchor an
  informal long-run inflation target.
• The Feds policy has generally been successful.
• Disadvantages
• Fed officials have a lot of discretion (or power
  to choose their policy independently) too much?
• The Feds policies would be more credible and
  transparent if the inflation target were formal.

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The Feds Monetary Policy Strategy

• Ben Bernanke is a strong advocate of a more
  formal inflation target.
• The Fed might move slowly toward a greater
  reliance on inflation targeting.