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10.1 Central Banks

Learning Objectives

After you have read this section, you should be able to answer the following questions:

  1. When and why was the Federal Reserve System created in the United States?
  2. What are the connections between the Federal Reserve System and the executive and legislative branches of the US government?
  3. How does our study of monetary policy apply to other central banks around the world?

We start our discussion with institutions.

The Federal Reserve

The Federal Reserve System was formally established in an act of Congress on December 23, 1913, called the Federal Reserve Act (http://www.federalreserve.gov/aboutthefed/fract.htm). The stated purpose of the act was as follows: “To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”The Federal Reserve Act is found at “Federal Reserve Act,” Board of Governors of the Federal Reserve System, accessed September 20, 2011, http://www.federalreserve.gov/aboutthefed/fract.htm, and the structure of the Federal Reserve System is presented at “The Structure of the Federal Reserve System,” The Federal Reserve Board, accessed September 20, 2011, http://www.federalreserve.gov/pubs/frseries/frseri.htm. The Federal Reserve System is built around a 7-member Board of Governors together with 12 regional banks. The members of the board are appointed by the president and approved by Congress to serve for 14 years. The FOMC, which is instrumental in the conduct of monetary policy, has 12 members.

Although the president and Congress play a role in the appointment of members of the Fed, their direct control stops there. The Fed is an independent body. The executive and congressional branches of the government have no formal input into the determination of monetary policy. Congressional control is limited to the fact that the chair of the Fed is required to report to Congress periodically and to Congress eventually having the power to change the laws governing the Fed’s conduct.

The goals of the Fed are specified in the section of the Federal Reserve Act titled “Monetary Policy Objectives”: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”“Federal Reserve Act: Monetary Policy Objectives,” Federal Reserve, December 27, 2000, accessed August 6, 2011, http://www.federalreserve.gov/aboutthefed/section2a.htm. These objectives provide guidance to the Fed: it is required to pay attention to the level of economic activity (“maximum employment”) and to the level of inflation (“stable prices”). Exactly how the Fed promotes these goals—and chooses among them if necessary—is not specified. In some cases, the different aims of the Fed may conflict. For example, promoting employment may not be consistent with low inflation. The February 2, 2005, statement explicitly notes the balance between these goals.

The Fed has three main ways of affecting what goes on in the economy. The first was alluded to, although not mentioned by name, in the February 2, 2005, policy announcement. It is called open-market operations and represents the main way that the Fed influences interest rates. A second tool—the discount rate—was mentioned explicitly in the policy announcement. The third tool—reserve requirements—was not mentioned on February 2, 2005, but is nonetheless an important weapon in the Fed’s arsenal. Later on in this chapter, we examine the tools of the Fed in detail. For the moment, it is enough to know that the Fed affects the economy through changes in interest rates.

Central Banks in Other Countries

Our discussion in this chapter applies to not only the United States but also other countries. Wherever there is a currency, there is a monetary authority—a central bank—charged with the control of that currency. For example, in Europe, the European Central Bank (ECB; http://www.ecb.int/home/html/index.en.html) dictates monetary policy for all those countries that use the euro. In Australia, the Reserve Bank of Australia (RBA; http://www.rba.gov.au) manages monetary policy.

Different central banks do not all function in exactly the same way. To illustrate, here are policy announcements from the Bank of England (BOE; http://www.bankofengland.co.uk/publications/news/2006/078.htm), the Central Bank of Egypt (CBE; http://www.cbe.org.eg/public/PRESS_Release_For_Monetary_Policy/2011/MPC_PressRelease_09_06_2011_E.pdf), and the RBA (http://www.rba.gov.au/media-releases/2011/mr-11-09.html). The details of the announcements are not critical. However, all have a “Monetary Policy Committee” rather than an FOMC. The different banks target slightly different interest rates: the BOE targets the “Bank rate paid on commercial bank reserves”; the CBE refers to overnight deposit and lending rates, the “7-day repo,” and the discount rate; and the RBA refers to the “cash rate.” You do not need to worry about exactly what these different rates are. All three banks are looking at the overall state of the economy, in terms of both output and inflation, and are setting interest rates to pursue broadly similar goals.

News Release: Bank of England Raises Bank Rate by 0.25 Percentage Points to 4.75 Percent, 3 August 2006“News Release,” Bank of England, August 3, 2006, accessed July 20, 2011, http://www.bankofengland.co.uk/publications/news/2006/078.htm.

The Bank of England’s Monetary Policy Committee today voted to raise the official Bank rate paid on commercial bank reserves by 0.25 percentage points to 4.75 percent.

The pace of economic activity has quickened in the past few months…As a result, over the past few quarters GDP [gross domestic product] growth has been at, or a little above, its long-run average and business surveys point to continued firm growth.…

CPI [Consumer Price Index] inflation picked up to 2.5 percent in June, and is expected to remain above the 2.0 percent target for some while. Higher energy prices have led to greater inflationary pressures, notwithstanding muted earnings growth and a squeeze on profit margins.…

Against the background of firm growth, limited spare capacity, rapid growth of broad money and credit, and with inflation likely to remain above the target for some while, the Committee judged that an increase of 0.25 percentage points in the official Bank rate to 4.75 percent was necessary to bring CPI inflation back to the target in the medium term.

Press Release, June 9, 2011: The Central Bank of Egypt Decided Not to Raise Its Policy Rates“Press Release,” Central Bank of Egypt, June 9, 2011, accessed July 20, 2011, http://www.cbe.org.eg/public/PRESS_Release_For_Monetary_Policy/2011/MPC_PressRelease_09_06_2011_E.pdf.

In its meeting held on June 9, 2011, the Monetary Policy Committee (MPC) decided to keep the overnight deposit and lending rate unchanged at 8.25 and 9.75 percent, respectively, and the 7-day repo at 9.25 percent. The discount rate was also kept unchanged at 8.5 percent.

Headline CPI increased by 0.20 percent in May [month to month] following the 1.21 percent in April, bringing the annual rate down to 11.79 percent from 12.07 percent registered in April. …

Meanwhile, real GDP contracted by 4.2 percent in 2010/2011 Q3 which marks the first negative year-on-year growth since the release of quarterly data in 2001/2002. …

Against the above background, the slowdown in economic growth should limit upside risks to the inflation outlook. Given the balance of risks on the inflation and GDP outlooks and the increased uncertainty at this juncture, the MPC judges that the current key CBE [Central Bank of Egypt] rates are appropriate.

Media Release Number 2011-09: Statement by Glenn Stevens, Governor: Monetary Policy DecisionGlenn Stevens, “Media Release,” Reserve Bank of Australia, June 7, 2011, accessed July 20, 2011, http://www.rba.gov.au/media-releases/2011/mr-11-09.html.

At its meeting today, the Board decided to leave the cash rate unchanged at 4.75 per cent.

The global economy is continuing its expansion, led by very strong growth in the Asian region, though the recent disaster in Japan is having a major impact on Japanese production, and significant effects on production of some manufactured products further afield. Commodity prices have generally softened a little of late, but they remain at very high levels, which is weighing on income and demand in major countries and also pushing up measures of consumer price inflation. …

Growth in employment has moderated over recent months and the unemployment rate has been little changed, near 5 per cent. Most leading indicators suggest that this slower pace of employment growth is likely to continue in the near term…

CPI inflation has risen over the past year, reflecting the effects of extreme weather and rises in utilities prices, with lower prices for traded goods providing some offset. The weather-affected prices should fall back later in the year, though substantial rises in utilities prices are still occurring. The Bank expects that, as the temporary price shocks dissipate over the coming quarters, CPI inflation will be close to target over the next 12 months.

At today’s meeting, the Board judged that the current mildly restrictive stance of monetary policy remained appropriate. In future meetings, the Board will continue to assess carefully the evolving outlook for growth and inflation.

In this chapter, we talk, for the most part, about the Federal Reserve. We focus on the United States principally because we do not want to get too bogged down in learning the different languages used by different central banks. From looking at the statements of the Fed, the BOE, the CBE, and the RBA, we see that the terminology of monetary policy varies greatly from country to country, the names of the key interest rates differ, and so forth. The underlying principles of monetary policy are largely the same in all countries, however.

Key Takeaways

  1. The Federal Reserve System of the United States was created in 1913. A key motivation for the creation of a central bank was to manage the stock of currency and thus influence the state of the aggregate economy, particularly output and prices.
  2. In the United States, the central bank is independent. Decisions about monetary policy are made within the Federal Reserve System. Members of the Board of Governors of the Federal Reserve System are nominated by the president and approved by the Senate.
  3. There are central banks around the world, conducting monetary policy with similar tools and with the same basic model of the aggregate economy in mind.

Checking Your Understanding

  1. What is the input of the US president in determining monetary policy?
  2. By learning about how the Federal Reserve System in the United States conducts monetary policy, what can we learn about other countries?