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Chapter 04 Preview
Session 09
Central Banks and the
Federal Reserve System
Prepared by Dr. Nguyen Nhat Tan
Chapter 04 Learning objectives
Recognize the historical context of the development
of the Federal Reserve System.
Describe the key features and functions of the
Federal Reserve System.
Assess the degree of independence of the Federal
Reserve.
Summarize the arguments for and against the
independence of the Federal Reserve.
Chapter 04 I- History of Central Bank
- In 1668, the Swedish parliament approved a new bank to
replace the Bank of Stockholm. Ultimately, that new bank
became the present-day Swedish central bank, the Sveriges
Riksbank, currently the world’s oldest central bank.  The use
of banknotes as a medium of exchange survived and gradually
became embedded in our modern economies.
- Later on, many other central banks were also created to
help finance government spending, particularly to finance
wars:
(1) the Bank of England – 1694,
(2) the Bank of France -1800,
(3) the Bank of Spain - 1782)
 Among the most important players in financial markets
throughout the world are central banks, the government
authorities in charge of monetary policy.
 Central banks’ actions affect interest rates, the amount of
credit, and the money supply, all of which have direct impacts
not only on financial markets, but also on aggregate output
and inflation.
 To understand the role that central banks play in financial
markets and the overall economy, we need to understand
how these organizations work. Who controls central banks
and determines their actions? What motivates their behavior?
Who holds the reins of power?
Chapter 04 Learning objectives (cont)
Identify the ways in which the theory of bureaucratic
behavior can help explain Federal Reserve actions.
Identify the structure and independence of the
European Central Bank and discuss central banks
around the world.
Assess the degree of independence of other major
central banks around the world.
Chapter 04 I- History of Central Bank
- Modern central banks have many commonalities, as well as
differences, depending on their historical contexts and their
guiding philosophies.
+ Most modern central banks now focus on delivering
low, stable inflation and financial stability, and are prohibited
from directly financing government spending.
+ To deliver low, stable inflation and financial stability,
however, different central banks often take different
operational approaches.
+ Furthermore, the full-employment mandate
reemphasized by the Federal Reserve in the wake of the
2007–2010 financial crisis still remains quite unique.
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Chapter 04 I- History of Central Bank
 Central banking has evolved considerably since its start
about 400 years ago. Starting with coin sorting and storing,
and in certain cases war financing, central banks have taken
on the functions of banknote issuers, banker to the
government, banker to banks, protector of the financial
system, bank supervisor, as well as conductor of monetary
policy.
 What is a 'Central Bank‘?
A central bank, or monetary authority, is a monopolized
and often nationalized institution given privileged control over
the production and distribution of money and credit. In modern
economies, the central bank is responsible for the formulation
of monetary policy and the regulation of member banks.
Chapter 04 1- Monetary stability
- Theoretical developments over the past four decades and
various high inflation experiences around the world suggest
that to support long-term economic growth, the best thing a
central bank can do is to deliver an environment of monetary
stability; that is, an environment in which inflation is low and
stable.
- In such an environment, households and firms are more
likely to be able to optimize investment and consumption. This
stands in contrast to the call for a central bank to always keep
directly stimulating the economy.
- The continued stimulation of the economy is likely to result in
an upward spiral of inflation, which prevents households and
firms from making optimal decisions.
Chapter 04 3- Prohibition on direct lending to the government
- Although many early central banks were originally founded to help
finance their governments, direct lending by the central bank to the
government is now often prohibited in most modern economies, as it
was found to lead down the dangerous path of hyperinflation.
- Direct lending to the government is akin to printing money and
giving it to the government so that the government can use it to
finance its purchases of goods and services. Printing money and
giving it directly to the government cheapens the value of money
relative to other goods and services.
- Under the law of supply and demand, the more the central bank
supplies money, the lower the price (or the value) of money will be. If
done in massive amounts the purchasing power of money could fall
very fast, since people will no longer trust that the money in their
hands is a good store of value, which could easily result in
hyperinflation.
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Chapter 04 II- Commonalities in Modern Central Banking
- Despite differences in the timing and circumstances
of their origins, by the late 2000s it could be argued
that modern central banks shared a number of
underlying commonalities:
(1) the focus on the maintenance of monetary
stability,
(2) the focus on the maintenance of financial
stability, and
(3) the prohibition on direct lending to the
government.
Chapter 04 2- Financial stability
- On the financial stability front, experiences from various
financial crises around the world (particularly the 2007–2010
global financial crisis) suggest that to ensure long-term
economic growth, central banks should have a direct role in
the maintenance of financial stability, and that this role should
apply regardless of whether the central bank has a bank
supervisory function.
- Central banks can help maintain financial stability, either as
regulators who help to ensure that the system is resilient
beforehand, or as lenders of last resort who help prevent the
total collapse of the financial system.
- A smooth functioning financial system ensures that capital is
distributed efficiently, and is thus vital to the long-term,
sustainable growth of an economy.
Chapter 04 III- The Federal Reserve Systems
- The central bank of the United States is the Federal
Reserve System, or “the Fed,” which Congress
established with the 1913 Federal Reserve Act.
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Chapter 04 1-Origins of the Federal Reserve System
• 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
• Federal Reserve Act of 1913
 Elaborate system of checks and balances
 Decentralized
Chapter 04 3-Federal Reserve Banks
• Quasi-public institution owned by private commercial banks
in the district that are members of the Fed system
• These member banks have purchased stock in their district
Federal Reserve bank (a requirement of membership), and
the dividends paid by that stock are limited by law to 6%
annually.
Chapter 04 Figure 1 Federal Reserve System
Source: Federal Reserve Bulletin
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Chapter 04 2-Structure of the Federal Reserve System
• The writers of the Federal Reserve Act wanted to diffuse
power along regional lines, between the private sector and
the government, and among bankers, business people, and
the public.
• This initial diffusion of power 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
• Around 2,900 member commercial banks
Chapter 04 3-Federal Reserve Banks
• Member banks elect six directors for each district; three more
are appointed by the Board of Governors
 Three A directors are professional bankers
 Three B directors are prominent leaders from industry, labor,
agriculture, or consumer sector
 Three C directors appointed by the Board of Governors
are not allowed to be officers, employees, or stockholders of banks
 Designed to reflect all constituencies of the public
• Nine directors appoint the president of the bank; subject to
approval by Board of Governors
Chapter 04 3.1- Functions of the Federal Reserve 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 to expand their activities
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Chapter 04 3.1- Functions of the Federal Reserve Banks
• Act as liaisons between the business community
and the Federal Reserve System
• Examine bank holding companies and state-
chartered member banks
• Collect data on local business conditions
• Use staffs of professional economists to research
topics related to the conduct of monetary policy
Chapter 04 5- Member Banks
• All national banks are required to be members of
the Federal Reserve System
• Commercial banks chartered by states are not
required but may choose to be members
• Depository Institutions Deregulation and Monetary
Control Act of 1980 subjected all banks to the same
reserve requirements as member banks and gave
all banks access to Federal Reserve facilities
Chapter 04 6.1- Duties of the Board of Governors
• Votes on conduct of open market operations
• Sets reserve requirements
• Controls the discount rate through “review and
determination” process
• Sets margin requirements
• Sets salaries of president and officers of each Federal
Reserve Bank and reviews each bank’s budget
• Approves bank mergers and applications for new
activities
• Specifies the permissible activities of bank holding
companies
• Supervises the activities of foreign banks operating in
the U.S.
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Chapter 04 4- Federal Reserve Banks and Monetary Policy
• Directors “establish” the discount rate
• Decide which banks can obtain discount loans
• Directors select one commercial banker from each
district to serve on the Federal Advisory Council
which consults with the Board of Governors and
provides information to help conduct monetary
policy
• Five of the 12 bank presidents have a vote in the
Federal Open Market Committee (FOMC)
Chapter 04 6- Board of Governors of the Federal Reserve System
• Seven members headquartered in Washington,
D.C.
• Appointed by the president and confirmed by the
Senate
• 14-year non-renewable term
• Required to come from different districts
• Chairman is chosen from the governors and serves
four-year term
Chapter 04 6.2- Chairman of the Board of Governors
• Advises the president on economic policy
• Testifies in Congress
• Speaks for the Federal Reserve System to the
media
• May represent the U.S. in negotiations with foreign
governments on economic matters
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Chapter 04 7- Federal Open Market Committee (FOMC)
• Meets eight times a year
• Consists of seven members of the Board of
Governors, the president of the Federal Reserve
Bank of New York and the presidents of four other
Federal Reserve banks
• Chairman of the Board of Governors is also chair of
FOMC
• Issues directives to the trading desk at the Federal
Reserve Bank of New York
Chapter 04 8- How Independent is the Fed?
• Instrument and goal independence.
• Independent revenue
• Fed’s structure is written by Congress, and is
subject to change at any time.
• Presidential influence
+ Influence on Congress
+ Appoints members
+ Appoints chairman although terms are not
concurrent
Chapter 04 8.1-The Case for Independence
• Political pressure would impart an inflationary bias
to monetary policy
• Political business cycle
• Could be used to facilitate Treasury financing of
large budget deficits: accommodation (Fed under
the control of the Treasury)
• Too important to leave to politicians - the principal-
agent problem is worse for politicians
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Chapter 04 7.1-FOMC Meeting
• Report by the manager of system open market
operations on foreign currency and domestic open
market operations and other related issues
• Presentation of Board’s staff national economic
forecast
• Outline of different scenarios for monetary policy
actions
• Presentation on relevant Congressional actions
• Public announcement about the outcome of the
meeting
Chapter 04 8- How Independent is the Fed?
• The Case for Independence
 The strongest argument for an independent central bank
rests on the view that subjecting it to more political pressures
would impart an inflationary bias to monetary policy.
• The Case Against Independence
 Proponents of a central bank under the control of the
president or parliament argue that it is undemocratic to have
monetary policy (which affects almost everyone in the
economy) controlled by an elite group that is responsible to
no one.
Chapter 04 8.2-The Case Against Independence
• Undemocratic
• Unaccountable
• Difficult to coordinate fiscal (management of
government spending and taxation) and monetary
policy
• Has not used its independence successfully
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Chapter 04 9-Explaining Central Bank Behavior Chapter 04 9-Explaining Central Bank Behavior

• One view of government bureaucratic behavior is • Theory of bureaucratic behavior: objective is to

that bureaucracies serve the public interest (this is maximize its own welfare which is related to power
the public interest view). Yet some economists have and prestige
developed a theory of bureaucratic behavior that • Fight vigorously to preserve autonomy

suggests other factors that influence how • Avoid conflict with more powerful groups

bureaucracies operate. • Does not rule out altruism

• The theory of bureaucratic behavior may be a useful
guide to predicting what motivates the Fed and other
central banks.

Chapter 04 IV-Structure and Independence of the European Central Bank Chapter 04 Structure and Independence of the European Central Bank

• The central bank responsible for the monetary system of • January 1999: Start-up of the European Central
the European Union (EU) and the eurocurrency. The bank
was formed in Germany in June 1998 and works with the Bank (ECB) and European System of Central Banks
other national banks of each of the EU members to (ESCB). These conduct monetary policy for
formulate monetary policy that helps maintain price stability
countries that are members of the European.
in the European Union.
• The European Central Bank has been responsible for the • Patterned after the Deutsche Bundesbank, (the
monetary policy of the European Union since January 1,
German central bank); the central banks for each
1999, when the euro currency was adopted by the EU
members. The responsibilities of the ECB are to formulate country have a similar role to that of the Lander
monetary policy, conduct foreign exchange, hold currency
Banks.
reserves and authorize the issuance of bank notes, among
many other things.

Differences Between the European System of Central Banks

Chapter 04 Structure and Independence of the European Central Bank Chapter 04 and the Federal Reserve System

• Monetary Union Central banks from each country play similar • National Central Banks control their own budgets
role as Fed banks
and the budget of the ECB
• ESCB encompasses the ECB and the National Central
• Monetary operations are not centralized
Banks of the 28 EU member states (including the 2013
addition of Croatia as the 28th EU member state). • Does not supervise and regulate financial
• The Euro system comprises of the ECB and the NCBs of only institutions
the 19 countries that have adopted the euro.
• Executive Board
 President, vice-president and four other members
 Eight year, nonrenewable terms

• Governing Council

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Chapter 04 Governing Council
• Monthly meetings at ECB in Frankfurt, Germany
• Six Executive Board members, governors of 19
National Central Banks
• Operates by consensus
• ECB announces the target rate and takes questions
from the media
• To stay at a manageable size as new countries join,
the Governing Council will be on a system of rotation.
Chapter 04 Structure and Independence of Other Foreign Central Banks
• Deutsche Bundesbank
 Coordinated policies and ensured that the Länder central banks
maintained some autonomy
• Bank of Canada
 Essentially controls monetary policy
• Bank of England
 Has some instrument independence.
• Bank of Japan
 Recently (1998) gained more independence
 The trend toward greater independence
• Central banks of the Gulf Cooperation Council nations
 Possess limited independence
Chapter 04 V- State Bank of Vietnam - SBV
1- History of SBV
- When Indochina was under French rule, the colonial
government governed the Indochinese monetary system
through Indochinese Bank, which also acted as a
commercial bank in French Indochina.
- After the August Revolution in 1945, the government of
the Democratic Republic of Vietnam gradually attempted to
exercise a monetary system independent from France.
- On 6 May 1951, president Hồ Chí Minh signed decree
15/SL on establishment of National Bank of Vietnam (Ngân
hàng Quốc gia Việt Nam).
- On 21 January 1960, the governor of the bank signed
an ordinance on behalf of the prime minister to rename the
bank State Bank of Vietnam (Ngân hàng Nhà nước Việt
Nam).
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Chapter 04 How Independent Is the ECB?
• Most independent in the world
• Members of the Executive Board have long terms
• Determines own budget
• Less goal independent
 Price stability
• Charter cannot by changed by legislation; only by
revision of the Maastricht Treaty
Chapter 04 Structure and Independence of Other Foreign Central Banks
• Reserve Bank of Africa
 One of the most independent central bank in Africa that
freely implements monetary policy.
• Bank of Indonesia
Has some instrument independence.
• Central Bank of Costa Rica
 Relatively independent, insufficient resources to effectively
implement monetary policy.
• The trend toward greater independence
Chapter 04 V- State Bank of Vietnam - SBV
1- History of SBV
- After the fall of Saigon, the two Vietnams were united
but not until July 1976 did the two countries’
administrations and institutions unite. In July 1976,
the National Bank of Vietnam (the central bank
of Republic of Vietnam) was merged into the State Bank
of Vietnam.
- In the Doi moi liberalisation era, the banking system
of Vietnam was reformed. New banks were created,
starting with the Industrial and Commercial Bank of
Vietnam(VietinBank - now the largest listed bank) and
the Vietnam Bank for Agriculture in 1988, and the role of
the State Bank was gradually narrowed to that of a
central bank.
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Chapter 04 V- State Bank of Vietnam - SBV
1- History of SBV
- In 1990, an ordinance reorganized the state bank
and redefined its function as: "on behalf of the State, of
managing money, credit, and banking operations
throughout the country in order to stabilize a value of
money, and is the only agency with power to circulate the
currency of the Socialist Republic of Vietnam“
- Law No. 01/1997/QH10 on the State Bank of Vietnam
and Law No. 10/2003/QH11 Amending and
Supplementing a Number of Articles of the Law on the
State Bank of Vietnam.
- Law No. 46/2010/QH12, June 16, 2010 on the State
Bank of Vietnam - This Law provides for the organization
and operation of the Stale Bank of Vietnam.
Chapter 04 V- State Bank of Vietnam - SBV
3- Tools for the implementation of the national monetary
policy
3.1. Re-financing
- Re-financing means a form of extending credits by the
State Bank, aiming to provide short-term capital and
payment instruments for credit institutions.
- The State Bank shall provide for and effect the re-
financing to credit institutions in the following forms:
+ Granting loans secured by the pledge of valuable
papers;
+ Discounting valuable papers;
+ Other forms.
Chapter 04 V- State Bank of Vietnam - SBV
3- Tools for the implementation of the national monetary
policy
3.3. Exchange rates
- Exchange rates of Vietnam dong shall be determined on
the basis of the foreign currency supply and demand in
the state-regulated market.
- The State Bank shall announce exchange rates and
decide on the exchange rate regime and management
mechanisms
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Chapter 04 V- State Bank of Vietnam - SBV
2- Position and functions of the SBV
- The SBV is a ministerial - level agency of the
Government and the central bank of the Socialist
Republic of Vietnam.
- The State Bank is a legal entity with its legal capital
being under the state ownership and its head office
located in Hanoi.
- The State Bank performs the state management of
monetary, banking and foreign exchange (below referred
to as monetary and banking) operations and performs the
function of a central bank in issuing money, a bank of
credit institutions and a provider of monetary services for
the Government.
Chapter 04 V- State Bank of Vietnam - SBV
3- Tools for the implementation of the national monetary
policy
3.2. Interest rates
- The Stale Bank shall announce the refinancing interest
rate, prime interest rate and other interest rates to serve
the regulation of the monetary policy and the fight against
usury.
- In case abnormal developments are seen in the
monetary market, the State Bank shall provide for a
mechanism for regulating interest rates applicable to
credit institutions in their relations with others and their
clients and in other credit relations.
Chapter 04 V- State Bank of Vietnam - SBV
3- Tools for the implementation of the national monetary
policy
3.4. Compulsory reserves
- Compulsory reserves means a sum of money to be deposited
by a credit institution at the State Bank to serve the
implementation of the national monetary policy.
- The State Bank shall provide for the compulsory reserve ratio
applicable to each type of credit institution and each kind of
deposit at credit institutions to serve the implementation of the
national monetary policy.
- The State Bank shall provide for the payment of interests on
compulsory reserve deposits and deposits in excess of
compulsory reserves applicable to each type of credit institution
and each kind of deposit.
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Chapter 04 V- State Bank of Vietnam - SBV

3- Tools for the implementation of the national monetary

policy
3.5. Open-market operations
- The State Bank shall carry out open-market
operations through the purchase and sale of
valuable papers with credit institutions.
- The Stale Bank shall provide for types of valuable
papers permitted for trading via open-market
operations.