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Frank J. Bonello, an associate professor of economics at the University of Notre Dame in South Bend, Indiana, explains why Federal Reserve Chairman Alan Greenspan usually makes front-page news. Bonello provides a brief introduction to the Federal Reserve System and clarifies why it’s important to the United States economy.
By Frank J. Bonello
During the tightly contested U.S. presidential election of 2000, one commentator joked that the outcome did not really matter, because whatever happened, economic conditions would be determined by Alan Greenspan and not the president. Greenspan is the present chair of the Board of Governors of the Federal Reserve System, often called the Fed. His decisions and comments are front-page stories in newspapers and news magazines around the world. Some people would argue that the Fed’s impact on the U.S. economy makes it the most influential organization in the world today. Greenspan’s predecessor, Paul Volcker, once summed up the power of the position, “You’ve got all the cards…”
Created in 1913 after a series of financial crises, the Federal Reserve System is the government agency responsible for monetary policy. The actions taken by the Fed have direct effects on money supply, interest rates, and credit conditions. They can have dramatic indirect effects on stock prices, causing Wall Street numbers to soar or plummet. But what is this system? What does it actually do? And why?
The Federal Reserve is a central bank. It is the bank used by the U.S. government and by other banks. It issues the national currency, it executes monetary policy, and it has a key role in regulating the banking industry. Most important is the execution of monetary policy. The Fed’s Open Market Committee meets approximately every six weeks to assess the state of the economy and determine what actions will be taken with regard to the money supply, interest rates, and credit conditions.
It takes money to make money. Much of the capital used in business is borrowed. The cost of borrowing money depends critically on the money supply and on interest rates. An expansionary monetary policy will increase the growth rate of the money supply, expand credit, and lower interest rates. This option is attractive when the unemployment rate is too high or the growth of output is inadequate. The increased money supply and lower interest rates encourage businesses to borrow money, expand, and hire more workers.
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A contractionary monetary policy, on the other hand, will decrease the rate of growth of the money supply, limit credit, and increase interest rates. Such a policy may slow economic growth, but when growth is too rapid, there may be significant increases in the level of prices, or inflation.
The discount rate, the interest rate banks pay when they borrow from the Fed, rose from 4.5 percent in July 1999 to 6 percent in August 2000 because the Federal Open Market Committee, which sets the rate, felt that the economy was headed in an inflationary direction. These figures look small, but this 33.3 percent increase in the cost of money creates a big difference in business costs.
The Federal Open Market Committee (FOMC) has 12 voting members, including the Fed’s Board of Governors and the president of the New York Federal Reserve District Bank. The other voting positions rotate among the other district-bank presidents. The FOMC meets in Washington, D.C. When the media mention a Federal Reserve meeting, they are almost always referring to a FOMC meeting.
The Board of Governors has seven members, appointed for 14-year terms by the president and confirmed by the Senate. Governors leave office only by the expiration of their term, by resignation, by death, or by impeachment. One of the governors is selected by the U.S. president to serve a four-year term as the chair of the Board. Alan Greenspan was initially appointed as a governor and chair by President Ronald Reagan in 1987, then reappointed by President George Bush in 1992, then reappointed two more times by President Bill Clinton in 1996 and 2000. Paul Volcker, who took office as chair in 1979, served until 1987, during Democratic and Republican administrations. Commentators often argue that the nation’s interests are best served by such separation of the Fed’s chair and governors from changes in elected administrations. The system is not supported by federal money; it pays its own way from income on loans and investments.
There are 12 Federal Reserve district banks. These district banks engage in activities such as clearing checks, issuing new currency, making discount loans to banks in their districts, and collecting data on local business conditions. Each district bank has a president who is appointed by the nine district-bank directors, but the Board of Governors must approve the appointment. Three of the nine district-bank directors must be professional bankers, and three are prominent leaders in business, labor, or agriculture. The Board of Governors appoints three directors to represent the public interest.
Commercial banks are either national banks or state banks. All national banks must be members of the Federal Reserve System, while state banks have the option to become members. All member banks are required to purchase stock in their Federal Reserve District Bank. By law, they receive a 6 percent annual dividend on their holdings.
The desirability of a central bank was the subject of fierce arguments before the creation of the Fed. There were initial attempts with the First and Second Banks of the United States (1791-1811 and 1816-1836). During the following decades, the banking system suffered repeated collapses and failures of confidence. The Federal Reserve System has helped prevent such banking collapses (with the exception of the Great Depression) and helped make the U.S. economy the strongest in the world. While it may seem surprising that so much depends on governors that the people do not elect, the results speak for themselves.
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Federal Reserve System; Greenspan, Alan
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