Econ 450 Homework

Economics 431

Homework #2

Spring 2014

1. (15 points) The Federal Reserve Bank of the United States is considered to be a very independent central bank. Explain what makes the US Federal Reserve independent from the US government. Explain some of the ways in which the Fed is not entirely disconnected from the government. What are the benefits of independence? What are some of the costs?

a. Two types of independence for central banks: Instrument Independence (ability to set monetary policy instruments) and Goal Independence (ability to set goals of monetary policy). The Federal Reserve is both. Members of Board of Governors are appointed a 14 year term, nonrenewable term, which helps eliminate some incentive for them to do favors for congressional officials.

The Federal Reserve makes a substantial source of revenue from its securities holdings, loans to banks, etc. But the Federal Reserve returns a large percentage of their revenue to the Treasury, it does not make a profit. It therefore is not controlled by congress. Officials do not have the power to audit monetary policies or the foreign exchange market.

b. The Fed is not entirely independent, some congressional influence can find its way into the Federal Reserve. Legislators can threaten to weaken the Fed’s power, because the Fed is structured by legislation. If legislators are unhappy with the Fed’s actions, they can impose these threats to hinder their ability to perform their original intended purpose. The president also has influence over the Fed because the president has influence on congress. Also, the president is able to appoint members to the Fed’s Board of Governors, and also the chairman (now chairwoman).

c. Benefits of independence include free from bias monetary policy set forth by political pressures. This could ruin elections for politicians who would do anything to win or get reelected. This indicates a principal-agent problem, which is far...