Intro to Econ: The Federal Reserve and Other Economic Institutions

Economics is a social science concerned with the production, distribution, and consumption of goods and services. It studies how individuals, businesses, governments, and nations make choices on allocating resources to satisfy their wants and needs, trying to determine how these groups should organize and coordinate efforts to achieve maximum output.

Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the aggregate economy, and microeconomics, which focuses on individual consumers and businesses.

One of the earliest recorded economic thinkers was the 8th-century B.C. Greek farmer/poet Hesiod, who wrote that labor, materials, and time needed to be allocated efficiently to overcome scarcity. But the founding of modern Western economics occurred much later, generally credited to the publication of Scottish philosopher Adam Smith’s 1776 book, An Inquiry Into the Nature and Causes of the Wealth of Nations.

The principle (and problem) of economics is that human beings have unlimited wants and occupy a world of limited means. For this reason, the concepts of efficiency and productivity are held paramount by economists. Increased productivity and a more efficient use of resources, they argue, could lead to a higher standard of living.

Despite this view, economics has been pejoratively known as the “dismal science,” a term coined by Scottish historian Thomas Carlyle in 1849. He used it to criticize the liberal views on race and social equality of contemporary economists like John Stuart Mill, though some sources suggest Carlyle was actually describing the gloomy predictions by Thomas Robert Malthus that population growth would always outstrip the food supply.

Economic Institutions

The term “Economic Institutions” refers to two things:

1. Specific agencies or foundations, both government and private, devoted to collecting or studying economic data, or commissioned with the job of supplying a good or service that is important to the economy of a country. The Internal Revenue Service (the IRS—the government tax-collection agency), the U.S. Federal Reserve (the government producer of money), the National Bureau of Economic Research (a private research agency) are all examples of economic institutions.
2. Well-established arrangements and structures that are part of the culture or society, e.g., competitive markets, the banking system, kids’ allowances, customary tipping, and a system of property rights are examples of economic institutions.

There are five basic tenets of a society or culture that fosters a market economy:

1. Private Property
2. Free Markets
3. Competition
4. Division and Combination of Labor
5. Social Cooperation

Economic Institutions: Private Property

A property right is the exclusive authority to determine how a resource is used, whether that resource is owned by government or by individuals. Society approves the uses selected by the holder of the property right with governmental administered force and with social ostracism. If the resource is owned by the government, the agent who determines its use has to operate under a set of rules determined, in the United States, by Congress or by executive agencies it has charged with that role.

Private property rights have two other attributes in addition to determining the use of a resource. One is the exclusive right to the services of the resource. Thus, for example, the owner of an apartment with complete property rights to the apartment has the right to determine whether to rent it out and, if so, which tenant to rent to; to live in it himself; or to use it in any other peaceful way. That is the right to determine the use. If the owner rents out the apartment, he also has the right to all the rental income from the property. That is the right to the services of the resources (the rent).

Finally, a private property right includes the right to delegate, rent, or sell any portion of the rights by exchange or gift at whatever price the owner determines (provided someone is willing to pay that price). If I am not allowed to buy some rights from you and you therefore are not allowed to sell rights to me, private property rights are reduced. Thus, the three basic elements of private property are :

1. exclusivity of rights to choose the use of a resource
2. exclusivity of rights to the services of a resource
3. rights to exchange the resource at mutually agreeable terms.

Economic Institutions: Free Markets

Free market” is a summary term for an array of exchanges that take place in society. Each exchange is undertaken as a voluntary agreement between two people or between groups of people represented by agents. These two individuals (or agents) exchange two economic goods, either tangible commodities or nontangible services. Thus, when I buy a newspaper from a newsdealer for fifty cents, the newsdealer and I exchange two commodities: I give up fifty cents, and the newsdealer gives up the newspaper. Or if I work for a corporation, I exchange my labor services, in a mutually agreed way, for a monetary salary; here the corporation is represented by a manager (an agent) with the authority to hire.

Both parties undertake the exchange because each expects to gain from it. Also, each will repeat the exchange next time (or refuse to) because his expectation has proved correct (or incorrect) in the recent past. Trade, or exchange, is engaged in precisely because both parties benefit; if they did not expect to gain, they would not agree to the exchange.

Economic Institutions: Competition

Economic competition takes place in markets—meeting grounds of intending suppliers and buyers. Typically, a few sellers compete to attract favorable offers from prospective buyers. Similarly, intending buyers compete to obtain good offers from suppliers. When a contract is concluded, the buyer and seller exchange property rights in a good, service, or asset. Everyone interacts voluntarily, motivated by self-interest.

Economic Institutions: Division and Combination of Labor

Division of labor combines specialization and the partition of a complex production task into several, or many, sub-tasks. Its importance in economics lies in the fact that a given number of workers can produce far more output using division of labor compared to the same number of workers each working alone. Interestingly, this is true even if those working alone are expert artisans. The production increase has several causes. According to Adam Smith, these include increased dexterity from learning, innovations in tool design and use as the steps are defined more clearly, and savings in wasted motion changing from one task to another.

Economic Institutions: Social Cooperation

Division of labor and social cooperation cannot be considered apart. Each implies the other. No can can specialize if he lives alone and must provide for all his own needs. Division and combination of labor already imply social cooperation. They imply that each exchanges part of the special product of his labor for the special product of the labor of others. But division of labor, in turn, increases and intensifies social cooperation. As Adam Smith put it: “The most dissimilar geniuses are of use to one another; the different produces of their respective talents, by the general disposition to truck, barter, and exchange, being brought, as it were, into a common stock, where every man may purchase whatever part of the produce of other men’s talents he has occasion for.”

Modern economists make the interdependence of division of labor and social cooperation more explicit: “Society is concerted action, cooperation. . . . It substitutes collaboration for the—at least conceivable—isolated life of individuals. Society is division of labor and combination of labor. . . . Society is nothing but the combination of individuals for cooperative effort.

Federal Reserve System

The Federal Reserve System is the central bank of the United States. It performs five general functions to promote the effective operation of the U.S. economy and, more generally, the public interest. The Federal Reserve:

• conducts the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy;
• promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad;
• promotes the safety and soundness of individual financial institutions and monitors their impact on the financial system as a whole;
• fosters payment and settlement system safety and efficiency through services to the banking industry and the U.S. government that facilitate U.S.-dollar transactions and payments; and
• promotes consumer protection and community development through consumer-focused supervision and examination, research and analysis of emerging consumer issues and trends, community economic development activities, and the administration of consumer laws and regulations.

In establishing the Federal Reserve System, the United States was divided geographically into 12 Districts, each with a separately incorporated Reserve Bank. District boundaries were based on prevailing trade regions that existed in 1913 and related economic considerations, so they do not necessarily coincide with state lines. Federal Reserve District boundaries are based on economic considerations; the Districts operate independently but under the supervision of the Federal Reserve Board of Governors.

As originally envisioned, each of the 12 Reserve Banks was intended to operate independently from the other Reserve Banks. Variation was expected in discount rates–the interest rate that commercial banks were charged for borrowing funds from a Reserve Bank. The setting of a separately determined discount rate appropriate to each District was considered the most important tool of monetary policy at that time. The concept of national economic policymaking was not well developed, and the impact of open market operations–purchases and sales of U.S. government securities–on policymaking was less significant.

As the nation’s economy became more integrated and more complex, through advances in technology, communications, transportation, and financial services, the effective conduct of monetary policy began to require increased collaboration and coordination throughout the System. This was accomplished in part through revisions to the Federal Reserve Act in 1933 and 1935 that together created the modern-day Federal Open Market Committee (FOMC).

The Depository Institutions Deregulation and Monetary Control Act of 1980 (Monetary Control Act) introduced an even greater degree of coordination among Reserve Banks with respect to the pricing of financial services offered to depository institutions. There has also been a trend among Reserve Banks to centralize or consolidate many of their financial services and support functions and to standardize others. Reserve Banks have become more efficient by entering into intra-System service agreements that allocate responsibilities for services and functions that are national in scope among each of the 12 Reserve Banks.

Central Banking

The framers of the Federal Reserve Act purposely rejected the concept of a single central bank. Instead, they provided for a central banking “system” with three salient features:

1. a central governing Board
2. a decentralized operating structure of 12 Reserve Banks
3. a combination of public and private characteristics.

Although parts of the Federal Reserve System share some characteristics with private-sector entities, the Federal Reserve was established to serve the public interest.

There are three key entities in the Federal Reserve System:

• The Board of Governors, an agency of the federal government that reports to and is directly accountable to Congress, provides general guidance for the System and oversees the 12 Reserve Banks.
• Federal Reserve Banks (Reserve Banks)
• Federal Open Market Committee (FOMC).

Within the System, certain responsibilities are shared between the Board of Governors in Washington, D.C., whose members are appointed by the President with the advice and consent of the Senate, and the Federal Reserve Banks and Branches, which constitute the System’s operating presence around the country. While the Federal Reserve has frequent communication with executive branch and congressional officials, its decisions are made independently.

Board of Governors

The Board of Governors of the Federal Reserve System, commonly known as the Federal Reserve Board, is the main governing body of the Federal Reserve System. It is charged with overseeing the Federal Reserve Banks and with helping implement the monetary policy of the United States. Governors are appointed by the president of the United States and confirmed by the Senate for staggered 14-year terms

Federal Reserve Banks

A Federal Reserve Bank is a regional bank of the Federal Reserve System, the central banking system of the United States. There are twelve in total, one for each of the twelve Federal Reserve Districts that were created by the Federal Reserve Act of 1913. The banks are jointly responsible for implementing the monetary policy set forth by the Federal Open Market Committee.

Federal Open Market Committee

The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System (the Fed), is charged under United States law with overseeing the nation’s open market operations (e.g., the Fed’s buying and selling of United States Treasury securities). This Federal Reserve committee makes key decisions about interest rates and the growth of the United States money supply.

Under the terms of the original Federal Reserve Act, each of the Federal Reserve banks was authorized to buy and sell in the open market bonds and short term obligations of the United States Government, bank acceptances, cable transfers, and bills of exchange; hence, the reserve banks were at times bidding against each other in the open market. In 1922, an informal committee was established to execute purchases and sales. The Banking Act of 1933 formed an official FOMC.

The FOMC is the principal organ of United States national monetary policy. The Committee sets monetary policy by specifying the short-term objective for the Fed’s open market operations, which is usually a target level for the federal funds rate (the rate that commercial banks charge between themselves for overnight loans). The FOMC also directs operations undertaken by the Federal Reserve System in foreign exchange markets, although any intervention in foreign exchange markets is coordinated with the U.S. Treasury, which has responsibility for formulating U.S. policies regarding the exchange value of the dollar.

Two other groups play important roles in the Federal Reserve System’s core functions:

1. depository institutions–banks, thrifts, and credit unions; and
2. Federal Reserve System advisory committees, which make recommendations to the Board of Governors and to the Reserve Banks regarding the System’s responsibilities.

Depository Institutions

Depository institutions offer transaction, or checking, accounts to the public, and may maintain accounts of their own at their local Federal Reserve Banks. Depository institutions are required to meet reserve requirements–that is, to keep a certain amount of cash on hand or in an account at a Reserve Bank based on the total balances in the checking accounts they hold.

Depository institutions that have higher balances in their Reserve Bank account than they need to meet reserve requirements may lend to other depository institutions that need those funds to satisfy their own reserve requirements. This rate influences interest rates, asset prices and wealth, exchange rates, and thereby, aggregate demand in the economy. The FOMC sets a target for the federal funds rate at its meetings and authorizes actions called open market operations to achieve that target.

Advisory Councils

Four advisory councils assist and advise the Board on matters of public policy:

1. Federal Advisory Council (FAC). This council, established by the Federal Reserve Act, comprises 12 representatives of the banking industry. The FAC ordinarily meets with the Board four times a year, as required by law. Annually, each Reserve Bank chooses one person to represent its District on the FAC. FAC members customarily serve three one-year terms and elect their own officers.
2. Community Depository Institutions Advisory Council (CDIAC). The CDIAC was originally established by the Board of Governors to obtain information and views from thrift institutions (savings and loan institutions and mutual savings banks) and credit unions. More recently, its membership has expanded to include community banks. Like the FAC, the CDIAC provides the Board of Governors with firsthand insight and information about the economy, lending conditions, and other issues.
3. Model Validation Council. This council was established by the Board of Governors in 2012 to provide expert and independent advice on its process to rigorously assess the models used in stress tests of banking institutions. Stress tests are required under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The council is intended to improve the quality of stress tests and thereby strengthen confidence in the stress-testing program.
4. Community Advisory Council (CAC). This council was formed by the Federal Reserve Board in 2015 to offer diverse perspectives on the economic circumstances and financial services needs of consumers and communities, with a particular focus on the concerns of low- and moderate-income populations. The CAC complements the FAC and CDIAC, whose members represent depository institutions. The CAC meets semiannually with members of the Board of Governors. The 15 CAC members serve staggered three-year terms and are selected by the Board through a public nomination process.

Federal Reserve Banks also have their own advisory committees. Perhaps the most important of these are committees that advise the Banks on agricultural, small business, and labor matters. The Federal Reserve Board solicits the views of each of these committees biannually.

References:

1. Division of labor. (n.d.). Econlib. https://www.econlib.org/library/Enc/DivisionofLabor.html
2. Economic institutions. (n.d.). Econlib. https://www.econlib.org/library/Topics/HighSchool/EconomicInstitutions.html
3. Federal Reserve board – Structure of the Federal Reserve System. (n.d.). Board of Governors of the Federal Reserve System. https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm
4. Free market. (n.d.). Econlib. https://www.econlib.org/library/Enc/FreeMarket.html
5. Hazlitt, H. (2016, November 25). The five institutions of the market economy. Foundation for Economic Education. https://fee.org/articles/the-five-institutions-of-the-market-economy/
6. Property rights. (n.d.). Econlib. https://www.econlib.org/library/Enc/PropertyRights.html
7. Robinson, K. J. (n.d.). Depository institutions deregulation and monetary Control Act of 1980. Federal Reserve History. https://www.federalreservehistory.org/essays/monetary_control_act_of_1980

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