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Whoever controls the volume of money ... is absolute master of all industry and commerce.

President James A. Garfield

Efficient financial institutions are vital for macroeconomic performance. Money binds together individual markets for goods and resources. A country's central bank is charged with ensuring the efficiency and stability of the financial sector.

The central bank of a country: (a) controls the volume of money in circulation, (b) performs the government's banking functions, (c) regulates banks and other financial institutions and (d) serves as a "banker's bank"---holding deposits from commercial banks and making loans to them as needed.

The Federal Reserve System (FED) is the United States' central bank, and it may be the most powerful and independent of all U.S. government agencies. During hearings on FED policies, one senator compared getting a straight answer out of the chairman of the FED's Board of Governors to "nailing a chocolate cream pie to a wall."

The structure of the FED and the tools it uses to control the money supply and shape financial conditions are examined in this chapter. We also survey different types of financial institutions, the major goals of financial regulators, and the consequences of certain policies intended to alter macroeconomic activity.

The Purposes of Financial Regulations

Financial institutions are not lenders per se, but merely act as intermediaries between savers and borrowers. Nervous depositors sometimes try to withdraw all their savings simultaneously, but this is not always possible. With fractional reserve banking, a bank's assets (loans outstanding) are not collectible until the date due, but liabilities (e.g., checking deposits) are typically payable "on demand." A related problem occurs when inept or dishonest officers of financial institutions misuse the funds we entrust to them. Financial intermediation can be volatile. Savings-and-loans toppled like rows of dominoes amid widespread charges of fraud in the 1980s. It is not surprising that financial institutions are regulated more tightly than any other industry except, perhaps, secret weapons research or atomic energy. Thus, major goals for a central bank include (a) protection of depositors' savings, (b) macroeconomic stability, and (c) promotion of efficiency.

In this context, efficiency requires minimizing the costs of financial intermediation, or the bankers' "spread"---differences between the costs of loans to borrowers and the interest incomes received by depositors---the ultimate lenders. This is the financial equivalent of the principle that efficiency requires producing all services at the lowest possible opportunity cost. Unfortunately, protecting people's savings and ensuring economic stability can conflict with financial efficiency.

Early Central Banks

Many of this nation's founders feared that a central bank would concentrate economic and political power in the hands of a few. Alexander Hamilton's persuasive skills were stretched to the limit to establish the first Bank of the United States shortly after the U.S. Constitution was ratified. This central bank replaced a system in which the federal government, 13 states, and many private banks issued different currencies. The phrase "Not worth a continental" crept into our language after money issued by the Continental Congress became worthless. The dollar became sound only when the Bank honored federal debts incurred during the Revolutionary War.

The Bank of the United States was privately owned and operated, but it was also the government's bank because it (a) stored tax revenues, (b) paid the government's obligations, and (c) arranged loans to and from the government. The Bank was unpopular with most Westerners and agricultural interests, who felt it served only the rich "Eastern Establishment." The death of Hamilton and ascendance of his political rival, Thomas Jefferson, led in 1811 to the end of our first experiment with central banking.

The Second Bank of the United States, chartered in 1816, was operated by Nicholas Biddle, a member of a prominent Philadelphia family. Despite some initial success, President Andrew Jackson vetoed the act to recharter it. In 1836, the original charter expired. Nicholas Biddle was disgraced in a minor financial scandal, and the Bank's collapse precipitated the financial crash of 1837. For the next 75 years, the American economy experienced substantial but erratic growth without a central bank.