The Role of the Federal Reserve in the U.S. Economy
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In this video, Chairman Bernanke explains the basic idea of the central bank and the role it plays in fostering a stable economy. He describes the central bank’s tools for maintaining a stable financial system and a healthy economy.
As you review the video, consider the following questions:
- What is a central bank?
- What is the economic and financial mission of a central bank?
- What tools does a central bank use to promote economic and financial stability?
- What is a "financial panic"? How does the Fed calm a financial panic as the "lender of last resort"?
- What is Bagehot’s dictum, and what guidance does it provide to the Federal Reserve to calm or mitigate financial panics?
Summary
A central bank
- is a government agency;
- stands at the center of a nation’s financial system;
- has played a key role in the development of the modern monetary system; and
- exists in virtually all countries.
The mission of a nation’s central bank is to
- promote macroeconomic stability by
- striving for low and stable inflation, and
- promoting stable growth in output and employment; and
- promote financial stability by
- trying to ensure that the nation’s financial system functions properly, and
- trying to prevent or mitigate financial panics or crises.
The policy tools of central banks include the following:
- monetary policy for macroeconomic stability
- in normal times, adjust the level of short-term interest rates to influence spending, production, employment, and inflation
- provision of liquidity for financial stability
- provide liquidity (short-term loans) to financial institutions or markets to help calm financial panics, serving as “lender of last resort”
- financial regulation and supervision
- supervise financial institutions; to the extent that supervision helps keep firms financially healthy, the risk of loss of confidence by the public and an ensuing panic is reduced.
A financial panic is possible in any situation where
- longer-term illiquid assets are financed by short-term liquid liabilities;
- short-term lenders or depositors may lose confidence in the institution they are financing or become worried others may lose confidence; and
- depositors attempt to withdraw cash in excess of the bank’s minimal cash reserves, requiring the bank to sell off assets at a discounted price; this can lead to bank failure.
Bagehot’s dictum: During a financial panic, a central bank should lend
- freely;
- against good assets; and
- at a penalty interest rate (to discourage excessive use).