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Appendix: The Independence of the Federal Reserve System
The Federal Reserve System is intended to be an independent central bank. Some nations have
created central banks that are relatively independent of political influence (like the Fed). Other
nations have central banks that are more influenced by elected officials. History indicates that the
more independent central banks are more successful at avoiding inflationary policies.
Example 7: According to a paper published by Patricia Pollard of the St. Louis Federal Reserve
Bank, “The empirical studies find that there is a negative correlation between central bank
independence and long-run average inflation. They also show a negative correlation between
independence and long-run average government deficits as a percent of GDP.”
The Fed is independent in that its decisions do not have to be approved by the President or by
Congress. The Board of Governors is only required to submit a bi-annual report to Congress on
the state of the economy and the conduct of monetary policy. The independence of the Fed is
intended to allow the Fed to make policy decisions relatively free of political influence.
The Fed’s political independence is enhanced by its financial independence. The Fed is not
dependent on Congress for its funding. In fact, the Fed is a unique government agency in that it
earns a profit every year. As of July 30, 2014, the Fed’s assets totaled over $4.4 trillion. The
Fed’s holdings of U.S. government securities made up about 55% of the Fed’s total assets. The
Fed had income in 2013 of over $85 billion. After paying operating expenses, the Fed transferred
over $79 billion to the U.S. Treasury.
Appendix: Financial Intermediation
The earliest banks simply provided a safe storage place for money. Banks continue to provide a
safe place to store money, but the primary function of banks today is financial intermediation.
Intermediate means “in between”. A bank stands in between savers, who supply funds to the
bank by making deposits, and borrowers, who borrow those funds from the bank. Savers can
provide funds directly to borrowers, e.g. by purchasing corporate or government bonds. But
savers often prefer to deposit their savings in a bank and let the bank select the ultimate
borrowers. And borrowers often prefer to borrow from banks rather than seek loans directly from
savers. Financial intermediation has a number of advantages for savers and borrowers, including:
1. Savers reduce their risk of loss.
Example 8A: Saver invests $10,000 in a bond issued by XYZ Corporation. If XYZ Corporation
fails, Saver may lose some or all of the $10,000.
Example 8B: Saver deposits $10,000 into 1 st Bank. 1 st Bank may make loans to XYZ
Corporation. But if XYZ Corporation fails, 1 st Bank will probably not fail since it has a diversified
portfolio of loans (doesn’t have all its financial eggs in one basket). And even if 1 st Bank fails,
Saver’s deposit is protected by federal deposit insurance.
2. Savers do not have to evaluate the ability of borrowers to repay a loan.
Example 9A: Saver has $10,000 available to lend. Saver places an ad on Craigslist notifying
prospective borrowers of Saver’s willingness to make a loan. A large number of prospective
borrowers apply for the loan. Saver would need to evaluate the ability of each prospective
borrower to repay the loan. Saver’s transaction cost of making the loan would be very high.
Example 9B: Saver deposits $10,000 into 1 st Bank. 1 st Bank has expertise in evaluating the
ability of prospective borrowers to repay a loan and can make much larger loans than a typical
saver could. Thus, 1 st Bank can loan Saver’s money at a much lower transaction cost.
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Monetary Policy 12 - 6