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A political compromise enabled Congress to find a majority to support the Federal Reserve Act of 1913. New York bankers wanted control vested in bankers, and favored a model based on the Bank of England. Rural and agricultural interests wanted political control to remain with the government. The compromise created twelve semiautonomous Reserve banks controlled by bankers, with a Reserve Board in Washington, D.C., appointed by the president with the consent of Congress. The compromise left open the question of degree of independence: Who would make the decisions, Reserve banks or the Board?
Policy decisions were in fact limited. The authors accepted the international gold standard as a monetary rule and the real bills doctrine as an operating procedure. That limited scope for discretion in decisions about the timing of discount rate changes.
Almost immediately, conflict over decisions began between the Board and the Reserve banks. The banks, led by Benjamin Strong of the New York Reserve bank, dominated decisions until Strong’s death in 1928. Strong and his associates soon recognized that the real bills doctrine had a major flaw: It implied that a central bank could control the quantities of money and credit by controlling their quality. Specifically, they concluded that efforts to prevent speculative lending would not succeed. The Board adhered to the real bills doctrine and, until 1933, the gold standard. The result of this policy was to deepen the Great Depression. The Federal Reserve was inactive from 1933 to 1951, under the control of the Treasury. In 1935 Congress approved changes in the Federal Reserve Act that shifted control of decisions from the Reserve banks to the Board of Governors. Once the Federal Reserve resumed active policymaking in 1951, the Board began to change procedures to strengthen its control. At the time, it lacked a clear vision of its proper objectives and how to achieve them.
Congress passed two pieces of legislation at the end of World War II (1939–1945). The Employment Act (1946) made a vague commitment to economic stability. The Bretton Woods Agreement (1944) called for fixed but adjustable exchange rates. Monetary policy could achieve domestic stability or exchange rate stability, but not both. The Federal Reserve and many others interpreted the Employment Act as a commitment to “full employment,” and although the Reserve never defined what that meant in practice, it gradually came to mean unemployment rates of about 4 to 5 percent. Federal Reserve Chairman William McChesney Martin Jr. stressed the importance of maintaining low inflation and a fixed exchange rate, but he did not develop procedures to achieve either.
One reason for this failure was the effort to coordinate monetary and fiscal policy actions. A popular belief at the time held that coordination would contribute to stability and prosperity; overlooked was the loss of Federal Reserve independence and the increased political influence on monetary policy actions. The administration of Lyndon Johnson wanted the Federal Reserve to coordinate by keeping interest rates from rising so they could finance their persistent budget deficits at lower cost. The Federal Reserve did just that. Also, when it became concerned enough to act against inflation by reducing money growth in 1966, homebuilding declined sharply. Political pressures increased.
Mistaken beliefs about the conduct of monetary policy added to the problem. Economists developed the Phillips curve, relating inflation and unemployment, and policy makers used this construct to reduce unemployment rates by increasing inflation. They discovered after the fact that the reduction in the unemployment rate did not persist, but inflation persisted. The Federal Reserve tried several times—in 1969, 1973, and 1976—to reduce inflation. When the unemployment rose to 7 percent or more, they abandoned the efforts.
Persistent and rising inflation brought an end to the Bretton Woods System of fixed exchange rates. European nations and Japan became willing to give up the fixed exchange rate system in order to free themselves from the effect of U.S. inflationary policies. By the end of the 1970s it was apparent to all that instead of trading off lower unemployment for higher inflation, U.S. policy resulted in higher inflation and higher unemployment. Public attitudes changed, and the change affected some congressional leaders. President Jimmy Carter appointed Paul Volcker as chairman of the Board of Governors of the Federal Reserve. Volcker made two lasting changes. First, he reestablished Federal Reserve independence of political control. This was a necessary step, but it required an acceptance of responsibility for policy outcomes that Chairmen Martin and Burns had been unwilling to make. Second, he accepted the temporary increase in unemployment needed to convince the public that he would not return to inflationary policy. High real interest rates and falling real balances produced a severe recession, with the unemployment rate reaching 10 percent.
But Volcker succeeded. The Federal Reserve and many others adopted and repeated a new mantra, very different from the Phillips curve, that low inflation was the best way to assure low unemployment. From the 1980s to 2005 the United States experienced the two longest peacetime expansions in its history, with inflation generally modest. Despite large budget deficits in the 1980s and after 2001, variability of output and inflation declined to low levels. The public remained confident that monetary policy would remain sufficiently independent to prevent a return to the instability of the 1970s, and that helped to build a political consensus and popular support for low inflation.
Meltzer, Allan H. 2003. A History of the Federal Reserve. Chicago: University of Chicago Press.
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