Information, Incentives, and Organization: The Microeconomics of Central Banking

Abstract

Both the Fed’s defenders and critics focus on macroeconomic questions. What is the correct monetary policy? Does the economy need an “activist” Fed? Should the central bank intervene to reduce unemployment, or focus on keeping prices stable? Should the Fed target interest rates or nominal GDP? Has the Fed done a good job? These are critically important questions. Ultimately, however, the Fed’s behavior derives from the way it is organized, managed, and governed. In other words, the macroeconomic problem is built upon a more fundamental, underlying microeconomic problem: How is the Fed’s behavior enabled, shaped, and constrained by its mandate, its legal authority, and its organizational design? For a fuller understanding of the Fed, and central banking more generally, we should turn not only to macroeconomics, but also to microeconomics, specifically at the economic theory of organizations — their nature, emergence, boundaries, internal structure, and governance. This chapter evaluates the Federal Reserve System, and the institution of central banking more generally, from the perspective of organizational economics, and concludes that independent, unaccountable central banks are inefficient, inherently politicized, and incapable of performing the functions assigned to them.

Keywords: Central banking, Federal Reserve System, incentives, organization, governance

JEL Classification: L20, L32, N12