This is the latest in a series of posts by Professor Brian Cutsinger on issues in price theory. Subscribe to Cutsinger’s EconLog RSS feed to see all Cutsinger issues and solutions. Please share your proposed solutions in the comments. Professor Cutsinger will be participating in the comments over the next few weeks and will post his proposed solution shortly thereafter. May the graph be favorable to you and may the price theory endure!
Question: The U.S. Federal Reserve differs from most government agencies in two important ways.
The Federal Reserve determines its own operating budget and remits the remaining proceeds to the U.S. Treasury. Because the Fed derives its income from printing money and holding interest-bearing assets, it has some control over its revenues. Issuing more currency than is consistent with price stability can increase this income in the short term.
However, unlike private corporations, no individual or entity owns the Federal Reserve’s residual income.
(a) Explain how the absence of residual claimants affects the Federal Reserve’s incentives in choosing the size of its operating budget. In particular, discuss whether this institutional arrangement promotes least-cost production methods.
(b) Even if price stability is an official policy goal, explain how the Federal Reserve’s ability to generate revenue through money creation can create an inflationary bias.
(c) Why does transferring excess revenue to the Treasury not completely eliminate these incentive problems?Use basic economic theory to explain.
