• This is the latest in our series of posts in our series on price theory problems with Professor Bryan Cutsinger. You can see all of Cutsinger’s problems and solutions by subscribing to his EconLog RSS feed. Share your proposed solutions in the comments. Professor Cutsinger will be present in the comments for the next couple of weeks, and we’ll post his proposed solution shortly thereafter. May the graphs be ever in your favor, and long live price theory!

Question: The U.S. Federal Reserve differs from most government agencies in two important ways:

1. The Federal Reserve determines its own operating budget and remits any remaining revenue to the U.S. Treasury.
2. The Federal Reserve has some control over its revenue, since it earns income from issuing money and holding interest-bearing assets. Issuing more money than is consistent with price stability can increase this revenue in the short run.

Unlike a private firm, however, no individual or group owns the Federal Reserve’s residual income.

(a) Explain how the absence of a residual claimant affects the Federal Reserve’s incentives when choosing the size of its operating budget. In particular, discuss whether this institutional arrangement encourages the least-cost method of production.

(b) Explain how the Federal Reserve’s ability to generate revenue through money creation could create an inflationary bias, even if price stability is an official policy objective.

(c) Why might remitting excess revenue to the Treasury fail to fully eliminate these incentive problems? Explain using basic economic reasoning.