Central Banks in the World Today

1
Chapter 15

• Central Banks in the World Today

2
The Functions of a Modern Central Bank
3
The Objectives of a Modern Central Bank

• Low, Stable Inflation
• Inflation creates confusion and makes planning
  difficult. When inflation is high, growth is
  low.
• High, Stable Growth
• When growth is predictable, it is faster than
  when it is unpredictable.

4
The Objectives of a Modern Central Bank
5
Central Bank Independence and Macroeconomic
Performance Throughout the World

• Empirical work suggests that countries with the
  most independent central banks do the best job
  controlling inflation.
• Evidence also shows that this is achieved without
  negative impacts on the real economy.

6
The Objectives of a Modern Central Bank
7
The Objectives of a Modern Central Bank

• Financial System Stability
• A stable financial system is a necessity for an
  economy to operate efficiently.
• Stable Interest Rates
• Interest rate volatility creates risk for both
  lenders and borrowers.
• Stable Exchange Rates
• Variable exchange rates make the revenues from
  foreign sales and the cost of purchasing imported
  goods hard to predict.
• Independence
• To keep inflation low, monetary decisions must be
  made free of political influence

8
Principles of Central Bank Design
9
Principles of Central Bank Design

• Decision-making by Committee
• Pooling the knowledge of a number of people
  yields better decisions than decision making by
  an individual.
• Accountability
• Policymakers must be held accountable to the
  public they serve.
• Transparency
• Policymakers must clearly communicate their
  objectives, decisions, and methods to the public.
• Policy Framework
• Policymakers must clearly state their policy
  goals and the tradeoffs among them.

10
Chapter 16

• The Structure of Central Banks
• The U.S. Federal Reserve and the European Central
  Bank

11
Federal Reserve Act of 1913

• Fear of centralized power guided central bank
  activities in the 19th century
• The First Bank of the U.S. was disbanded in 1811
• The Second Bank of the U.S. was disbanded in 1836
  
• As a result, banking panics became regular
  events, culminating in the panic of 1907.
• Widespread bank failures and depositor losses
  convinced the U.S. that a central bank was
  needed.
• Questions arose as to whether such a monetary
  authority would be private or a government
  institution.
• Federal Reserve Act of 1913 was a compromise that
  created the Federal Reserve.

12
Formal Structure of the Federal Reserve System

• Design was intended to diffuse power along the
  following dimensions
• Regions of the U.S.
• Government and private sector interests
• Needs of bankers, businesses, and the public
• The system as it exists now includes
• Twelve Federal Reserve Banks
• Member Banks (around 3,600)
• Board of Governors (BOG) of the Federal Reserve
  System
• Federal Open Market Committee (FOMC)
• Federal Advisory Council

13
Member Banks

• National banks (banks chartered by the Office of
  the Comptroller of the Currency) are required to
  be members.
• State commercials banks may elect to join.
• Prior to 1980, only member banks were required to
  maintain reserves.
• By 1987, all depository institutions were
  required to maintain reserves, eliminating this
  downside of membership.

14
Federal Reserve Banks
15
The Federal Reserve System

• As the bank for the U.S. government, they
• issue new currency (Federal Reserve Notes) and
  destroy old, worn currency
• maintain the U.S. Treasury's bank account, paying
  checks, and processing electronic payments and
• manage the U.S. Treasurys borrowings. That
  means issuing, transferring, and redeeming U.S.
  Treasury bonds, notes, and bills.
• the Treasury decides what they want, and the
  Federal Reserve Banks implements it.

16
The Federal Reserve System

• As the Bankers Bank, they
• hold deposits for the banks in their districts
• on which they pay no interest
• operate and ensure the integrity of a payments
  network for clearing checks and transferring
  funds electronically
• make funds available to commercial banks within
  the district through discount loans,
• they charge the discount rate

17
The Federal Reserve System

• As the Bankers Bank, they
• Act as liaisons between business community and
  the Federal Reserve System
• Collect data on local business conditions
• Research on monetary policy
• Examine bank holding companies and
  state-chartered member banks
• supervise and regulate financial institutions in
  the district to ensure their safety and soundness
• Also evaluate proposed bank mergers and new
  operations
• collect and make available data on business
  conditions.

18
Twelve Federal Reserve Banks

• Each district has a main Federal Reserve Bank and
  at least one branch office
• The banks are quasi-public
• Owned by member commercial banks in the district
• Member banks elect six directors, while three
  directors are appointed by the Board of Governors
• Directors represent professional bankers,
  prominent business leaders, and public interests
  (three from each group)

19
Board of Governors

• The seven governors are appointed by the
  President, and confirmed by the Senate
• Server 14-year terms on a rotating schedule every
  2 years.
• Chairman and Vice Chairman appointed by the
  President for four-year renewable terms.
• The Chairman is considered one of the most
  powerful positions affecting world economies
• Ben Bernanke replaced Alan Greenspan
• All are members of the FOMC.
• Serve in an advisory capacity to the President of
  the United States, and represent the U.S. in
  foreign economic matters.
• Each district banks has a 9 member board
  comprised of 3 appointments from Washington and 6
  from the local banking community

20
Chairman of the Federal Reserve System

• Spokesperson for the entire Federal Reserve
  System
• Negotiates, as needed, with Congress and the
  President of the United States
• Sets the agenda for FOMC meetings
• The chairman has effective control over the
  system, even though he doesnt have legal
  authority to exercise control over the system and
  its member banks.

21
The Federal Reserve System

• The Board of Governors
• Analyzes financial and economic conditions, both
  domestic and international.
• Sets the reserve requirement
• the level of reserves banks are required to hold.
• Effectively set the discount rate.
• Administers consumer credit protection laws.
• Approves bank merger applications.

22
The Board of Governors

• Along with the Reserve Banks,
• regulates and supervises the banking system,
• examining individual banks for safety and
  soundness and for compliance with the law.
• Supervises and regulates the regional Reserve
  Banks
• their budgets and their presidents salaries.
• Collects and publishes detailed statistics about
  the system's activities and the economy at large.
  
• On the Board's Website, you can find information
  about
• the amount of money in the economy (M1, M2, and
  so on)
• interest rates, exchange rates inflation
• the banking systems assets and liabilities
• the level of production in U.S. industry the
  level of household wealth.

23
The Federal Reserve System

• Federal Open Market Committee (FOMC)
• Twelve Voting Members
• Seven Governors
• President of the Federal Reserve Bank of New York
• Four (of the 12) Regional Reserve Bank Presidents
• On a rotating basis
• The chairman of the BOG is also the chair of this
  committee

24
Federal Open Market Committee

• Make decisions regarding open market operations,
  to influence the monetary base.
• Open market operations are the most important
  tool that the Fed has for controlling the money
  supply
• along with reserve requirements and the discount
  rate
• All actions are directed from the Federal Reserve
  Bank of New York, where securities are bought
  /sold as required.

25
Federal Open Market Committee Meeting

• Meet eight times each year (about every six
  weeks)
• Important agenda items include
• Reports on open market operations (foreign and
  domestic)
• National economic forecasts are presented
• Discussion of monetary policy and directives,
  including views of each member
• Formal policy directive made (change ff rate?)
• Post-meeting announcements, as needed

26
The Federal Reserve System

• Policy Framework
• "The Board of Governors of the Federal Reserve
  System and the Federal Open Market Committee
  shall maintain long run growth of the monetary
  and credit aggregates commensurate with the
  economy's long run potential to increase
  production, so as to promote effectively the
  goals of maximum employment, stable prices, and
  moderate long-term interest rates."

27
The European Central Bank
28
ECB

• European Central Bank
• Executive board consists of the president, vice
  president, and four members, all serving
  eight-year terms.
• The policy group consists of the executive board
  and governors from the 11 member countries
  central banks.
• The ECB is the most instrument and goal
  independent central bank in the world.

29
The European Central Bank

• Differences between ECB and The Fed
• ECB does not regulate financial institutions
• ECBs monetary intervention is accomplished by
  all the National Central Banks.
• ECBs budget is controlled by the National
  Central Banks

30
The European Central Bank

• Policy Framework
• "The primary objective of the European System of
  Central Banks shall be to maintain price
  stability. Without prejudice to the objective of
  price stability, the ECB shall support the
  general economic policies in the European
  Community," including the objective of
  sustainable and noninflationary growth.

31
Federal Reserve Power Structure
32
How Independent is the Fed?

• How free the Fed is from presidential and
  congressional pressure in pursuing its goals?
• Instrument Independence
• The ability of the central bank to set monetary
  policy instruments.
• Goal Independence
• The ability of the central bank to set the goals
  of monetary policy.
• Congress can enact legislation to gain control of
  the Fed
• For example, Congress requires the Fed to
  announce its objective growth rate for the money
  supply.
• Evidence suggests that the Fed is free along both
  dimensions.
• The 14-year terms (non-renewable) limits the
  incentives to curry favor with either the
  President or Congress.

33
The Feds Goals and Targets

• The Fed conducts the nations monetary policy,
  which means that it adjusts the quantity of money
  in circulation.
• The Feds goals are to keep inflation in check,
  maintain full employment, moderate the business
  cycle, and contribute to achieving long-term
  growth.
• In pursuit of its goals, the Fed pays close
  attention to interest rates and sets a target
  that is consistent with its goals for the federal
  funds rate, which is the interest rate that the
  banks charge each other on overnight loans of
  reserves.

34
Case for Independence

• The notion of the political business cycle stems
  from the previous argument.
• Expansionary monetary policy leads to lower
  unemployment and lower interest rates
• A good idea just before elections.
• Post-election, this policy leads to higher
  inflation, and therefore, higher interest rates
• Political pressure will tend to add an
  inflationary bias to monetary policy.
• This stems from short-sighted goals of
  politicians.
• In the short-run, high money growth does lead to
  lower interest rates. In the long-run, however,
  this also leads to higher inflation.

35
Case for Independence

• Other arguments include
• The Treasury may seek to finance the government
  through bonds purchased by the Fed. This may
  lead to an inflationary bias.
• Politicians have repeatedly shown an inability to
  make hard choices for the good of the economy
  that may adversely affect their own well-being.
• Its independence allows the Fed to pursue
  policies that are politically unpopular, yet in
  the best interest of the public.

36
Case Against Independence

• Some view Fed independence as undemocratic
• An elite group controlling an important aspect of
  the economy with little accountability
• We hold the President and Congress accountable
  for the state of the economy, yet they have
  little control over one of the most important
  tools to direct the economy.
• Further, the Fed has not always been successful
  in the past.
• It has made mistakes during the Great Depression
  and inflationary periods in the 1960s and 1970s.
• The Fed can succumb to political pressure
  regardless of any state of independence.

37
The Four Players in the Money Supply Process

• Central bank the Fed
• Banks
• Depositors
• Borrowers from banks

38
The Federal Reserves Balance Sheet

• On the Feds balance sheet, the largest and most
  important asset is U.S. government securities.
• The most important liabilities are Federal
  Reserve notes in circulation and banks deposits.
• The sum of Federal Reserve notes, coins, and
  banks deposits at the Fed is the monetary base.

39
A few preliminaries

• Reserves (R )
• the portion of deposits that banks have not lent.
• A banks liabilities include deposits, assets
  include reserves and outstanding loans.
• 100-percent-reserve banking
• a system in which banks hold all deposits as
  reserves.
• Fractional-reserve banking
• a system in which banks hold a fraction of their
  deposits as reserves.

40
Deposit Creation

• Creation of Deposits
• (assuming 10 Reserve Requirement and 100
  increase in reserves)

41
The Federal Reserves Balance Sheet Liabilities

• The monetary liabilities of the Fed include
• Currency in circulation
• The physical currency in the hands of the public,
  which is accepted as a medium of exchange
  worldwide.
• Reserves
• All banks maintain deposits with the Fed, known
  as reserves.
• The required reserve ratio determines the
  required reserves that a bank must maintain with
  the Fed.
• Any reserves deposited with the Fed beyond this
  amount are excess reserves.
• The Fed does not pay interest on reserves, excess
  reserves are usually kept to a minimum.

42
The Federal Reserves Balance Sheet Assets

• The monetary assets of the Fed include
• Government Securities
• These are the U.S. Treasury bills and bonds that
  the Federal Reserve has purchased in the open
  market.
• Purchasing Treasury securities increases the
  money supply.
• Discount Loans
• Loans made to member banks at the current
  discount rate.
• An increase in discount loans will increase the
  money supply.

43
FED Monetary Policy Tools Interest rates

• The Federal Reserve induces interest rate changes
  by changing the money supply
• If more money is injected into the economy, then
  there is an increase in loanable funds (supply of
  money), and rates drop.
• When the FED tightens monetary policy, money
  supply drops, interest rates increase and
  consumers feel less wealthy.
• The Fed Open Market Committee (FOMC)
• The major monetary policy-making body of the FR
  System
• Main responsibilities are to formulate policies
  to promote full employment, economic growth,
  price stability, a sustainable pattern of
  international trade
• Open market operations the purchase and sale of
  U.S. government and federal agency securities
• Sets ranges for growth of monetary aggregates and
  directs the FR in foreign exchange markets

44
3 Monetary Policy Tools

• Tools used by the FRB (FED) for implementing
  monetary policy
• Open market transactions Buying and selling of
  treasury securities changes the money supply in
  the economy, affecting interest rates
• Perhaps the most frequently used tool available
  by the FED
• Decisions are made by the FOMC (Fed Open Market
  Committee)
• Reserve requirements changes the amount of
  reserves that banks must hold, affecting the
  amount of money creation, and thus supply.
• Powerful tool, but infrequently used (once a
  decade or so) because of the disequilibrium that
  it creates
• Discount window lending Sets the base lending
  rate among financial institutions
• A somewhat imaginary rate since few institutions
  actually borrow from the Fed, so this requires
  nothing other than a statement by the Fed Chairman

45
Reserve Requirements (RR)

• An increase in the rr ratio boosts the reserves
  that banks must hold
• By decreasing their lending, and decreases the
  quantity of money.
• If the Fed increases the reserve requirement from
  10 to 12, then banks would have to recall loans
  to the extent that is necessary to meet reserve
  requirements
• Consider this affect on a monetary base of 1,000
  billion, assuming that no money leaves the
  banking system (all loans return as deposits)
• Money Supply with
• 10 reserve requirement 1,000B(10)/(.10)
  10,000 billion
• 12 reserve requirement 1,000B(10)/(.120)
  8,333 billion
• The change in total quantity of money (supply) is
  1,667 billion or 17
• The reserve requirement rarely change and is not
  an instrument that the FED uses for short-term
  policy implementation.

46
Controlling the Quantity of Money

• How an Open Market Operation Works
• When the Fed conducts an open market operation by
  buying a government security, it increases banks
  reserves.
• Banks loan the excess reserves.
• By making loans, they create money.
• The reverse occurs when the Fed sells a
  government security.
• An open market operation that increases banks
  reserves also increases the monetary base.

47
The Federal Reserves Balance Sheet Impact of
Open Market Operations

• The impact of open market operation
• Purchase of bonds increases the money supply
• Decreases the fed funds rate
• Making discount loans increases the money supply
• Decreases the fed funds rate short-term (days)

48
Commercial Banks Balance Sheet
Commercial Bank
Assets
Liabilities
Reserves (R) Outstanding loans
Deposits (D)
49
Control of Monetary Base

• Open Market Purchase From a Bank

Manhattan CommercialBank
Federal Reserve Bank of New York
Liabilities
Liabilities
Assets
Assets
Result R ? 100, MB ? 100
50
The Federal Reserve Balance Sheet

• Discount Lending

Result ?R ? 100, MB 100
What happens to interest rates?
51
Market for Reserves and the Fed Funds Rate

• Federal funds rate
• The rate banks charge each other for overnight
  loans.
• The rate that is directly effected by open market
  operations
• Discount rate
• The rate the banks pay to borrow from the fed
• Higher than the fed funds rate
• Fed is often called the lender of last resort

52
Market for Reserves and the Fed Funds Rate

• Demand curve slopes down because iff ?, ER ? and
  Rd up
• Equilibrium iff where Rd Rs
• Supply curve is flat because if iff is higher
  than id then banks will only borrow at id

53
Market for Reserves and the Fed Funds Rate

• Open market purchase, Rs shifts to right and iff
  ?
• Expansionary monetary policy

54
Market for Reserves and the Fed Funds Rate

• The Fed lowers id, but does not cross the demand
  curve
• Rs shifts down but no impact on the fed funds
  rates
• As long as id gtiff

55
Market for Reserves and the Fed Funds Rate

• ? in reserve req.
• Require reserves ?, Rd shifts to right, iff ?
• Banks must hold more reserves with the Fed

56
Tools of Monetary Policy Open Market Operations
at the Trading Desk

• The staff reviews the activities of the prior day
  and issue forecasts of factors affecting the
  supply and demand for reserves.
• This information is used to determine reserve
  changes needed to obtain a desired fed funds
  rate.
• Government securities dealers are contacted to
  better determine the condition of the market.
• Projections are compared with the Monetary
  Affairs Division of the BOG, and a course of
  action is determined.
• Once the plan is approved, the desk carries out
  the required trades.

57
Monetary Policy Example
BoA has 100 Billion in deposits and keeps 10
billion in reserve while loaning the rest.
The Fed wants to change interest rates, so it
buys Treasuries from BoA for 10B
What happens to the demand and supply of loans?
Which changes first? What happens to interest
rates?
58
Tools of Monetary Policy Discount Loans

• The Feds discount loans are primarily of three
  types
• Primary Credit
• Policy whereby healthy banks are permitted to
  borrow as they wish from the primary credit
  facility.
• Secondary Credit
• Given to troubled banks experiencing liquidity
  problems.
• Seasonal Credit
• Designed for small, regional banks that have
  seasonal patterns of deposits.

59
Tools of Monetary Policy Discount Loans

• The Fed stands ready to lend.
• As demand increases, Rs shifts, limiting the
  impact on iff.

60
Tools of Monetary Policy Discount Loans

• Lender of Last Resort Function
• To prevent banking panics FDIC fund not big
  enough
• Examples Continental Illinois and Franklin
  National Banks
• To prevent nonbank financial panics
• Example 1987 stock market crash
• Announcement Effect
• Announced changes to the discount rate does not
  effect interest rates

61
Tools of Monetary Policy Reserve Requirements

• Advantages
• Powerful effect
• Disadvantages
• Small changes have very large effect on Ms
• Raising rates can cause liquidity problems for
  banks
• Frequent changes cause uncertainty for banks

62
Goals of Monetary Policy

• Goals
• High employment
• Economic growth
• Price stability (inflation)
• Interest rate stability
• Financial market stability
• Foreign exchange market stability
• Goals often in conflict
• 12 vs. 34

63
Tools of Monetary Policy Advantages of Open
Market Operations

• Open market operations are initiated by the Fed
• the volume of these transactions is entirely
  under the control of the Board of Governors.
• The operations are flexible and concise, useful
  for both small and large changes in the monetary
  base.
• Unanticipated effects are easily reversed, if
  needed (overshooting the target).
• the policy is implements quickly, avoiding
  administrative delays.

64
Central Bank Strategy Use of Targets

• Generally, the Fed wishes to achieve certain
  goals, but the tools at its disposal only allow
  for indirect influence.
• All central banks, then, are limited to aiming at
  variables that lie between their tools and the
  achievement of the desired goals.
• The central bank identifies intermediate targets
  which it aims to affect via its operating
  targets.
• The following diagram help explain these concepts.

65
Central Bank Strategy Use of Targets
66
Central Bank Strategy Criteria for Choosing
Targets

• Criteria for Intermediate Targets
• Measurability
• Controllability
• Predictably effect on goals
• Interest rates aren't clearly better than Ms on
  criteria 1 and 2 because hard to measure and
  control real interest rates
• Criteria for Operating Targets
• Same criteria as above
• Reserve aggregates and interest rates about equal
  on criteria 1 and 2, but for 3 if intermediate
  target is Ms then reserve aggregate is better

67
Central Bank Strategy Choosing the Targets

• As shown in the previous figure, the Fed can use
  two different target variables interest rates
  and aggregates.
• The Fed can only choose one of the two variables.
  
• Any action which affects one of the targets will
  have some impact on the other target.

68
Fed Policy Procedures Historical Perspective

• Early Years Discounting as Primary Tool
• Real bills doctrine
• Belief that providing loans to support the
  production of goods and services would not be
  inflationary
• Rise in discount rates in 1920 recession
  19201921
• Increase from 4 ¾ to 6, caused a large decline
  in money supply
• Discovery of Open Market Operations
• Made discovery accidentally
• In 1920s, purchased bonds to generate income
• Noticed that Fed purchases caused reserves to ?
  and interest rates to ?
• Great Depression
• Failure to prevent bank failures
• Did not step in as the lender of last resort
• Result sharp drop in Ms

69
Fed Policy Procedures Historical Perspective

• Targeting Monetary Aggregates 1970s
• Federal funds rate as operating target with
  narrow band
• Procyclical Ms
• New Fed Operating Procedures 19791982
• De-emphasis on federal funds rate
• Nonborrowed reserves operating target
• The Fed still used interest rates to affect
  economy inflation
• De-emphasis of Monetary Aggregates 1982 1990s
• Targeted 3 for the fed funds rate from late
  1992Early 1994
• Raised the rate to 6 by early 1995.
• Lowered the rate in the face of a slowing economy
  and LTCM crisis.
• Continued this trend in 2001, when the economy
  faced a recession.

70
Monetary Targeting in Other Countries

• United Kingdom
• Targets M3 and later M0
• Problems of M as monetary indicator
• Canada
• Targets M1 till 1982, then abandons it
• 1988 declining p targets, M2 as guide
• Germany
• Targets central bank money, then M3 in 1988
• Allows growth outside target for 23 years, but
  then reverses overshoots

71
Monetary Targeting in Other Countries

• Japan
• Forecasts M2 CDs
• Innovation and deregulation makes less useful as
  monetary indicator
• Lessons from Monetary Targeting
• Success requires correcting overshoots
• Operating procedures not critical
• Breakdown of relationship between M and goals
  made M-targeting untenable led to inflation
  targeting

72
The New International Trend in Monetary Policy
Strategy Inflation Targeting

• New Zealand
• Passed the Reserve Bank of New Zealand act (1990)
• Policy target agreement set an annual inflation
  target in the range of 0 to 2
• Canada
• Established formal inflation targets, starting in
  1991
• Targets have also been adjusted as needed
• United Kingdom
• Established formal inflation targets, starting in
  1992
• Targets have also been adjusted as needed

73
The New International Trend in Monetary Policy
Strategy Inflation Targeting

• Lessons from Inflation Targeting
• Decline in inflation still led to output loss
• Worked to keep inflation low
• Kept inflation in public eyereduced political
  pressures for inflationary policy