Central Banks, Banks and the money Supply process

Part 1:

Goals and Structure of Central Banks (MMG, Ch. 13)

Part 2:

Money and Money Supply Process (MMG, Ch. 3 and 14)

Price Stability Goal •

Main goal of central banks: price stability

•

Benefits of price stability 1. 2. 3. 4. 5. 6.

•

Improving transparency of relative prices Reducing distortions of tax and social security systems Preventing arbitrary redistribution of wealth and income Reducing inflation risk premia in interest rates Avoiding unnecessary hedging activities Increasing benefits of holding cash

Empirical evidence: higher inflation produces lower economic growth in the long run (e.g. particularly in hyperinflation countries)

Other Goals of Monetary Policy • High employment or low unemployment (consistent with natural rate of unemployment)

• Economic growth in the long run • Stability of financial markets • Interest-rate stability

• Foreign exchange market stability

Price Stability as the Primary Goal? • Long run: no trade off between price stability and other goals (e.g. price stability enhances long-run economic growth as well as financial and interest-rate stability) • Short run: trade off between price stability and other goals (e.g. monetary expansion (M  or i ↓) => output  and inflation ) • Time-inconsistency problem: stimulating systematically output in the short run leads to long-run inflation

Time-Inconsistency Problem • Good long-run plan, reneged by short-run temptations => good long-term plan is time-inconsistent • In monetary policy: – Long-run goal: price stability – Short-run temptation: expansionary short-term policy to increase output (but this produces higher inflation) – Rational agents (workers and firms) are aware of these shortterm incentives and raise their inflation expectations – Higher inflation expectations drive wages and prices up

• How to solve the time-inconsistency problem? • Delegate monetary policy to an independent central bank with a pre-set behavior rule to achieve price stability

Behavioral Rule and Nominal Anchor • Behavior rule implies choosing a nominal anchor (or target) to which the central bank commits its policy

• Typical nominal anchors: exchange rate, monetary aggregate, inflation rate (next week) • If behavior rule is credible (likely with independent central bank), the time-inconsistency problem is solved • Nominal anchor as basis to which agents can form their inflation expectations which drive current inflation

Structure of the Bank of England • Founded in 1694, the Bank of England (BoE) is one of the oldest in the world

• Main decision making body: Monetary Policy Committee (MPC) • MPC meets monthly and consists of 9 members: Governor + 2 Deputy Directors + 6 other members • Decisions on monetary policy made by voting

Structure of Federal Reserve System Main entities of the Federal Reserve System: 1. 12 Federal Reserve Banks (FRBs) 2. Board of Governors (BG)

3. Federal Open Market Committee (FOMC)

Federal Reserve Banks: Structure • Quasi-public institution owned by private commercial banks in the district that are members of the Fed system • Bank members in each district elect 6 directors; 3 more are appointed by the BG • 9 directors appoint the president of the bank subject to approval by the BG

• 5 of the 12 FRB’s presidents have a vote in the Federal Open Market Committee (FOMC) – the president of the NY Fed permanent member of the FOMC

Federal Reserve Banks: Functions • Hold deposits for banks in the district

• Administer and make loans to banks in their districts • Ensure working of payment system

• Supervise and regulate financial institutions • Issue new currency and withdraw damaged currency from circulation • Collect data on local conditions and research topics related to the conduct of monetary policy

Board of Governors: Structure • 7 members headquartered in Washington, D.C.

• Each member appointed by the U.S. president and confirmed by the Senate • Required to come from different districts • To limit government’s control, 14-year non-renewable term

• Chairman is chosen from the governors and serves fouryear (renewable) term • BG has the majority of the votes in the FOMC

Board of Governors: Functions • Votes on the conduct of open market operations within the FOMC • Board also sets reserve requirements • Controls the discount rate • Bank regulation functions: (i) approves bank mergers and applications for new activities, (ii) specifies permissible activities of bank holding companies, (iii) supervises activities of foreign banks operating in the U.S.

Federal Open Market Committee • 12 members: 7 BG members + president of NY Fed (permanent) + 4 presidents of other FRBs (rotation) • Meets eight times a year (about every six weeks) • Issues directives to the trading desk at the NY Fed (implementation of monetary policy is centralized) • Chairman: Janet Yellen (also chairman of BG)

Structure of the European Central Bank • Structure similar to the Federal Reserve System • European System of Central Banks (ESCB) = ECB + 28 National Central Banks (NCBs) of all EU countries • Eurosystem: ECB + 19 NCBs of the euroarea countries • Main ECB’s decision-making bodies – Executive Board (EB): 6 members – Governing Council (GC): 6 EB members + 19 NCB governors

Governing Council • 25 members: 6 EB members (President, vice-president and four other members) + 19 NCB governors • Meets every month at ECB in Frankfurt (Germany) • Decides on key interest rates, reserve requirements and provision of liquidity to banking system of euro area • Normally operates by consensus • GC operates on a rotating system of votes • President: Mario Draghi (since 1st Nov 2011)

National Central Banks • Implement monetary policy set by the GC (providing liquidity to banking system in their countries)

• Ensure settlement of domestic and cross-border payments (payment system) • Issuing and handling euro notes in their countries • Collection of national statistical data • Depending on national laws, NCBs “might” be involved in banking supervision in particular with reference to liquidity and capital requirements (e.g. DNB)

Single Supervisory Mechanism (SSM) • Since November 2014, the ECB fully assumed supervisory tasks and responsibilities in the framework of the Single Supervisory Mechanism (SSM)

• The ECB oversees all "significant" and "less significant" credit institutions in the participating countries through direct and indirect supervision. • To qualify as significant, banks must fulfil at least one of these criteria in terms of (1) size, (2) economic importance, (3) cross-border activities and (4) direct public financial assistance

Central Bank Independence • How independent from political pressures (e.g. government) are central banks? • Two main types of independence of central banks: 1. Instrument Independence: ability of the central bank to set monetary policy instruments 2. Goal Independence: the ability of the central bank to set the goals of monetary policy

How Independent is the BoE? • Instrument independence: Government can overrule the Bank and set rates only in in “extreme economic circumstances” • Goal independence: Inflation target set by the Chancellor of the Exchequer • Financial independence: determines its own budget • Political independence: Governor appointed by Chancellor (5-year term, renewable) • Bank of England less independent than Fed and ECB

How Independent is the Fed? • Both instrument and goal independent • Financial independence: independent revenue due to holdings of securities (and loans to banks) • Political independence: Fed is structured by legislation from Congress and accountable for its actions Also presidential influence – Through his influence on Congress – Appoints members of Board of Governors – Appoints chairman although terms are not concurrent

How Independent is the ECB? • Most instrument and goal independent in the world (based on Maastricht Treaty) • Financial independence: determines its own budget and Eurosystem is prohibited from financing governments • Political independence: – Executive-Board members: 8-year term (non renewable) – removal only in case of “incapacity and serious misconduct” – appointed by heads of states of all EMU members – NCB governors appointed by national governments for a minimum of 5 years

Should Central Banks be Independent? Cases For Independence: 1. Independent central bank likely to have longer-run objectives (e.g. price stability), politicians don't 2. Avoids political business cycle (e.g. stimulating economy to maximize re-election chances) 3. Less likely budget deficits financed by printing money or directly purchasing government bonds (primary market) 4. Too important (and complicated) to leave to politicians

Should Central Banks be Independent? Cases Against Independence:

1. Undemocratic – lack of accountability 2. Lack of coordination between monetary and fiscal policy 3. Independent central bank not always operate successfully (e.g. Fed during the Great Depression) => Trend towards greater independence (empirical evidence: higher independence => lower inflation)

Inflation and Independence

Part 2: Money and Money Supply Process Economist‟s Meaning of Money (“or Money Supply”): Anything that is generally accepted in payment for goods and services or in repayment of debts

Functions of Money 1. Medium of exchange: Eliminates the trouble of finding a double coincidence of needs (reduces transaction costs). As medium of exchange money must: – – – – –

be easily standardized be widely accepted be divisible be easy to carry not deteriorate quickly

2. Unit of account: used to measure value in the economy 3. Store of value: used to save purchasing power over time; most liquid of all assets but loses value during inflation

Evolution of Payments System Payment system: method of conducting transactions in the economy. It evolves over time: 1. Commodity Money: precious metals (e.g. gold or silver)

2. Fiat Money: paper money decreed by governments as legal tender 3. Cheques: instruction to your bank to transfer money from you account 4. Electronic payments (e.g. online bill pay)

5. E-Money (electronic money): Debit cards, Stored-value cards, Smart cards, E-cash

Measuring Money •

Various definitions of monetary aggregates: 1. Differences in what members of each society accept as a medium of exchange. 2. Due to financial innovations, some assets are accepted as money in some societies but not in others. 3. Differences amongst institutions responsible for issuing monetary aggregates, normally the central bank and depository institutions.

Measuring Money M1 – The narrowest measure of money – More or less the same for most countries – M1 consists of currency as well as demand deposits + other chequeable deposits M2 – Monetary aggregates broader than M1 – Considerably differs from one country to another – The savings deposits and most time deposits are usually included in M2

Measuring Money M3 – Broadest definition of money – Definitions vastly differ from one country to another – Many central banks (e.g. ECB and BoE) calculate it – However, a number of central banks no longer do (e.g. Fed discontinued calculating M3 in March 2006)

Which Is The Most Accurate Aggregate? •

Which measure should central banks consider when trying to affect variables (e.g. inflation) in the economy? –

If the monetary aggregates move together, it does not matter much – If they do not move together, then what one monetary aggregate tells us is happening to the money supply might be quite different from what another aggregate would tell us

•

M3 is less affected by substitution between various liquid asset categories and is more stable than narrower definitions of money like M1

M1 and M3 in the Euro Area

Money Supply Process Three Players:

1. Central bank (CB): government agency that oversees the banking system and is responsible for the conduct of monetary policy (ECB, Fed, BoE, etc) 2. Banks: depository institutions like commercial banks and saving and loan institutions

3. Depositors: individuals and institutions holding deposits at banks

The CB’s Balance Sheet Assets

Liabilities

Government securities (S)

Currency in circulation (C)

Loans to Banks (LB)

Reserves (R)

Monetary Base (or high-powered money) (MB) MB = C + R

The CB’s Balance Sheet Liabilities Currency in circulation (C): in the hands of the public Reserves (R): bank deposits at the CB and vault cash. Two categories: required reserves and excess reserves

Assets Government securities (S): holdings by the CB that affect money supply and earn interest Loans to Banks (LB): provision of reserves or loans to banks by CB at the lending rate

Control of the Monetary Base How is the MB (= C + R) controlled by the CB?

1. Open Market Operations (OMOs): purchase or sale of government securities in the open market 2. Loans to Banks (LB): loans to banks by CB at a lending rate

The ‘composition’ of the MB can change as a result of 3. Currency Withdrawal (e.g. shifts from deposits into currency)

1.

Open Market Operations

1 Open Market Purchase of CB from a Bank Banking System Assets Liabilities Securities – 100 Reserves + 100

Assets

Central Bank Liabilities

Securities + 100

Reserves + 100

Result: R  100 (C unchanged) => MB  100 2.1 Open Market Purchase from Non-Bank Public „If Person Deposits Cheque‟ Assets

Non-Bank Public Liabilities

Securities – 100 Deposits + 100 Banking System Assets Liabilities

Reserves + 100

Assets

Central Bank Liabilities

Securities + 100

Reserves + 100

Deposits + 100

Result: R  100 (C unchanged) => MB  100 (same as above !)

1.

Open Market Operations of CB

2.2 Open Market Purchase from Non-Bank Public “If Person cashes Cheque” Assets

Non-Bank Public Liabilities

Securities – 100 Currency + 100

Assets

Central Bank Liabilities

Securities + 100

Currency + 100

Result: C  (R unchanged) => MB  100

–

The effect of an open market purchase on reserves (R) depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits (effect is uncertain)

–

The effect of an open market purchase on the monetary base (MB) always increases the base by the amount of the purchase (effect is certain)

2.

Loans to Banks from CB

1 CB makes a loan to a bank that requests it Banking System Assets Liabilities Reserves + 100 Loan +100

Central Bank Assets Liabilities Loan + 100 Reserves + 100

Result: R  100 (C unchanged) => MB  100

2 Bank pays off a loan from CB Banking System Assets Liabilities Reserves - 100 Loan - 100

Central Bank Assets Liabilities Loan - 100 Reserves - 100

Result: R  100 (C unchanged) => MB  100

3.

Currency Withdrawal

Non-Bank Public Assets Liabilities Deposits – 100 Currency + 100

Central Bank Assets Liabilities Currency + 100 Reserves – 100

Banking System Assets Liabilities Reserves – 100 Deposits – 100

Result: R  100, C  100 => MB unchanged (only change in the composition of MB)

Deposit Creation Step 1: Open Market Purchase of CB from Safe Bank Safe Bank Liabilities

Assets Securities Reserves

– 100 + 100

Safe bank’s excess reserves increase by 100. Step 2 Suppose the bank decides to make a loan of 100. When it makes a loan, it sets up a check account and puts the proceed of the loan into this account: Safe Bank Liabilities

Assets

Securities Reserves Loans

– 100 100 + 100

deposits 100

*** the bank has created (chequable) deposits by its act of LENDING. Because deposits are part of the money supply: the bank’s act of lending has created MONEY

The final T account of Safe Bank is Safe Bank Liabilities

Assets Securities Loans

– 100 + 100

Step 3 Borrower of Safe Bank spends loan in favor of customer of Bank A Bank A

Assets Reserves

Liabilities + 100

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Deposits + 100

14-47

Deposit Creation: Banking System Step 4: Bank A makes loan after holding required reserves (r = 10%) Bank A

Assets Reserves Loans

Liabilities Deposits

+ 10 + 90

+ 100

Step 5: Borrower of Bank A purchases goods and services with the loan in favor of customer of Bank B Bank B Assets Liabilities Reserves + 90 Deposits + 90

Step 6: The process goes on…. Assets Reserves Loans

+ 9 + 81

Bank B Liabilities Deposits

+ 90

Deposit Creation If Bank A buys securities with € 90 check Bank A Assets Liabilities Reserves Securities

+ 10 + 90

Deposits

+ 100

Seller deposits € 90 at Bank B and process is same Whether a bank chooses to use its excess reserves to make loans or to buy securities, the effect on deposit expansion is the same

Simple Deposit Multiplier Deriving the formula R = RR = r  D D =

1 r

R

D =

1 r

 R

(assuming ER=0) 1/r = deposit multiplier

ΔD = change in total chequable deposits

r = required reserve ratio ΔR = change in reserves

Deposit Creation: Banking System as a Whole Banking System Assets Liabilities Securities – 100 Deposits + 1000 Reserves + 100 Loans + 1000 Critique of Simple Model Deposit creation stops or is reduced if: 1.Banks holds excess reserves (ER) 2.Proceeds from loan are kept in currency (C)

Money Multiplier • The money supply process is more complicated than the simple model

• Money Multiplier Model extends the latter with: 1. Banks’ decision on level of excess reserves (ER) Assumption: ER = e * D (e = excess reserve ratio) 2. Depositors’ decision on currency holding (C) Assumption: C= c*D (c = currency ratio)

Deriving the Money Multiplier Money Multiplier M = m  MB Deriving Money Multiplier R = RR + ER RR = r  D R = (r  D) + ER

M = money supply m = money multiplier MB = monetary base

R = total reserves RR = required reserves ER = excess reserves

r = RR/D = required reserve ratio

Adding C to both sides R + C = MB = (r  D) + ER + C MB = (r  D) + (e  D) + (c D) = (r + e + c)  D

e = ER/D = excess reserve ratio c = C/D = currency ratio

D = deposits C = currency

Deriving the Money Multiplier D=

1 r+e+c

 MB

M = (D + C) = D + (c  D ) = (1 + c)  D M= m = m < 1/r

m>1

1+c r+e+c 1+c r+e+c

 MB m = Money Multiplier

(Why? No multiple expansion for currency and excess reserves) (as long as (r + e) < 1)

Deriving the Money Multiplier • Numerical example Required reserve ratio => Excess reserve ratio => Currency Ratio =>

r = 10 % e = 10 % c = 20 %

m = (1+0.2)/(0.1+0.1+0.2) = 3

With simple deposit multiplier => 1/r = 1/0.1 = 10

Factors Affecting the Money Supply M =

1+c MB r+e+c

where MB = MBn + BR

MBn = non-borrowed MB (controlled with OMOs by CB)

BR = borrowed reserves from CB (under banks’ discretion) 1.

Changes in MBn (MBn , M  )

2.

Changes in BR (BR , M  )

3.

Changes in the Required Reserve Ratio, r (r , m  , M )

4.

Changes in the Currency Ratio, c (c , m  , M  )

5.

Changes in the Excess Reserve Ratio, e ( e , m  , M  )

Can the CB Control the Money Supply? • If c and e are stable and predictable, we can expect a close link between MB and M (e.g. m stable) • However, money multiplier m tends to show large swings (mostly due to changes in c and e) • Money supply control very difficult in practice

• One of the main reasons why nowadays most CBs don’t use monetary base as instrument but interest rates (next week)