Chapter VIII: Money supply and monetary policy

1. Chapter VIII: Money supply and monetary policy A. The ECB and the Fed B. The supply of base money C. Controlling the money supply D. Open market operations E. The conduct of monetary policy F. Application: German hyperinflation

2. European System of Central Banks

3. The Eurosystem

4. European System of Central Banks • The European System of Central Banks (ESCB) consists of the European Central Bank (ECB) and the national central banks of the EU Member States • The activities of the ESCB are carried out in accordance with the Treaty establishing the European Community (Treaty) and the Statute of the European System of Central Banks and of the European Central Bank (ESCB/ECB Statute)

5. Main consequences of single currency • There is a single exchange rate • There is no escape through lax monetary policy possible • Prices are tied to the same unit of account • Price differences are solely attributable to market forces, not to policy differentials • Price expectations should converge • Nominal interest rates will also converge

6. Convergences of inflation rates

7. Convergence of lendingrates (interbank)

8. ESCB: Basic tasks • The basic tasks by the Eurosystem are: • to define and implement the monetary policy of the euro area; • to conduct foreign exchange operations; • to hold and manage the official foreign reserves of the Member States; and • to promote the smooth operation of payment systems • In addition, the Eurosystem contributes to the prudential supervision of credit institutions and the stability of the financial system

9. Should central banks be independent? • A cornerstone of the monetary constitution of the euro area is the independence of the ECB and of the NCBs (Article 108) • There are fears that a dependent ECB • could succumb to financing large budget deficits of the government • could be asked to monetize too much debt, which would entails an inflationary bias • Central banking also requires expertise and “should not be left to politicians”

10. Should central banks be independent? • Counterarguments: • It is undemocratic to have monetary policy controlled by a non-elected elite group • There is no accountability in central banking, which is a precondition for, and core element of, democratic legitimacy • There is need to coordinate monetary and fiscal policies • The ECB could pursue a policy of self-interest

11. The objectives of the ESCB • The primary objective of the ESCB, as defined in Article 105 of the Treaty, is to maintain price stability • Without prejudice to the primary objective, the ESCB has to support the general economic policies in the EU • In pursuing its objectives, the ESCB has to act in accordance with the principle of an open market economy with free competition, favoring an efficient allocation of resources

12. The supply of “base money” • The central bank creates money of highest liquidity: “high-powered” money or “base money” • She “monetizes” assets by acquiring them and issuing central bank money • Such assets are gold, foreign exchange, and selected securities • We assume for a moment, “base money” = currency in circulation

13. The money supply process • There are four players in the money supply process • The central bank (ECB, Federal Reserve) • Depository institutions (banks) • Depositors (individuals and institutions) • Borrowers (individuals and institutions) • The central bank conducts monetary policy to gear the supply of “base money”

14. Gold Forex Balance sheet of a central bank Assets Liabilities Base money (we simplify:only cash) Securities

15. Central bank assets • Gold and SDR certificates. The latter are issued by the IMF to settle international debt • Foreign exchange. • Claims denominated in foreign currency • Claims against foreigners denominated in euros • Securities of euro area residents. They are denominated in euros (treasury bills and banker’s acceptances) • Intra-Eurosystem claims

16. Eurosystem’s international reserves • The reserve assets of the euro area consist of the Eurosystem’s reserve assets: • the reserve assets of the ECB • the reserve assets held by the national central banks (NCBs) of the participating Member States • Reserve assets must be under the effective control of the relevant monetary authority • They consist of highly liquid, marketable and creditworthy foreign currency-denominated claims on non-residents of the euro area, plus gold, SDRs and reserve positions in the IMF

17. Official reserves (excluding gold) 2007 • Japan and China have accumulated the largest reserves in the world • Russia follows third

18. The euro and globalforeign exchange reserves

19. The control of the monetary base • The quantity-oriented approach to monetary policy purports that the central bank can control the monetary base • It is basically effected via open market operations with commercial banks • The ECB can control OMOs more effectively than foreign reserves, but she can also use interventions in forex markets to change the monetary base

20. Controlling the money supply • Under fixed exchange rates controlling the money supply is more difficult • In this case the central bank has to “sterilize” inflows or outflows of foreign exchange • It renders interest rates endogenous, i.e. they vary in response to sterilizing interventions • Forex interventions will be discussed later

21. Gold Forex Forex inflows with sterilization Assets Liabilities Base money remains fixed Securities

22. OMOs • Among the OMOs, the main refinancing operations (MROs) are the most important, playing a pivotal role in steering liquidity and signaling the stance of monetary policy • Three quarters of liquidity is provided by MROs • MROs were conducted as fixed rate and variable rate tenders with a minimum bid rate • The MROs are regular, liquidity providing, reverse transactions, conducted as standard tenders, with a weekly frequency and normally a maturity of two weeks

23. Longer-term refinancing (LTROs) • Longer-term refinancing operations (LTROs) are carried out through monthly standard tenders and have a maturity of three months • LTROs are regular open market operations executed by the Eurosystem also in the form of a reverse transaction • On average over the year, LTROs provided about one quarter of the total refinancing of banks

24. Reserve requirements of banks • The Eurosystem requires banks to hold minimum reserves equal to 2% of certain short-term liabilities. It is part of base money • The purpose is the stabilization of short-term interest rates and the enlargement of the structural liquidity deficit of banks • Reserve requirements bear interest, and must only be fulfilled on average over a one-month reserve maintenance period • It has a significant smoothing effect on the behavior of short-term interest rates

25. Short-term liquidity policy • The monetary base is also affected when a central bank makes a discount loan to a bank. The ECB does not use this instrument however • There are two standing facilities offered by the Eurosystem • the marginal lending facility and • the deposit facility • These instruments provide and absorb overnight liquidity, signal the stance of monetary policy and set an upper and lower limit for the overnight market interest rate

26. Key ECB interest rates • The key ECB interest rates are at present • the minimum bid rate on the main refinancing operations, • the interest rate on the marginal lending facility • and the interest rate on the deposit facility

27. Key ECB interest rates

28. Central bank lending ratesinternational comparison

29. The monetary policy goals of the ECB • The primary objective of the European System of Central Banks (ESCB) is to maintain price stability   • Without prejudice to the primary objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community • In pursuing its objectives, the ESCB shall act in accordance with the principle of an open market economy with free competition, favoring an efficient allocation of resources

30. Transmission processes of policies • Central banks, cannot control the price level directly. They face a complex transmission process from their own monetary policy actions to changes in the general price level • These transmission mechanisms are characterized by the existence of several distinct channels, each with long, and variable reaction lags • Moreover, the transmission mechanisms themselves are evolving over time due to behavioral and institutional change

31. Policy goals and targeting • The strategy of central banks is to aim at variables between the goals to be achieved and the tools available: • Intermediate targets. These can be monetary aggregates (M1, M2, M3) or interest rates (short, long) • Operating targets (or “instruments”): They can be directly adjusted (monetary base, reserves, minimum bid rate of the main refinancing operations)

32. Rs ist Rs’ ist* Rd Quantity of reserves What instruments has a central bank? • Open market operationsPurchases in the open market causes the short-term interest rate (federal funds rate) to fall.It affects the supply of reserves

33. Rs ist Rs’ ist* Rd Quantity of reserves What instruments has a central bank? • Discount lendingIt also raises the quantity of reserves supplied which causes the short-term interest rate (federal funds rate) to fall

34. Rs ist ist* Rd’ Rd Quantity of reserves What instruments has a central bank? • Reserve requirementsIt increases the quantity of reserves demanded which causes the short-term interest rate (federal funds rate) to increase

35. Advantages of OMOs • OMOs are under the full control of a central bank. This is not the case for discount operations • OMOs can be carried out in small quantities to “smooth” developments • OMOs can easily be reversed (repos) • OMOs can be implemented without delays

36. Characteristics of discount policy • The main advantage is that the central bank can use it in its function as “lender of last resort” • But there are three main disadvantages: • The announcement of a discount rate change can create confusion if it contradicts the policy stance • If the discount rate is set at a given level, the spread between id and the market interest rate can vary wildly • Discount operations are difficult to reverse

37. Characteristics of reserve requirements • The advantage is that they affect all banks equally and have an effect on the supply of money • But reserves requirements are hard to engineer because of multiple deposit contractions (expansions) • Raising reserve requirements can cause immediate liquidity problems

38. Targeting : the NASA strategy • By analogy, NASA’s strategy of sending spaceships to the moon also works through “operating targets” • The pace of spaceships is continuously adjusted to “intermediate targets”, and finally to the “goal”

39. Example of central bank strategy: • Suppose the central bank’s price-level goal is consistent with a nominal GDP growth rate of 5% • The bank may then feel that this goal can be achieved • by a 4% growth rate for M2 (intermediate target), and • by a 3.5% growth rate for the monetary base (operating target = tool)

40. Adjustments of central bank policy • After implementing the policy, the central bank may fine-tune, for instance • because the monetary base may be growing too slowly (which calls for an increase of OMO purchases); • or M2 may not grow in line with the monetary base (which also requires an adjustment of policy instruments such as OMOs)

41. Types of target variables • The central bank has the choice between two different types of target variables: • monetary aggregates (monetary base, reserve requirements, M1, M2, M3, etc.) • and interest rates • Can a central bank pursue both targets at the same time?

42. Ms i* Md M* Quantity of money The answer is no! Why? • If a monetary aggregate is used, the control of the interest rate is lost:

43. iu Mdu i* il Mdl Quantity-oriented strategy: problem • If the money demand curve shifts unexpectedly, the interest rate will fluctuate: Ms Md* M* Quantity of money

44. Interest rate-oriented strategy: problem • In order to keep the interest rate at a given level (target), the central bank must accept variations in monetary aggregates: Ms Msl Msu Mdu Targetrate i* Md* Mdl Quantity of money

45. What criteria to decide on the target? • There are three criteria for choosing an intermediate target: • It must be accurately measurable, and the indicator should be available rapidly; • it must be controllable by the central bank; • and it must have a predictable effect on the policy goal.

46. Measurability • GDP figures and price indices become available only after a time lag, and they are often revised • Monetary aggregates are obtained quicker (2 weeks), but are often revised • Interest rates are obtained instantly and are not revised • Are interest rates the best target? Be careful: What we need are real interest rates!

47. Controllability and predictability • A central bank has the ability to exercise a powerful effect on the money supply, although control is not perfect • Although it appears that the central bank can also control interest rates, it cannot fully control inflationary expectations • The linkage between intermediate targets and the policy goal is controversial, so the predictability issue is highly contentious

48. A historical perspective: the Fed • When the Fed was created in 1914, the discount rate was the primary tool • OMOs were not yet discovered, and the Federal Reserve Act had no provisions to change reserve requirements • The policy was based on the “real bills doctrine” (loans only for “productive purposes”)  which papers are ‘eligible’

49. The Fed after World War I • By the end of World War I, the (re-)discounting of eligible papers (including Treasury bills) had led to inflation, and the “real bills doctrine” became discredited • The Fed abandoned its passive role, and it increased the discount rate from 4.75% to 7% in 1920, which (after a short recession in 1920-21) brought inflation under control • This paved the way for the “Roaring Twenties”

50. The discovery of OMOs • The Fed discovered open market operations by accident: • It revenue (mainly from discount loans to member banks) shrank during the 1920-21 recession, so the Fed was under pressure • It reacted by purchasing income-earning securities to compensate for the losses • It then discovered that reserves in the banking industry grew (credit multiplier)