Chapter VIII: Money supply and monetary policy

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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

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European System of Central Banks
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The Eurosystem
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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)

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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

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Convergences of inflation rates
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Convergence of lendingrates (interbank)
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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

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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

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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

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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

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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

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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

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Balance sheet of a central bank
Assets
Liabilities
Base money (we simplifyonly cash)
Securities
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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
  bankers acceptances)
• Intra-Eurosystem claims

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Eurosystems international reserves

• The reserve assets of the euro area consist of
  the Eurosystems 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

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Official reserves (excluding gold) 2007

• Japan and China have accumulated the largest
  reserves in the world
• Russia follows third

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The euro and globalforeign exchange reserves
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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

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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

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Forex inflows with sterilization
Assets
Liabilities
Base money remains fixed
Securities
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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

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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

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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

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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

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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

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Key ECB interest rates
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Central bank lending ratesinternational
comparison
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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

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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

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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)

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What instruments has a central bank?

• Open market operations Purchases in the open
  market causes the short-term interest rate
  (federal funds rate) to fall.It affects the
  supply of reserves

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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

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What instruments has a central bank?

• Reserve requirements It increases the quantity
  of reserves demanded which causes the short-term
  interest rate (federal funds rate) to increase

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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

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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

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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

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Targeting the NASA strategy

• By analogy, NASAs 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

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Example of central bank strategy

• Suppose the central banks 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)

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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)

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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?

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The answer is no! Why?

• If a monetary aggregate is used, the control of
  the interest rate is lost

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Quantity-oriented strategy problem

• If the money demand curve shifts unexpectedly,
  the interest rate will fluctuate

Ms
Md
M
Quantity of money
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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
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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.

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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!
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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

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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

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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

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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)

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World War I and the Reichsbank

• In 1914, the Reichsbank had suspended the
  convertibility of its notes in gold
• Much of the government borrowing was discounted
  by the Reichsbank
• At the end of the war, money in circulation had
  increased four-fold
• The consumer price index had risen 140 by
  December 1918
• Yet floating debt of the Reichsbank had increased
  from 3 to 55 billion marks

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The Reichsbank After WW I

• Inflation was fueled by
• Germanys reparation payments, which triggered a
  devaluation of the mark
• A decline in confidence in the mark
• Hoarded savings entered the market place
• By February 1920, the price index was 5 times as
  high as at armistice, but it held almost stable
  for 15 months
• This chance of monetary policy was spoiled

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The pace to hyperinflation

• During these fifteen months the government kept
  issuing new money
• The currency in circulation increased by 50 and
  the floating debt of the Reichsbank by 100,
  providing fuel for a new outbreak
• In May 1921, price inflation started again, and
  by July 1922 prices had risen 700
• After July 1922 the phase of hyperinflation began

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The German hyperinflation 1922-23
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Stabilization program of 1923/24

• In November 1923, a currency reform was
  undertaken
• A new bank, the (private) Rentenbank, was to
  issue a new currency the Rentenmark
• This money was exchangeable for bonds backed up
  by land and industrial plant
• A fixed amount of 2.4 billion Rentenmarks was
  created, and each Rentenmark was valued at one
  trillion old paper marks
• The Rentenmarks held their value. Inflation
  ceased even for the Reichsmark

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Completing the 1923 reform

• In August 1924 the reform was completed by the
  introduction of a new Reichsmark, equal in value
  to the Rentenmark
• The Reichsmark had a 30 gold backing. It was not
  redeemable in gold, but the government undertook
  to support it by buying in the foreign exchange
  markets as necessary
• The Reichsbank became independent from the
  government and government loans were limited
• Drastic new taxes were imposed, and with the
  inflation ended, tax receipts increased
  impressively. In 1924-1925 the government had a
  surplus

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The Roaring Twenties and the Fed

• The stock market boom of 1928/29 created a
  dilemma for the Fed
• tempering the boom would have required a higher
  discount rate
• the Fed hesitated to do that because of
  legitimate credit needs
• When the discount rate was finally raised (August
  1929), it was too late

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The Bank Panics of 1930-33

• Substantial withdrawals from banks ended in a
  full-fledged panic at the end of 1930
• One bank after the other closed, but the Fed did
  not perform its role as lender of last resort
• It did not understand the impact of bank failures
  on money supply and economic activity
• Moreover there was political haggling that
  entailed policy inactivity

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The switch to monetary targeting

• In the early 1970s (Arthur Burns), the Fed
  adopted a policy of monetary targeting, but its
  commitment to the new policy was weak
• (The Bundesbank followed in 1974)
• The policy was to pre-announce target ranges for
  the growth rates of money aggregates
• However the Fed continued to use the federal
  funds rate as an operating target
• In 1979 (Paul Volcker) the Fed officially changed
  its policy, using reserves as the instrument

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Returning to interest-rate policies

• Once inflation was checked, the Fed deemphasized
  monetary aggregate targets and returned to a
  policy of smoothing interest rates
• In 1993, Alan Greenspan testified in Congress
  that the Fed would no longer use monetary targets
• During the 1990, with strong growth and low
  inflation, the Fed focused on interest rate
  policies, with a defensive stance

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The ECBs monetary policy strategy

• The ECB's stability-oriented monetary policy
  strategy consists of three main elements a
  quantitative definition of price stability, and
  the two "pillars" used to achieve this objective.
  
• These two pillars are
• a prominent role for money, as signaled by the
  announcement of a quantitative reference value
  for the growth rate of a broad monetary
  aggregate
• and a broadly based assessment of the outlook for
  price developments and risks to price stability
  in the euro area as a whole.

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The definition of price stability

• The Governing Council of the ECB has adopted the
  following definition
• Price stability shall be defined as a
  year-on-year increase in the Harmonized Index of
  Consumer Prices (HICP) for the euro area of below
  2
• Price stability according to this definition is
  to be maintained over the medium term

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Reference value problems

• First, to ensure that the reference value is
  consistent with the maintenance of price
  stability, money must have a stable relationship
  with the price level. The stability of this
  relationship is typically assessed in the context
  of a money demand function
• Second, substantial or prolonged deviations of
  monetary growth from the reference value signal
  risks to price stability over the medium term. It
  requires that monetary growth is a leading
  indicator of price developments

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The broadly based outlook for prices

• It is based on a large number of indicators
• The range of indicators includes many variables
  that have leading indicator properties for future
  price developments
• They include, inter alia, wages, the exchange
  rate, bond prices and the yield curve, various
  measures of real activity, fiscal policy
  indicators, price and cost indices and business
  and consumer surveys

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Reading

• Reading 8-1 Too hot or too cold?, The
  Economist, June 12th, 2008
• Reading 8-2 Please re-read Reading 1-6 ECB A
  decade in the sun, The Economist, June 5th 2008
• Reading 8-3 Hubble, bubble, asset-price
  trouble, The Economist, September 1999 (optional)

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Discussion 8Money supply and monetary policy

• How does a central bank gear the money supply?
• Do you think that the central bank can control
  the money supply, if not Why not?
• What instruments has the central bank at its
  disposal?

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