Central Bank PotpourriECON 40364: Monetary Theory & Policy

Eric Sims

University of Notre Dame

Spring 2020

1 / 33

Readings

I Mishkin Ch. 13

I Crowe and Meade (2007)

I Haedtler, Levin, and Wilson (2016)

I Mankiw (2019)

2 / 33

Central Bank

I In modern economies, central banks manage the currency,money supply, and target short-term interest rates in aneconomy

I They have monopoly power over the monetary baseI Unlike a regular bank, can increase size of balance sheet via

issuing liabilities as it pleases

I Central banks perform the following key functions:

1. Check-clearing2. Lender of last resort3. Supervision and regulation4. Macroeconomic stabilization

3 / 33

History of Central Banks

I Banking as we know it developed in Europe in the MiddleAges

I Basic structure of financial intermediation – borrow short-term(e.g. deposits) and lend longer-term (e.g. loans), earn spread

I This allows for check-writing which makes exchange moreefficient

I But check-clearing is potentially costly and the liquiditymismatch on bank balance sheets exposes them to “runs”(much more on this later)

4 / 33

Check-Clearing

I When a depositor writes a check on her account from Bank Ato Bank B, A must transfer money to Bank B

I Informal “clearinghouses” developed early onI “Runners” from different banks would carry currency around to

different banks, balancing the books each dayI Eventually they started meeting in public houses (i.e. bars)

and doing it all at onceI This led to the establishment of private clearinghouses –

consortiums of banks that would coordinate on check-clearingand inter-bank transfers to cut down on costs of sending outrunners carrying large quantities of cash

I Clearinghouses were essentially banks for banks – banks wouldhold account balances (i.e. reserves) at the clearinghouse, andcredits and debits would just be applied to balances to cutdown on clearing costs

5 / 33

Liquidity Mismatch

I Bank liabilities are more liquid than assetsI Deposits payable on demand, but the cash has been lent out

and is not easy to come up with on demand

I This exposes banks to runs – more demand for currency thanthey have on hand

I Clearinghouses, in serving as banks for banks, could makeemergency loans to particular banks facing liquidity pressure –lender of last resort

6 / 33

Supervision

I Because of problems of runs (i.e. liquidity mismatch) andmoral hazard (more on this later), it is important to regulateand supervise financial intermediaries for banking to work well

I Private clearinghouses originally performed these functions

1. Set reserve requirements (liquidity mismatch) and capitalrequirements (moral hazard) to ensure safety and soundness

2. More generally monitored the behavior of member institutions3. This monitoring was meant to give the public confidence4. Confidence is key to avoiding financial crises

7 / 33

Central BanksI To some degree, private clearinghouses worked well

I See the US experience during the Free Banking era in thesecond half of the 19th century (see, e.g., Gorton and Tallman2018)

I But obvious problems:I No monopoly power on base money – limited lender of last

resort capabilitiesI As financial system developed, grew, and became more

complex and less localized, local clearinghouses (such as inNew York) couldn’t handle the job

I Central banks, in particular the Federal Reserve, were createdto better perform the functions private clearinghouses weretasked with

I In history of central banking, monetary policy asmacroeconomic stabilization comes in much later

I Primary motivations for establishment of central banks werethe lender of last resort, check-clearing, and supervisoryfunctions

8 / 33

History of Central Banks

I Oldest are the Riksbank (Sweden, 1668) and the Bank ofEngland (1694), though their functions and powers haveevolved over time

I Federal Reserve System in US established in 1913I Peculiar structure:

I Board of Governors (federal)I 12 Reserve Banks (quasi-private)I Member banksI Federal Open Market Committee (FOMC) hybrid between

Board and regional reserve banks, directs open marketoperations

9 / 33

10 / 33

Federal Reserve Powers and Functions

1. Open market operations, FFR (FOMC)

2. Check-clearing (reserve banks)

3. Supervision (reserve banks, Board)

4. Reserve requirements, discount rate (Board)

11 / 33

Central Bank Independence

I By design, most of the world’s central banks are structured asat least partially independent from the political system

I Why?

I Insulation from political pressures to pursue short-runobjectives

I In terms of AD-AS model:

π = πe + γ(Y − Y p) + ρ

I Independent central bank: low πe

I Less independent central bank: higher πe

I Time consistency problem (Chari and Kehoe, 2006)

I Over long run, independence should correlate with loweraverage inflation and no loss in output/unemployment

12 / 33

𝐴𝑆(𝜋0

𝑒)

𝑌0 = 𝑌1

𝜋0 = 𝜋0𝑒

𝑌

𝜋

𝐿𝑅𝐴𝑆

𝐴𝐷

𝐴𝑆(𝜋1𝑒)

𝜋1 = 𝜋1𝑒

More independent: 𝜋0𝑒

Less independent: 𝜋1𝑒 > 𝜋0

𝑒

13 / 33

Independence and Avg. Inflation

Source: Alessina and Summers (1983)14 / 33

Independence and Avg. Unemployment

Source: Alessina and Summers (1983)15 / 33

Measuring Independence

I Crowe and Meade (2007) discuss measurement of centralbank independence

I Based on things like:

1. Appointment/dismissal/term of office2. Influence of fiscal authority on policy formulation3. Depth of mandate (i.e. single or dual)4. Limitations on ability of central bank to lend to the

government

16 / 33

Measures of Independence

Source: Crowe and Meade (2007)17 / 33

Independence over Time

I Over time, there has been a big push towards more centralbank independence across the globe

I In early sample, Federal Reserve was one of most independent.Now below mean!

I This move towards independence has coincided with decline ininflation rates across the globe

I Now, the cross-sectional relationship between independenceand inflation highlighted by Alessina and Summers (1983) ismuch weaker / non-existent

I Crowe and Meade (2007) discuss possible reasons why anddifferent measures of independence that have strongerpredictive power for inflation

18 / 33

Transparency

I Crowe and Meade (2007) loosely define transparency as acentral bank doing a good job communicating its policies andthe reasons for those policies

I Transparency requires effective communication

I Central banks in the last several years have made manyattempts to be more transparent

I For example, prior to 1994, the Fed did not publicly announcethe FFR target!

I Has really picked up steam since Bernanke became chairI Now we have an explicit inflation target, things like the “dot

plots” showing individual FOMC participants’ projections, etc.

19 / 33

Transparency at the Fed

Source: Crowe and Meade (2007)20 / 33

Transparency Has Increased Over Time

Source: Crowe and Meade (2007)21 / 33

Transparency vs. Independence

I Transparency and independence don’t mean the same thing;indeed, they may be in conflict with one another

I There is some overlap in how these are measured/defined inCrowe and Meade (2007) – e.g. a single price stabilitymandate makes both independence and transparency scoreshigher

I I kind of think of these as reflecting different moments of πe :I More independence: lower average level of πe

I More transparency: lower volatility of πe (Meade 2006)

I Obviously there are potentially effects of both independenceand transparency on both the mean and variance of expectedinflation, but useful to think about it this way

22 / 33

Less Transparency = More Volatility

𝐴𝑆(𝜋0𝑒)

𝑌0

𝜋0 = 𝜋0𝑒

𝑌

𝜋

𝐿𝑅𝐴𝑆

𝐴𝐷

𝐴𝑆(𝜋1𝑒)

𝜋1

𝐴𝑆(𝜋2𝑒)

𝜋2

𝑌1 𝑌2

Less transparency → more volatile

inflation expectations → more volatile

output and inflation

23 / 33

Downsides to Transparency and Independence

I Transparency:I Too much transparency could actually increase volatility

instead of reducing itI Could result in less honest deliberationsI Could make it more difficult to engage in data-driven changes

in the policy stance

I Independence:I Is independence consistent with democratic society?I What kind of independence: instrument independence (set

instruments, given a goal), or goal independence (chooseobjectives, within bounds), or both?

I How to balance independence with accountability

24 / 33

Haedtler, Levin, and Wilson (2016)

I HLW argue that the there is not enough oversight over theFed and that it needs to be more accountable to the public

I Argue further that the Fed’s institutional structures areoutdated

I Feel that the Fed is not diverse enough, too involved in“group think”

I They want to make the Fed fully public, while still preservingsome level of operational independence

25 / 33

Reserve Bank Presidents

I The twelve regional reserve banks are quasi-private, in effectowned by commercial banks in their districts

I Though in principle only five of 12 FOMC votes from theReserve Banks (NY Fed plus rotation of other four banks), inpractice Reserve Bank presidents have had majority much ofthe time and play an increasingly large role in public policydebates

I Reserve bank presidents are in large part chosen by the Boardsof Directors, which are comprised of bankers whom thereserve banks regulate

I Regulators are, in part, chosen by the regulated

I In practice, appointments to reserve bank presidencies havebeen “inside baseball” appointments

26 / 33

Private to Public

I Right now, commercial banks own non-tradeable shares in thereserve banks

I They receive dividends: either the 10 year Treasury yield orfixed 6 percent depending on size

I Their proposal: cancel shares and remit to reserves. Just achange in composition of liabilities

I Argue this would save the US Taxpayer money (FederalReserve profit remitted to US Treasury)

27 / 33

Leadership Transparency

I The Fed is quite transparent in terms of what it is doing froma policy perspective

I But the selection of its leadership is not transparent at all

I HLW would like to open things up along this dimension, boththe selection of directors and presidents

I They also want to (i) increase the term of the Chair of theBoard of Governors (to give more independence) but (ii)reduce the terms of the other board members (to enhanceaccountability)

I They also want increased oversight by organizations such asthe Government Accountability Office (GAO)

28 / 33

Modern Monetary Theory (MMT)

I It’s not always 100 percent clear to me what ModernMonetary Theory (MMT) is all about

I It’s favored by progressive politicians (e.g. Bernie Sanders andAlexandria Ocasio-Cortez)

I The central tenet seems to be, roughly, that governments arenot financially constrained because they can print money

I So this implies:

1. Don’t worry about government debt and deficits2. Promise lots of free stuff and don’t worry about how to pay for

it

29 / 33

Mankiw (2019)

I Mankiw (2019) provides a nice, skeptical summary

I Government flow budget constraint:

PtGt + it−1BG ,t−1 − PtTt = MBt −MBt−1 + BG ,t − BG ,t−1

I Government can finance deficit either by issuing debt (like ahousehold) or by printing money (unlike a household)

I For a household, there is a limit to how much debt it canissue – essentially a terminal condition that maximum debtissuance is the maximum amount it can pay back

I That basic logic holds for a government, too

I But the government has another source of finance – issuingbase money

30 / 33

Does the “Printing Press” Free Government of BudgetConstraint?

I Not really:

1. If interest is paid on reserves (i.e. base money), then issuemore base money is functionally like issuing more debt

2. If interest is not paid on reserves, then it is likely thatexpansion of base money will result in increase in the moneysupply (which would be inflationary)

3. If inflation gets high, demand for real balances potentiallydepressed, and in real terms government could be on thewrong side of the seigniorage Laffer curve

31 / 33

Heterodox Theory of Inflation

I MMT proponents would argue that massive expansions in themonetary base have not led to more inflation

I This is true, but we now pay interest on reserves

I They argue that there is no relationship between moneygrowth and inflation

I This isn’t true – quantity theory works quite well in long-runand in low-frequency cross-country comparisons

I They have an odd theory of inflationI Mankiw emphasizes potentially important difference between

potential output, Y P , and efficient output, Y e . Could wellhave Y P < Y e , but it’s Y − Y P that matters for inflation,not Y e

I History suggests, time and again, that fiscal profligacy leadsto massive inflation

32 / 33

33 / 33