Chapter VIII: Money supply and monetary policy

Goethe Business SchoolGoethe Business School

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


The Eurosystem

3


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)


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

5


Convergences of inflation rates

6


Convergence of lendingrates (interbank)

7


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

Balance sheet of a central bank

Assets Liabilities

Base money (we simplify:

only cash)

Gold

Forex

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


The euro and globalforeign exchange reserves

18


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

Forex inflows with sterilization

Assets Liabilities

Base money remains fixed

Gold

Forex

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


Key ECB interest rates

27


Central bank lending ratesinternational comparison

28


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

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

ist

Quantity of reserves

Rs

Rd

ist*

Rs’


33

What instruments has a central bank? Discount lending

It also raises the quantity of reserves supplied which causes the short-term interest rate (federal funds rate) to fall

ist


Rs

Rd

ist*

Rs’


34

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

ist


Rs

Rd

ist*Rd’


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

The answer is no! Why?

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

Quantity of money

Ms

Md

i*

M*


43Quantity of money

Ms

Md*

Quantity-oriented strategy: problem If the money demand curve shifts unexpectedly,

the interest rate will fluctuate:

i*

Mdl

il

Mdu

iu

M*


44Quantity of money

Ms

Md*

i*

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:

Mdl

Mdu

Msl Ms

u

Targetrate


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)


51

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


52

The Reichsbank: After WW I Inflation was fueled by

Germany’s 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


53

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


54

The German hyperinflation 1922-23

Whole sale price index

1,E+00

1,E+01

1,E+02

1,E+03

1,E+04

1,E+05

1,E+06

1,E+07

1,E+08

1,E+09

1,E+10

1,E+11

1,E+12

July 1914 Jan 1919 July 1919 Jan 1920 Jan 1921 July 1921 Jan 1922 July 1922 Jan 1923 July 1923 Nov 1923


55

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


56

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


57

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


58

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


59

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


60

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


61

The ECB’s 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.


62

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”


63

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


64

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

The broadly based outlook for prices


65

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)


66

Discussion 8:Money 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?

Chapter VIII: Money supply and monetary policy

Documents

Transcript of Chapter VIII: Money supply and monetary policy