Money and Banking

Lecture II: Central Banking and Conventional Monetary PolicyTools

Guoxiong ZHANG, Ph.D.

Shanghai Jiao Tong University, Antai

September 19th, 2017

First Impression of the Federal Reserve

Source: https://politicalgraffiti.files.wordpress.com/

History of Central Banking

Central banks emerge as paper money became popular

Commodity money ⇒ paper money: gold standard → fiat money

Rudiment type of central banks:

Paper money authorities in Song, Yuan and early Ming dynastiesof China (1020’s to 1450’s)Bank of Amsterdam (1609), Sveriges Riksbank (1664)

Modern central banks

Bank of England (1694), Banque de France (1800), Bank ofJapan (1882), Federal Reserve Bank of the US (1913), DeutscheBundesbank (1957), People’s Bank of China (1979)

Origin of the FED

Resistance to establishment of a central bank:

Fear of centralized powerDistrust of moneyed interests

No lender of last resort

Nationwide bank panics on a regular basisPanic of 1907 so severe that the public was convinced a centralbank was needed

Federal Reserve Act of 1913 officially established the FED

A quasi-public institution

Structure of the Federal Reserve

Source: Mishkin (2013)

Functions of the FED

clear checks

issue new currency

withdraw damaged currency from circulation

administer and make discount loans to banks in their districts

evaluate proposed mergers and applications for banks to expandtheir activities

act as liaisons between the business community and the FederalReserve System

examine bank holding companies and state-chartered memberbanks

collect data on local business conditions

use staffs of professional economists to research topics related tothe conduct of monetary policy

How Independent is the FED?

Very independent:

independent revenue (Federal Reserve Transparency Act)independent monetary policy target and toolslong tenure of the members of the board of governors

Not fully independent:

Fed’s structure is written by the Congress, and is subject tochange at any timeThe chairman has to frequently testify in front of the CongressPresidential influence

FED is the most independent central bank in the world (only theECB is comparable)

Central Bank Independence

Two types of independence:

goal independenceinstrument indepence

Reason for central bank independence: free of political pressuresthat usually cause short-sighted and inflation biased policy

Reason against central bank independence: a joint usage ofmonetary policy and fiscal policy would be more effective

Measure of central bank independence:

ownership of the bank capitalthe bank’s affiliation (congress, treasury department or cabinet)relationship with the treasury (source of funding, obligation tomake loans to the government)appointment of the bank officialsrepresentatives from government to the policy committee in thebank

Central Bank Independence in Advanced Economies

Source: Alesina and Summers (1993)

Central Bank Independence and Inflation Level

Source: Alesina and Summers (1993)

Central Bank Independence and Inflation Volatility

Source: Alesina and Summers (1993)

Central Bank Independence and Inflation, EmergingMarket Economies

Source: Haan and Kooi (2000)

Balance Sheet of Commercial Banks

Source: Mishkin (2013)

Balance Sheet of the FED

http://www.federalreserve.gov/releases/h41/current/h41.

htm#h41tab9

Monetary Base and Its Determination

Monetary base (high power money) = currency in circulation +reserves

FED, commercial banks and households jointly determine themonetary base

The FED can only determine the non-borrowed monetary basethrough open market operationThe borrowed reserve is determined by FED and the commercialbanksThe households decide whether to hold currency or to deposit:change the composition of monetary base but not its total size

Conventional Monetary Policy Tools

Open market operation:

primary monetary policy tool for the FEDuses both repo and revers-repo

Discount windows:

primary credit: standing lending facility, “icing on the cake”secondary credit: lender of last resort, “send charcoal in snowyweather”seasonal credit

Required reserve ratio:

varies according to the total amount of checkable depositusually about 10% (8% - 14%), can be as high as 18% at extremecases

Interest on reserves

Multiple Deposit Creating

Source: Mishkin (2013)

Deposit Multiplier

Assuming that banks does not hold excessive reserve and thathouseholds do not hold cash, then required reserve must equalthe total reserve:

R = RR = rr×D ⇒ D =1

rrR⇒ ∆D =

1

rr∆R,

that is the deposit multiplier is 1rr .

In reality, the deposit multiplier should be much smaller thanthis one.

Money Supply

Source: Mankiw (2010)

Money Multiplier

Define: currency ratio: c = CD ; excessive reserve ratio: e = ER

D ;

required reserve ratio: r = RRD

MB = required reserve + excessive reserve+ currency=(r + c + e)D

Hence D = 1r+e+cMB

Money supply: M = checkable deposit + currency = (1 + c)D

Money multiplier: m ≡ MMB = 1+c

r+e+c

The money multiplier is jointly determined by the FED,commercial banks and households

Excessive Reserve Ratio and Currency Ratio, 1929 -1933

Source: Mishkin (2013)

Money Multiplier, 1929 - 1933

Source: Mishkin (2013)

Excessive Reserve Ratio and Currency Ratio, 2007 -2009

Source: Mishkin (2013)

Money Multiplier, 2007 - 2009

Source: Mishkin (2013)

The Market for Reserves and Federal Funds Rate

Source: Mishkin (2013)

Open Market Operation and Federal Funds Rate

Source: Mishkin (2013)

Discount Rate and Federal Funds Rate

Source: Mishkin (2013)

Required Reserve Ratio and Federal Funds Rate

Source: Mishkin (2013)

Interest Rate on Reserves and Federal Funds Rate

Source: Mishkin (2013)

Advantages of Open Market Operation

Open market operations occur at the initiative of the Fed, whichhas complete control over their volume;

Open market operations are flexible and precise; they can beused to any extent;

Open market operations are easily reversed;

Open market operations can be implemented quickly

Does not work well under two scenarios:

when the Fed wants to raise interest rates after banks haveaccumulated large amounts of excess reserveswhen the Fed to perform its role of lender of last resort