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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 simplify:
only cash)
Gold
Forex
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 banker’s acceptances)
Intra-Eurosystem claims
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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
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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
Gold
Forex
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
ist
Quantity of reserves
Rs
Rd
ist*
Rs’
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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
Quantity of reserves
Rs
Rd
ist*
Rs’
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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
ist
Quantity of reserves
Rs
Rd
ist*Rd’
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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, 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”
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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)
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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:
Quantity of money
Ms
Md
i*
M*
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Ms
Md*
Quantity-oriented strategy: problem If the money demand curve shifts unexpectedly,
the interest rate will fluctuate:
i*
Mdl
il
Mdu
iu
M*
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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
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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
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
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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
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
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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 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.
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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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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
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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 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?