Central Banks

Question 1

Role of central banks in an economy

Answer 1

Affect:
» Interest rates.
» Amount of credit available.
» Money supply.
These factors have direct impact on financial markets, aggregate output and inflation.

Institutions in charge of monetary policy

» Monetary policy
» Supervisor for banking system – ensure stability, licensing and liquidity rules and capital adequacy standards
» Banker for banking system – holds bank accounts with CB for reserves on deposits and day-to-day activities

» Banker for government - holds government’s bank account and performs banking operations for the government

Question 2

CB’s as banker for government

Answer 2

• Manager of national debt
• Manager of currency reserves – government’s reserves of gold and foreign exchange held at CB
• Issuer of national currency
• Lender of last resort to provide emergency liquidity to banks and to provide liquidity to the government in a crisis
• Helps to stabilise expectations in the economy
• When a CB must bail out a government, it increases the sovereign risk – bond sell off likely and so bond price goes down – interest rate increases
• Increases governments default risk – so CB buys the governments bonds as emergency liquidity

Question 3

Central bank as lender of last resort

Answer 3

Government is responsible for solvency of the banking system;

» CB is the lender of last resort (LOLR) to both banks and governments.
Mutual confidence between the government and CB is important for the governance system:
» Confidence that CB acts as LOLR to government helps stabilise expectations.

Question 4

What happens when the different elements of the governance arrangement do not exist?

Answer 4

Monetary unions such as the Eurozone at its formation did not have this governance structure while the US has one in place.
During the global financial crisis of 2007-2009

• To bailout Eurozone banks, government debt was issued in Euro
  ECB was prevented by mandate to act as LOLR.
  » Fear of government illiquidity.
  » Government bond interest rate increased – so price of bonds fell – so assets are effectively less valuable
  Eurozone banks are major holders of government bonds.
  Result - the Eurozone crisis.

Question 5

The Eurozone crisis

Answer 5

• » High levels of public debt for Eurozone members compared to the US states.
• » US debt is mainly federal - the Fed is LOLR to federal government.
• Without a central bank being a LOLR to government, a country is prone to sovereign debt crisis.
• However, Eurozone countries have proposed other solutions such as a banking union.

Question 6

» The Federal Reserve System (The Fed) - structure

Answer 6

No lender of last resort.
Decentralised.

The writers of the Federal Reserve Act wanted to diffuse power along regional lines

» The Federal Reserve banks.
» The board of governors of the Federal Reserve System.
» The Federal Open Market Committee (FOMC).
» The Federal Advisory Council.
» Around 2,900-member commercial banks.

Question 7

FED board of governors

Answer 7

Seven members headquartered in Washington, D.C.
Appointed by the president and confirmed by the Senate.
14-year non-renewable term.
Required to come from different districts.
Chairman is chosen from the governors and serves four year term.

Question 8

FED governor duties

Answer 8

Votes on conduct of open market operations.
Sets reserve requirements.
Controls the discount rate through ‘review and determination’ process.
Sets margin requirements.
Sets salaries of president and officers of each Federal Reserve Bank and reviews each bank’s budget.
Approves bank mergers and applications for new activities. Specifies the permissible activities of bank holding companies.
Supervises the activities of foreign banks operating in the United States.
- The Chairman of the governors advises the president on economic policy, testifies in congress, may represent the US in negotiations with foreign governments on economic matters

Question 9

FED open market committee

Answer 9

Meets eight times a year.
Consists of seven members of the board of governors, the president of the Federal Reserve Bank of New York, and the presidents of four other Reserve banks.
Chairman of the board of governors is also chair of FOMC.
Issues directives to the trading desk at the Federal Reserve Bank of New York.

Question 10

FED reserve banks

Answer 10

Quasi-public institution owned by private commercial banks in the district that are members of the Fed system.
Member banks elect six directors for each district; three more are appointed by the board of governors.
* » Three A directors are professional bankers.
* » Three B directors are prominent leaders from industry, labour,
agriculture, or consumer sector.
* » Three C directors appointed by the board of governors are not allowed
to be officers, employees, or stockholders of banks.
* » Designed to reflect all constituencies of the public.
Nine directors appoint the president of the bank: subject to approval by board of governors.

Question 11

Functions of the federal reserve banks

Answer 11

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 expand their activities.
Act as liaisons between the business community and the Federal Reserve System.
Examine bank holding companies and state-chartered member banks. Collect data on local business conditions.
Use staffs of professional economists to research topics related to the conduct of monetary policy.

Question 12

Federal reserve banks and monetary policy

Answer 12

Directors ‘establish’ the discount rate.
Decide which banks can obtain discount loans.
Directors select one commercial banker from each district to serve on the Federal Advisory Council which consults with the board of governors and provides information to help conduct monetary policy.
Five of the 12 bank presidents have a vote in the Federal Open Market Committee (FOMC).

Question 13

Member banks of the FED

Answer 13

All national banks are required to be members of the Federal Reserve System.
Commercial banks chartered by states are not required but may choose to be members.
Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all banks to the same reserve requirements as member banks and gave all banks access to Federal Reserve facilities

Question 14

Origin of the ECB and European system of central banks

Answer 14

• Came into existence in 1998 to deal with transitional issues of the nations making the Eurozone (countries with Euro as currency)
• Responsibility of monetary policy was transferred from national central banks to ECB
• All countries have their central banks, but the Euro system’s rules and monetary policy are set centrally by ECB
• The Euro system comprises the ECB and the NCBs of those EU member states that have adopted the Euro

Question 15

Members of ECB and ESCB

Answer 15

• 19 countries; all those in EU outside of Eurozone have chosen to adopt their own national currency or do not comply with the convergence criteria that allows them to adopt the Euro
• The ESCB was established alongside the Euro system to comprise the ECB and all NCBs of EU member states
• These outside member states are allowed to adopt their own monetary policies and so don’t take decisions that affect the monetary policy of the Euro area

Question 16

Structure of ECB

Answer 16

• The capital stock of the ECB is owned by central banks of the current 27 member states
• The balance sheet is held by the NBCs so the 19 NBCs of the Euro area act as branches of the ECB

Question 17

ECB decision-making bodies

Answer 17

• Governing council – conducts monetary policy and maintain price stability in the euro area (chaired by ECB president)
• Executive board – responsible for day-to-day operations and management of ECB and Euro system – appointed by European council – can give instructions to corresponding NCBs
• General council – comprises of the VP and president of the ECB and governors of the NBCs of all 27 EU member states – encourages cooperation between NCBS of the member states of the EU – collects statistical information, preparing ECB annual reports and accounting and reporting

Question 18

Role of ECB

Answer 18

• Maintain price stability
• Support economic policies of Euro zone nations
• Ensure independent and open market economy

Question 19

Differences between ECB and FED

Answer 19

ECB and Fed have different mandates or objectives and accordingly adopt different methods to achieve these objectives
- ECB focuses primarily on price stability whereas the Fed will do this alongside aiming to achieve growth and employment
- Fed ignores temporary effects of price changes as views unemployment as a bigger priority
The Board of Governors controls the budgets of the Federal Reserve banks, whereas the NCBs control their own budgets and the budget of the ECB in Frankfurt
- ECB, therefore, has less power than does the Board of Governors in the Fed system

The Monetary operations of the Euro system are conducted by the NCBs of each country, so monetary operations aren’t centralized like they are in the Fed system

The ECB is not involved in supervision and regulation of financial institutions unlike the Fed, these tasks are left to the individual countries in the European Monetary Union

In order to finance fiscal budget deficits, the Fed buys government bonds outright, whereas the ECB accepts them as collateral for new loans to the banking system
- In this case, the governments of weaker economies can use the ECB to finance their fiscal deficits and externalize the costs of a loss of purchasing power of the euro onto the entire economies of the Eurozone

Question 20

Similarities between ECB and FED

Answer 20

• Both bind number of regional/national central banks together
• Both are independent institutions with a decentralized structure
• Both employ basic monetary tools such as legal reserve requirements, interest rates, and open market operations

Question 21

BoE origin

Answer 21

• 1694 – is the second oldest central bank in the world

Question 22

BoE structure

Answer 22

• The Court of Directors comprise five executive members from the bank and up to 9 non-executives
• Accountable to parliament
• The King upon recommendation of the PM appoints all members of the Court

Question 23

BoE responsibilities

Answer 23

• Makes independent monetary policy decisions
• Monetary Policy Committee (MPC) makes these
• Sets interest rates to deliver price stability, growth and employment
• Quantative easing – when central banks create new money electronically to buy financial assets from businesses
• Aims directly to increase private sector spending in the economy and return inflation to target
• The Chancellor of the Exchequer announces government inflation target each year
• The minutes of the MPC meetings are published simultaneously with the interest rate decision which gives the BoE less autonomy in comparison with the Fed

Question 24

Financial services act 2012, post GFC

Answer 24

created 3 new bodies:
1. An independent Financial Conduct Authority (FCA.)
2. 2Prudential Regulation Authority (PRA), created as a subsidiary of the bank.
3. 3Financial Policy Committee (FPC).

2 & 3 means new BoE responsibilities for supervising financial market infrastructure providers in the banking system and other financial sectors.

Question 25

Bank of Canada overview

Answer 25

• 1935 in Ottawa, turned publicly owned in 1938
• Practices regulatory and supervisory responsibilities over Canadian banks and reports its monetary policy decisions to House of Commons twice a year
• In the event of a disagreement between the bank and government, minister of finance can issue a directive that the bank must follow
• The Bank of Canada and the government set the goal for monetary policy, a target for inflation, jointly, so the Bank of Canada has less goal independence than the Fed
• Mandate to keep inflation low and preserve value of money

Governing council of BoC, consisting of 4 deputy governors and the governor is the main body compared to the FOMC of the Fed
Monetary Policy Review Committee (MPRC) and economics departments at the Bank assist

Question 26

Bank of Japan overview

Answer 26

• Founded in 1992, in Tokyo, has 32 branches
• Bank of Japan Act 1997 – gave greater instrument and goal independence to the Bank
• Mandates include price stability and sustainable macroeconomic growth
• The Policy Board determines the monetary policy
• Government can send 2 representatives to these meetings but don’t have voting rights, can only request delays
• Ministry of Finance has lost its authority to oversee operations, but has control over the part of the banks budget unrelated to monetary policy
• The BoJ lacks the autonomy to influence the yen exchange rate and acts on behalf of the Ministry of Finance, which instructs the BoJ to conduct foreign exchange intervention by buying/selling yen against foreign currencies using government funds as well as BoJ foreign assets
• Thus, BoJ Act has reduced the independence of the BoJ in comparison to European counterparts

Question 27

People’s Bank of China overview

Answer 27

• Now has largest asset holdings and foreign currency reserves of any CB globally
• Founded in 1949 as merger of 3 of the largest commercial banks
• In an endeavour to liberalise the economy, public allowed to hold minority shares in banks
• Mandate to maintain stability of currency, reduce risk, and promote stability of financial system to enhance growth
• PBoC reports to Standing Committee of the National People’s Congress
• Monetary Policy Committee (MPC) has 13 members including PBoC governor
• Also has key members from various government institutions which reduces its independence

PBoC has been slowly liberalising interest rates, continually publishing deposit and lending rates and has now set banks free to pay depositors whatever interest rate they like

This will increase competition and incentives to the banking sector to create new products in order to increase their profits

PBoC still however remains one of the least independent central banks

Question 28

Independence of Central Banks

Answer 28

When taking about independence we need to think two dimensions of independence:
1. Goal - the ability of the CB to set its own monetary policy objectives or goals.
2. Instrument - the ability of the CB to freely implement monetary policy instruments to meet its monetary goals.
1 and 2 are primary dimensions but political independence has to be considered.
» Free from political interference.

Question 29

The Case for CB independence

Answer 29

Subjecting a central bank to more political pressures would impart an inflationary bias to monetary policy.
» Political business cycle.
Too important to leave monetary policy to politicians.
» The principal-agent problem is worse for politicians.
Politicians often opt for more central bank independence to avoid public criticism.

Question 30

The Case against CB independence

Answer 30

Undemocratic to have monetary policy controlled by an elite group that is responsible to no one.
» Unaccountable.

Difficult to coordinate fiscal and monetary policy. Central banks are not immune from political pressures. CBs have not used their independence successfully.

Question 31

Independence of the FED

Answer 31

Instrument and goal independence. Independent revenue.
Fed’s structure is written by congress, and is subject to change at any time.
Presidential influence:
» Influence on Congress.
» Appoints members.
» Appoints chairman although term are not concurrent.

Question 32

Independence of the ECB

Answer 32

Most independent in the world since it is free from political interference.
Members of the executive board have long terms. Determines own budget.
Less goal independent.
» Price stability.
ECB Charter cannot by changed by legislation; only by revision of the Maastricht Treaty.

Question 33

Independence of the BoE

Answer 33

Has some instrument independence.
* » In 1997, the then Chancellor of the Exchequer, Gordon Brown, announced that the Bank would be granted operational independence over monetary policy.
* » BoE is still owned by the government and operates within a framework that it sets.
Compared to the Fed and ECB, it is not goal independent.

Question 34

Independence of other CB’s

Answer 34

Bank of Canada
» Essentially controls monetary policy
» Less goal independence compared to the Fed.

Bank of Japan.
» In 1998 gained more independence.
» Less independent than its European counterparts.

The People’s Bank of China.
» Remains one of the least independent central banks.

Reserve Bank of India.
» Has some degree of instrument independence.
For these CBs, the trend is toward greater independence

Question 35

Explaining central bank behaviour

Answer 35

One view of government bureaucratic behaviour is that bureaucracies serve the public interest.
Yet some economists have developed a theory of bureaucratic behaviour that suggests other factors that influence how bureaucracies operate.
Theory of bureaucratic behaviour: objective is to maximise its own welfare that is related to power and prestige.

What motivates CB’s could be thus:

» Fight vigorously to preserve autonomy.
» Avoid conflict with more powerful groups.