Lecture 10 - The goals and structure of central banks: the Bank of England, the Federal Reserve of the US and the European Central Bank

Question 1

Central banks’ actions affect…

Answer 1

Interest rates, the amount of credit and the money supply, all of which have direct impacts not only on financial markets, but also on aggregate output and inflation.

Question 2

Price stability, which central banks define as…

Answer 2

Low and stable inflation, is increasingly viewed as the most important goal of monetary policy.

Question 3

What are central banks?

Answer 3

Government authorities in charge of conducting monetary policy and supervising the banking sector.

Question 4

Why is price stability desirable?

Answer 4

A rising price level (inflation) creates uncertainty in the economy, and that uncertainty might hamper economic growth. This view is supported by a growing body of evidence suggesting that inflation leads to economic growth. Furthermore, inflation can strain a country’s social fabric, resulting in severe conflicts.

Question 5

Benefits of price stability.

Answer 5

• Facilitates the efficient allocation of resources in the economy by making it easier for people to disentangle changes in relative prices (that is movements in prices of individual goods and services) from changes in the price level.
• Reduces the distortionary effects of the tax and social security systems.
• Prevents arbitrary redistribution of wealth.
• Benefits economic growth via a reduction of inflation risk premia in interest rates.
• Contributes to avoiding unnecessary hedging activities.
• Increases the benefit of holding cash.

Question 6

Why is high employment a worthy goal?

Answer 6

• The alternative, high unemployment causes much human misery.
• When unemployment is high, the economy has both idle workers and idle resources resulting in a loss of output (lower GDP).

Question 7

Why is unemployment not zero when the economy is at full employment?

Answer 7

• Frictional unemployment, involves searches by workers and firms to find suitable matches. This can be beneficial to the economy.
• Structural unemployment is when there is a mismatch between job requirements and the skills or availability of local workers. This is clearly undesirable.

Question 8

What is the goal for high employment?

Answer 8

The goal for high employment is not an unemployment level of zero but a level above zero, consistent with full employment, at which the demand for labour equals the supply of labour. This level is called the natural rate of unemployment.

Question 9

What are current estimates of the natural rate of unemployment?

Answer 9

Between 4% and 6%, this is subject to much uncertainty and disagreement.

Question 10

How is the goal of economic growth closely related to the high employment goal?

Answer 10

Businesses are more likely to invest in capital equipment to increase productivity and economic growth when unemployment is low. Conversely, if unemployment is high and factories are idle, it does not pay for a firm to invest in additional plants and equipment.

Question 11

Policies can be specifically aimed at promoting economic growth by…

Answer 11

Directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest. This is the stated purpose of supply side economics policies which are intended to spur economic growth by providing tax incentives for businesses to invest in facilities and equipment and for taxpayers to save more.

Question 12

Financial crises can interfere with the ability to channel funds to people with productive investment opportunties and lead to a sharp contraction in economic activity. The promotion of a more stable financial system in which…

Answer 12

Financial crises are avoided is thus an important goal for a central bank.

Question 13

Why is interest rate stability desirable?

Answer 13

Fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future. Consumers may be unwilling to buy certain goods and businesses may be reluctant to invest in physical capital. Upward movements in interest rates generate hostility toward central banks and lead to demands that their power be curtailed. An increase in interest rates produces large capital losses on long term bonds and mortgages, losses that can cause the failure of the financial institutions holding them.

Question 14

With the increasing importance of international trade…

Answer 14

The value of the domestic currency of a country relative to foreign currencies has become a major consideration for the central banks. For example, a rise in the value of the national currency makes domestic industries less competitive with those abroad, and declines in the value of the national currency stimulate inflation in the economy. A sharp decline in the value of the pound stimulates inflation in the UK.

Question 15

Preventing large changes in the value of the domestic currency makes…

Answer 15

It easier for firms and individuals purchasing or selling goods abroad to plan ahead.

Question 16

The natural rate of unemployment is not…

Answer 16

Lowered by high inflation, so higher inflation cannot produce lower unemployment or more employment in the long run. There is no long run trade off between inflation and employment.

Question 17

In the long run, price stability promotes…

Answer 17

Economic growth as well as financial and interest rate stability. Although price stability is consistent with the other goals in the long run, in the short run price stability often conflicts with the goals of high employment and interest rate stability. For example, when the economy is expanding and unemployment is falling, the economy may become overheated, leading to a rise in inflation. To pursue the price stability goal, a central bank would prevent this overheating by raising interest rates, an action that would initially lower employment and increase interest rate instability.

Question 18

Central banks wish to achieve certain goals but they do not directly influence those goals. Central banks typically have a set of 3 tools that they can employ to affect their goals indirectly and with a lag. What are these?

Answer 18

• Open market operations.
• Standing facilities.
• Reserve requirements.
  Consequently, all central banks conduct monetary policy by aiming at variables that lie between their tools and the achievement of their goals.

Question 19

After deciding on its goals, the central bank chooses a set of variables to aim for, called intermediate targets, which have a direct effect on the goals. What are these?

Answer 19

• Monetary aggregates.

- Long term interest rates.

Question 20

However, even these intermediate targets are not directly affected
by the central bank’s policy tools. Therefore, it chooses another set of variables to aim for, called…

Answer 20

Operating instruments, which are more responsive to its tools. These are banks’ reserves, monetary base and short term interest rates. By using intermediate and operating targets, it can more quickly judge whether its policies are on the right track, rather than waiting until it sees the final impact of its policies on its goals.

Question 21

What is instrument independence?

Answer 21

The ability of the central bank to set monetary policy instruments.

Question 22

What is goal independence?

Answer 22

The ability of the central bank to set the goals of monetary policy.

Question 23

What drove the establishment of the Bank of England?

Answer 23

• Public finances were weak at the end of the seventeenth century. The government’s pressing need for money called for a bank designed to provide and arrange loans to the government.
• There was a sense of being on the brink of an enormous expansion of trade. A national bank was needed to mobilise the country’s resources in order to provide finance for trade.

Question 24

Bank Act of 1998 innovated the…

Answer 24

Monetary Policy Committee. According to the Bank Act of 1998, the main policy objectives of the MPC are to maintain price stability, and, subject to that, to support the government’s economic policy in terms of growth and employment. Mandates of this type which put the goal of price stability first, and then say that as long as it is achieved other goals can be pursued, are known as hierarchical mandates.

Question 25

What is the MPC responsible for?

Answer 25

The formulation of monetary policy. It meets monthly and is formed of 9 members.

Question 26

The decision to set interest rates resides with the…

Answer 26

MPC.

Question 27

The inflation target for the Bank of England is, however, set by the…

Answer 27

Chancellor of the Exchequer.

Question 28

The Bank of England is less…

Answer 28

Goal independent than the European Central bank and the Federal Reserve.

Question 29

The BofE has not been granted total instrument independence that is…

Answer 29

The government can overrule the Bank and set rates in ‘extreme economic circumstances’ and ‘for a limited period’.

Question 30

In 1997, the BofE was stripped of two of its prime functions, namely…

Answer 30

The national debt management and the supervision of the banking sector. Both these roles were given to the Debt Management Office and the Financial Services Authority respectively. However, the experience of the global financial crisis led policymakers to abolish the tripartite regime. The FSA was criticised for weak enforcement of regulations and for the inability to properly monitor and regulate the financial sector, hence contributing to the global financial crisis. In favour of a more efficient system of prudential regulation, full responsibility over financial supervision to the Bank of England was returned.

Question 31

What is the history of the Federal Reserve System?

Answer 31

Before the 20th century, a major characteristic of American politics was the fear of centralised power. Open hostility of the American public to the existence of a central bank resulted in the demise of the first two experiments in central banking, whose function was to police the banking system. In absence of a national supervisory body, in the 19th and early 20th centuries, nationwide bank panics became a regular event, culminating in the panic of 1907. The 1907 panic resulted in such widespread bank failures and such substantial losses to depositors that the public was finally convinced that a central bank was needed to prevent future panics. The hostility of the American public to banks and centralised authority created great opposition to the establishment of a single central bank. In 1913, a compromise was struck in the Federal reserve Act, which created the Federal reserve System. the writers of the act wanted to diffuse power along the regional lines, between the private sector and the government, among bankers, business people and the public.

Question 32

The Federal Reserve System has three main entities. What are they?

Answer 32

• Federal Reserve banks.
• Board of Governors of the Federal Reserve System.
• Federal Open Market Committee.

Question 33

How many Federal Reserve districts are there?

Answer 33

Twelve. Each district has one main Federal Reserve bank, which may have many branches in other cities in the district.

Question 34

Reserve banks are quasi public institutions owned by…

Answer 34

The private commercial banks in their district that are members of the Federal Reserve System. These member banks have purchased stock in their district Federal Reserve bank.

Question 35

What are the main functions of Federal Reserve banks?

Answer 35

• Hold deposits for the banks in their district.
• Administer and make loans to banks in their district.
• Operate and ensure the proper working of the payment system for clearing cheques and transferring of electronic payments.
• Supervise and regulate financial institutions in their district, and evaluate proposed mergers and applications for banks to expand their activities.
• Issue new currency and withdraw damaged currency from circulation.
• Collect and make available data on local business conditions. Moreover, they use their staffs of professional economics to research topics related to the conduct of monetary policy. The twelve Federal Reserve banks are directly involved in formulating monetary policy.

Question 36

What are open market operations?

Answer 36

The purchase and sale of government securities that affect both interest rates and the amount of reserves in the banking system.

Question 37

Where is the most important Federal Reserve bank?

Answer 37

New York. The president of the New York Fed is a permanent member of the FOMC and therefore, always has a vote on the FOMC.

Question 38

The Board of Governors is headquartered where?

Answer 38

Washington DC and is made up of 7 members. Each governor is appointed by the president of the US and confirmed by the Senate.

Question 39

To limit the president’s control over the Fed and insulate the Fed from other political pressures, the governors can serve…

Answer 39

One full non renewable fourteen year term plus part of another term, with one governor’s term expiring every other January. The governors are required to come from different Federal Reserve districts to prevent the interest of one region of the country from being overrepresented. The chairman of the Board of Directors is chosen from among the seven governors and serves a four year renewable term. It is expected that once a new chairman is chosen, the old chairman resigns from the Board of Governors, even if there are many years left to his or her term as a governor.

Question 40

What is the Board of Governors involved in?

Answer 40

Decisions concerning the conduct of monetary policy. All 7 governors are members of the FOMC and vote on the conduct of open market operations. As there are only 12 voting members on the FOMC (7 governors and 5 presidents), the Board has the majority of the votes. The Board also sets reserve requirements (within limits imposed by legislation) and effectively controls the discount rate.

Question 41

The chairman of the Board advises the president of the US on…

Answer 41

Economic policy, testifies in Congress, and speaks for the Federal Reserve System to the media. They may also represent the US in negotiations with foreign governments on economic matters.

Question 42

The Board has substantial bank regulatory functions. What are they?

Answer 42

• Approves bank merger applications.
• Supervises and regulates the Reserve Banks (including their budget).
• Together with Federal Banks it supervises and regulates the banking system.

Question 43

What does the Federal Operations Market Committee do?

Answer 43

They usually meet 8 times a year (every 6 weeks) and make decisions regarding the conduct of open market operations, which influence the money supply and interest rates.

Question 44

Even though only the presidents of five Federal Reserve banks are voting members of the FOMC, the other seven presidents of the district banks…

Answer 44

Attend FOMC meetings and participate in discussions. Hence, they have some input into the committee’s decisions.

Question 45

As open market operations are the most important policy tool that the Fed has, the FOMC is necessarily the focal point for policymaking in the…

Answer 45

Federal Reserve System. Although reserve requirements and the discount rate are not actually set by the FOMC, decisions in regard to these policy tools are effectively made there. The FOMC itself does not actually carry out securities purchases or sales.

Question 46

Summarise the Federal Reserve System.

Answer 46

In practice decision-making authority has become highly centralised. The Federal Reserve System can be thought of as one central bank headquartered in Washington. It is practically controlled by the Board of Governors, which in turn is
dominated by the chairman. The chairman:
– Sets the agenda of the Board and FOMC meetings.
– Acts as spokesperson for the Fed.
– Negotiates with Congress and the president of the US.
– Influences the Board through the force of stature and personality.

Question 47

The Federal Reserve has both…

Answer 47

Instrument and goal independence and is remarkably free from the political pressures that influence other government securities. Members of Board of Governors are appointed for a long non renewable 14 year term which eliminates some of the incentive for the governors to seek the approval of the president and Congress. The legislation defining the mission of the Fed states that the goals of maximum employment, stable prices and moderate long term interest rates have been put on the same level. As long term interest rates will be very high if there is high inflation, the Fed has received a dual mandate to achieve two coequal objectives; price stability and maximum employment.

Question 48

How is the Fed financially independent?

Answer 48

It gains a substantial source of revenue from its holdings of securities.

Question 49

Yet, the Federal Reserve is still subject to the…

Answer 49

Influence of Congress, because the legislation that structures it is written by Congress and is subject to change at any time. When legislators are upset with the Fed’s conduct of monetary policy, they frequently threaten to take control of the Fed’s finances and force it to submit a budget request like other government agencies. The president can also influence the Federal Reserve. As congressional legislation can affect the Fed directly or affect its ability to conduct monetary policy, the president can be a powerful ally through his influence on Congress. Additionally, the president is able to appoint a new chairman of the Board of Governors every four years, and a new chairman who is not reappointed is expected to resign from the board so that a new member can be appointed.

Question 50

What is the Maastricht Treaty of 1992?

Answer 50

This created the European Central Bank. It states that “the primary objective of the European System of Central Banks (ESCB) shall be to maintain price stability”. The ESCB still supports other general economic policies such as a high level of employment and sustainable and non inflationary growth.

Question 51

The European Central Bank conducts monetary policies for countries that are members of…

Answer 51

The Economic and Monetary Union (EMU).

Question 52

The ESCB comprises…

Answer 52

The ECB and the National Central Banks (NCBs) of the 27 EU members whether or not they use the euro as their domestic currency.

Question 53

Once all 27 countries of the ESCB adopt the euro the…

Answer 53

ECB and the NCBs of all these countries will merge.

Question 54

The ECB and the NCBs of the 19 countries (Jan 2018) that have adopted the euro form the…

Answer 54

Eurosystem.

Question 55

The Eurosystem includes three main entities. What are they?

Answer 55

• National central banks (Federal Reserve banks).
• Executive board (Board of Governors).
• Governing Council (FOMC).

Question 56

What is the main responsibility of the Governing Council?

Answer 56

Formulate the monetary policy for the euro area. The monetary policy decisions of the Governing Council relate to meeting the general monetary objectives of the eurozone, authorisation of the NCBs to issue currency notes, changes in interest rates and supervising the proper management of foreign reserves. It is also responsible for giving guidelines to NCBs for the implementation of those decisions. Therefore, different from the Federal Reserve System, the decisions in the Eurosystem are implemented via the NCBs in a decentralised way.

Question 57

Why does the Governing Council not have a formal vote, although its members have a legal right?

Answer 57

Instead, the council operates by consensus. One reason it does this is because of worries that the casting of individual votes could lead the heads of NCBs to support a monetary policy that would be appropriate for their individual countries, but not necessarily or the countries in the euro area as whole.

Question 58

What does the ECB do when a Governing Council meeting concludes?

Answer 58

Announces the target for a similar short term interest rate for interbank loans. It then holds a press conference in which the president and vice president of the ECB take questions from the news media.

Question 59

What is the main tasks of the Executive Board?

Answer 59

To ensure the day to day implementation of the monetary policy through giving detailed instructions to all the NCBs in accordance with the guidelines of the Governing Council. It is responsible for managing the daily business of the ECB. With more countries opting to join the euro area it becomes difficult to reach a consensus. To deal with this potential problem, the Governing Council has decided on a complex system of rotation, in which the national central banks from larger countries will vote more often than national central banks from smaller countries.

Question 60

The ECB is the most independent central bank in the world. How can you conclude this?

Answer 60

Like the board of Governors, the members of the Executive Board have long terms (8 years), while heads of NCBs are required to have at least five years long. Like the Fed, the Eurosystem determines its own budget, and the governments of the member countries are not allowed to issue instructions to the ECB. It is prohibited from granting loans to national public sector entities, in order to shield it from any influences by public authorities. Moreover, to ensure the independence of NCBs, the ECB strictly forbids them from taking instructions from European Community institutions, any government of an EU member state or any other international body. This ensures total conformity of the NCBs with monetary policy decisions undertaken by the Governing Council.

Question 61

The ECB is both…

Answer 61

Instrument and goal independent of the national governments.

Question 62

Arguments for independence.

Answer 62

• Subjecting central banks to more political pressures would impart an inflationary bias to monetary policy.
• Politicians may be short sighted because they are driven by the need to win their next election. With this as their primary goal, they are unlikely to focus on long run objectives such as promoting a stable price level. Instead they will seek short run solutions to problems, such as high unemployment and high interest rates, even if the short run solutions have undesirable long run consequences. A politically insulated central bank is more likely to be concerned with short run objectives.
• The political process in democratic societies could lead to a political business cycle, in which just before an election, expansionary policies are pursued to lower unemployment and interest rates. After the election, the bad effects of these policies, high inflation and high interest rates, cause problems requiring contractionary policies that politicians hope the public will forget before the next election.
• Putting the central bank under the control of the Treasury or fiscal agent of the government (making it more subject to influence by the leader of the country) is also considered dangerous because the central bank can be used to facilitate financing of large budget deficits by its purchases of government securities. Government pressure on the central bank to ‘help out’ could lead to more inflation in the economy. An independent central bank is better able to resist this pressure from the government.
• Control of monetary policy is too important to leave to politicians, a group that has repeatedly demonstrated a lack of expertise at making hard decisions on issues of great economic importance, such as reducing the budget deficit or reforming the baking system.
• Both the central bank and politicians are agents of the public (the principals) and they have incentives to act in their own interest rather than in the interest of the public. The principal agent problem is worse for politicians than for the central bank because politicians have fewer incentives to act in the public interest. An independent central bank can pursue policies that are politically unpopular, yet in the public interest.

Question 63

Arguments against independence.

Answer 63

• It is undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group that is responsible to no one. If the central bank performs badly, there is no provision for replacing members (as there is with politicians). In view of the danger that an independent central bank will not be accountable, delegation of power to an independent institution requires guaranteeing its accountability. For this reason, several institutional reforms geared towards more accountability of central banks have been implemented in order to limit the costs associated with a higher degree of autonomy.
• The public holds the president, the cabinet and the parliament responsible for the economic well being of the country, yet they lack control over the government agency that may well be the most important factor in determining the health of the economy. In addition, to achieve a cohesive programme that will promote economic stability, monetary policy must be coordinated with fiscal policy. Only by placing monetary policy under the control of the politicians who also control fiscal policy can these two policies be prevented from working at cross purposes.
• An independent central bank has not always used its freedom successfully. For example, the Fed failed miserably in its stated role as lender of last resort during the Great Depression, and its independence certainly didn’t prevent it pursuing an overly expansionary monetary policy in the 1960s and 1970s that contributed to rapid inflation in that period.
• Central banks are not immune from political pressures and that independence may encourage them to pursue a course of narrow self interest rather than public interest. In particular, the theory of bureaucratic behaviour argues that an important factor affecting central banks’ behaviour is their attempt to increase their power and prestige. An implication of this incentive is that central banks will fight vigorously to preserve their autonomy and will try to avoid conflict with political groups that may threaten to curtail their power and reduce their autonomy.

Question 64

People who like the central bank policies are more likely to…

Answer 64

Support its independence, while those who dislike its policies advocate a less independent central bank.

Question 65

Inflation performance is found to be the best for countries with…

Answer 65

The most independent central banks. Although a more independent central bank appears to lead to a lower inflation rate, this is not achieved at the expense of poorer real economic performance. Countries with independent central banks are no more likely to have high unemployment or greater output fluctuations than countries with less independent central banks.