Money and Banking. Lecture II: Central Banking and Conventional Monetary Policy Tools. Guoxiong ZHANG, Ph.D. Shanghai Jiao Tong University, Antai

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1 Money and Banking Lecture II: Central Banking and Conventional Monetary Policy Tools Guoxiong ZHANG, Ph.D. Shanghai Jiao Tong University, Antai September 19th, 2017

2 First Impression of the Federal Reserve Source:

3 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 dynasties of 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 of Japan (1882), Federal Reserve Bank of the US (1913), Deutsche Bundesbank (1957), People s Bank of China (1979)

4 Origin of the FED Resistance to establishment of a central bank: Fear of centralized power Distrust of moneyed interests No lender of last resort Nationwide bank panics on a regular basis Panic of 1907 so severe that the public was convinced a central bank was needed Federal Reserve Act of 1913 officially established the FED A quasi-public institution

5 Structure of the Federal Reserve Source: Mishkin (2013)

6 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 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

7 How Independent is the FED? Very independent: independent revenue (Federal Reserve Transparency Act) independent monetary policy target and tools long tenure of the members of the board of governors Not fully independent: Fed s structure is written by the Congress, and is subject to change at any time The chairman has to frequently testify in front of the Congress Presidential influence FED is the most independent central bank in the world (only the ECB is comparable)

8 Central Bank Independence Two types of independence: goal independence instrument indepence Reason for central bank independence: free of political pressures that usually cause short-sighted and inflation biased policy Reason against central bank independence: a joint usage of monetary policy and fiscal policy would be more effective Measure of central bank independence: ownership of the bank capital the bank s affiliation (congress, treasury department or cabinet) relationship with the treasury (source of funding, obligation to make loans to the government) appointment of the bank officials representatives from government to the policy committee in the bank

9 Central Bank Independence in Advanced Economies Source: Alesina and Summers (1993)

10 Central Bank Independence and Inflation Level Source: Alesina and Summers (1993)

11 Central Bank Independence and Inflation Volatility Source: Alesina and Summers (1993)

12 Central Bank Independence and Inflation, Emerging Market Economies Source: Haan and Kooi (2000)

13 Balance Sheet of Commercial Banks Source: Mishkin (2013)

14 Balance Sheet of the FED htm#h41tab9

15 Monetary Base and Its Determination Monetary base (high power money) = currency in circulation + reserves FED, commercial banks and households jointly determine the monetary base The FED can only determine the non-borrowed monetary base through open market operation The borrowed reserve is determined by FED and the commercial banks The households decide whether to hold currency or to deposit: change the composition of monetary base but not its total size

16 Conventional Monetary Policy Tools Open market operation: primary monetary policy tool for the FED uses 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 snowy weather seasonal credit Required reserve ratio: varies according to the total amount of checkable deposit usually about 10% (8% - 14%), can be as high as 18% at extreme cases Interest on reserves

17 Multiple Deposit Creating Source: Mishkin (2013)

18 Deposit Multiplier Assuming that banks does not hold excessive reserve and that households do not hold cash, then required reserve must equal the total reserve: R = RR = rr D D = 1 rr R D = 1 rr R, that is the deposit multiplier is 1 rr. In reality, the deposit multiplier should be much smaller than this one.

19 Money Supply Source: Mankiw (2010)

20 Money Multiplier Define: currency ratio: c = C ER D ; excessive reserve ratio: e = D ; required reserve ratio: r = RR D MB = required reserve + excessive reserve+ currency= (r + c + e)d Hence D = 1 r+e+c MB Money supply: M = checkable deposit + currency = (1 + c)d Money multiplier: m M MB = 1+c r+e+c The money multiplier is jointly determined by the FED, commercial banks and households

21 Excessive Reserve Ratio and Currency Ratio, Source: Mishkin (2013)

22 Money Multiplier, Source: Mishkin (2013)

23 Excessive Reserve Ratio and Currency Ratio, Source: Mishkin (2013)

24 Money Multiplier, Source: Mishkin (2013)

25 The Market for Reserves and Federal Funds Rate Source: Mishkin (2013)

26 Open Market Operation and Federal Funds Rate Source: Mishkin (2013)

27 Discount Rate and Federal Funds Rate Source: Mishkin (2013)

28 Required Reserve Ratio and Federal Funds Rate Source: Mishkin (2013)

29 Interest Rate on Reserves and Federal Funds Rate Source: Mishkin (2013)

30 Advantages of Open Market Operation Open market operations occur at the initiative of the Fed, which has complete control over their volume; Open market operations are flexible and precise; they can be used 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 have accumulated large amounts of excess reserves when the Fed to perform its role of lender of last resort