Global Financial Systems The Central Bank

The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Global Financial Systems

Chapter 5
The Central Bank
Jon Danielsson
London School of Economics
2013
To accompany
Global Financial Systems: Stability and Risk
http://www.globalfinancialsystems.org/
Published by Pearson 2013
Global Financial Systems 2013 Jon Danielsson, page 1 of 50
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Book and slides
The tables and graphs are
the same as in the book

See the book for
references to original data
sources
Updated versions of the
slides can be downloaded
from the book web page
www.globalfinancialsystems.org
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Central Bank (CB)
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Role of the central bank

The most important institution in the financial system
Has monopoly on printing money liquidity, QE,...
Functions
1. Monetary policy
2. Macroeconomic objectives
3. Financial stability
4. Supervision
5. (Bailing out governments)
Over time, the relative importance of those changes
frequently
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Background
Often was a private bank
Perhaps established to help in war financing
And may retain some private ownership or connections
But generally is under the control of the government
In some countries private banks may issue money
Danske bank in Northern Ireland, HSBC in Hong Kong,
etc.
May have other names such as monetary authority or
reserve bank or federal reserve system

We use the term central bank to encompass all these
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Some central banks
First: Swedish Riksbank 1668

Second: Bank of England (BoE, Bank) 1694
Last among major countries: Federal Reserve System
(Fed) in the US, 1913
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Supervision
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Supervision and regulation

Regulations refers to the law and the interpretation of the
law by regulators
Supervision refers to the enforcement of regulations
The boundary can be blurred supervisors need to
interpret regulations
Becomes especially problematic if supervisors and
regulators belong to different agencies
Like in Europe Common rulebook the goal to aspire to
While we will discuss financial regulations in detail later,
the key question here is
Should supervision be a part of the central bank?
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Arguments for separation
Conflict of interest
1. Monetary policy should be countercyclical, while the
effects of regulation and supervision tend to be
procyclical
Reputation risks
1. The reputation of the central bank is more likely to
suffer, than to benefit, from bank supervision
2. e.g. BCCI in 1991
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Arguments against separation
Central banks have no choice but to engage with financial
stability, and need to have information and power

Information
1. Supervisory information is valuable for forecasting key
macroeconomic variables and thus implementing
monetary policy
2. CBs also have the responsibility for ensuring the smooth
working of various payment systems
3. CBs need to be informed to act as a LOLR
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Supervisory structure in the US
The Fed shares the responsibility for regulating and
supervising the US financial system with other agencies

Including the SEC, OCC and FDIC
The Fed also serves as the umbrella supervisor of all bank
holding companies
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Supervisory structure in the UK

In 1998, the Financial Services Authority (FSA) was
established to supervise commercial banks in UK

During this financial crisis, the UKs tripartite
regulatory system BoE, FSA and the Treasury failed
in a number of important ways
e.g. the run on Northern Rock, RBS buying ABN Amro
The FSA has been abolished and the Prudential
Regulation Authority (PRA) is now part of the BoE
The independent Financial Conduct Authority (FCA) is
tasked with microprudential duties
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Supervisory structures in Europe
In the euro area, the ECB is responsible for monetary
policy
Supervision is still in the hands of the nation state
This is not optimal since European banks operate across
borders
Ideally we would have a European supervisor
European banking union is discussed later
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Monetary policy
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Money
World before 1870:
GOLD
SILVER
BIMETALLISM
Mercantilism, increasing capital
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Fiat money
Money created by governments

First example in China in the 12th century led to high
inflation
Often ends up in too much money being printed, inflation
and failure of the issuing bank
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Monetary policy
The maindaytoday function of the central bank
Often paired with fiscal policy
These two are used to meet government objectives,
perhaps
level of aggregate output
employment
inflation
By controlling
the supply of money
availability of money
cost of money or rate of interest
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Money supply and objectives
Money is M (recall M0, M1, M2 and M3 )

Expansionary monetary policy M Typical objective to
combat unemployment or stimulate the economy, or

prevent deflation
Contractionary monetary policy M Combat inflation
and overheating economy
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Interest rates
The central banks control the shortest interest rates

Why?
There are many different names and mechanisms
CBs do not directly control rates for longer maturities
Twist operations can be used
Often they use inflation targeting and some form of the
Taylor rule (next page)
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Taylor rule
By having a formal rule, a central bank may avoid
inefficiencies induced by a discretionary policy

it = t + rt + a (t t ) + ay (yt yt )
it is the target shortterm nominal interest rate
t the inflation rate (the GDP deflator)
t the desired rate of inflation
rt is the equilibrium real interest rate
yt an estimate of the logarithm of real GDP and yt is the
logarithm of potential output, obtained by a linear trend
yt yt is the output gap
The parameters are restricted to be positive, a , ay > 0,
and Taylor proposed setting them at 0.5
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Central bank lending
Effectively a ceiling for market (riskfree) rates

In some countries also a floor by setting a slightly lower
rate on reserves held by banks

Also used to provide emergency liquidity in crises
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Open market operations

Most common procedure trading government bonds
on the open market

Buying M increase the reserve account of sellers
bank
Increases the total volume of reserves in the system
If there are aggregate excess reserves, market rates are
competed down
Hence expansionary open market operations do r
And vice versa
Most common in developed economies
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Recall reserve requirements

Reserve requirement the minimum reserve a bank
must hold at the CB

Lowering reserve requirements reduces the demand for
reserves
Contrast with expansionary open market operations which
increase the supply of reserves
But roughly the same effect r
M1 = M0 =
Changing the reserve requirements, , changes the money

multiplier, , and hence the volume of M1 given an
amount of M0
Most common in emerging markets (e.g. China)
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Chinese reserve requirements

20%
15%
10%
5%
0%
2004
2005
2006
2007
2008
2009
2010
2011
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Quantitative easing QE
Used when danger of deflation and interest rates are close
to 0
Traditional monetary policy tools dont work
Interest cant be below 0 and banks hoard balances at
the central bank

Involves buying securities typically government bonds
but can be anything from the public

The difference between QE and open market operations is
scale, scope and motivation
More efficient might be helicopter drops of money (next
slide)
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Helicopter drops of money

The central bank directly increases money supply
Let us suppose now that one day a

helicopter flies over this community and drops
an additional $1000 in bills from the sky, ... Let
us suppose further that everyone is convinced
that this is a unique event which will never be
repeated,
Milton Friedman 1969
Friedman suggested that a monetary authority can escape
a liquidity trap by bypassing financial intermediaries to

give money directly to consumers or businesses
This is referred to as a money gift or as helicopter money
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
QE in UK
The BoEs QE operations amount to 375 billion
Or 6,048 for each of the 62 million people that live in
the UK
Instead of buying government bonds, the Banks QE
operations would likely have been much more effective if
It simply had sent an envelope with 6,048 in notes to
each person in the UK

Except of course the real purpose of QE is perhaps to bail
out the Treasury

At the expense of savers (works like a tax on pensions
savings)
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Financial Stability
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Financial stability
A modern term that encompasses additional functions of
the central bank

Because it has a monopoly on printing money it is the
only institution that can provide liquidity support in a
crisis
We discuss this in detail in a later chapter
So generally, the central bank has the ultimate
responsibility for the stability of the financial system
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
However
Financial stability and monetary stability are often in
conflict
Increasing liquidity in a crisis can be inflationary
And the education and experience of central bank staff
dealing with monetary policy is very different from
financial stability
When central banks neglect financial stability, as was
common before the crisis, they can be woefully
illprepared when a financial crisis happens
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Bailing Out Governments
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Bailing out governments
Its not one of the four core functions listed above

But always has been a core function
Even a founding function
BoE founded to help with war funding
Usually viewed as dirty or unseemly
However, under the right conditions it is appropriate
We see the danger a few slides down
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Mechanisms
Print money and buy government bonds

Unexpected inflation
Why cant it be expected?
Cagan double exponential model below
Seigniorage
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Central bank holdings of government bonds

relative to GDP, end of year
16%
UK
USA
12%
8%
4%
0%
2005
2006
2007
2008
2009
2010
2011
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Pros and cons

Only recommended in exceptional circumstances
When done routinely it locks in inflationary expectations
very costly to eventually fight

If the economy is in deep recession (way below output
potential)
And inflation negligible
Justified for two reasons
1. relieves pressure on government
2. reverses contracting money supply
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Case of one CB one nation state

In most cases the CB belongs to a single nation state
In that case, using the CB to bail out the state is
effectively a tax
And like any other tax has distributional effects
Disproportionately falling on pensioners and savers (who
often cant do much about it)

And benefiting borrowers
Most of the cost falls on domestic residents

For all the talk of the cost of QE in the US and the
impact on China, that is only a small fraction of the
overall impact, the vast majority falling on US residents
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
European Central Bank (ECB)

Belongs to 17 governments
By using the ECB to bail out (private or public entities) it
is a tax on all residents of the euro zone for the benefit of

some countries only
Turns the EU into a transfer union
This limits the legitimacy of the ECB to fulfil its core
functions
Two possibilities
because the ECB belongs to no one, it is easy to abuse it
and therefore it is subject to excessive amounts of rules
and restrictions limiting its flexibility
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Challenges for Central Banking
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Conflict between financial stability and

monetary policy
During the gold standard, financial stability was the main
priority as monetary policy took care of itself

After World War II, the financial system was highly
regulated with very few financial crises
Financial stability low priority
Governments misinterpreted Keynes and used monetary
policy routinely to stimulate the economy
End result stagflation
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
From the 1980s

Inflation a serious issue
Consequently, central banks focused much more on
monetary policy than financial stability

As a consequence, in the 1980s and 1990s monetary
policy
became the main even only objective of central banks
Successful generals syndrome
Decoupling supervision from the central banks
exacerbated this problem

This left them woefully unprepared in 2007
This is a key explanation for how poorly many central
banks reacted to the crisis
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Objectives may coincide
Deleveraging during crises leads to a reduction in money
supply even deflation

Increase in liquidity needed for both financial stability and
monetary policy
One tool two purposes
Interest rates needed for two different purposes
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Central bank independence
Monetary policy suggests central bank independence

Because politicians like to use interest rates for
shortterm political gains

The case is not as clear cut for financial stability
The use of taxpayers money to help private institutions is
a political matter, involving the finance ministry/treasury
It is unlikely to be the best equipped, but is the most
appropriate
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
When things go wrong

Ideally, inflation should be constant at a low rate e.g.
3%
The reason is price uncertainty holds back economic
growth
High inflation is costly not to mention hyperinflation
Deflation is costly
The best way to destroy the capitalist system is to debauch
the currency. Vladimir Lenin
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Hyperinflation
Hyperinflation over 50% per month

Most of the important episodes occurred in
Europe after WWI and WWII
Latin American in the 1980s and 1990s
Former Soviet Union in the 1990s
All-time record: Hungary 1945-1946, prices tripled daily
Large costs of inflation
One cause is seignorage to finance budget deficits
The Central Bank
Country
Supervision
Monetary policy
Highest
month
Hungary
Jul 1946
Zimbabwe Nov 2008
Yugoslavia Jan 1994
Germany
Oct 1923
Greece
Oct 1944
China
May 1949
Financial stability
Highest monthly
inflation rate
4.19 1016 %
8 1010 %
3 108
29,500%
13,800%
2,178%
Bailing
Challenges
Prices
double
15.0
24.7
1.4
3.7
4.3
6.7
hours
hours
days
days
days
days
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
The Weimar republic (Germany) 19211923
First documented economic behavior of hyperinflation

Dramatic increases in prices and interest rates,
redenomination of the currency, flight from cash to hard

assets etc.
Main cause was the treaty of Versailles and war
reprarations
60 marks per dollar in 1921 to 8000 end of 1922
Ended with the introduction of the Rentenmark
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Zimbabwe from 1980

Chronic hyperinflation since independence in 1980
1 Zimbabwe dollar was worth about USD 1.25
Inflation 624% in 2004, 1,730% in 2006
August 2006 revalued currency at 1,000 :1
Inflation 11,000% 2007, issue of larger denomination
notes
100m, 250m, 500m, 25b then 100b between May and July
November 2008, inflation 516 quintillion percent
On 16 January 2009, issued a ZWD 100 trillion bill
Redenomination on February 2009 removing 12 zeroes
(and 10 zeros in August 2008)
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Hyperinflation in Germany and Zimbabwe

Notice the similar course of price growth
Consistent with Cagans 1956 empirical model
Jan/1922
1014
Jul/1922
Jan/1923
Jul/1923
1010
Zimbabwe
Germany
1010
107
104
106
101
10
2001
2002
2003
2004
2005
2006
2007
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Deflation
When prices fall
It is costly because
1. Those with money postpone purchases because things
will be cheaper in the future
2. This makes prices fall even more
3. A vicious cycle
Benefits those who own money
Is costly for most businesses (who borrow to operate)
And regular workers who see salaries drop
The Central Bank
Supervision
Monetary policy
Financial stability
Bailing
Challenges
Some examples
The gold standard

The Great Depression
Japan from 1990
Adjusting to it is costly
1. Not quite deflation but Germany reduced domestic
factor costs in the 2000s internal devaluation
2. Similar to problems facing European sovereigns in
trouble

Global Financial Systems The Central Bank

Uploaded by

Copyright:

Available Formats

Global Financial Systems The Central Bank

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Global Financial Systems The Central Bank

Uploaded by

Copyright:

Available Formats

The Central Bank