Central Banks and Monetary Policy Flashcards

Origins of the Central Banking System

• The oldest central bank: Sveriges Riksbank (Bank of Sweden), established in 1668.
• Bank of England (BoE) founding in 1694: the archetype for central banks.
• Initially, central banks were private or joint-stock, offering commercial and banking services.
• They issued currency, held gold reserves, and acted as repositories for banks.
• Many central banks were nationalized after the Great Depression, gaining autonomy in monetary policy.
• Some, like the Federal Reserve, remained private to ensure autonomy, raising conflict of interest concerns.

Ownership of Central Banks: Public vs. Private

• Public ownership: Acts in the public interest via shared community representation.
• Addresses concerns that private ownership can bias banks toward profit-making, increasing risks.
• Private ownership: Guarantees independence from government fiscal concerns.
• Limits control via share restrictions and dividend limits; private owners elect audit committee members and advisors.
• Public ownership ensures transparency, while private ownership increases independence.
• Broader governance rules enhance the efficiency and economic roles of central banks.
• As long as the central bank is accountable to the parliament and obliged to meet the monetary goals of the economy, ensure financial steadfastness, maintain price stability and pursue economic growth, then central bank ownership does not really matter.

Evolution and Functions of Central Banks

• Central banks in Europe were considered essential for bank oversight, while Americans were wary of centralized power.
• The Federal Reserve was established in 1913 with distributed power among 12 regional banks.
• Central bank functions expanded to include regulating currency value, financing government, and acting as a lender of last resort.
• While most are publicly owned, some, like the Federal Reserve and Bank of Italy, are privately owned.
• The roles of central banks have grown in importance over time and their activities continue to evolve.

The European Central Bank (ECB) and the Eurosystem

• Established June 1, 1998, to handle Eurozone transitional issues.
• The Eurozone includes EU member states that adopted the euro.
• The Eurosystem comprises the ECB and the National Central Banks (NCBs) of Eurozone members.
• The European System of Central Banks (ESCB) includes the ECB and all EU NCBs, whether in the Eurozone or not.
• ECB capital is owned by EU central banks, with shares weighted by population and GDP.

Decision-Making Bodies of the ECB

• Governing Council: Formulates monetary policy; consists of the ECB president/vice-president, Executive Board members, and 19 National Central Bank governors.
• Executive Board: Manages day-to-day operations and implements Governing Council decisions.
• General Council: Encourages cooperation among EU NCBs; includes the ECB president/vice-president and the governors of the 28 EU member states.

Monetary Policy within the ECB

• Objectives: Price stability (inflation below 2%), support Eurozone economic policies, and ensure an independent market economy.
• The Governing Council controls money supply and sets interest rates:
  • Deposit facility rate.
  • Refinancing rate.
  • Marginal lending facility rate.
• Operational framework includes:
  • Open market operations.
  • Standing facilities for overnight liquidity.
  • Minimum reserve requirements.
• Unconventional measures like emergency liquidity assistance (ELA) and quantitative easing (APP, SMP) have been used.
• Since 2014, the ECB has introduced a negative interest rate policy (NIRP) on bank deposits.

The Importance of the Bundesbank within the ECB

• Modeled after the Deutsche Bundesbank, the ECB is headquartered in Frankfurt, Germany.
• The Bundesbank has influence due to its size but faces burdens during crises, such as bailouts.
• It protests the ECB's monetary financing of budget deficits, demanding a greater role in banking supervision.

Non-Euro Central Banks and EU Membership

• Nations like the UK, Denmark, and Sweden avoided euro adoption to retain fiscal and monetary autonomy.
• Floating exchange rates and independent policies help non-Eurozone EU members absorb external shocks.
• EU rules allow conventional monetary policies but require coordination with the ECB during financial crises.

The Federal Reserve System (The Fed)

• Independent entity privately owned by member banks, subject to congressional oversight.
• Supervises financial institutions and acts as their banker.
• 12 regional Federal Reserve banks implement the Fed’s dual mandate: long-term price stability and macroeconomic stability.
• The system consists of:
  • Federal Reserve Board of Governors (FRB).
  • Federal Open Market Committee (FOMC).
  • 12 Federal Reserve banks.
  • Private U.S. member banks.
  • Federal Advisory Council.

Difference between the ECB and the Fed

• Both bind regional central banks, are independent, and use monetary tools like reserve requirements and open market operations.
• The ECB aims for price stability, while the Fed has a dual mandate of price stability and macroeconomic objectives.
• The ECB lacks power compared to the Fed because National Central Banks control their own budgets.
• Monetary operations in the Eurosystem are decentralized, unlike the centralized Federal Reserve System.
• The ECB does not supervise financial institutions; these are left to individual countries.
• The Fed buys government bonds outright, while the ECB accepts them as collateral.

The Bank of England (BoE)

• Founded in 1694; its model has been the basis of most other central banks of the world.
• The government has statutory authority over the Bank of England.
• The Court of Directors is accountable to Parliament.
• The Monetary Policy Committee (MPC) conducts monetary policy independently from the ECB.
• The MPC sets interest rates to deliver price stability and support economic objectives.
• The BoE uses quantitative easing as an unconventional policy, with inflation targets announced annually.

Brexit and the BoE

• Brexit refers to the United Kingdom’s intended withdrawal from the EU.
• Macroeconomic concerns influenced the Brexit decision, including weakened demand in the UK due to the euro area crisis.
• Brexit will have economic and financial repercussions, with potential increases in costs and difficulties in regulating financial firms.
• The repercussions depend on the future relationship between the UK and the EU (hard vs. soft Brexit).

Structure of Central Banks of Larger Economies

• Bank of Canada (BoC):
  • Started operations in 1935, becoming publicly owned in 1938.
  • Regulatory and supervisory responsibilities over Canadian banks.
  • Directors appointed by the Minister of Finance.
  • Monetary policy goal set jointly by the Bank of Canada and the government.
  • The Governing Council, assisted by other committees, makes monetary policy decisions.
• Bank of Japan (BoJ):
  • Founded in 1882; restructured after WWII.
  • The main mandates are price stability and financial sector stability.
  • The Policy Board determines monetary policy.
  • The government may send representatives to board meetings, but they no longer have voting rights.
  • The Ministry of Finance controls the part of the Bank’s budget that is unrelated to monetary policy.
• People’s Bank of China (PBoC):
  • Founded in 1949.
  • Main mandate is to maintain currency stability, reduce risk, and promote financial system stability.
  • The Monetary Policy Committee (MPC) makes monetary policy decisions quarterly.
  • High reserve requirements are used to control liquidity.
  • Slowly liberalizing interest rates, but remains one of the least independent central banks.

Structure and Independence of Central Banks of Emerging Market Economies

• EMEs' central banks play complex roles, including financial infrastructure development and macroeconomic development.
• They also manage foreign exchange reserves and promote growth and exports.
• Central banks enhance credit flow to productive industries and implement financial inclusion policies.
• Coordination with fiscal agents reduces independence.

Central Banks and Independence

• Independence consists of goal independence and instrument independence.
• Arguments for independence:
  • Addresses potential inflationary biases and political business cycles.
  • Avoids politically motivated decisions due to public distrust.
  • Politicians can grant independence to avoid criticism during unpopular decisions.
• Arguments against independence:
  • Macroeconomic stability best achieved with coordinated monetary and fiscal policy.
  • Central banks may pursue self-interest at the expense of public interest.
• The trend toward greater independence:
  • Most central banks are made accountable to parliaments and transparent about operations.
  • Fiscal and monetary agents increasingly coordinate policies.

Key Terms

• Brexit: The United Kingdom’s intended withdrawal from the EU in the wake of a 51.9% referendum vote on June 23, 2016
• Emerging market economies: fast growing export-oriented economies in Asia, Latin America and Eastern Europe.
• Euro area or zone: economic and monetary union comprising of the member states of the European Union (EU) that have adopted the euro as their currency.
• European Central Bank (ECB)
• European System of Central Banks (ESCB)
• Eurosystem: comprises the ECB and the National Central Banks (NCBs) of those EU member states that have adopted the euro.
• Executive Board of the ECB
• Federal Open Market Committee (FOMC)
• Federal Reserve Board of Governors (FRB)
• Federal Reserve System
• Financial inclusion policies
• General Council of the ECB
• Goal independence: institutional characteristics that insulate the central bank from political influence in defining its monetary policy objectives
• Governing Council of the ECB:
• Instrument independence: ability of the cen- tral bank to freely implement policy instruments in its pursuit to meet its monetary goals.
• Political business cycle:
• Quantitative easing: unconventional form of monetary policy where a central bank creates new money electronically to buy financial assets from businesses.