CENTRAL BANK

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CENTRAL BANK
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The Picture of a Cautious Central Banker
The Suspenders
ECB President Wim Duisenberg, wears both a belt
and suspenders. Theres no chancehis pants
will fall down!
The Belt
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• A central bank, reserve bank or monetary
  authority, is an entity responsible for the
  monetary policy of its country or of a group of
  member states. Its primary responsibility is to
  maintain the stability of the national currency
  and money supply, but more active duties include
  controlling loan interest rates, and acting as a
  "bailout" lender of last resort to the banking
  sector during times of financial crisis.

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• It may also have supervisory powers, to ensure
  that banks and other financial institutions do
  not behave recklessly or fraudulently.

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• In most countries the central bank is state
  owned and has a minimal degree of autonomy, which
  allows for the possibility of government
  intervening in monetary policy. An "independent
  central bank" is one which operates under rules
  designed to prevent political interference
  examples include the European Central Bank, and
  the Federal Reserve.

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GOALS

• Goals low inflation, output stability, external
  balances,full employment etc.
• Unless it has only a single goal, the central
  bank is forced to strike a balance among
  competing objectives

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• Difficulties for deriving an optimal policy
  rule
• Defining the objective function
• Weights of these objectives,
• Central banks must in a figurative, not literal
  sense create their own social welfare function
  based on their legal mandate, their own value
  judgment and perhaps their reading of the
  political will. (Alan S. Blinder-Former Deputy
  Chairman of FED)

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Difficulties for deriving an optimal policy
rule

• Macro Model Uncertainty Monetary policy making
  requires more than just qualitative information
  that theory provides
• Economies change over time
• Exogenous factors

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• Lags in policy implementation
• Monetary policy operates on an economy with
  long and variable lags.
• Monetary policy horizon estimate for
• UK 8 quarters, Turkey 6 quarters.
• Monetary policy decision must be thought of as a
  first step along a path

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Different interpretations for the utility
function

• At a time when the price level is rising and
  employment is relatively full, price stability
  takes precedence over full employment as a policy
  objective. At a time when prices are stable and
  unemployment is rising, on the other hand
  employment becomes the prime objective.
• Charles E. Whittlesey (1970)

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• The country specific factors, the economic
  conditions, the status of the Central Banks as
  well as many other factor determine the process
  of prioritizing goals.

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• The main goal of monetary policy for most
  central banks is to maintain the internal and
  external value of the domestic currency. In the
  domestic economy this means to keep inflation low
  and steady. In order to achieve the goal, the
  authorities need to decide on targets against
  which the implementation of monetary policy can
  be assessed and the monetary policy instruments
  used to achieve the target(s).

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Impossible Trinity

• In a fully liberalised system, including full
  convertibility on the external current and
  capital accounts, the central bank cannot for
  very long maintain both an independent domestic
  monetary policy - whether on interest rates or
  the money supply - and the exchange rate. If it
  has an independent target for interest rates, for
  example, it will have to accept the
  market-determined exchange rate. If, on the other
  hand, it targets the
• exchange rate it will have to accept the
  interest rates (and quantity of domestic money)
  necessary to keep the exchange rate stable.

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• The point is that you can't have it all A
  country must pick two out of three. It can fix
  its exchange rate without emasculating its
  central bank, but only by maintaining controls on
  capital flows (like China -1999) it can leave
  capital movement free but retain monetary
  autonomy, but only by letting the exchange rate
  fluctuate (like Britain--or Canada) or it can
  choose to leave capital free and stabilize the
  currency, but only by abandoning any ability to
  adjust interest rates to fight inflation or
  recession (like Argentina -1999)."
• Paul Krugman(1999)

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• Monetary operations refer to the implementation
  of monetary policy.Under this broad umbrella, the
  monetary authorities need to decide which
  specific targets to aim at, and which policy
  instruments should be used. For most countries
  the final long-term monetary target of the
  central bank is low and stable inflation. For
  operational purposes, however, the day-today
  target is usually to achieve a particular level
  of interest rates, commercial banks reserves or
  the exchange rate.

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• In market economies it is widely held that in
  the long run the most efficient instruments of
  monetary policy are those which best complement
• the workings of a market system. This is why
  indirect and market-based instruments are
  preferred to administrative controls. The latter
  may work for a while, but tend to distort markets
  and are open to evasion.

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• The main monetary policy instruments available
  to central banks are
• open market operation,
• bank reserve requirement,
• interest-rate policy,
• re-lending and re-discount (including using the
  term repurchase market),
• credit policy

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Development of Central Banking Functions
Functions Monetary Policy(egsetting int.rates
or exchange rates) Financial Sector
Stability(egBanking supervision) Government
Debt Man. Payment Systems Branch Network
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• How to read the graph
• A point close to the center of the chart
  indicates little or no involvement
• At the edge full involvement
• Note issuance is at the center

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Functions of the Central Bank

• In general a look at a specific central banks
  balance sheet indicates the functions of that
  particular central bank. The following ten
  accounts, five asset and five liabilities
  account, typically appear on the balance sheet of
  a central bank.

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Liabilities

• Notes payable
• Deposits of banks
• Treasury deposits
• Foreign deposits
• Deferred availability items

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Assets

• Gold
• Loans to banks
• Government Securities
• Foreign Securities
• Items being collected

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• Notes payable Central banks issue currency.
• Deposits of banks Central banks play the role of
  banker to commercial banks. Commercial banks use
  central bank in a manner analogous to the way
  that a citizen uses a local bank.
• Treasury deposits Central banks play the role of
  banker to governments.

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• Foreign deposits Central banks play banker for
  other central banks and other official or
  authorized institutions of foreign governments.
• Deferred availability items Central banks often
  clear checks for commercial banks just as
  commercial banks will clear customers check.

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• Gold Central banks hold gold as a safe asset
  class and for long term investment.
• Loans to banks Central banks make loans to
  commercial banks.
• Government Securities Central banks hold
  government securities whether issued by the
  Treasury or other federal agencies. Sometimes
  central banks will hold securities of private
  corporations or perhaps even shares of stock
  traded on exchanges.

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• Foreign Securities Central banks hold foreign
  exchange in the form of securities denominated in
  the currency of other currencies.
• By watching changes in each of the balance sheet
  items,one can interpret the actions taken by
  managers of central banks and discern the role
  that a central bank plays in the economy. The
  role played by central banks is not so evident in
  the balance sheet items.

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Federal Reserve System

• Conducting the nations monetary policy by
  influencing the monetary and credit conditions in
  the economy in pursuit of maximum employment,
  stable prices and moderate long term interest
  rates

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• Supervising and regulating banking institutions
  to ensure the safety and soundness of the
  nations banking and financial system and to
  protect the credit rights of consumers.

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• Maintaining the stability of the financial
  system and containing systemic risks that may
  arise in financial markets.
• Providing financial services to depository
  institutions, the US government, and foreign
  official institutions, including playing a major
  role in operating the nations payment systems.

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The European System of Central Bank

• The primary objective of the ESCB is to maintain
  price stability. Without prejudice to this goal,
  the ESCB also aims to support the general
  economic policies in the Community with a view to
  contributing the achievement of the objectives of
  the objectives of the Community as laid down in
  Article 2, which include high level of employment
  and sustainable , non-inflationary growth.

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Central Bank Goals
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CENTRAL BANK OF TURKEY

• The primary objective of the Bank is to achieve
  and maintain price stability. Provided that it is
  not be in confliction with the primary objective,
  The Bank shall support the growth and employment
  policies of the Government.

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Basic Data on Central Banks
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• In Europe prior to the 17th century most money
  was commodity money, typically gold or silver.
  However, promises to pay were widely circulated
  and accepted as value at least five hundred years
  earlier in both Europe and Asia. The medieval
  European Knights Templar ran probably the best
  known early prototype of a central banking
  system, as their promises to pay were widely
  regarded, and many regard their activities as
  having laid the basis for the modern banking
  system. At about the same time, Kublai Khan
  introduced fiat currency to China, which was
  imposed by force by the confiscation of specie.

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• The oldest central bank in the world is the
  Riksbank in Sweden, which was opened in 1668 with
  help from Dutch businessmen. This was followed in
  1694 by the Bank of England, created by Scottish
  businessman William Paterson in the City of
  London at the request of the English government
  to help pay for a war. The Bulgarian National
  Bank was established on 25 January 1879. The US
  Federal Reserve was created by the U.S. Congress
  through the passing of the Glass-Owen Bill,
  signed by President Woodrow Wilson on December
  23, 1913.

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Number of Central Banks
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How many Central Bankers?(2005)
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Central Bankers Salaries (000)
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Guiding Principles for Central Banks
1. Price stability provides substantial benefits
2. Fiscal policy should be aligned with monetary
policy
3. Time inconsistency is a serious problem to be
avoided
4. Monetary policy should be forward looking
5. Accountability is a basic principle of
democracy
6. Monetary policy should be concerned about
output as well as price fluctuations
7. The most serious economic downturns are
associated with financial instability
Source Mishkin, 2000
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