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3.1

The Central Bank: Mission and behavior

Central Banks Mission

Central Banks are institutions that receive their mission from a political power. From our study of systems in equilibrium, the role of monetary policy in the long run is to ensure price stability. This allows economic agents to undertake long term actions with certain amount of condence as it decreases real interest risk (remember Fishers law in the neoclassical model.) In the short run, according to the Keynesian model, monetary policy can inuence the level of economic activity. Proactive policies to achieve this inuence can lead to the risk of creating a tension between long run goal and short run government desires. For this reason, in the end of the 1980s many countries established a clear separation between monetary policy, under the control of the Central Banks, and public decit management, under the control of the Government. Most countries in fact assigned to the Central Bank a the priority to control ination, leaving a secondary role, or no role at all, for boosting economic activity. In the US, the Federal reserve (FED) is responsible of monetary policy since 1913. In this course we will focus on the European monetary system, noticing the main dierences with the US when necessary. Since 1999, 11 out of 15 country members of the European Union (twelve in 2002) adopted the euro as common currency. The management of the euro was assigned to a new institution, the European Central Bank (ECB). The ECB is at the top of the Eurosystem, which integrates the old state level central banks, that act today as subsidiaries of the ECB in the European Union. At birth, the ECB declared that its goal was price stability, dened by an ination rate close but lower to 2% per year. Note this implies a tolerance for positive ination. Actually, deation is a phenomena to be avoided as well.

3.2

Interventions of the ECB in the money base market

How does the ECB intervenes to modify the money base? The rst type of operation consists in modifying the absorbtion of securities by the Central 9

Bank, according to the notion of open market operation applied massively by the US FED. In contrast, the ECB relies much less heavily on this type of operation. Decreasing or increasing its demand of securities, the Central Bank aects the interest rate and the money demand from the private sector, as described previously in the course. The second type of intervention a central bank can carry out is to inuence the terms at which commercial banks borrow from the Central Bank (also known as discount window operations) or among each other (inter bank money market). When a commercial bank has above minimum reserves, it can lend its excess reserves to another bank or to the Central Bank itself, both very short term operations. Similarly, a commercial bank failing to reach the minimum reserve threshold, can borrow from another bank or from the Central Bank to reach it. The overnight borrowing and lending between commercial banks and the ECB can take the following forms: - A commercial bank can lend reserves to the ECB for 24hours (overnight). The ECB pays a return relatively low, called the deposit rate (see gure) - A commercial bank can borrow reserves to the ECB for 24 hours paying the marginal lending rate (see gure). The average rate of the set of lending and borrowing operations taking place in the interbank market is, logically, in between these two overnight rates set by the ECB. In particular, the EONIA rate, the euro overnight index average of transactions between banks is in between as in chart 4. In the gure, the minimum bid rate is the rate at which the ECB lends money to commercial banks for 7 days, known as main Repo operations. The allocation of money to the interbank market by the ECB is done via an auction system, that starts with a maximum bid rate. The ECB satises renancing demands for dierent rates moving down from the maximum one. To ration the amount of credit supplied, the ECB can refuse to renance demands for rates close or equal to the minimum bid rate. Below this rate no money demand from commercial banks to

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the ECB will be satised (see below the table distinguishing the ECB operations in normal times versus during the crisis). The marginal rate is dened as the smallest value of the rate at which the demand is entirely satised. Every month the Governors council of the ECB decides the minimum bid rate, below which no renancing demand will be satised. The average bid rate and marginal bid rate, on the contrary, result from the renancing demand and the quantity allotted to the market. In practice, the dierences between these are very small. Therefore, the minimum bid rate is the main instrument of monetary policy of the ECB. If curious, check http : //www.ecb.int/home/html/index.en.html and http : //www.ecb.int/press/tvservices/webcast/html/webcast1 10407.en.html which is the most recent press conference of president of the ECB Jean Claude Trichet on April 7, 2011 about the Governors meeting and its decision to increase the key ECB interest rate by 25 basis point (0.25%) In the US the overnight inter bank rate (equivalent to EONIA) is the Federal Funds rate. The FED intervenes in the inter bank market by buying or selling treasury securities via open market operations. The rate that the FED uses to signal its monetary policy stance is the Federal Funds Target rate, which is the rate wished by authorities, reached after several operations in the securities market. These actions modify the reserves of banks that have to borrow and lend to each other in the inter bank market to satisfy the mandatory level of reserves. The inuence of the FED is less direct than the one of the ECB. Its ability to carry its monetary policy via this mechanism is in part resulting from the depth of the securities market in the US.

3.3

The ECB in normal times and during the crisis.2

Description of terms: : In normal times, commercial banks take loans against collateral for 7 days with the Central Bank, with the commitment to reimburse after 7 days. During the crisis the ECB extended the duration of loans to 3 months, 9 months and even a year. : In normal times, the collateral requirement that the ECB requires from commercial banks
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I thank Radu Vranceanu for help in doing this table, all remaining errors are my own.

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Main Repo Operations Collateral Tender procedure Amount Interbank Money market

Normal times 7 days Strict Rules Variable rate auction Limited Stable

Crisis Extended loans up to 3m, 9m, 1 year Lax rules Fixed rate Unlimited Unstable

Table 1: ECB procedures in normal times and during the crisis

are mainly triple A company loans, high quality assets, treasury bonds. With the crisis, the assets of commercial banks downgraded. For example, many German banks holding Greek treasury bonds. Yet, the ECB accepted lower quality collateral. : In normal times the ECB follows an auction procedure to allocate loans to banks. It does so by setting a maximum bid rate and a minimum bid rate, which is the so called policy rate (or in French taux dinteret directeur). : During the crisis the ECB behaved as lender of last resort, and satised the demand for loans at xed rate. In normal times the ECB auction system is used to ration a limited amount of loans. : Commercial banks borrow money to each other in the inter bank money market, typically of 3months duration. The European interbank interest rate is the Euribor. It is an indicator of nancial stability. Comment: As this table puts in evidence, the ECB main goal during the crisis was systemic risk management, and to act as lender of last resort. To understand why, remember from reading 1 of the course that commercial banks had toxic assets in their balance sheet (subprime mortgage back securities) in unknown amounts to the market. Lack of condence and uncertainty led to a collapse in the interbank money market, and a corresponding lack of liquidity that posed systemic risk dangers. To restore liquidity, the ECB acted as lender of last resort, nancing commercial banks with up to one year loans, accepting low quality collateral from banks. Today, the question is how will the ECB unwind these special measures and regain control over the money stock. In the US, the FED injected liquidity to the market via open market operations.

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