FINA3010 Financial Markets

Chris Leung, Ph.D., CFA, FRM

Email: chrisleung@cuhk.edu.hk

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Lecture 5

Central Bank and Monetary Policy

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Lecture Preview

 Central Banks
⚫ The government authorities in charge
of monetary policy.
⚫ For example, in the U.S., the central
bank is the Federal Reserve System.
⚫ Although we typically hear about
central banks in connection with
interest rates, their actions also affect
credit, the money supply, inflation and
more important asset pricing.
 Lecture Preview

 We examine the role of

government authorities over the
money supply
 We focus primarily on the role of
the U.S. Federal Reserve System,
but the principles also apply to
similar organizations in other
nations.

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Lecture Preview

 We will discuss Fed’s monetary

policy.
 Monetary policy
⚫ The management of the money
supply.

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 Origins of the Federal
Reserve System
 Fear of centralized power guided central bank
activities in the 19th century
 The First Bank of the U.S. was disbanded in 1811
 The Second Bank of the U.S. was disbanded in
1836 when President Andrew Jackson vetoed its
renewal.
 As a result, banking panics became regular
events, culminating in the panic of 1907.
 Widespread bank failures and depositor losses
convinced the U.S. that a central bank was
needed.

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 Federal Reserve Act of 1913
 Fear of a “central authority”—people worried that
powerful Wall Street interests would manipulate
the system and that federal operation of central
bank might result in too much government
intervention in affairs of private banks.
 Questions arose as to whether such a monetary
authority would be private or a government
institution.
 Federal Reserve Act of 1913 was a compromise
that created the Federal Reserve System
including checks and balances.

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 Formal Structure of the Federal
Reserve System
 Design was intended to diffuse power along
the following dimensions:
⚫ 12 Regions of the U.S.
⚫ Government and private sector interests
⚫ Needs of bankers, businesses, and the public

 The banks are “quasi-public”

⚫ Owned by member commercial banks in the district
⚫ Member banks elect six directors, while three
directors are appointed by the Board of Governors
⚫ Directors represent professional bankers,
prominent business leaders, and public interests
(three from each group)
https://www.federalreserve.gov/aboutthefed/structure-federal-reserve-system.htm
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 Federal Reserve Banks Functions:
Monetary Policy

 Establish the “discount rate” at which member

banks may borrow from the Federal Reserve
Bank (subject to BOG review)
 Determine which bank receive loans
 Each bank elects one member to the Federal
Advisory Council
 Five of the 12 bank presidents vote in the
Federal Open Market Committee

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 Board of Governors
 The seven (max. 7, now 5) governors are
appointed by the President, and confirmed by
the Senate, for 14-year terms on a rotating
schedule.
 All are members of the FOMC.
 Effectively set the “discount rate”.
 Serve in an advisory capacity to the President
of the United States, and represent the U.S.
in foreign economic matters.
http://www.federalreserve.gov/aboutthefed/bios/board/default.htm

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 Federal Open Market Committee
 Make decisions regarding open market
operations, to influence the monetary base.
 The chairman of the BOG is also the chair of
this committee
 Open market operations are the most important
tool that the Fed has for controlling the money
supply (along with reserve requirements and
the discount rate)
 All actions are directed the Federal Reserve
Bank of New York, where securities are bought /
sold as required.
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Federal Open Market
Committee Meeting

 Meet eight times each year (about every

six weeks)
 Important agenda items include
⚫ Reports on open market operations (foreign
and domestic)
⚫ National economic forecasts are presented
⚫ Discussion of monetary policy and directives,
including views of each member
⚫ Formal policy directive made
⚫ Post-meeting announcements, as needed

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Chairman of the
Federal Reserve System

 Spokesperson for the entire Federal

Reserve System
 Negotiates, as needed, with Congress and
the President of the United States
 Sets the agenda for FOMC meetings
 With these, the chairman has effective
control over the system, even though
he/she doesn’t have legal authority to
exercise control over the system and its
member banks.

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 Explaining Central Bank Behavior
 Two competing theories try to explain the
observed behavior of central banks:
⚫ Public Interest View: the central bank serves the
public interest.
⚫ Theory of Bureaucratic Behavior: the central bank
will seek to maximize its own welfare.
 The Fed often fights to maintain autonomy
while avoid conflict with Congressional
power groups. These seem to favor the
latter theory, but this view is probably too
extreme.

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Should the Fed Be Independent?
 Every few years, the question arises in
Congress as to whether the
independence of the Fed should be
reduced in some fashion. This is usually
motivated by politicians who disagree
with current Fed policy.
 Arguments can be made both ways, as
we outline next.

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 Case for Independence
 The strongest argument for independence
is the view that political pressure will tend
to add an inflationary bias to monetary
policy. This stems from short-sighted
goals of politicians. For example, in the
short-run, high money growth does lead to
lower interest rates. In the long-run,
however, this also leads to higher inflation.

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Case for Independence
 The notion of the political business
cycle stems from the previous
argument.
⚫ Expansionary monetary policy leads to
lower unemployment and lower interest
rates—a good idea just before elections.
⚫ Post-election, this policy leads to higher
inflation, and therefore, higher interest
rates—effects that hopefully disappear
(or are forgotten) by the next election.

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Case for Independence
 Other arguments include:
⚫ The Treasury may seek to finance the
government through bonds purchased by the
Fed. This may lead to an inflationary bias.
⚫ Politicians have repeatedly shown an inability
to make hard choices for the good of the
economy that may adversely affect their own
well-being.
⚫ Its independence allows the Fed to pursue
policies that are politically unpopular, yet in the
best interest of the public.

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Case Against Independence
 Some view Fed independence as “undemocratic”—
an elite group controlling an important aspect of
the economy but accountable to no one.
 If this argument seems unfounded, then ask why
we don’t let the other aspects of the country be
controlled by an elite few. Are military issues, for
example, any less complex?
 Indeed, we hold the President and Congress
accountable for the state of the economy, yet
they have little control over one of the most
important tools to direct the economy.

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 Case Against Independence
 Further, the Fed has not always been
successful in the past. It has made mistakes
during the Great Depression and inflationary
periods in the 1960s and 1970s.
 Lastly, the Fed can give way to political
pressure regardless of any state of
independence. This pressure may be worse
with few checks and balances in place.

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How Independent is the Fed?
 A broad question of policy for the Federal Reserve
Systems is how free the Fed is from presidential
and congressional pressure in pursuing its goals.
 Instrument Independence: the ability of the
central bank to set monetary policy instruments.
 Goal Independence: the ability of the central bank
to set the goals of monetary policy.
 Evidence suggests that the Fed is free along both
dimensions. Further, the 14-year terms limit
incentives to curry favor with either the President
or Congress.

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How Independent is the Fed?
Other Evidence

 The Fed is usually generates revenue in

excess of its expenses, so it is not typically
under appropriations pressure.
 However, Congress can enact legislation to
gain control of the Fed, a threat exercised
as needed.
 Presidential appointment clearly sets the
direction of the Fed.

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Central Bank Independence and Macroeconomic
Performance Throughout the World

 Empirical work suggests that

countries with the most
independent central banks do the
best job controlling inflation.
 Evidence also shows that this is
achieved without negative impacts
on the real economy.

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Trend toward Independence

In recent years, we have seen a

remarkable trend toward increasing
independence. The Fed used to be
substantially more independent than
other central banks, but this has
changed with the formation of the
ECB and changes at other central
banks. This trend should continue.
uReply 5-1
The Federal Reserve’s Balance Sheet

The conduct of monetary policy by the

Federal Reserve involves actions that affect
its balance sheet. This is a simplified
version of its balance sheet, which we will
use to illustrate the effects of Fed actions.

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 The Federal Reserve’s
Balance Sheet: Liabilities

 The monetary liabilities of the Fed

include:
─ Currency in circulation: the physical
currency in the hands of the public.
─ Reserves: All bank deposits with the Fed.
The Fed sets the required reserve ratio.
Any reserves deposited with the Fed
beyond this amount are excess reserves.
─ The sum of these two items is the
monetary base.
 The Federal Reserve’s Balance Sheet:
Assets
 The monetary assets of the Fed include:
⚫ Government Securities: These are the U.S.
Treasury bills and bonds that the Federal
Reserve has purchased in the open market.
As we will show, purchasing Treasury
securities increases the money supply.
⚫ Discount Loans: These are loans made to
member banks at the current discount rate.
Again, an increase in discount loans will
also increase the money supply.
⚫ MBS: Only after 2008 Financial Tsunami

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The Federal Reserve’s Balance Sheet:
Impact of Open Market Operations
In the next four slides, we will examine the
impact of open market operation on the Fed’s
balance sheet and on the money supply. As
suggested in the last slide, we will show the
following:
⚫ Purchase of bonds increases the money supply
⚫ Making discount loans increases the money supply

Naturally, the Fed can decrease the money

supply by reversing these transactions.

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 The Federal Reserve Balance Sheet
 Open Market Purchase ($100) from Public (by Cash)
Public The Fed
Assets Liabilities Assets Liabilities
Currency in
Securities Securities circulation
–$100 +$100 +$100
Cash
+$100

Result CC  $100, MB  $100

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 The Federal Reserve Balance Sheet
Open Market Purchase ($100) from Primary Dealer
Banking System The Fed
Assets Liabilities Assets Liabilities
Securities Securities Reserves
–$100 +$100 +$100
Reserves
+$100

Result R  $100, MB  $100

 The Federal Reserve Balance Sheet
 Open Market Purchase ($100) from Public (by Check)
Public The Fed
Assets Liabilities Assets Liabilities
Securities Securities Reserves
–$100 +$100 +$100
Deposits
+$100
Banking System
Assets Liabilities
Reserves Deposits
+$100 +$100 Result R  $100, MB  $100
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 The Federal Reserve Balance Sheet

 Discount Lending ($100)

Banking System The Fed

Assets Liabilities Assets Liabilities
Reserves Discount loans Discount loans Reserves
+$100 +$100 +$100 +$100

Result R  $100, MB  $100

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Supply and Demand in the
Market for Reserves

Next, we will examine how this

change in reserves affects the
federal funds rate, the rate banks
charge each other for overnight loans.
Further, we will examine a third tool
available to the Fed—the ability to set
the required reserve ratio for
deposits held by banks.
Supply and Demand in the
Market for Reserves

 Demand side
⚫ Excess reserves are insurance against
deposit outflows
⚫ Since 2008 the Fed start to pay interest
to excess reserves
 Supply side
⚫ Reserves by Fed’s open market
operation
⚫ Reserves borrowed the Fed, i.e. the
discount rate
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 Supply and Demand in the
Market for Reserves

Equilibrium iff
where Rs = Rd
Response to Open Market
Operations (Buy/Sell Bonds)
Response to Change in Discount Rate
(Interest of Lending Money to Banks)
Response to Change in Required Reserves
Response to Change the Interest Rate on
Reserves (Interest Paying to Reserves of Banks)
How Operating Procedures Limit Fluctuations in Fed
Funds Rate
Tools of Monetary Policy

Now that we have seen and

understand the tools of monetary
policy, we will further examine each
of the tools in turn to see how the
Fed uses them in practice and how
useful each tools is.

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Tools of Monetary Policy:
Open Market Operations

 Open Market Operations

1. Dynamic: to change reserves
2. Defensive: to offset other factors affecting
Reserves, typically uses repos

 Advantages of Open Market Operations

1. Fed has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly

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Tools of Monetary Policy:
Discount Loans
 Lender of Last Resort Function (The Original
Primary Function of The Central Bank)
1. To prevent banking panics, FDIC fund not big
enough
Examples: Financial Tsunami September 2008
2. To prevent nonbank financial panics
Example: 1987 stock market crash and 911
attack

 Announcement Effect
1. Problem: false signals

 Banks and other financial institutions may take on

more risk (moral hazard) knowing the Fed will
come to the rescue

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Tools of Monetary Policy:
Reserve Requirements

 Advantages
1. Powerful effect

 Disadvantages
1. Small changes have very large effect
on Ms
2. Raising causes liquidity problems for
banks
3. Frequent changes cause uncertainty
for banks

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 Tools of Monetary Policy: Advantages of
Open Market Operations
 Open market operations are initiated by
the Fed, so the volume of these
transactions is entirely under the control of
the Fed.
 The operations are flexible and concise,
useful for both small and large changes in
the monetary base.
 Unanticipated effects are easily reversed,
if needed.
 Once the course of action is approved,
the policy is implements quickly, avoiding
administrative delays.
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 Fed Lending Facilities During the Global
Financial Crisis

Nonconventional Monetary Policy Tools and Quantitative Easing

 Fed Lending Facilities During the Global
Financial Crisis

Nonconventional Monetary Policy Tools and Quantitative Easing

 Liquidity Provisions
 Discount windows expansion –
discount rate lowered several times.
 Term auction facility – another loan
facility, offering another $400 billion
to institutions.
 New lending programs – included
lending to investment banks, and
lending to promote purchase of
asset-backed securities.
Nonconventional Monetary Policy Tools and Quantitative Easing
 Asset Purchases
(Quantitative Easing)

 Nov 2008 – QE1 established,

purchasing $1.25 trillion in MBSs.
 Nov 2010 – QE2, Fed purchases
$600 billion in Treasuries, lower
long-term rates.
 Sept 2012 – QE3, Fed commits to
buying $40 billion in MBSs each
month.
Nonconventional Monetary Policy Tools and Quantitative Easing
 Total Federal Reserve Assets, 2007 – 2016

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/WALCL#0.

The Expansion of the Federal Reserve’s Balance Sheet
During and After the Global Financial Crisis

https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
Price Stability Goal
& the Nominal Anchor
 Policymakers have come to recognize the
social and economic costs of inflation.
 Price stability, therefore, has become a
primary focus.
 High inflation seems to create uncertainty,
hampering economic growth.
 Indeed, hyperinflation has proven
damaging to countries experiencing it.

uReply 5-2

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Price Stability Goal
& the Nominal Anchor
 Policymakers must establish a nominal
anchor which defines price stability. For
example, “maintaining an inflation rate
between 2% and 4%” might be the anchor.
 An anchor also helps avoid the time-
inconsistency problem.

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Price Stability Goal
& the Nominal Anchor

 The time-inconsistency problem

is the idea that day-by-day policy
decisions lead to poor long-run
outcomes.
⚫ Policymakers are tempted in the short-run to
pursue expansionary policies to boost output.
However, just the opposite usually happens.
⚫ Central banks will have better inflation control
by avoiding surprise expansionary policies.
⚫ A nominal anchor helps avoid short-run
decisions.

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Other Goals of Monetary Policy

 Goals
1. High employment
2. Economic growth
3. Interest rate stability
4. Financial market stability
5. Foreign exchange market stability

 Goals often/sometimes in conflict

(at least in the short-run)

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Should Price Stability be the
Primary Goal?

 Price stability is not inconsistent

with the “other goals” in the long-
run. For example, there is no
trade-off between inflation and
employment in the long-run.
 However, there are short-run trade-
offs. For example, an increase in
interest rates will help prevent
inflation, but does increase
unemployment in the short-run.
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 Should Price Stability be the
Primary Goal?
 The ECB uses a hierarchical mandate,
placing the goal of price stability above all
other goals.
 The Fed, in contrast, uses a dual mandate,
where “maximizing employment, stable
prices, and moderate long-term interest
rates” are all given equal importance.

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 Should Price Stability be the
Primary Goal?
Which is better?
 If “maximum employment” is defined as the
natural rate of unemployment, then both
hierarchical and dual mandates achieve the
same goal. However, it’s usually more
complicated in practice.
 Also, short-run inflation may be needed to
maintain economic output. So, long-run
inflation control should be the focus.

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 Should Price Stability be the
Primary Goal?
Which is better?
 The dual mandate can lead to expansionary
policies that increase employment, output, but
also increases long-run inflation.
 However, a hierarchical mandate can lead to
over-emphasis on inflation alone – even in the
short-run.
 The answer? It depends. As long as it helps
the central bank focus on long-run price stability,
either is acceptable.

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Inflation Targeting

Inflation targeting involves:

1. Announcing a medium-term inflation
target (nominal anchor)
2. Commitment to monetary policy to
achieve the target
3. Inclusion of many variables to make
monetary policy decisions
4. Increasing transparency through
public communication of objectives
5. Increasing accountability for missed
targets
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Inflation Targeting:
Pros and Cons

 Advantages
─ Easily understood by the public
─ Helps avoid the time-inconsistency
problem since public can hold central
bank accountable to a clear goal
─ Forces policymakers to communicate
goals and discuss progress regularly
─ Performance has been good!
 Inflation Targeting:
Pros and Cons

 Disadvantages
─ Signal of progress is delayed
 Affects of policy may not be realized for
several quarters.
─ Policy tends to promote too much rigidity
 Limits policymakers ability to react to
unforeseen events
 Usually “flexible targeting” is implemented,
focusing on several key variables and targets
modified as needed
 Inflation Targeting:
Pros and Cons

 Disadvantages
─ Potential for increasing output fluctuations
 May lead to a tight policy to check inflation at
the expense of output, although policymakers
usually pay attention to output
─ Usually accompanied by low economic
growth
 Probably true when getting inflation under
control
 However, economy rebounds
 Tactics: Choosing the Instrument

Now we turn to how monetary policy is

conducted on a daily basis. First, understand
that a policy instrument/operating target (for
example, the fed funds rate) responds to the
Fed’s tools. There are two basic types of
instruments: reserve aggregates and short-term
interest rates.
An intermediate target (for example, a long-
term interest rate) is not directly affected by a
Fed tool, but is linked to actual goals (e.g., long-
run price stability). 64
Central Bank Strategy:
Use of Targets

policy instrument

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 Tactics: Choosing the Instrument

• The key thing to understand is that the Fed can

only attempt to implement its goals using either
reserve aggregates or short-term interest rates.
Not both. For example, suppose the Fed
believed it could achieve its employment goals by
achieving a 3% growth rate in nonborrowed
reserves. Or by setting the fed funds rate at 4%.
• Why can’t the Fed do both?

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Nonborrowed Reserves Target

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Federal Funds Rate Target

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Criteria for Choosing Policy
Instruments

 Criteria for Policy Instruments

1. Observable and Measurable
 Some are observable, but with a lag (e.g.
reserve aggregates)
2. Controllable
 Controllability is not clear-cut. Both
aggregates and interest rates have
uncontrollable components.
3. Predictable effect on goals
 Generally, short-term rates offer the best links
to monetary goals. But reserve aggregates
are still used.

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Assignment 2.1

 Textbook Chapter 9 (page 243)

 Questions: 11
 Quantitative Problems:
 Textbook Chapter 10 (page 282)
 Questions: 12

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