Global Money and Banking — Where Central Banks Fit into the World Economy1

Chapter Nine

Global Money and Banking — Where Central Banks Fit into the World Economy

I. Fundamental Issues
  1. What are the responsibilities of the world’s central banks?

2.What are the primary instruments of monetary policy available to central banks, and how do monetary policy actions affect market interest rates?

  1. How do economists measure a nation’s aggregate output and price level?
  2. How are the equilibrium levels of aggregate output and prices determined, and how do central bank actions altering the quantity of money or exchange rates influence equilibrium real output and the price level?
  3. How do central banks intervene in foreign exchange markets?
  4. How effective are foreign exchange interventions?
II. Chapter Outline
  1. The Role of Central Banks
  2. Central Banks as Government Banks
  3. Central Banks as Bankers’ Banks
  4. Central Banks as Monetary Policymakers
  5. Central Bank Balance Sheet Assets and Liabilities
  6. Policy Notebook: Monetary Policy Goes Multilingual in Europe

2.Banking, Money and Interest Rates

  1. Instruments of Monetary Policy
  2. Monetary Policy and Market Interest Rates
  3. Visualizing Global Economics Issues: Influencing the Equilibrium Interest Rate
  1. Money, Prices and Exchange Rates
  2. National Income and Price Deflators
  3. Aggregate Demand, Aggregate Supply, and Where Exchange Rates Fit In
  4. Visualizing Global Economics Issues: Aggregate Demand, Aggregate Supply, and Equilibrium Output and the Price Level
  5. Visualizing Global Economics Issues: Monetary Policy, Aggregate Demand, and Equilibrium Output and Prices

  1. Foreign Exchange Market Interventions
  2. Mechanics of Foreign Exchange Interventions
  3. Sterilizations of Interventions
  4. Do Interventions Matter ?
  5. Gauging the Short-Term Effects of Interventions
  6. Can Even Coordinated Interventions Work in the Long Run?
  7. Questions and Problems
III. Chapter in Perspective

This chapter discusses the roles that central banks play in the global economy. The main functions of central banks are to act as a bank for the government, monitor the private banking system, formulate and implement domestic monetary policy, and influence the nation’s currency value, sometimes in cooperation with other central banks. The authors discuss the major monetary policy tools available to central banks and introduce the concepts of aggregate demand and supply along with real and nominal GDP. The efficacy of sterilized and non-sterilized interventions is also presented.

IV. Teaching Notes
  1. The Role of Central Banks

The U.S. Federal Reserve system was founded in 1913 because of a series of financial panics in the late 1800s and early 1900s, culminating in a severe bank panic in 1907 that resulted in losses to many influential people. The creation of the Fed was designed to end bank runs, but as we know they failed to prevent the wholesale bank runs of the Depression in 1929 and in the early 1930s. Deposit insurance was required to eliminate bank runs.

  1. Central Banks as Government Banks

Central banks assist government finances by:

  • maintaining government deposits arising from tax collections, etc, and
  • acting as fiscal agent in issuing, servicing and redeeming government debt.

In less developed countries, both of these roles are usually more critical because the private banking systems and private capital markets may be less well developed.

  1. Central Banks as Bankers’ Banks

Central banks act as a lender of last resort (LLR) for banks to help prevent bank failures. Due to the risk of contagion that could result in a systemic failure, central banks may desire to provide large amounts of temporary liquidity to a bank so that the bank can meet its obligations in a timely fashion.

  1. Central Banks as Monetary Policymakers

Central banks are also usually charged with formulating and implementing monetary policy. A key goal of monetary policy is normally taken to be promoting stable, non-inflationary real growth in national output. Some economists believe that monetary policy should seek to be countercyclical, meaning that central banks should attempt to stimulate the economy when real growth is low or negative, and should attempt to slow growth that is inflationary. Other economists feel central banks should not attempt to actively manage the economy via monetary policy changes, but should follow some set rule of money supply growth.

  1. Central Bank Balance Sheet Assets and Liabilities

The major assets of large central banks are:

  • Domestic government securities
  • Loans to private banks
  • Foreign currency reserves

Domestic securities and loan assets are called domestic credit. Loans to private banks are usually discounted loans, and in the United States the interest rate charged on advances to banks is called the discount rate.

The major liabilities of large central banks are:

  • Currency notes
  • Bank reserve deposits
  • Domestic government deposits

The monetary base (also called high-powered money) consists of either: 1) domestic credit plus foreign exchange reserves, or 2) currency plus bank reserves.

  1. Policy Notebook: Monetary Policy Goes Multilingual in Europe

For Critical Analysis: Under what circumstances could linguistic miscommunications actually result in monetary policy mistakes?

This could be a problem in any country or economic union where different languages are employed. This problem would seem to be most severe for the EC, in which the individual countries’ central banks are involved in approving and implementing to approve the ECB’s decisions. It is possible that individual central banks could take actions counter to the intent of the ECB due to a misunderstanding.

2.Banking, Money and Interest Rates

  1. Instruments of Monetary Policy

The primary instruments of monetary policy include:

  • Interest rates on loans to private banks (discount rates)

In Europe, the ECB maintains two discount rates, a lower-than-market rate and a penalty rate. The latter is called the marginal interest rate or the Lombard rate. The Bank of Japan employs a below market discount rate, but limits access at its discretion.

  • Reserve requirements

A central bank could change reserve requirements and thereby change the money multiplier, resulting in large changes to the money supply. This would be a very blunt and unpredictable instrument, so most central banks do not manipulate reserve requirements to implement monetary policy decisions.

  • Open market operations

A primary method of implementing domestic monetary policy decisions for central banks in developed economies is via open market operations. In the United States, the Federal Open Market Committee, consisting of the Board of Governors of the Fed, the President of the New York Federal Reserve Bank and five other presidents of Federal Reserve banks (chosen on a rotating basis) formulate the FOMC Directive specifying short-term targets for the federal funds rate and the monetary aggregates. The trading desk of the Federal Reserve Bank of New York then implements the directive by buying and selling U.S. government securities.

Teaching Tip:

For discussion purposes, ask your students to consider whether using a credit card and a debit card changes the money supply. Using a credit card changes the money supply, but not a debit card. What does this imply about the central bank’s ability to control the money supply?

  • A central bank can also impose controls on private interest rates and controls on the quantity of private credit available to attempt to change the quantity of money in the economy. These methods are particularly used in less developed countries, where extensive open market operations are not feasible due to the lack of developed money markets.
  1. Monetary Policy and Market Interest Rates

If a central bank wishes to increase the money supply, it can buy government securities. The securities are paid for by the crediting the securities seller with new reserves at the central bank. The new reserves are then deposited in a bank. If the funds are deposited in a deposit account, subject to reserve requirements, the bank must hold a fraction q. As the remaining funds are loaned out, the borrower will deposit funds in the same or another bank, and the process continues with more loans and more deposits created, so that one injection of reserves can result in multiple deposits being created. At the limit if there are no drains then from a given change in reserves ∆R:

∆Deposits = 1/q * ∆R, where 1/q is called the money multiplier. If customers permanently keep the loan proceeds in the form of cash holdings or if banks choose to increase their reserve levels above those required, then the actual change in deposits will be less than the given predicted change.

  1. Visualizing Global Economics Issues: Influencing the Equilibrium Interest Rate

For Critical Analysis: How would a central bank go about trying to push up the equilibrium interest rate?

The following are possible policy responses:

  • Use open market operations by selling government securities. Payment is made to the central bank by the reduction of reserves.
  • Increase the discount rate.
  • Raise reserve requirements.
  1. Money, Prices and Exchange Rates
  1. National Income and Price Deflators

The value of all final goods and services produced by the domestic economy within a given time period is called gross domestic product (GDP), denoted Y. To measure the price-level-adjusted value of all final goods and services, we use the GDP price deflator (P) so that real gross domestic product (real GDP), denoted y, equals Y/P. In the United States, the current base year for the GDP price deflator is 1996, so in 1996 Y= y in the United States.

  1. Aggregate Demand, Aggregate Supply, and where Exchange Rates Fit In

The overall price level in an economy adjusts until total desired spending on domestic output of goods and services equals aggregate real output that all domestic businesses are willing and able to produce at various price levels. Aggregate demand is inversely related to the price level, aggregate supply is directly related to the price level. In the short run, the aggregate supply curve is not vertical, meaning that as aggregate demand increases, there is a tendency to see both prices and real output increases. In the long run, the aggregate supply curve is vertical, which may be thought of as related to the capacity to produce a given level of output in an economy. The central bank can attempt to manage real GDP by manipulating aggregate demand via changes in the money supply. For instance, an increase in the money supply would result in an increase in aggregate demand (borrowing costs would be reduced, and firms and consumers would desire to borrow more). This in turn would result in an increase in both prices and real output in the short-run, but would result in only inflation in the long run.

  1. Visualizing Global Economic Issues: Aggregate Demand, Aggregate Supply, and Equilibrium Output and the Price Level

For Critical Analysis: Is it likely that changes in aggregate demand can affect a nation’s real output in the long run?

Not if the long run aggregate supply curve (LRAS) is truly vertical. Absent government controls or monopolies the LRAS should be vertical or nearly so.

  1. Visualizing Global Economic Issues: Monetary Policy, Aggregate Demand, and Equilibrium Output and Prices

For Critical Analysis: How would an increase in the value of the nation’s currency affect equilibrium real output and the equilibrium price level?

An increase in the value of the currency would tend to make domestic goods and services relatively more expensive to foreign residents, thereby reducing foreign spending in the domestic economy and resulting in a decrease in aggregate demand, thereby reducing real output.

  1. Foreign Exchange Market Interventions
  1. Mechanics of Foreign Exchange Interventions

Central banks periodically intervene in currency markets. Today, however, rather than try to maintain a currency’s value at some level inconsistent with economic realities, central banks are more likely to intervene to lean against the wind to slow down swings in exchange rates. Volatility in exchange rates is sometimes thought to be bad for economies as it increases the risks and costs of international trade.

Interestingly, the U.S. Treasury has the primary responsibility for initiating foreign exchange interventions, although the Fed conducts the intervention.

  1. Sterilizations of Interventions

Sterilization of central bank interventions in foreign exchange markets leaves the global supply of the currency unchanged. For instance if the Fed intervenes in the currency market, perhaps buying dollars and selling foreign currency reserves to increase the value of the dollar, they would then attempt to sterilize the injection in the foreign currency market by doing the opposite in the domestic market, in this case perhaps by buying government securities.

Teaching Tip:

In a sterilized intervention, if the Fed increases (decreases) the supply of dollars internationally, to sterilize it must decrease (increase) the supply of dollars domestically to keep the global supply unchanged.

  1. Do Interventions Matter
  1. Gauging the Short-Term Effects of Interventions

Some economists maintain that sterilized interventions can have an effect on exchange rates via two mechanisms:

  • The portfolio balance effect:
    If the intervention changes the desired holdings of U.S. assets relative to foreign assets then even a sterilized intervention can affect the exchange rate.
  • The announcement effect:
    To the extent that the intervention provides currency traders and other market participants with new information, the intervention can cause an exchange rate change.

  1. Can Even Coordinated Interventions Work in the Long Run?

From time to time central banks have coordinated their interventions into currency markets (recall the Plaza Agreement and the Louvre Accord). These coordinated interventions can have a large announcement effect, but they are unlikely to be able to maintain a currency’s value at a level inconsistent with economic forces for an indefinite time period. The reason is that the level of daily foreign exchange trading is so large that private capital flows dwarf the resources that even coordinated interventions can bring to the foreign exchange markets.

  1. Answers to End of Chapter Questions

1. Central banks act as banks for governments, banks for private banks, and monetary policymakers. A student can reasonably argue that any one of these is most important. In principle, a central bank could perform one role without performing the others. Some central banks, for instance, act as monetary policymakers but are not directly involved in their countries’ banking systems. Others, such as in countries with currency boards, are primarily banker’s banks but have little role in monetary policymaking.

2. The monetary base is a large part of any central bank’s liabilities. To the extent that a central bank can control the size of its own balance sheet, therefore, it can control the monetary base.

3. In principle, the answer is yes, because variations in the rate on advances causes private banks’ borrowings of reserves from the central bank to change, thereby altering the monetary base.

4. Changes in nominal GDP include the effects of inflation, whereas changes in real GDP do not, so that the latter is a better measure of the actual change in a nation’s output of goods and services over time.

5. GDP does not include nonmarket transactions, such as household services provided by stay-at-home spouses, nor does it account for possible negative spillovers, such as effects of pollution, resulting from increased production of goods and services.

6. Factors such as wage rigidities and imperfect adjustment of other prices of inputs in production make businesses more likely to raise output in response to higher prices caused by a rise in the quantity of money in circulation.

7.It is also true that the real output effects of a policy action that reduces the value of a nation’s currency are likely to be larger if there are greater rigidities in wages and other input prices.

8.The quantity of money is affected by a foreign exchange intervention, such as a purchase of foreign exchange reserves, only if the intervention is nonsterilized—that is, if the central bank does not keep the monetary base from changing by altering domestic credit, perhaps by selling securities.

9.To raise the value of its currency, the central bank would sell foreign exchange reserves, which would tend to reduce the monetary base. To sterilize this intervention, the central bank could reduce the rate on advances to induce private banks to borrow more reserves, thereby raising the monetary base.

10.In principle, central banks can conduct interventions by buying or selling forward contracts, but this is relatively rare. Students can offer various views on this suggested approach to intervening in foreign exchange markets.