Chapter VIII:
Money supply and monetary policy
A. The ECB and the Fed
B. The supply of base money
C. Controlling the money supply
D. Open market operations
E. The conduct of monetary policy
F. Application: German hyperinflation
Goethe Business School
European System
of Central Banks
2
Goethe Business School
The Eurosystem
3
Goethe Business School
European System
of Central Banks


The European System of Central Banks (ESCB)
consists of the European Central Bank (ECB)
and the national central banks of the EU
Member States
The activities of the ESCB are carried out in
accordance with the Treaty establishing the
European Community (Treaty) and the Statute of
the European System of Central Banks and of
the European Central Bank (ESCB/ECB Statute)
4
Goethe Business School
Main consequences of
single currency






There is a single exchange rate
There is no escape through lax monetary
policy possible
Prices are tied to the same unit of account
Price differences are solely attributable to
market forces, not to policy differentials
Price expectations should converge
Nominal interest rates will also converge
5
Goethe Business School
Convergences of inflation
rates
6
Goethe Business School
Convergence of lending
rates (interbank)
7
Goethe Business School
ESCB: Basic tasks

The basic tasks by the Eurosystem are:
 to define and implement the monetary policy of the
euro area;
 to conduct foreign exchange operations;
 to hold and manage the official foreign reserves of the
Member States; and
 to promote the smooth operation of payment systems

In addition, the Eurosystem contributes to the
prudential supervision of credit institutions and
the stability of the financial system
8
Goethe Business School
Should central banks
be independent?


A cornerstone of the monetary constitution of the
euro area is the independence of the ECB and
of the NCBs (Article 108)
There are fears that a dependent ECB
 could succumb to financing large budget deficits of
the government
 could be asked to monetize too much debt, which
would entails an inflationary bias

Central banking also requires expertise and
“should not be left to politicians”
9
Goethe Business School
Should central banks
be independent?

Counterarguments:
 It is undemocratic to have monetary policy
controlled by a non-elected elite group
 There is no accountability in central banking,
which is a precondition for, and core element
of, democratic legitimacy
 There is need to coordinate monetary and
fiscal policies
 The ECB could pursue a policy of self-interest
10
Goethe Business School
The objectives of the ESCB



The primary objective of the ESCB,
as defined in Article 105 of the Treaty,
is to maintain price stability
Without prejudice to the primary objective,
the ESCB has to support the general economic
policies in the EU
In pursuing its objectives, the ESCB has to act in
accordance with the principle of an open market
economy with free competition, favoring an
efficient allocation of resources
11
Goethe Business School
The supply of “base money”




The central bank creates money
of highest liquidity:
“high-powered” money or “base money”
She “monetizes” assets by acquiring them
and issuing central bank money
Such assets are gold, foreign exchange,
and selected securities
We assume for a moment,
“base money” = currency in circulation
12
Goethe Business School
The money supply process

There are four players in the money
supply process





The central bank (ECB, Federal Reserve)
Depository institutions (banks)
Depositors (individuals and institutions)
Borrowers (individuals and institutions)
The central bank conducts monetary
policy to gear the supply of “base money”
13
Goethe Business School
Balance sheet
of a central bank
Assets
Gold
Forex
Liabilities
Base money (we simplify:
only cash)
Securities
14
Goethe Business School
Central bank assets


Gold and SDR certificates.
The latter are issued by the IMF
to settle international debt
Foreign exchange.
 Claims denominated in foreign currency
 Claims against foreigners denominated in euros


Securities of euro area residents.
They are denominated in euros
(treasury bills and banker’s acceptances)
Intra-Eurosystem claims
15
Goethe Business School
Eurosystem’s
international reserves

The reserve assets of the euro area consist of
the Eurosystem’s reserve assets:
 the reserve assets of the ECB
 the reserve assets held by the national central banks
(NCBs) of the participating Member States


Reserve assets must be under the effective
control of the relevant monetary authority
They consist of highly liquid, marketable and
creditworthy foreign currency-denominated
claims on non-residents of the euro area, plus
gold, SDRs and reserve positions in the IMF
16
Goethe Business School
Official reserves
(excluding gold) 2007


Japan and
China have
accumulated
the largest
reserves in
the world
Russia
follows third
17
Goethe Business School
The euro and global
foreign exchange reserves
18
Goethe Business School
The control
of the monetary base



The quantity-oriented approach to
monetary policy purports that the central
bank can control the monetary base
It is basically effected via open market
operations with commercial banks
The ECB can control OMOs more
effectively than foreign reserves, but
she can also use interventions in forex
markets to change the monetary base
19
Goethe Business School
Controlling the money supply




Under fixed exchange rates controlling
the money supply is more difficult
In this case the central bank has to “sterilize”
inflows or outflows of foreign exchange
It renders interest rates endogenous,
i.e. they vary in response to sterilizing
interventions
Forex interventions will be discussed later
20
Goethe Business School
Forex inflows with
sterilization
Assets
Gold
Forex
Liabilities
Base money remains fixed
Securities
21
Goethe Business School
OMOs




Among the OMOs, the main refinancing
operations (MROs) are the most important,
playing a pivotal role in steering liquidity and
signaling the stance of monetary policy
Three quarters of liquidity is provided by MROs
MROs were conducted as fixed rate and variable
rate tenders with a minimum bid rate
The MROs are regular, liquidity providing, reverse
transactions, conducted as standard tenders, with
a weekly frequency and normally a maturity of
two weeks
22
Goethe Business School
Longer-term refinancing
(LTROs)



Longer-term refinancing operations (LTROs)
are carried out through monthly standard
tenders and have a maturity of three months
LTROs are regular open market operations
executed by the Eurosystem also in the form
of a reverse transaction
On average over the year, LTROs provided
about one quarter of the total refinancing of
banks
23
Goethe Business School
Reserve requirements
of banks




The Eurosystem requires banks to hold minimum
reserves equal to 2% of certain short-term liabilities.
It is part of base money
The purpose is the stabilization of short-term interest
rates and the enlargement of the structural liquidity
deficit of banks
Reserve requirements bear interest, and must only be
fulfilled on average over a one-month reserve
maintenance period
It has a significant smoothing effect on the behavior of
short-term interest rates
24
Goethe Business School
Short-term liquidity policy


The monetary base is also affected when a central bank
makes a discount loan to a bank. The ECB does not use
this instrument however
There are two standing facilities offered
by the Eurosystem
 the marginal lending facility and
 the deposit facility

These instruments provide and absorb overnight
liquidity, signal the stance of monetary policy and set an
upper and lower limit for the overnight market interest
rate
25
Goethe Business School
Key ECB interest rates

The key ECB interest rates are
at present
 the minimum bid rate on the main
refinancing operations,
 the interest rate on the marginal lending
facility
 and the interest rate on the deposit facility
26
Goethe Business School
Key ECB interest rates
27
Goethe Business School
Central bank lending rates
international comparison
28
Goethe Business School
The monetary policy goals
of the ECB



The primary objective of the European System of
Central Banks (ESCB) is to maintain price stability
Without prejudice to the primary objective of price
stability, the ESCB shall support the general economic
policies in the Community with a view to contributing to
the achievement of the objectives of the Community
In pursuing its objectives, the ESCB shall act in
accordance with the principle of an open market
economy with free competition, favoring an efficient
allocation of resources
29
Goethe Business School
Transmission processes
of policies



Central banks, cannot control the price level
directly. They face a complex transmission
process from their own monetary policy actions
to changes in the general price level
These transmission mechanisms are
characterized by the existence of several
distinct channels, each with long, and variable
reaction lags
Moreover, the transmission mechanisms
themselves are evolving over time due to
behavioral and institutional change
30
Goethe Business School
Policy goals and targeting

The strategy of central banks is to aim
at variables between the goals to be
achieved and the tools available:
 Intermediate targets. These can be
monetary aggregates (M1, M2, M3) or interest
rates (short, long)
 Operating targets (or “instruments”):
They can be directly adjusted (monetary
base, reserves, minimum bid rate of the main
refinancing operations)
31
Goethe Business School
What instruments
has a central bank?

Open market operations
Purchases in the open market causes the shortterm interest rate (federal funds rate) to fall.
It affects the supply of reserves
Rs s’
ist
R
ist*
Rd
Quantity of reserves
32
Goethe Business School
What instruments
has a central bank?
Discount lending

It also raises the quantity of reserves supplied
which causes the short-term interest rate
(federal funds rate) to fall
Rs
ist
Rs’
ist*
Rd
Quantity of reserves
33
Goethe Business School
What instruments
has a central bank?

Reserve requirements
It increases the quantity of reserves demanded
which causes the short-term interest rate
(federal funds rate) to increase
Rs
ist
ist*
Rd’
Rd
Quantity of reserves
34
Goethe Business School
Advantages of OMOs




OMOs are under the full control of a
central bank. This is not the case for
discount operations
OMOs can be carried out in small
quantities to “smooth” developments
OMOs can easily be reversed (repos)
OMOs can be implemented without delays
35
Goethe Business School
Characteristics
of discount policy


The main advantage is that the central bank can
use it in its function as “lender of last resort”
But there are three main disadvantages:
 The announcement of a discount rate change can
create confusion if it contradicts the policy stance
 If the discount rate is set at a given level,
the spread between id and the market interest rate
can vary wildly
 Discount operations are difficult to reverse
36
Goethe Business School
Characteristics
of reserve requirements



The advantage is that they affect all banks
equally and have an effect on the supply
of money
But reserves requirements are hard to
engineer because of multiple deposit
contractions (expansions)
Raising reserve requirements can cause
immediate liquidity problems
37
Goethe Business School
Targeting :
the NASA strategy


By analogy, NASA’s
strategy of sending
spaceships to the moon
also works through
“operating targets”
The pace of spaceships is
continuously adjusted to
“intermediate targets”,
and finally to the “goal”
38
Goethe Business School
Example
of central bank strategy:


Suppose the central bank’s price-level
goal is consistent with a nominal GDP
growth rate of 5%
The bank may then feel that this goal can
be achieved
 by a 4% growth rate for M2 (intermediate
target), and
 by a 3.5% growth rate for the monetary base
(operating target = tool)
39
Goethe Business School
Adjustments
of central bank policy

After implementing the policy, the central
bank may fine-tune, for instance
 because the monetary base may be growing
too slowly (which calls for an increase of OMO
purchases);
 or M2 may not grow in line with the monetary
base (which also requires an adjustment of
policy instruments such as OMOs)
40
Goethe Business School
Types of target variables

The central bank has the choice between
two different types of target variables:
 monetary aggregates (monetary base,
reserve requirements, M1, M2, M3, etc.)
 and interest rates

Can a central bank pursue both targets at
the same time?
41
Goethe Business School
The answer is no! Why?

If a monetary aggregate is used, the
control of the interest rate is lost:
Ms
i*
Md
M*
Quantity of money
42
Goethe Business School
Quantity-oriented strategy:
problem

If the money demand curve shifts unexpectedly,
the interest rate will fluctuate:
Ms
iu
Mdu
i*
il
Mdl
M*
Md*
Quantity of money
43
Goethe Business School
Interest rate-oriented
strategy: problem

In order to keep the interest rate at a given level
(target), the central bank must accept variations
in monetary aggregates:
Ms
Msl
Msu
Mdu
i*
Mdl
Target
rate
Md*
Quantity of money
44
Goethe Business School
What criteria
to decide on the target?

There are three criteria for choosing an
intermediate target:
 It must be accurately measurable, and the
indicator should be available rapidly;
 it must be controllable by the central bank;
 and it must have a predictable effect on the
policy goal.
45
Goethe Business School
Measurability




GDP figures and price indices become
available only after a time lag, and they
are often revised
Monetary aggregates are obtained quicker
(2 weeks), but are often revised
Interest rates are obtained instantly and
are not revised
Are interest rates the best target?
Be careful: What we need are real interest rates!
46
Goethe Business School
Controllability
and predictability



A central bank has the ability to exercise a
powerful effect on the money supply,
although control is not perfect
Although it appears that the central bank
can also control interest rates, it cannot
fully control inflationary expectations
The linkage between intermediate targets
and the policy goal is controversial, so the
predictability issue is highly contentious
47
Goethe Business School
A historical perspective:
the Fed



When the Fed was created in 1914, the
discount rate was the primary tool
OMOs were not yet discovered, and the
Federal Reserve Act had no provisions to
change reserve requirements
The policy was based on the “real bills
doctrine” (loans only for “productive
purposes”)  which papers are ‘eligible’
48
Goethe Business School
The Fed after World War I



By the end of World War I, the (re-)discounting
of eligible papers (including Treasury bills) had
led to inflation, and the “real bills doctrine”
became discredited
The Fed abandoned its passive role, and it
increased the discount rate from 4.75% to 7%
in 1920, which (after a short recession
in 1920-21) brought inflation under control
This paved the way for the “Roaring Twenties”
49
Goethe Business School
The discovery of OMOs

The Fed discovered open market
operations by accident:
 It revenue (mainly from discount loans to
member banks) shrank during the 1920-21
recession, so the Fed was under pressure
 It reacted by purchasing income-earning
securities to compensate for the losses
 It then discovered that reserves in the banking
industry grew (credit multiplier)
50
Goethe Business School
World War I
and the Reichsbank





In 1914, the Reichsbank had suspended the
convertibility of its notes in gold
Much of the government borrowing was
discounted by the Reichsbank
At the end of the war, money in circulation had
increased four-fold
The consumer price index had risen 140% by
December 1918
Yet floating debt of the Reichsbank had
increased from 3 to 55 billion marks
51
Goethe Business School
The Reichsbank: After WW I

Inflation was fueled by
 Germany’s reparation payments, which
triggered a devaluation of the mark
 A decline in confidence in the mark
 Hoarded savings entered the market place


By February 1920, the price index was 5
times as high as at armistice, but it held
almost stable for 15 months
This chance of monetary policy was
spoiled
52
Goethe Business School
The pace to hyperinflation




During these fifteen months the government kept
issuing new money
The currency in circulation increased by 50%
and the floating debt of the Reichsbank
by 100%, providing fuel for a new outbreak
In May 1921, price inflation started again,
and by July 1922 prices had risen 700%
After July 1922 the phase of hyperinflation
began
53
Goethe Business School
The German hyperinflation
1922-23
Whole sale price index
1,E+12
1,E+11
1,E+10
1,E+09
1,E+08
1,E+07
1,E+06
1,E+05
1,E+04
1,E+03
1,E+02
1,E+01
Ja
n
Ju
ly
19
14
19
19
Ju
ly
19
19
Ja
n
19
20
Ja
n
19
21
Ju
ly
19
21
Ja
n
19
22
Ju
ly
19
22
Ja
n
19
23
Ju
ly
19
23
No
v
19
23
1,E+00
54
Goethe Business School
Stabilization program
of 1923/24

In November 1923, a currency reform was
undertaken
 A new bank, the (private) Rentenbank, was to issue
a new currency: the Rentenmark
 This money was exchangeable for bonds backed
up by land and industrial plant
 A fixed amount of 2.4 billion Rentenmarks was
created, and each Rentenmark was valued at one
trillion old paper marks

The Rentenmarks held their value. Inflation
ceased even for the Reichsmark
55
Goethe Business School
Completing the 1923 reform




In August 1924 the reform was completed by the
introduction of a new Reichsmark, equal in value to
the Rentenmark
The Reichsmark had a 30% gold backing. It was not
redeemable in gold, but the government undertook to
support it by buying in the foreign exchange markets
as necessary
The Reichsbank became independent from the
government and government loans were limited
Drastic new taxes were imposed, and with the inflation
ended, tax receipts increased impressively. In 19241925 the government had a surplus
56
Goethe Business School
The “Roaring Twenties”
and the Fed

The stock market boom of 1928/29
created a dilemma for the Fed:
 tempering the boom would have required a
higher discount rate;
 the Fed hesitated to do that because of
“legitimate credit needs”

When the discount rate was finally raised
(August 1929), it was too late
57
Goethe Business School
The Bank Panics of 1930-33




Substantial withdrawals from banks ended in a
full-fledged panic at the end of 1930
One bank after the other closed, but the Fed did
not perform its role as lender of last resort
It did not understand the impact of bank failures
on money supply and economic activity
Moreover there was political haggling that
entailed policy inactivity
58
Goethe Business School
The switch
to monetary targeting





In the early 1970s (Arthur Burns), the Fed adopted a
policy of monetary targeting, but its commitment to the
new policy was weak
(The Bundesbank followed in 1974)
The policy was to pre-announce target ranges for the
growth rates of money aggregates
However the Fed continued to use the federal funds rate
as an operating target
In 1979 (Paul Volcker) the Fed officially changed its
policy, using reserves as the instrument
59
Goethe Business School
Returning
to interest-rate policies



Once inflation was checked, the Fed
deemphasized monetary aggregate targets and
returned to a policy of smoothing interest rates
In 1993, Alan Greenspan testified in Congress
that the Fed would no longer use monetary
targets
During the 1990, with strong growth and low
inflation, the Fed focused on interest rate
policies, with a defensive stance
60
Goethe Business School
The ECB’s
monetary policy strategy


The ECB's stability-oriented monetary policy
strategy consists of three main elements:
a quantitative definition of price stability, and the
two "pillars" used to achieve this objective.
These two pillars are:
 a prominent role for money, as signaled by the
announcement of a quantitative reference value for
the growth rate of a broad monetary aggregate;
 and a broadly based assessment of the outlook for
price developments and risks to price stability in the
euro area as a whole.
61
Goethe Business School
The definition of price stability

The Governing Council of the ECB has
adopted the following definition:
 “Price stability shall be defined as a year-onyear increase in the Harmonized Index of
Consumer Prices (HICP) for the euro area of
below 2%”
 Price stability according to this definition “is to
be maintained over the medium term”
62
Goethe Business School
Reference value: problems
First, to ensure that the reference value is
consistent with the maintenance of price
stability, money must have a stable
relationship with the price level. The stability
of this relationship is typically assessed in the
context of a money demand function
Second, substantial or prolonged deviations of
monetary growth from the reference value
signal risks to price stability over the medium
term. It requires that monetary growth is a
leading indicator of price developments
63
Goethe Business School
The broadly based
outlook for prices



It is based on a large number of indicators
The range of indicators includes many variables
that have leading indicator properties for future
price developments
They include, inter alia, wages, the exchange
rate, bond prices and the yield curve, various
measures of real activity, fiscal policy indicators,
price and cost indices and business and
consumer surveys
64
Goethe Business School
Reading



Reading 8-1: “Too hot or too cold?”, The
Economist, June 12th, 2008
Reading 8-2: Please re-read Reading 1-6:
“ECB: A decade in the sun“, The Economist,
June 5th 2008
Reading 8-3: “Hubble, bubble, asset-price
trouble“, The Economist, September 1999
(optional)
65
Goethe Business School
Discussion 8:
Money supply and monetary policy



How does a central bank gear the money
supply?
Do you think that the central bank can
control the money supply, if not: Why not?
What instruments has the central bank at
its disposal?
66
Goethe Business School