Central Bankers

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        The Picture of a Cautious Central Banker

                                 ECB President
                                 Wim Duisenberg, wears
                                 both a belt
                                 and suspenders.
                                 There’s no chance
                                 his pants will
                                 fall down!

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

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
  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)
  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
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
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
Charles E. Whittlesey (1970)
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.
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).
          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.
“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 -
Paul Krugman(1999)
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.
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.
    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
  Development of Central Banking

•Monetary Policy(eg:setting int.rates or exchange
•Financial Sector Stability(eg:Banking
•Government Debt Man.
•Payment Systems
•Branch Network
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
  Functions of the Central Bank
• In general a look at a specific central bank’s
  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.
•   Notes payable
•   Deposits of banks
•   Treasury deposits
•   Foreign deposits
•   Deferred availability items
•   Gold
•   Loans to banks
•   Government Securities
•   Foreign Securities
•   Items being collected
• Notes payable: Central banks issue
• 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.
• Foreign deposits: Central banks play banker
  for other central banks and other official or
  authorized institutions of foreign
• Deferred availability items: Central banks
  often clear checks for commercial banks
  just as commercial banks will clear
  customer’s check.
• 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.
• 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.
   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
Supervising and regulating banking
institutions to ensure the safety and
soundness of the nation’s banking and
financial system and to protect the credit
rights of consumers.
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 nation’s
payment systems.
The European System of Central
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.
Central Bank Goals
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.
Basic Data on Central Banks
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.
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.
Number of Central Banks
How many Central Bankers?


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         Fe           Fr
             de           an
                                                                                       Central Bankers’ Salaries

                ra            ce
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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