Geld, Krediet en Bankwezen

Money, Credit and Banking

2010-2011
Week 6

Part 1: Tools of Monetary Policy: ECB

(M, cha 15 + ECB, cha 4)

Part 2: Conduct of Monetary Policy:

Goals, Strategy and Tactics
(M, cha 16 + ECB, Sections 3.1,
3.3, 3.4 and 3.5)
 Monetary Policy Tools of ECB
1. Open market operations (OMOs)
– Buy and sell eligible assets to affect
reserves and, as a result, interest rate
that European banks charge each other for
overnight funds: EONIA (Euro Over Night
Index Average) rate
– Implemented by NCBs (in the U.S. by NY Fed)
– Main form: Main Refinancing Operations
(MROs) (weekly reverse transactions) (like
Fed’s repo’s)
– Main Refinancing Rate (MRR) is applied in
the MROs (equivalent to Fed’s Federal Fund
Target)
 Monetary Policy Tools of ECB
2. Standing facilities for banks
– Available to banks on their own initiative
– Marginal lending facility to obtain
overnight liquidity from NCBs (like Fed’s
discount window)
• Marginal lending rate = MRR+100bp (!
currently 75bp)
• No limit, provided collateral
• Ceiling for EONIA rate
– Deposit facility to make overnight
deposits at NCBs (introduced also by Fed)
• Deposit rate = MRR–100bp (!currently
75bp)
• Floor for EONIA rate
 Key ECB interest rates plus EONIA and euribor
Daily data
6 .0

5 .5

5 .0

4 .5

4 .0

Marginal Lending rate

3 .5

3 .0

2 .5

2 .0

1.5

1.0

Deposit rate
0 .5

0 .0
199 9 200 2 001 20 0 200 200 200 200 2 00 200 200 2010

EONIA Main refinancing rate 1-month euribor

 Monetary Policy Tools of ECB
3. Reserve Requirements
– All deposit-taking institutions are required to hold
2% of short-term deposits in reserves at the NCBs
– ECB pays interest rate on required reserves (average
MRR over maintenance period) (like Fed
since crisis)
– Institutions subject to reserve requirements have
access to the ECB’s standing facilities and participate
in OMOs
 Conduct of Monetary Policy: Goals,
Strategy and Tactics

• Goals of central banks

• Possible Strategies

• Choice of policy Instruments

 Price Stability Goal
• Main goal of central banks: price stability

• Benefits of price stability (ECB, Section

3.1, pp. 42-43)
1. Improving transparency of relative prices
2. Reducing inflation risk premia on interest rates
3. Avoiding unnecessary hedging activities
4. Reducing distortions of tax and social security
systems
5. Increasing benefits of holding cash
6. Preventing arbitrary redistribution of wealth and
income

• Empirical evidence: higher inflation produces

lower economic growth in the long run (e.g.
particularly in hyperinflation countries)
 Other Goals of Monetary Policy
• High employment or low unemployment
(consistent with natural rate of
unemployment)

• Economic growth in the long run

• Stability of financial markets (above

all now!)

• Interest-rate stability

• Foreign exchange market stability

 Price Stability as the Primary Goal?
• Long run: no trade off between price
stability and other goals (e.g. price
stability enhances long-run economic
growth as well as financial and interest-
rate stability)

• Short run: trade off between price

stability and other goals (e.g. monetary
expansion (M or i ↓) output and
inflation 

• Time-inconsistency problem: stimulating

systematically output in short run leads
to long-run inflation
 Time-Inconsistency Problem
• Good long-run plan, reneged by short-run temptations
=> good long-term plan is time-inconsistent
• In monetary policy:
– Long-run goal: price stability
– Short-run temptation: expansionary short-term policy to
increase output (but this produces higher inflation)
– Rational agents (workers and firms) are aware of these short-
term incentives and raise their inflation expectations
– Higher inflation expectations drive wages and prices up

• Solutions to time-inconsistency problem?

• Delegate monetary policy to an independent central bank
with a pre-set behavior rule to achieve price stability
 Behavioral Rule and Nominal Anchor
• Behavior rule implies choosing a nominal anchor (or
target) to which the central bank commits its policy

• Typical nominal anchors: exchange rate, monetary

aggregate, inflation rate
• If behavior rule is credible (likely with independent
central bank), the time-inconsistency problem is solved

• Nominal anchor provides the basis to which agents can

form their inflation expectations which drives current
inflation
 Monetary Policy Strategies
Main monetary policy strategies (characterized by
different nominal anchors) are:
1. Monetary Targeting: use of a specific monetary
aggregate as an intermediate target
2. Inflation Targeting: use of a specific medium-term
numerical target for inflation
3. Implicit Nominal Anchor (e.g. Fed)
4. Exchange Rate Targeting (not covered)
 1. Monetary Targeting
• Advantages
– Almost immediate signals help fix inflation
expectations and produce less inflation
– Almost immediate accountability

• Disadvantages
– Rely on stable relationship between inflation and
targeted monetary aggregate
– Must have full control over monetary aggregate
 2. Inflation Targeting
• First introduced by New Zealand in 1990. Since then
adopted by Canada (1991), the United Kingdom (1992),
Sweden and Finland (19930, and many others

• Public announcement target for inflation (e.g. 2% or

between 2-3%) over the medium-term (e.g. 2 years)

• Institutional commitment to price stability as the

primary, long-run goal of monetary policy and a
commitment to achieve the inflation goal

• Information-inclusive approach in which many variables

are used in making decisions
 2. Inflation Targeting
• Advantages
– Easily understood by public
– Does not rely on one variable to achieve target (as in
monetary targeting)
– Stresses transparency and accountability
• Disadvantages
– Delayed signaling
– Too much rigidity?
– Potential for increased output fluctuations?
 3. Implicit Nominal Anchor
• There is no explicit nominal anchor in the
form of an overriding concern for the Fed

• Also called “Just do it” approach of Fed

• Forward-looking behavior and periodic

“preemptive strikes” against the threat of
inflation

• The goal is to prevent inflation from

getting started

• Dual mandate: achieve price stability and maximum

employment
 3. Implicit Nominal Anchor
• Advantages
– Uses many sources of information
– Demonstrated success

• Disadvantages
– Lack of transparency
– Strong dependence on the preferences, skills, and
trustworthiness of individuals in charge
– Low accountability
 ECB’s Monetary Policy: Goal
• Price stability, defined as “…a year-on-year increase in
the Harmonized Index of Consumer Prices (HICP) for the
euro area, close but below 2%”

• “ …maintained over the medium term” (roughly 2 years)

• No mention of other objectives

 HICP inflation
Procentuele jaarmutaties
4.5

3.5

2.5

1.5

0.5

-0.5

-1.5
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
HICP - totaal
'core-inflatie': HICP exclusief onbewerkt voedsel en energie
 ECB’s Monetary Policy:
Two-Pillar Strategy
• First pillar: Economic Analysis
– Monitoring of indicators (wages, energy
prices, exchange rate, yield curve, etc)
to assess the short to medium-term risks
to price stability
• Second pillar: Monetary Analysis
– Money stock is ‘reference value’ to
assess the medium to long-term risks to
price stability
– M3 reference value: 4.5% (consistent with
2% inflation in the long run)
– Same procedure as Bundesbank
 Money growth euro area
Annual percentage changes
14.0

12.0

10.0

8.0

6.0

4.0

2.0

0.0

-2.0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

M3 M3 (three month centred moving average) Reference value

 Tactics: Choosing the Policy Instrument
• Tools (directly controlled by CB)
– Open market operation
– Discount rate or lending rate
– Reserve requirements
• Policy instrument (operating instrument):
variable that responds to tools
– Reserve aggregates (R, NBR, MB, MB n)
– Interest rates (e.g. federal fund rate or EONIA)
• Can the CB target the level of NBR and
interest rate simultaneously?
• No, interest-rate and reserve targets are
incompatible
 Linkages Between Tools, Policy
Instruments, Intermediate Targets,
and Goals
Targeting Non-borrowed Reserves
Targeting the Interest Rate
 Criteria for Choosing the Instrument
• Observability and Measurability: policy instrument
should be quickly observable and measurable

• Controllability: policy instrument should be fully

controlled with tools

• Predictable effect on Goals: policy instrument must

have a stable and predictable relationship with goal

 Nowadays , most central banks target short-term interest

rates as policy instrument

 But how should this target be chosen?

 Taylor Rule

i ff = equilibrium real i ff + inflation rate

+ 1/2 (inflation gap) + 1/2 (output gap)
• Inflation gap = (inflation rate – inflation
target)
– If inflation rate above target, CB should
increase iff
– Taylor principle: if inflation rate ↑ 1% , CB
should ↑ iff 1.5%
• Output gap
– Stabilizing real output is an important concern
– Output gap is an indicator of future inflation
The Taylor Rule for the Federal
Funds Rate, 1970–2008