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Central Banking from theory to practice: An international comparison ÁNGEL GARCÍA University of Siena, Pontignano Meeting 03-07-2007, Siena, Italy.

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Presentation on theme: "Central Banking from theory to practice: An international comparison ÁNGEL GARCÍA University of Siena, Pontignano Meeting 03-07-2007, Siena, Italy."— Presentation transcript:

1 Central Banking from theory to practice: An international comparison ÁNGEL GARCÍA University of Siena, Pontignano Meeting 03-07-2007, Siena, Italy

2 2 (1) Are there any substantial differences among monetary practices throughout the world? (2) If yes, what are those differences based on? (3) How can they be observed? (4) How are they related to the different theoretical views of money? (5) Which economies tend to follow similar patterns? (6) And why do such differences exist? 1. Introduction

3 3 Argentina Brazil America and LA Mexico Peru USA Venezuela England Europe EU Norway 1. Introduction (Continued): Economies Studied China Japan Asia Kuwait India Saudi Arabia UAE Central bank balance sheet data: 48 months of observations from Jan 2003 to Dec 2006. Overnight Interbank Interest Rate and FX data: an average of 1045 daily observations from Jan 2003 to Dec 2006.

4 4 The short answer is yes, there are substantial differences among monetary practices throughout the world, although these differences have been reduced as most central banks have abandoned policies based on monetary targeting in favor of those based on interest rate targeting. The differences in monetary practices are related to international monetary asymmetries, the differences between the large and closed economy and the small open economy and between the old exogenous theory of money and the endogenous theory of money. 1. Introduction (Continued)

5 5 2. The two theories of money Concept The Exogenous Theory of MoneyThe Endogenous Theory of Money PostulateImplicationsPostulateImplications Technology Decreasing Returns to Scale. Investment highly depends on interest rates. Automatic adjustment through a price mechanism which secures a tendency towards full employment Increasing Returns to Scale. Investment mostly depends on the preservation of a normal level of capacity utilization. Incomplete adjustment through variations in quantities, leading to multiplier/accelerator effects. Distribution of Income Labor is a commodity. Salaries are determined by marginal productivity. The distribution of income is harmonic. Every one gets his marginal contribution. Salaries are negotiated and determined within a conflictive process. The distribution of income is not harmonic and represents the major influence over costs of production and inflation.

6 6 2. The two theories of money Concept The Exogenous Theory of MoneyThe Endogenous Theory of Money PostulateImplicationsPostulateImplications Financial System Savings precede Investment. Deposits and reserves are required to extend new loans. Portfolio adjustments are irrelevant. Investment precedes savings. Loans create deposits, and the availability of reserves does not constraint the expansion of loans. Savings are just a residual which reduces aggregate demand. Portfolio adjustments are deterministic. Monetary System Money is a commodity which reduces transaction costs. The value of money is tied to a commodity. Monetary reserves are physically restricted and interest rates are determined by the market and scarcity. Money is a fiat money which circulates by means of coercive power and the imposition of tax liabilities. The value of money has no anchor. Monetary reserves face no restriction and interest rates are exogenously determined by the State and the central bank.

7 7 2. The two theories of money Concept The Exogenous Theory of MoneyThe Endogenous Theory of Money PostulateImplicationsPostulateImplications Direction of Causality From the money supply to nominal income. Inflation is a demand phenomenon and excess money is its cause From expected and actual nominal income to the money supply. Money is an effect and not a cause. Money is demand determined, and demand is not determined by the money supply. Economic Policy The role of monetary policy is emphasized. Fiscal policy is rather ineffective because it leads to crowding out and reduces investment. Monetary authorities must reduce the output gap and control inflation by controlling the amount of money or the interest rate. Monetary Policy is accommodative. Fiscal policy and Incomes Policies are effective to stabilize inflation and output. Monetary authorities should accommodate the demand for reserves and stabilize the interest rate to guarantee the well functioning of the payments and financial systems.

8 8 In the LCE reserves face no constraint. Only expectations regarding bank profitability may restrict credit activity along the credit cycle, without having to affect the tendency towards economic growth and credit expansion. But in the SOE, there are adverse effects arising from actual and expected variations in both the level of international reserves (as a quantity) and the foreign exchange rate (as a price) which represent in practice an indirect factor which restricts the domestic credit activity of central banks, but not that of commercial banks. 3. The complexities of the Open Economy

9 9 In short, while the LCE is not required to build a stock of foreign currency assets and is not concerned about fluctuations in the FX rate, the SOE is. The reason is the former supplies the international reserve currency, the latter does not – e.g. there are international monetary asymmetries. The local currency of the SOE is not accepted abroad. 3. The complexities of the Open Economy (Continued)

10 10 3. The complexities of the Open Economy (Continued) Exogenous factors affecting liquidity preference in domestic and foreign currency: - The structure of the domestic the economy. - Economic and Political uncertainty. - Institutional arrangements and degree of financial development, availability of credit, liquidity restrictions, credit rationing, etc. Weak Liquidity Preference in Foreign Currency Local currency government securities do not have to compete against foreign currency securities. A larger stock of gross international reserves is not required for absorbing exogenous fiscal monetary components. Foreign currency assets tend to concentrate within private interbank systems, and the exchange rate regime gains flexibility. Portfolio adjustments in this case take place within the sphere of bank deposits, and do not require base money; hence, there is no bias towards interest rate volatility but towards two-side exchange rate volatility. Fiscal Policy does not necessarily tend to be pro-cyclical, as its monetary absorption is secured at any time. Two side-betting becomes the rule, reducing the preference for liquidity in foreign currency.

11 11 3. The complexities of the Open Economy (Continued) Exogenous factors affecting liquidity preference in domestic and foreign currency: - The structure of the domestic the economy. - Economic and Political uncertainty. - Institutional arrangements and degree of financial development, availability of credit, liquidity restrictions, credit rationing, etc. Strong Liquidity Preference in Foreign Currency Local currency government securities have to compete against foreign currency securities. Foreign currency assets tend to concentrate within the central bank, and the exchange rate regime looses flexibility. Portfolio adjustments in this case involve a temporary demand for base money in order to purchase foreign currency assets provided by the central bank. It requires the liquidation of (government) securities, and hence implies a bias towards interest rate volatility, unless the central bank is always ready to purchase the liquidated government securities. Fiscal Policy tends to be pro-cyclical, as its monetary absorption is facilitated precisely in the presence of balance of payments surpluses. One side-betting becomes the rule, reinforcing the strong preference for liquidity in foreign currency. A larger stock of gross international reserves is required for absorbing exogenous fiscal monetary components.

12 12 4. Central Banks Balance Sheets Assets, Liabilities and Capital A S S E T S Gross Intl Reserves (GRI) Gold and Gold Certificates Foreign Currency Assets Other International Reserve Assets Domestic Credit (DC=CG+CFS) Credit to Gov (CG) Credit to Financial Sys (CFSRED) IMF Subtotal Other Assets Other Assets in Foreign Currency not GRI Other Assets TOTAL ASSETS (ASS) Assets, Liabilities and Capital L I A B I L I T I E S International Reserve Liabilities IMF Base Money (BM =CASH+BRES) Notes and Coins in Circulation (CASH) Deposits of Banking Institutions (BRES) Debt Securities (DS) Deposits Public Adm (GD) Other Liabilities C A P I T A L

13 13 4. Central Banks Stereotypes Case DiagnosisSymptoms Is the Local Currency an International Reserve Currency? Influence of International Monetary Asymmetries Influence of variations in the FX Rate Monetary Policy and FX Rate Regime in Place Largest Component of Asset Side Largest Component of Liability Side Quantity EffectPrice Effect (1)YesNull Fully Flexible Domestic Credit Cash (2)NoWeak Flexible Domestic Credit Total Base Money (3)NoIntermediate Flexible/Fixed Domestic Credit Debt Sec. and Gov. Deposits (4)NoIntermediate Flexible/Fixed Gross Intl Reserves Total Base Money (5)NoStrong Fixed Gross Intl Reserves Debt Sec. and Gov. Deposits (6)NoStrong Fully Fixed Gross Intl Reserves Cash

14 14 5. Central Banks Quantitative Indexes (Continued) (1) Variable Flexible Exchange Rate RegimeFixed Exchange Rate Regime Very Short-run Short, Medium and Long-run Very Short-run Short, Medium and Long-run GIRExog Endo DCExogEndoExogEndo IRLEndoExogEndoExog BMExogEndoExogEndo DSExog GD*Endo K * Endogenous for the Central Bank but endogenous and exogenous for the Government as it can always affect its volume of Government Deposits (GD) held at the Central Bank beyond whatever is determined through taxation by means of the issuance of Treasury Securities.

15 15 A minimum degree of flexibility of monetary policy requires: or equivalently in terms of equation (1): Otherwise the ability of central banks to issue debt without having to pay an interest rate would tend to disappear – e.g. seignorage would fade away. But, overall, depending on liquidity preference, the fact that DS>BM may set out pressures leading to financial instability and interest rate volatility. 5. Central Banks Quantitative Indexes (Continued)

16 16 5. Central Banks Quantitative Indexes (Continued) 1) The ratio of the Original Sin – applicable when GIR>DC. Provided BM expands with GIR and DC, should R 1? Not necessarily, what if Gov stabilizes the FX? But, the greater R is the more flexible the exchange rate scheme and the monetary policy of the central bank. The minimum level so that BM>DS is: What is the effect of Δ(GIR-IRL), ΔT, ΔGS, Fiscal Deficit not fully absorbed by T-Securities, ΔCF…?

17 17 5. Central Banks Quantitative Indexes (Continued) 2) Domestic Freedom – applicable when DC>GIR. One would expect the value of the ratio to remain somewhere around the unit. A minimum level so that BM>DS In the case of the large economy in charge of supplying the international reserve currency (GIR-IRL)0 GD and K is always small Easy to satisfy by definition

18 18 5. Central Banks Quantitative Indexes (Continued) 3) The importance of the Extracting Liability Components – meaningful in all cases. R<100%, otherwise there is a loss of flexibility. 4) The ratio of Orthodox Favoritism – meaningful in all cases. R<50%, otherwise BM would tend to fade away from the monetary system.

19 19 5. Central Banks Quantitative Indexes (Continued) 5) Net Extraction of Internal Liquidity – applicable when DC>GIR. R<100%, otherwise a net drain of BM would take place. 6) Net Extraction of External Liquidity – applicable when GIR>DC. R<100%, otherwise the costs of preserving the exchange rate regime in place would rapidly increase.

20 20 5. Central Banks Quantitative Indexes (Continued) 7) Liquidity Requirements – applicable when DC>GIR. R<100%, otherwise a net drain of DC would take place.

21 21 6. Empirical Results A L L C O U N T R I E S TABLE ALL-1: PERIOD JAN 2003 TO DEC 2006-AVERAGE STRUCTURE OF (CENTRAL BANKS') MONTHLY BALANCE SHEETS Assets, Liabilities and Capital ARGBRAMEXPERUUSAVENENGEUNORCHIJAPKUWINDSAUUAE A S S E T S Gross Intl Reserves (GIR)39%32%74%89%2%78%34%20%56%4%98%86% Gold and Gold Certificates1%0% 4%1%17%15%0% 1%3% Foreign Currency Assets38%32%73%83%0%60%16%19%56%4%97%83% Other International Reserve Assets0% 1%2%0%2%3%0% Domestic Credit (DC=CG+CFS)29%65%19%1%93%7%49%2%31%94%0%3% Credit to Gov (CG)17%61%11%0%92%7%5%1%4%92%0%2% Credit to Financial Sys (CFS)12%4%7%1%0% 45%1%27%2%0%1% IMF (and other resources from other funds)22%0% 75%0% Subtotal Other Assets9%3%7%10%6%16%17%3%13%2% 12% Other Assets in Foreign Currency not GRI4%2%1%7%0%14%2%0%1%0% Other Assets6%1%6%3%6%2%15%3%11%2% 12% TOTAL ASSETS (ASS) Central Bank Stereotype (1), (2), …, (6)(4)(3)(4)(5)(1)(5) (1)(5)(4)(1)(4)

22 22 6. Empirical Results (Continued) A L L C O U N T R I E S THE EVOLUTION OF SOME KEY VARIABLES FROM YEAR-AVERAGE 2003 TO YEAR-AVERAGE 2006 Assets, Liabilities and Capital ARGBRAMEXPERUUSAVENENGEUNORCHIJAPKUWIND SAUSAU UAEUAE A S S E T S Gross Intl Reserves (GIR) 30-50%32-32%70-77%87-89%2-2%74-74%41-29%22-16%48-63%4-4%99-98%78-89% Domestic Credit (DC=CG+CFS) 26-39%64-66%22-19%1-3%92-93%6-14%42-51%2-2%40-26%94-93%0-1%8-1% IMF or Norways Oil Fund 37-0%68-82% FOREIGN EXCHANGE RATE Foreign Exchange Rate Variation against the US dollar 2.95 3.07 2.18 10.79 10.90 3.48 3.28 N/A 1607.60 2150.00 0.61 0.54 0.89 0.80 7.08 6.42 115.93 116.29 46.56 45.42 Foreign Exchange Rate Variation (%) 4.07%-29.0%1.02%-5.75%N/A33.74%-11.%-10.1%-9.32%0.31%-2.45% Central Bank Stereotype (1), (2), …, (6) (4)(3)(4)(5)(1)(5) (1)(5)(4)(1)(4)

23 23 6. Empirical Results (Continued) A L L C O U N T R I E S TABLE ALL-1: PERIOD JAN 2003 TO DEC 2006-AVERAGE STRUCTURE OF (CENTRAL BANKS') MONTHLY BALANCE SHEETS Assets, Liabilities and Capital ARGBRAMEXPERUUSAVENENGEUNORCHIJAPKUWINDSAUUAE L I A B I L I T I E S Reserve Liabilities (IRL)4%7%5%9%0%21%2%5%1%0%2%0% IMF and resources from other funds or Bank Reserves in foreign currency 28%10%0%45%0% 81%0% Base Money (BM =CASH+BRES)39%29%52%25%95%34%72%6%66%76%54%71% Notes and Coins in Circulation (CASH)28%11%30%18%92%14%55%3%29%55%29%55% Deposits of Banking Institutions (BRES)11%18%22%6%3%19%17%2%37%21%26%16% Debt Securities (DS)17%19%23%13%3%27%0% 14%17%4%5% Deposits Public Adm (DG)1%34%15%2%1%15%7%8%14%4%25%1% Other Liabilities10%1%5%6%1%4%19%0%5%3%15%23% TOTAL LIABILITIES (LIA)88%99% 103% 99%97%77%93% 100% 98%91% 100% C A P I T A L Capital (K)12%1%-3%1%3%22%7% 0%2%9%0% Central Bank Stereotype (1), (2), …, (6)(4)(3)(4)(5)(1)(5) (1)(5)(4)(1)(4)

24 24 6. Empirical Results (Continued) A L L C O U N T R I E S THE EVOLUTION OF SOME KEY VARIABLES FROM YEAR-AVERAGE 2003 TO YEAR-AVERAGE 2006 Assets, Liabilities and Capital ARGBRAMEXPERUUSAVENENGEUNORCHIJAPKUWIND SAUSAU UAEUAE L I A B I L I T I E S IMF or Perus Foreign Currency Bank Reserves and Norways Oil Fund 46-3%17-0%29-25%76-85% Base Money (BM =CASH+BRES) 36-49%24-35%51-54%18-30%95-95%34-36%68-72%8-4%67-56%79-75%66-50%73-72% Notes and Coins in Circulation (CASH) 22-38%8-14%29-30%16-21%92-93%17-13%51-56%4-3%35-23%55-62%27-25%58-55% Deposits of Banking Institutions (BRES) 13-11%16-22%22-24%2-10%3-2%17-23%18-16%4-1%32-33%23-13%38-26%15-17% Debt Securities (DS)6-30%22-19%27-18%8-11%3-3%18-42%0-0% 4-24%14-19%0-10%0-4% Deposits Public Adm (DG) 1-2%27-40%14-17%26-20%1-1%14-7%8-6% 25-11%5-4%21-22%0-2% FOREIGN EXCHANGE RATE Foreign Exchange Rate Variation against the US dollar 2.95 3.07 2.18 10.79 10.90 3.48 3.28 N/A 1607.60 2150.00 0.61 0.54 0.89 0.80 7.08 6.42 115.93 116.29 46.56 45.42 Foreign Exchange Rate Variation (%) 4.07%-29.0%1.02%-5.75%N/A33.74%-11%-10.1%-9.32%0.31%-2.45% Central Bank Stereotype (1), (2), …, (6) (4)(3)(4)(5)(1)(5) (1)(5)(4)(1)(4)

25 25 6. Empirical Results (Continued)

26 26 6. Empirical Results (Continued)

27 27 6. Empirical Results (Continued)

28 28 6. Empirical Results (Continued)


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