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International Financial Economics

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1 International Financial Economics
The European Central Bank (ECB) and the Federal Reserve (the Fed): differences and similarities in setup, operational procedure, and monetary policy Akmal Rahimov Hari Widodo Yudha Hadiyanto

2 OUTLINE: PART I : General Overview, Historical Background, Organizational Structure, Main Functions and Tasks of the Federal Reserve and ECB PART II : Differences and similarities in Operational Procedures of Federal Reserve and European Central Bank PART III : Monetary Policy

3 PART I: General Overview, Historical Background, Organizational Structure, Main Functions and Tasks of the Federal Reserve Bank and European Central Bank (ECB)

4 The Role of Central Bank
Issuer of the currency Controller of the money supply Lender of the Last Resort

5 Why the US need a central bank?
The United States lacked a central bank until the twentieth century Needs a money manager, to handle the nation's financial system. Financial panics, the Bank Panic of 1907 convinced the public that a central bank was necessary.

6 Why the US need a central bank?(Continued)
To reform the financial system to be more integrated and secure in supporting the developing economy. In 1913, after considerable debate, Congress passed the Federal Reserve Act to balance the financial needs of the country.

7 Why European System of Central Bank (ESCB) is needed?
Primary objective : to maintain price stability, as defined in Article 2 of the Statute of the ESCB and of the ECB. Price stability : a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%. To be maintained over the medium term. The Governing Council announced that, in the pursuit of price stability, it would aim to maintain inflation rates close to 2% over the medium term.

8 Historical Background
FEDERAL RESERVE Drafted by Congress as the Federal Reserve Act in 1913 The act began in 1908, when Congress set up the National Monetary Commission to pinpoint weaknesses in the nation’s financial system. Triggering Factors : Monetary panic (Bank commitment) The commission found that the United States lacked a reliable method to provide liquidity to the money supply. EUROPEAN CENTRAL BANK Established on 1 June 1998, as one of the world’s youngest central banks. Triggering factors : the presence of EMU (political decision), i.e. to maintain price stability EMU: Stage 1: Restriction on the movement of capital were abolished (1990) Stage 2:Establishment of EMI and ECB Stage 3:Irrevocable fixing of exchange rate

9 Historical Background(Continued)
President Woodrow Wilson signed the Federal Reserve Act into law on Dec. 23, 1913, to help to maintain a stable, healthy and growing economy. The legal basis : the Treaty on European Union signed on February 7, 1992 in Maastricht which established the European Community. The ESCB is composed of the ECB and the national central banks of all 15 EU Member States.

10 Stages to Monetary Union
1. Maastricht Treaty 2. Establishment of the EMU 3. Irrevocable fixing of exchange rates

11 Inseparable Story: EMU and the ECB Stage 1: Maastricht Treaty
1 July 1990, the first stage : movement of capital among the European Economic Community (EEC) countries should be demolished. the committee of governors decided to facilitate the preparatory work for the establishment of EMU (the Treaty of Rome) 1991 intergovernmental conference agreed to revise the Treaty of Rome in order to establish the required institutional structure. Represented on the Treaty on European Union, signed in Maastricht on February 7, 1992.

12 Stage 2 : Establishment of the EMU
1 January 1994 : The establishment of the European Monetary Institute (EMI)The EMI had no responsibility for the conduct of monetary policy in the European Union December 1995 : the European Council agreed to name the European currency unit to be introduced the "euro", and confirmed that Stage Three of EMU would start on 1 January 1999. December 1996 EMI also presented to the European Council, and subsequently to the public, the selected design series for the euro banknotes to be put into circulation on 1 January 2002.

13 25 May 1998 : the governments of the 11 participating Member States (Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland) appointed the President, the Vice-President and the four other members of the Executive Board of the ECB. With the establishment of the ECB on 1 June 1998, the EMI had completed its tasks. The EMI went into liquidation on the establishment of the ECB.

14 Stage 3: Irrevocable fixing of exchange rates
1 January 1999 : the irrevocable fixing of the exchange rates of the currencies of the 11 Member States initially participating in Monetary Union was commenced along with the conduct of a single monetary policy under the responsibility of the ECB. 1 January 2001 : Greece joined the EMU, making the number of participating Member States increased to 12.

15 Basic Tasks of Federal Reserve and European Central Bank
manages supply of money and credit keeps the wheels of business rolling serves as the banker for the federal government by providing financial services for the U.S. Department of the Treasury supervises and regulates a large share of the nation's banking and financial system; administers banking and finance-related consumer protection laws. European Central Bank To define and implement monetary policy in Euro area To maintain price stability and conduct foreign exchange operations Holding and manage the official foreign reserves of the Member States Promote the smooth operation of payment systems Provide prudential supervision of credit institutions and the stability of the financial system

16 Independence of the Central Bank
The ECB: Based on the Maastricht Treaty, neither ECB nor NCB nor any member of decision-making bodies are allowed to seek or to take instructions from community institution or bodies form any government of any member states or from any other bodies The Fed: Three structural features give the Fed independence in its conduct of monetary policy: The appointment procedure for Governor, procedure for Reserve Bank Presidents Funding. However, it is ultimately countable to Congress and come under government audit and review

17 Structure of the System of Federal Reserve

18 Board of Governor of The Fed
Seven-member Board of Governors. Appointed by the President of the United States and confirmed by the Senate Serve 14-year terms, arranged so that one expires in every even-numbered year. designed to be long enough to prevent day-to-day political pressures The President of the United States designates a Chairman and Vice Chairman from the Board to serve four-year terms.

19 Federal District Bank (12)
District Banks. There are 12 Federal Reserve Districts, or regions, throughout the United States. Regional headquarters are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Additionally, there are Branches of Reserve Banks in 25 other cities.

20 Federal Reserve Districts and Branches
Chicago Saint Louis Minneapolis Kansas City Dallas San Francisco Boston New York Philadelphia Cleveland Richmond Atlanta

21 Federal Open Market Committee
The Federal Open Market Committee (FOMC) consists of twelve members The seven members of the Board of Governors of the Federal Reserve System The president of the Federal Reserve Bank of New York; Four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee's assessment of the economy and policy options.

22 Federal Open Market Committee
The FOMC has the primary responsibility for conducting monetary policy. Director of each Reserve Bank contributes to monetary policy by making recommendations about the appropriate discount rate

23 Member Banks National banks chartered by the federal government are, by law, members of the Federal Reserve System. State-chartered banks may choose to become members of the Federal Reserve System if they meet the standards set by the Board of Governors.

24 Advisory Committee The Federal Reserve System uses advisory and working committees to advise the Board of Governors directly: • Federal Advisory Council. Consists of one member—traditionally a commercial banker—from each Federal Reserve District. Required by law to meet four times each year with the Board of Governors to discuss economic and banking matters. • Consumer Advisory Council. This statutory council has thirty members, meets with the Board three times a year on matters concerning consumers and the consumer credit protection laws administered by the Board. Consists of academics, legal specialists in consumer matters, and members representing the interests of consumers and the financial industry.

25 • Thrift Institutions Advisory Council.
Board of Governors established this council to obtain information and opinions on the needs and problems of thrift institutions. The council is made up of representatives of savings and loan associations, savings banks, and credit unions.

26 Flow of Command in the FED

27 Source : ECB Brochure

28 Executive Board The Executive Board comprises the President, the Vice-President and four other members. The main responsibilities of the Executive Board are: To implement monetary policy and, in doing so, to give the necessary instructions to the NCBs; To execute those powers which have been delegated to it by the Governing Council of the ECB.

29 Governing and General Council
The Governing Council is the supreme decision-making body of the ECB which comprises the members of the Executive Board of the ECB and the governors of the national central banks which have adopted the euro. Only members of the Governing Council present in person shall have the right to vote. General Council is one of the three decision-making bodies of the ECB. It comprises the President and the Vice-President of the ECB and the governors of all 15 EU national central banks.

30 PART II: Differences and similarities in Operational Procedures of Federal Reserve and European Central Bank

31 Operational Procedure
Operational Procedure is the set of instruments and procedures which a central bank uses to steer interest rate, signal monetary policy intentions, and manage liquidity in the money market. Operational Procedures related to the monetary policy and the instruments used such as open market Operation, standing facilities, and reserve requirement.

32 Monetary Policy Framework
The Fed: controlling inflation and promote economic growth There is no exact figure as reference of the price stability and inflation. Board of Governor and FOMC maintain growth of money and credit in line with the long-run economic performance such as employment rate, inflation rate, and moderate interest rate. ECB: Primary objective of ECB is maintaining the price stability. Operationally defined as controlling inflation to be less 2% in Harmonized Index Consumer Prices (HICP). In evaluating the financial market condition, (M3) as quantitative reference. Prediction of inflation and the risk price stability is crucial (broad based assessment)

33 Monetary Policy Framework
ECB announces target of money growth periodically since its inception Using M3 as the evaluation tool to the financial market condition has some technical problem. M3 is defined as currency, deposits, and marketable securities held by Euro-area resident. The fed has been announcing the target of money growth since 2002. The Fed does not have such kind of problems

34 Operational Procedure :
Both central banks use the similar tools but different method in managing money market and influencing short-term interest rate The ECB influence the liquidity in the market through the open market operation based on weekly pre-arranged schedule The instrument used in this operation is essentially repurchase agreement like in the Fed. ECB uses minimum reserve to stabilize money market interest rates. The ECB requires bank to hold required reserve based on the level of the liabilities. The Fed uses the Open Market Operation through over-night repurchase agreement in influencing market liquidity and. the two other tools, i.e reserve requirement and discount rate. Level of supply is determined every morning based on forecast for reserve demand. Reserve requirement is not used to influence inflation and growth, but to stabilize the demand for reserve to make easier to control the fed fund rate.

35 Operational Procedure :
The Fed provide loan at the discount window. The discount rate is subject to approval from the board of governors. Estimate the demand for reserves, and estimates the supply before any other open market operation, and arrange additional open market operations. The Fed conducts the OMO through the Fed of NY and involving a fewer financial institution. ECB also provides overnight loans to banks with the marginal lending rate. The spread is determined by governing council. The open market operations are done simultaneously by the NCB in the Euro-system. The OMO involving coordination among 15 NCB and hundreds financial institutions. It becomes more complicated.

36 Operational Procedure :
6.The Fed only deals with the US government securities as collateral. Due to the differences in financial structure among the countries, ECB deals with more various collateral 7. The sheer volume of funds that is refinanced on regular basis is larger than that of the Fed therefore ECB set up more cumbersome and risky.

37 PART III: Monetary Policy
Macroeconomic Performance Monetary Policy Instruments Monetary Policy Strategies

38 Key economic characteristics of the Euro Area, US and Japan

39 Unemployment rate in the Euro Area, the United States and Japan


41 Monetary Instruments

42 Tools of Monetary Policy of Federal Reserve and ECB

43 The instruments of ECB’s monetary policy
Open market operations The main refinancing operations are regular liquidity-providing reverse transactions with a weekly frequency and a maturity of two weeks. The longer-term refinancing operations are liquidity-providing reverse transactions with a monthly frequency and a maturity of three months.

44 The instruments of ECB’s monetary policy
Fine-tuning operations can be executed on an ad hoc basis with the aim of both managing the liquidity situation in the market and steering interest rates, in particular in order to smooth the effects on interest rates caused by unexpected liquidity fluctuations. In addition, the Eurosystem may carry out structural operations through the issuance of debt certificates, reverse transactions and outright transactions.


46 The instruments of ECB’s monetary policy
Standing facilities aim to provide and absorb overnight liquidity, signal the general monetary policy stance and bound overnight market interest rates. Marginal lending facility, is used by counterparties to obtain overnight liquidity from the NCBs against eligible assets. Deposit facility to make overnight deposits with the NCBs.

47 The instruments of ECB’s monetary policy
3. Minimum reserves The Governing Council of the ECB has decided to apply minimum reserves as an integral part of the operational framework for the monetary policy in Stage Three.

48 Three Tools of Federal Reserve Monetary Policy
1.Establishing reserve requirements, the minimum proportion (percentage) of bank deposits they must keep on deposit at the Fed. Increasing reserve requirements (%) increases the percentage of bank deposits kept in non-interest bearing deposits at the Fed and limits bank lending. Decreasing reserve requirements (%) reduces the percentage of bank deposits kept in the Fed and provides the banking system with excess reserves. Bank deposits (reserves) in the Fed are needed to clear checks and to satisfy reserve requirements.

49 Three Tools of Federal Reserve Monetary Policy (Continued)
Open market operations affect the level of member bank reserves and the monetary base. Buying government securities from the private sector, the Fed eventually credits member bank deposits, thus increasing the level of bank reserves and the banks' ability to make loans and expand the money supply. Selling securities (could be any asset) to private security dealers or banks, the Fed is paid with a bank check which reduces the level of member bank actual reserves


51 Three Tools of Federal Reserve Monetary Policy (Continued)
Discount Rate Policy -- The rate of interest depository institutions pay for borrowing from the Fed. Raising the discount rate increases the cost of borrowing for needed reserve balances. Lowering the discount rate lowers the cost of bank liquidity and encourages lending and money supply expansion.

52 Monetary Policy Strategy




56 An illustration of the transmission mechanism from interest rates to prices



59 Two Pillars of ECB’s Monetary Policy Strategy

60 First Pillar of ECB’s Monetary Policy Strategy: Economic analysis
The Economic Analysis focuses mainly on the assessment of current economic and financial developments and the implied short to medium-term risks to price stability. Includes: Analysis of real economy indicators. Analysis of financial market developments. Analysis of exchange rate developments. Euro area macroeconomic projections based on technical assumptions, models and technical expertise of staff

61 Second Pillar of ECB’s Monetary Policy Strategy: Monetary analysis
2. Monetary analysis focuses on a longer-term horizon, exploiting the long-run link between money and prices. The monetary analysis mainly serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications for monetary policy coming from the economic analysis. Includes: The analysis of special factors A comprehensive assessment of liquidity and credit conditions Analysis of components and counterparts of M3



64 Conclusion There is no blueprint for the structure and operations of a central bank. Although the structures of the Federal Reserve System and the Eurosystem are similar, there are many differences in the way they operate. The Eurosystem is more decentralized than the Federal Reserve.

65 Conclusion There is lesson for Fed to take from ECB:
To clarify the goals of monetary policy. Disagreements remain over how to best make policy transparent while at the same time reserving the independence of the central banks. Transparency of two FED and ECB has also increased. It is harder for the ECB to forecast the monetary magnitude compared with the Fed due to the relatively limited data available from the past (only 5 years)

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