Money, Banking, and International Finance ( PDFDrive )

Money, Banking, and International Finance

into another. Third, a single currency helps align political interests. The Eurozone members work and cooperate with each other as they strive for peace and stability. Finally, a single currency promotes competition and regions within the Eurozone begin to specialize.

Specialization can occur across many industries and countries. For instance, the financial institutions within the Eurozone can specialize and reduce their lending costs. Furthermore, countries can specialize. Germany specializes in automobile and machinery production while France specializes in pharmaceuticals, chemicals, and aerospace. As countries within the Eurozone specialize, the producers experience higher efficiency and greater productivity, and they have access to more consumers. Consequently, the zone helps integrate European countries, spurring economic growth and unleashing the competitive market forces. Over time, the Europeans should see their living standard rise and their unemployment rate fall.

The European Central Bank (ECB) manages the euro and is located in Frankfurt, Germany. ECB was modeled after the Bundesbank, which was Germany’s central bank. Primary goal of the ECB is to achieve price stability, keeping the euro stable with a low inflation rate. Euro is successful while the Eurozone rivals the United States in terms of GDP. Furthermore, the euro was appreciating against the U.S. dollar as it strove to become the new international currency because Europe’s financial markets and international trade rival the U.S.

Euro did well until the 2008 Financial Crisis struck the world’s economy. Euro began losing ground against the U.S. dollar. Subsequently, several EU member countries, such as Greece, Ireland, Portugal, and Spain were plagued with severe budget problems that led to the European Debt Crisis in 2012. We discuss the crisis at the end of the chapter.

Structure of the European Central Bank is similar to the structure of the Federal Reserve System. The Governing Council decides and formulates monetary policy for the European Central Bank and is similar to the Board of Governors of the Federal Reserve System. The council is composed of the Executive Board and 17 Governors. The Governors are the heads from their country’s central bank that are members of the Eurozone.

The Executive Board implements monetary policy and manages the day-to-day operation of the ECB, similar to the Federal Open Market Committee (FOMC). Board has a president, vice president, and four additional members, whom the European Council selects. The European Council consists of heads of state of the EU member countries. The European Council appoints members to the Executive Board for an eight-year term that is not renewable. Furthermore, the board members’ terms are staggered. Consequently, the European Council cannot change the board members all at once. President of the Executive Council also becomes the president of the Governing Council. The ECB president is selected from a central bank whose country is a member of the Eurozone. Winn Duisenburg, from the Netherlands, was the first ECB president.

EU countries retained their central banks, even countries that have adopted the euro. Country’s central banks remain independent of the EU, and the top official of a central bank in the Eurozone is a governor and a member of the Governing Council. Currently, 17 EU countries adopted the euro, which means the Governing Council has 17 Governors. Country’s government selects the governor who serves at least a five-year term. Furthermore, the governors have more influence on monetary policy within the European Central Bank than the presidents of the

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On the other hand, profits do not guide the government agencies, and no mechanism keeps a government agency in check. Every year, government agencies receive more funding, regardless of the agencies’ performance. Over time, bureaucrats become more concerned with funding, job security, and prestige, instead of following its original function. This explains why the public poorly rates its dissatisfaction of government agencies. Principal-agent view for the Fed is the chairman worries over his or her own self-interest and protects his friends, such as the large commercial and investment banks.

The Fed is independent of the U.S. Treasury Office, even though some Presidents tried to influence it. However, a government budget deficit could lead to money creation. If the Fed maintains a constant interest rate, and the U.S. government operates a budget deficit, the U.S. Treasury department can finance the deficit by issuing T-bills. Nevertheless, the T-bill supply rises, causing the market price of T-bills to fall. Thus, market interest rates rise. If the Fed maintains a fixed interest rate, it must buy the T-bills the Treasury issued, expanding both bank reserves and money supply. Consequently, a government budget deficit leads to inflation if a central bank focuses on the interest rate.

Foreign countries differ in their degree of independence between government and their central banks. For example, the Eurozone and Switzerland have the most independent central banks in the world. Thus, these countries experience the lowest inflation rates in the world. On the other hand, the central banks in Russia, Kazakhstan, Thailand, and Turkey have less independence from their governments, and these countries experience greater inflation rates.

A national government’s financial health determines the level of independence between the government and the central bank. Political leaders boost government spending to win favors with the public, but hesitant to raise taxes. Consequently, a government would suffer from a budget deficit that its treasury can finance by selling government bonds. As a government’s debt continually grows, investors will reach a point when they stop buying bonds. Unfortunately, political leaders refuse to cut government programs and subsidies or raise taxes. Only solution is the government forces its central bank to buy its bonds that investors do not want, even though it creates inflation.

Many Americans and experts believe the massive $17 trillion U.S. government debt will lead to inflation as the U.S. government forces the Federal Reserve to buy its bonds. Subsequently, the Federal Reserve would lose its independence.

The European Union experienced a similar situation. Greece, Spain, Ireland, and Portugal reached their debt limits, and investors no longer want to buy these governments’ bonds. The European Central Bank is independent of the member countries’ governments, and these countries cannot force the central bank to buy their bonds. Instead, the governments imposed austerity measures, where they increased taxes and reduced government programs and subsidies, sparking massive protests and demonstrations against the governments. Furthermore, increasing taxes or decreasing government spending hinders economic growth. Consequently, many European countries had entered a recession in 2012.

The Greek government cannot control its budget deficit, and it forced bonds holders to take a huge loss on the Greek bonds in 2010. Consequently, Greece lost its investors, and it will likely leave the Eurozone and reintroduce its currency, the drachma. The Greek citizens and

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10.Identify the benefits and problems for EU countries that are members of the Eurozone.

11.Distinguish between the public interest view and principal-agent view.

12.Explain why the degree of independence between the central bank and its government is very important.

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14.Monetary Policy Tools

This chapter introduces the Federal Reserve’s three significant tools for conducting monetary policy: open-market operations, discount policy, and reserve requirements. Furthermore, the Fed uses monetary policy to influence the important macroeconomic variables in society including the GDP growth rate and indirectly the unemployment rate, interest rates, currency exchange rates, and asset prices such as stock and bonds. Thus, many people, especially in the financial markets scrutinize the Fed’s actions to determine monetary policy. Accurately predicting the Fed’s actions, financial companies can reap large profits. Unfortunately, a central bank using monetary policy may create more instability for an economy because of time lags, so we discuss several problems of monetary policy.

Open-Market Operations

The Fed can use expansionary or contractionary monetary policies. Expansionary monetary policy is the Federal Reserve expands the money supply and indirectly reduces the short-term interest rates while contractionary monetary policy is the Federal Reserve contracts the money supply that raises short-term interest rates. Moreover, the Fed can use Open-Market Operations, Discount Policy, and Reserve Requirements to implement a monetary policy. OpenMarket Operations are the Fed’s purchase and sale of U.S. government securities, and its most important tool. Open-market operations have the same effect if the Fed purchased any shortterm, liquid securities. However, the Fed usually buys and sells U.S. government securities. We also discuss Discount Policy and Reserve Requirements in their sections in this chapter.

The Fed, for example, wants to expand the money supply by using expansionary monetary policy. In the T-bill market as represented in Figure 1, the original market price and quantity for T-bills are P* and Q*. Then the Fed buys T-bills, creating a greater demand for T-bills, shifting the demand function rightward. The Fed pays for the T-bills using a “Fed check.” After the seller deposits the check at his bank, then his or her bank's reserves increase, boosting the money supply as banks grant loans to borrowers. Consequently, both the market price and quantity of T-bills rises. Then the market interest rate falls for T-bills, when we calculate it using the present value formula.

Noticing one thing, open-market operations affect the interest rates because the T-bill is a short-term credit instrument. When the Fed purchases the T-bills, the T-bill's price rises while the T-bill interest rate falls. Consequently, the decrease in the short-term interest rates spreads to other markets, including the federal funds rate, commercial paper, and banker’s acceptances. Therefore, short-term interest rates on all short-term credit instruments will rise and fall together.

Contractionary monetary policy works similarly to expansionary monetary policy. Figure 2 depicts market price and quantity for T-bills as P* and Q*. The Fed sells T-bills, increasing the supply of T-bills and shifting the supply curve for T-bills rightward. Consequently, the market price of T-bills falls while the market interest rate for T-bills rises by using the present value

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formula. Furthermore, the short-term interest rates for other credit instruments rise. Finally, the banks’ reserves fall, and bankers grant fewer loans that shrink the money supply.

Treasury Bill Market

Figure 1. The Federal Reserve increases the money supply by purchasing T-bills

Treasury Bill Market

Figure 2. The Federal Reserve decreases the money supply by selling T-bills

The Fed can only control the growth rate of the money supply or short-term interest rates, but not both at the same time. For example, the Fed increases the M1 money supply by 3%. Consequently, the Fed keeps buying T-bills until the M1 money supply expands by 3%. However, short-term interest rates fall. The Fed cannot prevent the falling interest rates because it focused on the money supply. On the other hand, the Fed wants to reduce the short-term

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The Fed can do the opposite of a REPO, called the Reverse REPO. The Fed sells securities to the dealers, and the dealers sell the securities back to the Fed for a specific price and on a particular data in the future. Thus, the reserve REPO temporarily lowers excess reserves in the banking system.

The Fed has four reasons why open-market operations are its most popular and important tool. First, the Fed can completely control how many securities it buys or sells. Second, openmarket operations are very flexible. The Fed can influence bank reserves by a little amount by buying few U.S. government securities or by a large amount by buying many securities. Third, if the Fed makes a mistake by buying too many U.S. government securities, then it can turn around and sell them to correct its mistake. Finally, the Fed can implement open-market operations very quickly.

Many people scrutinize the Fed, and they read the Fed's directives for its open-market trading desk. However, these directives are vague and not precise, creating the principal-agent problem. If the directives are vague, then the outcome does not matter. The Fed can deem any outcome as a success, making the Fed unaccountable for errors.

Many central banks across the world, including the European Central Bank use openmarket operations similarly to the United States. Although some countries have a small market for government securities, central banks can buy and sell any assets.

Discount Policy

Fed’s second monetary policy tool is the discount policy. The Fed can grant loans to financial institutions. For example, a bank experiences financial problems and needs reserves. Consequently, the bank sells a $10,000 T-bill to the Fed, and the Fed boosts bank’s reserves by $9,000. The discount is the difference while the T-bill becomes the collateral of the loan. Eventually, the bank repays the Fed loan, and afterwards, the Fed returns the T-bill for $10,000 to the bank. The $1,000 difference reflects the interest rate the Fed charges for the loan, called the discount rate. Traditionally, the Fed only loaned to banks that were members of the Federal Reserve System. Currently, any bank in the U.S. can borrow from the Fed, and the Fed may not require collateral for the loan.

Each Fed district bank provides loans, known as the “discount window.” Furthermore, the Fed could use discount policy to influence the money supply and interest rates. For example, Figure 3 shows the Federal Funds Market, where banks lend their reserves at the Fed to other banks. Consequently, the banks electronically transfer these funds through the Fedwire. Demand function constitutes the banks’ demand for federal funds. These banks borrow funds to ensure they hold enough reserves to meet depositors’ withdrawals or satisfy the Fed’s reserve requirements. Demand curve is downward sloping because banks borrow more funds if the interest rate decreases (i.e. the loans are cheaper). Supply function represents the banks’ supply of federal funds to the market because these banks hold excess reserves. These banks temporarily lend out excess reserves, so they can earn interest income. Supply function is upward sloping because banks lend more funds for a greater interest rate (i.e. they earn higher profits). Intersection of the demand and supply curves determines the equilibrium interest rate (i*) and amount of reserves (R*).

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