The Operational Role of the Bank of England

1. The Operational Role of the Bank of England Guo Chenzi Nov.8

2. The Structure of Bank System Exchange market Central Bank Gilt market Money market

3. Part I the objectives of Bank’s market operation • Part of government’s overall economic strategies • Fulfill the monetary of price stability

4. Question 1: What is the role of central bank under gold standard? Question 2: What is the role of central bank under a floating exchange rate standard? Part II The Foreign Exchange Market

5. Q1 Assumption: • Domestic currency is maintained at a fixed rate against an external standard. • No government in the market could control such standard.

6. Q1:The market clearing condition • Priority is given to maintain the ratio between par value of money and gold • Increasing the money supply according to the gold reserve. • Central bank loses independent monetary policy.

7. Q1:the role of central bank The central bank, under the gold standard in the exchange market, could do nothing but just maintain such commitment that the price of domestic currency is fixed to a particular level.

8. Q2: Features in the market: • The price of domestic currency is basically determined by supply and demand in the market. • Government can intervene the market

9. Q2:the role of central bank • Central bank has independent monetary policy • Central bank could control exchange rate to some extent by selling or buying domestic currency.

10. Q2:two puzzles • Whether could the central bank foresee the appropriate equilibrium? • What determine the ability of central bank to intervene exchange market, especially while they want to achieve the interest rate stability?

11. Part III The Money Market The Bank’s operational aim is “to keep very short-term interest rates within an unpublished band”, which would be determined by the authority with a view to achieve their monetary objectives.

12. Two major questions: • What influence the operators in the Bank have upon money market interest rate? • How far these operators should concentrate their influence upon the quantity of cash in the system, rather than directly upon interest rate?

13. What we will discuss below about the money market. • Mechanics of the present arrangements designed in 1981 • Problems of the 1981’s arrangements • Relationship between cash flow and interest rate

14. Mechanics of the present arrangements designed in 1981(1) • Cash flow During the day, two things happen Government the amount of people using commercial banks Bank forecasting its likely cash position maintain operation balances at the bank

15. Mechanics of the present arrangements designed in 1981(2) • Cash flow at the end of the day Every bank settle their net difference with each other Difference is settled by debit or income at Bank

16. Mechanics of the present arrangements designed in 1981(3) Bank influence short-term interest rate in two ways Buy 3 months bills price of bill interest rate Policy implication, such as Green Span’s secret smile

17. Mechanics of the present arrangements designed in 1981(4)

18. Problems of the 1981’s arrangements (1) • The balances yield no interest at Bank. So, we should have to ask why banks should maintain its balance? (the incentive problem) • Sales of government debt cause regular and substantial shortage of cash

19. Problems of the 1981’s arrangements (2) • The influence of the authority is both visible and substantial. A sudden supply of money in the market Open market operation to maintain the interest rate (visible effect) Reluctant to increase the interest rate Change the expectation of financial institutions (substantial effect)

20. Relationship between cash flow and interest rate (1) The trade-off banks have to face with: Holding enough assets convertible Minimize the opportunity cost The equilibrium is determined by the attitudes of central bank

21. Relationship between cash flow and interest rate (2)—pegged interest rate • Proponents • In practice, pegged interest rate is inclined to achieve monetary target. • Market force in the present UK bank system could put pressure on such bias i Y X Q1 Q2 Q

22. Relationship between cash flow and interest rate (3)—Monetary Base Control • Proponents • Money would vary pro-cyclically Demand of credit P i i is determined by market • In practice, there is political difficulty of raising interest rate

23. Relationship between cash flow and interest rate (4)—Monetary Base Control • Opponents • Inelasticity of cash demand to interest rate • Interest rate could be more volatile

24. A further discussion Which one, between pegged interest rate and monetary base control, in your opinion, is better?

25. Part IV Gilt Market • The history of the gilt market • The role of central bank in the market • The problem about such operation

26. The history of the gilt market • World War I & II massive accumulation of debt to fund government deficits • After wars fund fiscal deficits monetary purposes

27. The role of central bank in the market when banks is over-funding the private sector, Raise medium term interest rate Restrain bank lending Central bank Offset the immediate impact on monetary aggregate Selling more public sector debts

28. The problem about such operation • Decrease the cash in the bank system, while decreasing the deposits in banks • The cooperation between Bank and Treasury in other nations

29. Part V something more about ECB

30. The reason of such structure of ESCB • The establishment of a single central bank for the whole euro area would not have been acceptable on political grounds. • The Eurosystem approach builds on the experience of the NCBs, preserves their institutional set-up, infrastructure and operational capabilities and expertise; • Given the large geographic area of the euro area, it was deemed appropriate to give credit institutions an access point to central banking in each participating Member State.

31. Thank you! Zhou Wei Chen Yu Xu Ting Guo Chenzi