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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. 1. Introduction. (1) Are there any substantial differences among monetary practices throughout the world?
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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
1. Introduction (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 (Continued): Economies Studied Argentina Brazil America and LA Mexico Peru USA Venezuela England Europe EU Norway 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.
1. Introduction(Continued) 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.
3. The complexities of the Open Economy 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 (Continued) 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) 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. 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. Foreign currency assets tend to concentrate within private interbank systems, and the exchange rate regime gains flexibility. 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. Weak Liquidity Preference in Foreign Currency
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. A larger stock of gross international reserves is required for absorbing exogenous fiscal monetary components. 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.
5. Central Bank’s Quantitative Indexes (Continued) 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 Bank’s 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…?
5. Central Bank’s 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
5. Central Bank’s 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.
5. Central Bank’s 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.
5. Central Bank’s Quantitative Indexes (Continued) 7) “Liquidity Requirements” – applicable when DC>GIR. R<100%, otherwise a net drain of DC would take place.
