© rainer maurer, pforzheim - 1 - prof. dr. rainer maure macroeconomics 6. the monetary policy of...

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- 1 -Prof. Dr. Rainer Maure

MacroeconomicsMacroeconomics

6. The Monetary Policy of the ECB6. The Monetary Policy of the ECB

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6.1. The Policy Target of the ECB6.1. The Policy Target of the ECB

6.2. The Policy Instruments of the ECB6.2. The Policy Instruments of the ECB

6.3. Money Creation by Commercial Banks6.3. Money Creation by Commercial Banks

6.4. Questions for Review6.4. Questions for Review

Literature:Literature:◆ Chapter 18, Mankiw, Gregory; Macroeconomics, Worth Publishers.Chapter 18, Mankiw, Gregory; Macroeconomics, Worth Publishers.◆ Kapitel 25, Blanchard / Illing, Makroökonomie, Pearson Studium.Kapitel 25, Blanchard / Illing, Makroökonomie, Pearson Studium.◆ Kapitel 17, 18, Baßler, Heinrich; et al. Grundlagen u. Probleme der Kapitel 17, 18, Baßler, Heinrich; et al. Grundlagen u. Probleme der

Volkswirtschaft, Schäfer und Poeschel.Volkswirtschaft, Schäfer und Poeschel.

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6. The Monetary Policy of the ECB6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB6.1. The Policy Target of the ECB

➤ The The policy target of the ECBpolicy target of the ECB is legally defined by the EU treaty is legally defined by the EU treaty (Art. 4.2; Art. 105) and in the (Art. 4.2; Art. 105) and in the ECB-StatuteECB-Statute (Art. 2): (Art. 2):

■Primary target is “Primary target is “to guarantee price stabilityto guarantee price stability“.“.

➤ In the so called “In the so called “Protocol on Convergence CriteriaProtocol on Convergence Criteria" article 1 " article 1 statues thatstatues that

■““price stability" is defined by the “price stability" is defined by the “Consumer Price IndexConsumer Price Index".".

➤ In a press release of 13.10.1998 the In a press release of 13.10.1998 the ECB-CouncilECB-Council declared: declared:

■““Price stability is defined as a yearly increase of the “Price stability is defined as a yearly increase of the “Harmonized Harmonized Consumer Price IndexConsumer Price Index” (HCPI) of the Euro Currency Area” (HCPI) of the Euro Currency Area of less of less than 2%than 2%. Price stability shall hold over the . Price stability shall hold over the medium termmedium term."."

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➤ In the pursuit of this target the ECB is In the pursuit of this target the ECB is independent fromindependent from the influence of the influence of governmentsgovernments or other political institutions. or other political institutions.

➤ This is guaranteed by article 107 of the This is guaranteed by article 107 of the ECB-Statute:ECB-Statute:

➤ Given this statute, the ECB is one Given this statute, the ECB is one of the most of the most independent central banks of the worldindependent central banks of the world..

Article 107 Article 107

““neither the ECBneither the ECB, nor a national central bank, nor any member of their , nor a national central bank, nor any member of their decisionmaking bodies decisionmaking bodies shall seek or take instructionsshall seek or take instructions from Community from Community institutions or bodies, from any government of a Member State or from any institutions or bodies, from any government of a Member State or from any other body.”other body.”

(Statute of the ESCB and of the ECB)(Statute of the ESCB and of the ECB)

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➤ Empirical studies show, that Empirical studies show, that political independencepolitical independence of of central banks leads to central banks leads to lowerlower average average inflation ratesinflation rates::

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➤ Similarly as the ECB, other modern central banks have also a publicly declared inflation target:

■Bank of England: 2,5% RPIX1) ≈ 1,75% HVPI1)

■Riksbank of Sweden: 2 ± 1% VPI1)

■Norwegian Central Bank: 2½ ± 1% VPI■Bank of Canada: 1% bis 3% VPI■Bank of Australia: 1 bis 3% VPI■Reserve Bank of New Zealand: 1% bis 3% VPI■Swiss Nationalbank: Adoption of the ECB inflation target■US-Federal Reserve System: : 1,5% - 2% PCE

1) RPIX = Retail Price Index; HVPI = Harmonisierter Verbraucherpreisindex; VPI = Verbraucherpreisindex; PCE= Personal consumption expenditures price index

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➤ It is important to understand that a constant inflation target implies anticyclical monetary policy.

➤ In order to keep the inflation rate constant, a central bank must■in a demand-side caused recession increase money supply

to strengthen the demand for goods and prevent deflation and

■in a demand-side caused boom decrease money supply to curb the demand for goods and prevent inflation

➤ This is implied for all kind of constant inflation targets – whether they are large or smaller than zero!

➤ Economists call this implication of a constant inflation target “divine coincidence”.

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➤ But why do basically all central banks have an inflation target above zero and not simply equal to zero?

➤ In the monetary policy debate, a couple of reasons for an inflation target larger than zero are discussed. The most important are:

1. Danger of a deflation spiral in the presence of a zero inflation target.

2. Potentially useful psychological effects in the presence of sticky nominal wages.

3. The possibility to generate negative real interest rates.

➤ All these arguments are heavily disputed – there exists no unanimity on these issues!

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1. Danger of a deflation spiral::■ How would you react, if you wanted to buy How would you react, if you wanted to buy new furniturenew furniture for your for your

apartment and you knew that the apartment and you knew that the prices for furniture would prices for furniture would decrease by 5%decrease by 5% over the next year? over the next year?

■ What would happen with the total demand for goods, if on average What would happen with the total demand for goods, if on average everybody would act this way?everybody would act this way?

■ How would this affect the business cycle?How would this affect the business cycle?■ In chapter 3 we simply assumed that households will not react in In chapter 3 we simply assumed that households will not react in

case of a deflation. However, this in not necessarily so:case of a deflation. However, this in not necessarily so:

◆ In the presence of deflation, it is possible that households In the presence of deflation, it is possible that households further postpone their consumptionfurther postpone their consumption into the future, because into the future, because they expect lower prices for goods in the future (they expect lower prices for goods in the future (naïve naïve expectationsexpectations).).

◆ This however means that the This however means that the consumption ratio will furtherconsumption ratio will further decreasedecrease and the and the recessionrecession will therefore will therefore deependeepen..

◆ Some historians are convinced that it was a mechanism like this Some historians are convinced that it was a mechanism like this one that has caused the one that has caused the world economic crisesworld economic crises of 1929-33. of 1929-33.

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6. The Monetary Policy of the ECB6. The Monetary Policy of the ECB6.1. The Policy Target of the ECB6.1. The Policy Target of the ECBInflation

Rate

TimeB O

O M

UPSWING DOWN-SWING

R E

C E

S S

I O

N

B O

O M

UPSWING

2%

3%

1%

0%

2%

3%

DOWN-SWING

R E

C E

S S

I O

N

Inflation Target (=Long Run

Average) = 2%

Actual Realization of Inflation

=> No deflation in recessions if the inflation target is “high enough”!

In reality no central bank succeeds in keeping the inflation rate exactly equal to the inflation target: In booms the inflation rate is larger and in

recessions the inflation rate is smaller than the target rate.

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Rate

TimeB O

O M

UPSWING DOWN-SWING

R E

C E

S S

I O

N

B O

O M

UPSWING

2%

3%

1%

0%

2%

3%

DOWN-SWING

R E

C E

S S

I O

N


Average) = 0%


=> Danger of deflation spirals!

=> Deflation in recessions if the inflation target is 0% !

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Rate

TimeB O

O M

UPSWING DOWN-SWING

R E

C E

S S

I O

N

B O

O M

UPSWING

2%

3%

1%

0%

2%

3%

DOWN-SWING

R E

C E

S S

I O

N


Average) = 0%


Deflation spirals can boost recessions!

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2. Psychological effects in the presence of sticky nominal wages : :■ One One assumptionassumption of the of the neoclassical modelneoclassical model (Chapter 2.1.) was the (Chapter 2.1.) was the

““absence of money illusionabsence of money illusion”. This means i.a. that an increase of ”. This means i.a. that an increase of goods prices goods prices PP↑↑ causes workers to demand an immediate increase causes workers to demand an immediate increase of nominal wages of nominal wages ww↑↑, such that real wages stay constant , such that real wages stay constant ww↑ / ↑ / PP↑.↑.

■ However, laboratory However, laboratory experiments showexperiments show that real-world people are that real-world people are notnot always always that rationalthat rational. If asked, what is more fair:. If asked, what is more fair:

(a)(a) A A decreasedecrease of nominal wages by of nominal wages by 2%2% given given 0%0% inflation or inflation or

(b)(b) an an increaseincrease of nominal wages by of nominal wages by 2%2% given given 4%4% inflation? inflation?

most people prefer option most people prefer option ( )( )..

■ Since there is always structural change in the economy, which Since there is always structural change in the economy, which urges a couple of industries to urges a couple of industries to reducereduce their their real wage in order to real wage in order to avoid dismissalsavoid dismissals (s. Chapter 5.1.3.5. “Mismatch Unemployment”.), (s. Chapter 5.1.3.5. “Mismatch Unemployment”.), an an inflation rate above zeroinflation rate above zero can can increase the “social acceptance”increase the “social acceptance” of of such real wage reductions. Critics argue however that this implies a such real wage reductions. Critics argue however that this implies a deception of workers – an exploitation of mental shortcomings.deception of workers – an exploitation of mental shortcomings.

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3. The possibility to generate negative real interest rates■ Imagine the Imagine the inflation rateinflation rate were equal to were equal to 5 %5 % and the interest and the interest

rate you have to pay for a credit were equal to rate you have to pay for a credit were equal to 2%2%. .

■ What kind of What kind of dealdeal would be would be profitableprofitable under such conditions? under such conditions?

■ What would happen with the What would happen with the total demandtotal demand for goods, if for goods, if everybody would act this way on average?everybody would act this way on average?

■ How would this affect the How would this affect the business cyclebusiness cycle??

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3.3. The possibility to generate The possibility to generate negative real interest ratesnegative real interest rates■ In order to create the above incentive, the nominal interest rate In order to create the above incentive, the nominal interest rate iitt

must be lower than the inflation rate must be lower than the inflation rate (P(Pt+1t+1-P-Ptt) / P) / Ptt::

iitt << (P(Pt+1 t+1 - P- Ptt) / P) / Ptt

■ The lowest level of the nominal interest rate a central bank can The lowest level of the nominal interest rate a central bank can reach with normal monetary policy is reach with normal monetary policy is iitt = 0= 0 (In this case the (In this case the

central bank must offer money credits at an interest rate of central bank must offer money credits at an interest rate of zero).zero).

■ Consequently at an inflation rate of zero, Consequently at an inflation rate of zero, (P(Pt+1 t+1 - P- Ptt) / P) / Pt t = 0= 0, it is , it is notnot

possiblepossible to createto create

iitt << (P(Pt+1 t+1 - P- Ptt) / P) / Pt t = 0= 0

■ Therefore in order to have the possibility Therefore in order to have the possibility to push the nominal interest to push the nominal interest rate below the inflation raterate below the inflation rate, the , the inflation rateinflation rate must be must be largerlarger than than zerozero!!

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3. The possibility to generate negative real interest rates■ If the nominal interest rate (e.g. 2%) is lower than the inflation

rate (e.g. 5%), the “real interest rate” is negative (e.g. -1%), because the real interest rate is defined as:

real interest rate = nominal interest rate ./. inflation rate

rt = it ./. (Pt+1 - Pt) / Pt

=> -3% = 2% ./. 5%

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➤ However, also a couple of reasons for an inflation target However, also a couple of reasons for an inflation target equal to zero are in the debate. The most important are:equal to zero are in the debate. The most important are:

1.1. Inflation Inflation increasesincreases the the costs of holding money.costs of holding money.

2.2. Inflation Inflation increasesincreases the real the real tax burdentax burden

3.3. Wrong decisions caused by Wrong decisions caused by money illusionmoney illusion

➤ These arguments too are heavily disputed – there exists These arguments too are heavily disputed – there exists no unanimity on these issues!no unanimity on these issues!

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1.1. Inflation Inflation increasesincreases the the costs of holding money.costs of holding money.■ How much money do you hold in your How much money do you hold in your moneybagmoneybag??

■ How much money would you hold, if the How much money would you hold, if the inflation rateinflation rate would would be be 10%10%??

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Money

Time

1st day

Money spent per day

All money spent in 6 days

=> New visit at the ATM…

=> Transaction costs…

10

0 €

with

dra

wn

at t

he

AT

M

6th day

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Money

Time

1st day

Money spent per day

All money spent in 3 days

=> New visit at the ATM…

=> Transaction costs…

50

€ w

ithd

raw

n a

t th

e A

TM

50% reduction of money holdings because of higher inflation

3rd day

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Money

Time

1 Day

Money spent per day50

€ w

ithd

raw

n a

t th

e A

TM

50% reduction of money holdings because of higher inflation

6th day

=>2 visits at the ATM in 6 days!

=> Double as high transaction costs!

=> Inflation increases the costs of holding money!

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2. Inflation increases the real tax burden:

■ Numerical example:(a)(a) The capital income tax rate is t=25%. The nominal interest is The capital income tax rate is t=25%. The nominal interest is

i=4%. The inflation rate is i=4%. The inflation rate is ππ = = 2%2%. What is the . What is the real capital real capital income tax rateincome tax rate??

(b)(b) The capital income tax rate is t=25%. The nominal interest is The capital income tax rate is t=25%. The nominal interest is i=4%. The inflation rate is i=4%. The inflation rate is ππ = = 0%0%.. What is the What is the real capital real capital income tax rateincome tax rate??

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2. Inflation increases the real tax burden■ In the above example, the capital income tax rate is constant.

■ For other kind of incomes, the tax rate increases however with the nominal level of income (tax progression).

■ As a consequence, if a household’s nominal income grows in order to compensate the household for inflation such that its real income stays constant, the household will have to pay more taxes – even if the household’s real incomes stays constant.

■ This is effect is called “bracket creep” (“Kalte Progression”).

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0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0 5000 10000 15000 20000 25000 30000 35000 40000 45000 50000 55000 60000 65000 70000

Nominal Marginal Income Tax Nominal Average Income Tax

Progressive Income Tax Tariff Germany(Income Tax Tariff of the Year 2009 inclusive Solidarity Tax Surcharge)

Income €

Tax RateMarginal income tax determined by tax law => Changing tax rate for every single Euro of income

Resulting average tax rates

Example: For a yearly income of 20000 Euro the average tax rate is 14,56%

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0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0 5000 10000 15000 20000 25000 30000 35000 40000 45000 50000 55000 60000 65000 70000

Nominal Marginal Income Tax Nominal Average Income Tax

Progressive Income Tax Tariff Germany(Income Tax Tariff of the Year 2009 inclusive Solidarity Tax Surcharge)

Income €

Tax Rate

Example: For a yearly income of 20400 Euro the average tax rate is 14,83%

Marginal income tax determined by tax law => Changing tax rate for every single Euro of income

Resulting average tax rates

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2. Inflation increases the real tax burden■ The following numerical example reveals this effect:

◆ A worker with an income of 20 000 € receives as a compensation for A worker with an income of 20 000 € receives as a compensation for an inflation rate of 2% an increase of his nominal wage of 2%. an inflation rate of 2% an increase of his nominal wage of 2%. According to the German income tax tariff, his income tax rate at the According to the German income tax tariff, his income tax rate at the income of 20 000 € was equal to income of 20 000 € was equal to 14,5614,56 %. After the increase of his %. After the increase of his income, the tax rate is equal to income, the tax rate is equal to 14,8314,83 %. %.

(a) Calculate the real increase in the household’s income (a) Calculate the real increase in the household’s income beforebefore tax. tax.

(b) Calculate the real (b) Calculate the real percentagepercentage increase in the tax burden. increase in the tax burden.

■ TThe following diagram applies the formula for the growth rate of the real income tax for an inflation rate of 2% and 4% to the average income tax rate according to the German income tax tariff:

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1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0 5000 10000 15000 20000 25000 30000 35000 40000 45000 50000 55000 60000 65000 70000

(C) R

aine

r Will

i Mau

rer,

Pfo

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im

Marginal Tax Rate (left scale)Nominal Average Tax Rate (left scale)Inflation caused Increase of the Real Tax Rate (2% inflation) (right scale)'Inflation caused Increase of the Real Tax Rate (4% inflation) (right scale)

Effect of Inflation on Real Income Tax Burden (Income Tax Tarif 2009 inclusive Solidarity Tax Surcharge)

Income €

Tax Rate


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2. Inflation increases the real tax burden■ It is of course possible to argue that it is not monetary policy

that is to be blamed for this effect but the tax system.

■ Countries like Switzerland allow their citizens to deflate their nominal incomes by the inflation factor (=divide by factor [1+inflation rate] ), before their tax rate is determined.

■ This way, the part of income growth that compensates only for inflation, is not taxed.

■ As a result, if incomes grow only by the inflation rate, the real tax burden stays constant.

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3. Wrong decisions caused by money illusion■ Theoretically most people understand the consequences of

inflation. However, in cases where they have to decide fast and base their decision on a gut level they very often make big mistakes.

■ These mistakes would not appear if the inflation rate where zero. The following experiment illustrates the problem:

■ Alex, Berta und Charly inherit 200 000 €. All invest their money in a house. After 10 years they resell their houses: ◆ Alex lives in a country, where prices on average have fallen by

25%, and receives a selling price, which is 23% lower than his purchase price.

◆ Berta lives in a country with zero inflation and receives a selling price that is lower than 1% of her purchase price.

◆ Charly lives in a country, where prices on average have grown by 25% and receives a selling price, which is 23% higher than its purchase price.

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3. Wrong decisions caused by money illusion■ Rank the profitability of the investments according to their real return:

■ The consequences of such wrong decisions would not happen in case of a zero inflation rate.

■ If one could be sure today that in 10 or 20 years the price level would be the same as today, many financial decisions would be become easier to make.

RankRank AlexAlex BertaBerta CharlyCharly

1.1. 2.2. 3.3.

RankRank AlexAlex BertaBerta CharlyCharly 1.1. 37 %37 % 15 %15 % 48 %48 % 2.2. 10 %10 % 74 %74 % 16 %16 % 3.3. 53 %53 % 11 %11 % 36 %36 %

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➤ To sum up:To sum up:■ In order to decide, whether the inflation target of a central In order to decide, whether the inflation target of a central

bank should be larger than zero bank should be larger than zero the pros and consthe pros and cons of such of such an inflation rate an inflation rate must be evaluatedmust be evaluated..

■ This is a complex task and can lead to This is a complex task and can lead to different conclusionsdifferent conclusions depending ondepending on the the subjective weightssubjective weights one applies to the one applies to the various arguments.various arguments.

■ The evaluation that the advantages of a “The evaluation that the advantages of a “not too high but not too high but constant inflation rate above zeroconstant inflation rate above zero" outweigh the " outweigh the disadvantages is internationally widespread a often called disadvantages is internationally widespread a often called the “the “consensus point of viewconsensus point of view”.”.

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6. The Monetary Policy of the ECB6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB6.2. The Policy Instruments of the ECB

➤ The The ECB CouncilECB Council decides about the application of the decides about the application of the monetary policy instruments of the ECB.monetary policy instruments of the ECB.

➤ The council regularly meets The council regularly meets every 2nd Thursdayevery 2nd Thursday. In . In normal times, monetary policy decisions are made every normal times, monetary policy decisions are made every 6 weeks.6 weeks.

➤ The 18 members of the council decide by The 18 members of the council decide by majority votemajority vote. . In case of a standoff the president decides.In case of a standoff the president decides.

…plus Slovenia, Malta, Cyprus,

Slovakia,Estonia, and Lettland

Eighteen

6 Members of the ECB Board

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6. The Monetary Policy of the ECB 6.2. The Policy Instruments of the ECB

In the year 2015 Lithunia will join the European Currency Union such that 19 countries will send members to the ECB Council.To keep the coor-dination process practicable, a monthly “rotation mechanism” will be implemented that allows to restrict the number of voting countries to 15. All countries keep always their voice in the council.

New Rotation Mechanism of the ECB-Council

ECB-Board (6 permanent voting rights)

2. Group of 14 Smaller

Countries with 11 Rotating

Voting Rights

1. Group of 5 Largest

Countries with 4 Rotating Voting

Rights

Total of 21 Voting Rights

= Germany, France, Italy,

Spain, Netherlands

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➤ What kind of instrumentsWhat kind of instruments does the ECB use to achieve the does the ECB use to achieve the decisions of the ECB Council?decisions of the ECB Council?

➤ The ECB uses the The ECB uses the supply of money to supply of money to commercial bankscommercial banks as as its instrument.its instrument.

➤ There are two kind of operations that are normally used to There are two kind of operations that are normally used to supply money to commercial banks:supply money to commercial banks:

1.1. Refinancing OperationsRefinancing Operations

◆ Main Refinancing OperationsMain Refinancing Operations

◆ Longer Term Refinancing OperationsLonger Term Refinancing Operations

2.2. Standing FacilitiesStanding Facilities::

◆ Marginal Lending FacilityMarginal Lending Facility

◆ Deposit FacilityDeposit Facility

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1.1. Refinancing OperationsRefinancing Operations

1.1.1.1. Main Refinancing Operations Main Refinancing Operations◆ Every workday Monday, an online-auction takes place where Every workday Monday, an online-auction takes place where

about 800 commercial banks bid for money credits with a about 800 commercial banks bid for money credits with a maturity of maturity of one weekone week..

◆ Banks must provide fixed rate securities (of high credit-Banks must provide fixed rate securities (of high credit-worthiness) as collateral.worthiness) as collateral.

1.2.1.2. Longer Term Refinancing Operations Longer Term Refinancing Operations◆ ……basically identical to Main Refinancing Operations with basically identical to Main Refinancing Operations with

exception of the maturity: exception of the maturity: 3 - 6 months. 3 - 6 months.

■ The standard auction (deviations are possible!) is based on The standard auction (deviations are possible!) is based on an action mechanism called „an action mechanism called „American Interest TenderAmerican Interest Tender“.“.

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0

2

4

6

8

1 0

1 2

1 4

1 6

1 8

2 0

2 2

2 4

2 6

2 8

3 0

0 2 4 6 8 1 0 1 2 1 4 1 6 1 8 2 0 2 2 2 4 2 6 2 8 3 0 3 2 3 4 3 6 3 8 4 0

American Interest TenderAmerican Interest Tender

i

Credit Volume in €

Maximum Bid Planed Allotment Volume

Minimum Bid Rate

Bids with Allotment Bids without Allotment

imin

Marginal Rate

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2.2. Standing FacilitiesStanding Facilities are intended to smooth the are intended to smooth the development of the interest rate on the interbank market. development of the interest rate on the interbank market. Therefore, they can be steadily used by commercial Therefore, they can be steadily used by commercial banks:banks:

2.1.2.1. Marginal Lending Facility Marginal Lending Facility◆ „„Overnight Credit“: Commercial banks can get a short-run Overnight Credit“: Commercial banks can get a short-run

credit in case of an credit in case of an unexpected liquidity shortageunexpected liquidity shortage. They have to . They have to pay a special interest rate called “pay a special interest rate called “marginal lending ratemarginal lending rate””

2.2.2.2. Deposit Facility Deposit Facility◆ „„Overnight Saving“: Commercial banks can deposit money at Overnight Saving“: Commercial banks can deposit money at

the ECB in the short run in case of an the ECB in the short run in case of an unexpected liquidity glut. unexpected liquidity glut. They receive a special interest rate called “They receive a special interest rate called “deposit ratedeposit rate”.”.

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➤ The impact of the ECB interest rates on the interbank The impact of the ECB interest rates on the interbank credit market:credit market:

■ Marginal Lending RateMarginal Lending Rate = Main Refinancing Rate + 1% (currently 0,3%)= Main Refinancing Rate + 1% (currently 0,3%)

■ Deposit RateDeposit Rate

= Main Refinancing Rate ./. 1% (currently = Main Refinancing Rate ./. 1% (currently -- 0,2%)0,2%)

■ As the following diagram shows, the As the following diagram shows, the EONIA rateEONIA rate (= the (= the interest rate on which banks lend overnight money among interest rate on which banks lend overnight money among each other) lies each other) lies always between the Marginal Lending Rate always between the Marginal Lending Rate and the Deposit Rateand the Deposit Rate..

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0,0%

1,0%

2,0%

3,0%

4,0%

5,0%

6,0%

1.11.98 1.11.99 31.10.00 31.10.01 31.10.02 31.10.03 30.10.04 30.10.05 30.10.06 30.10.07 29.10.08 29.10.09

The Interest Channel of the ECB and the Overnight Rate of the European Interbank Market (EONIA; 04.01.1999 - 30.11.2009)

Deposit Rate

Marginal Lending Facility

Main Refinancing RateEONIA Overnight

Rate

Source: ECB

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0,0

100,0

200,0

300,0

400,0

500,0

600,0

700,0

800,0

900,0

1998

W53

1999

W28

2000

W04

2000

W32

2001

W08

2001

W36

2002

W12

2002

W40

2003

W16

2003

W44

2004

W20

2004

W48

2005

W23

2005

W51

2006

W27

2007

W03

2007

W31

2008

W07

2008

W35

2009

W11

2009

W39

2010

W14

2010

W42

2011

W18

2011

W46

2012

W22

2012

W50

2013

W26

2014

W02

2014

W30

Deposits of Commercial Banks hold with the ECB(Deposit Facility)

bn Euro

Quelle: ECB, Datawarehouse

Levels in Normal Times

Lehman Brothers

"Big" Refinancing Operations of ECB

Euro-Crisis

Introduction of Negative Deposite

Rates

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0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10

Main Refinancing Rate

Consumer Credits1)

Mortgage Loans1)

Corporate Credits2)

The Impact of the ECB on Credit Interest Rates of Commercial Banks

Quelle: ECB1) Private Haushalte; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft2) Unternehmen außerhalb des Finanzsektors; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft

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6.3. Money Creation by Commercial Banks6.3. Money Creation by Commercial Banks

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6. The Monetary Policy of the ECB6. The Monetary Policy of the ECB6.3. Money Creation by Commercial Banks6.3. Money Creation by Commercial Banks

➤ Up to this point, we implicitly assumed that “money” is Up to this point, we implicitly assumed that “money” is always equal to “cash”.always equal to “cash”.

■ In reality however, In reality however, cashcash plays a plays a less and less importantless and less important role.role.

■ More and more paymentsMore and more payments are not carried out with cash but are not carried out with cash but with EC- or credit cards, i.e. with so called with EC- or credit cards, i.e. with so called “cashless” “cashless” money.money.

➤ Where does this “cashless” money come from?Where does this “cashless” money come from?

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Money creation in a two-tier banking systemMoney creation in a two-tier banking system*)*)::

Central Bank

Commercial Banks

Non-Banks= Households, Firms,

Government

Cash

Cash&

Deposit Money

*) Not all banking systems work as “two-tier banking systems”. An important example for a (nearly) pure open market system is the Fed-System. The creation of “deposit money” is similar in such a system.

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- 67 -Prof. Dr. Rainer Maure - 67 -Prof. Dr. Rainer Maurer

Why is „Why is „deposit money creationdeposit money creation“ possible?“ possible?

Commercial Bank

Firm

Household

10 € credit trans-ferred to the

deposit account of the firm

10 € wage payment transferred to the deposit account of

the household

2 € withdrawn from the deposit account

and used to pay goods in cash.

8 € payments for goods transferred via credit card to

the deposit account of the firm

10 € credit re-transferred to the deposit account

of the bank

This shows: The commercial bank

needs only 2 € cash to grant a credit of

10 € !

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➤It is simple to describe this relationship It is simple to describe this relationship mathematicallymathematically::■ Assume that “Assume that “cc” is equal to the percentage fraction of all transactions ” is equal to the percentage fraction of all transactions

which are conducted in cash. “c” is then called the “which are conducted in cash. “c” is then called the “cash ratiocash ratio”.”.■ Assume that the Assume that the amount of all credits amount of all credits commercial banks lend to non-commercial banks lend to non-

banks in form of banks in form of deposit moneydeposit money is equal to „ is equal to „MM“.“.■ Consequently, the amount of Consequently, the amount of cash needed by commercial bankscash needed by commercial banks „ „BB“ “

is given by the following equation:is given by the following equation:

B = c * MB = c * M

■ We can rewrite the equation in the following way:We can rewrite the equation in the following way:

B * (1 / c) = MB * (1 / c) = M■ Consequently, Consequently, if the central bank offersif the central bank offers an amount of money equal to an amount of money equal to

800 billion €800 billion € to commercial bank and the cash ratio is c = 20%, to commercial bank and the cash ratio is c = 20%, commercial banks can create a total amount of money (=cash + commercial banks can create a total amount of money (=cash + deposit money) equal todeposit money) equal to

800 bn € * (1 / 0,2) = 4000 bn €800 bn € * (1 / 0,2) = 4000 bn €■ Consequently, money creation by commercial banks equals Consequently, money creation by commercial banks equals 3200 3200

Billion €.Billion €.

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0%

10%

20%

30%

40%

50%

60%

70%

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Euro Area Low-Income EconomiesMiddle-Income Economies High-Income Economies ex USA & Euro Area

Entwicklung der Bargeldhaltungsquote(= Bargeldumlauf in % von M1)

What explains the downward trend of the average cash ratio in the high-income countries?

Source: IMF International Financial Statistics

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■ As the diagram shows, the As the diagram shows, the cash ratio “c”cash ratio “c” is is notnot perfectly perfectly stablestable, , but shows some fluctuations.but shows some fluctuations.

■ On the On the individual bankindividual bank level, these fluctuations are level, these fluctuations are even strongereven stronger than for the averaged values in the diagram.than for the averaged values in the diagram.

■ Therefore, commercial banks typically hold a voluntary Therefore, commercial banks typically hold a voluntary safety safety marginmargin „ „rrvv“ of additional cash for the case that “c” will become “ of additional cash for the case that “c” will become temporarily larger.temporarily larger.

■ Additionally, in most countries laws prescribe commercial banks Additionally, in most countries laws prescribe commercial banks to hold a “to hold a “required reserverequired reserve” of „” of „rrrr“.“.

■ Taking these reserves into account, the above formula must be Taking these reserves into account, the above formula must be rewritten in the following way:rewritten in the following way:

B = (c + rB = (c + rvv + r + rrr) * M) * M■ Consequently, if the central bank offers an amount of cash equal Consequently, if the central bank offers an amount of cash equal

to B, the to B, the maximum amountmaximum amount is is somewhat reducedsomewhat reduced by the by the necessity to hold these reserves:necessity to hold these reserves:

MM = B * (1 / (c + r= B * (1 / (c + rvv + r + rrr) )) )■ This formula is called the “This formula is called the “money multipliermoney multiplier”.”.

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■ For the For the European Currency UnionEuropean Currency Union the empirical value for the cash the empirical value for the cash ratio is ratio is c = 18 %c = 18 %, the voluntarily hold reserve ratio is , the voluntarily hold reserve ratio is rrvv ≈ 0,0≈ 0,0 and and the required reserve ratio is the required reserve ratio is rrrr = 0,02 = 0,02..

■ Consequently, if the European Central Banks offers an amount of Consequently, if the European Central Banks offers an amount of cash equal to cash equal to 1000 billion €1000 billion €, commercial banks in the European , commercial banks in the European Currency Union are able to offer a total amount of money equal to:Currency Union are able to offer a total amount of money equal to:

MM = 1000 bn € * (1 / (0,18+ 0,00 + 0.02) )= 1000 bn € * (1 / (0,18+ 0,00 + 0.02) )

MM = 5000 bn €= 5000 bn €■ Consequently, the amount of deposit money that can be created Consequently, the amount of deposit money that can be created

by commercial banks is equal to:by commercial banks is equal to:

D = M – B = D = M – B = 5000 bn € - 1000 bn € = 4000 bn €5000 bn € - 1000 bn € = 4000 bn €

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■ As the money multiplier formula shows the central bank is As the money multiplier formula shows the central bank is always able to steer the process of money creation by always able to steer the process of money creation by steering the amount of cash:steering the amount of cash:

MM ↑↑ = (1 / (c+ r= (1 / (c+ rvv + r + rrr) ) * B ) ) * B ↑↑

MM ↓↓ = (1 / (c+ r= (1 / (c+ rvv + r + rrr) ) * B ) ) * B ↓↓■ Consequently, even though commercial banks are able to Consequently, even though commercial banks are able to

increase the amount of money significantly by their creation increase the amount of money significantly by their creation of deposit money, the of deposit money, the central bank can steer the growth rate central bank can steer the growth rate of Mof M by steering the growth rate of B. by steering the growth rate of B.

■ If the If the trendtrend towards a “ towards a “cashless economycashless economy” ” holds onholds on (s. the (s. the above diagram) and the cash ratio grows smaller and above diagram) and the cash ratio grows smaller and smaller „smaller „cc↓↓“ so that commercial banks are able to create “ so that commercial banks are able to create more and more deposit money out of 1 €, the central bank more and more deposit money out of 1 €, the central bank can react with a can react with a reduction of Breduction of B or with an or with an increase of the increase of the required reserve ratio rrequired reserve ratio rvv ! !

■ Hence Hence central bank will always be able the to control the central bank will always be able the to control the seize of Mseize of M.. Ex 17

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0

200

400

600

800

1000

1200

1400

1600

180019

98M

ay19

99Ja

n19

99Se

p20

00M

ay20

01Ja

n20

01Se

p20

02M

ay20

03Ja

n20

03Se

p20

04M

ay20

05Ja

n20

05Se

p20

06M

ay20

07Ja

n20

07Se

p20

08M

ay20

09Ja

n20

09Se

p20

10M

ay20

11Ja

n20

11Se

p20

12M

ay20

13Ja

n20

13Se

p

Base Money

Base Money Trend(Jan.02-Sept.08)

Base Money./. Deposit Facility./. Excess Reserves

Money in CirculationTrend (Jan.02-Sept.08)

Money in Circulation

Deposit Facility +Excess Reserves

Deposit Facilty

Bn. €

ECB Base Money and Components

Source: ECB www.rainer-maurer.com

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0

500

1000

1500

2000

2500

3000

3500

4000

1998

May

1999

Jan

1999

Sep

2000

May

2001

Jan

2001

Sep

2002

May

2003

Jan

2003

Sep

2004

May

2005

Jan

2005

Sep

2006

May

2007

Jan

2007

Sep

2008

May

2009

Jan

2009

Sep

2010

May

2011

Jan

2011

Sep

2012

May

2013

Jan

2013

Sep

2014

May

Base Money

Excess Reserves

Base Money./. Excess Reserves

Money in Circulation

Base Money Trend(Jan.02-Sept.08)

Money in Circulation Trend(Jan.02-Sept.08)

Bn. $

US-Fed Base Money and Components

Source: Federal Reserve, St. Louis www.rainer-maurer.com

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➤ You should be able to answer the following questions You should be able to answer the following questions at the end of this chapter. All of the questions can be at the end of this chapter. All of the questions can be answered with the help of the lecture notes. If you have answered with the help of the lecture notes. If you have difficulties in answering a question, discuss this difficulties in answering a question, discuss this question with me at the end of the lecture, attend my question with me at the end of the lecture, attend my colloquium or send me an E-Mail.colloquium or send me an E-Mail.

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1.1. What is the policy target of the ECB?What is the policy target of the ECB?

2.2. What are the three principal arguments in favor of an inflation target What are the three principal arguments in favor of an inflation target above zero?above zero?

3.3. What are the four principal arguments against an inflation target What are the four principal arguments against an inflation target above zero?above zero?

4.4. Calculate the real tax rate, if the nominal tax rate is equal to 25%, the Calculate the real tax rate, if the nominal tax rate is equal to 25%, the nominal interest rate is 5% and the inflation rate is 4% and your nominal interest rate is 5% and the inflation rate is 4% and your investment is equal to 1€.investment is equal to 1€.

5.5. A worker with an income of 20 000 € receives as a compensation for A worker with an income of 20 000 € receives as a compensation for an inflation rate of 2% an increase of his nominal wage of 2%. an inflation rate of 2% an increase of his nominal wage of 2%. According to the German income tax tariff, his income tax rate at the According to the German income tax tariff, his income tax rate at the income of 20 000 € was equal to 14,5 %. After the increase of his income of 20 000 € was equal to 14,5 %. After the increase of his income, the tax rate is equal to 15,1%. Calculate the real increase in income, the tax rate is equal to 15,1%. Calculate the real increase in the tax burden. Calculate the real increase in the household’s after the tax burden. Calculate the real increase in the household’s after tax income.tax income.

6.6. Describe the function, composition and decision regularities of the Describe the function, composition and decision regularities of the Council of the European Central Bank.Council of the European Central Bank.

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7.7. Explain the policy instruments of the ECB. Explain the policy instruments of the ECB.

8.8. Explain the standard procedure of an “interest tender” of the ECB.Explain the standard procedure of an “interest tender” of the ECB.

9.9. Why does the overnight rate of the European interbank market Why does the overnight rate of the European interbank market (=EONIA) always lies in between the margin of the deposit facility and (=EONIA) always lies in between the margin of the deposit facility and the marginal lending facility?the marginal lending facility?

10.10. Describe the influence of the ECB on the capital market.Describe the influence of the ECB on the capital market.

11.11. On what segments of the capital market has the ECB a strong impact, On what segments of the capital market has the ECB a strong impact, on what segments the impact is weaker? What explains the on what segments the impact is weaker? What explains the difference?difference?

12.12. Explain the channel, which the ECB uses to influence the real Explain the channel, which the ECB uses to influence the real economy.economy.

13.13. Explain the process of money creation by commercial banks.Explain the process of money creation by commercial banks.

14.14. Why can deposit money be used as a means of payment?Why can deposit money be used as a means of payment?

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16.16. How large is the maximum amount of deposit money commercial How large is the maximum amount of deposit money commercial banks can create, if the sum of all cash credits from the central bank banks can create, if the sum of all cash credits from the central bank is equal to 2000 bn €, the cash ratio of non-banks is 5%, the voluntary is equal to 2000 bn €, the cash ratio of non-banks is 5%, the voluntary reserve ratio is 0%, the required reserve ratio 0% ? How does the reserve ratio is 0%, the required reserve ratio 0% ? How does the maximum amount of deposit money change, if the central bank maximum amount of deposit money change, if the central bank introduces a minimum reserve requirement of 5%?introduces a minimum reserve requirement of 5%?

17.17. Assume that the long-term downward trend in the cash ratio causes a Assume that the long-term downward trend in the cash ratio causes a decrease from 18% in the year 2009 to 16% in the year 2010. decrease from 18% in the year 2009 to 16% in the year 2010. Assume furthermore that the voluntary reserve ratio rAssume furthermore that the voluntary reserve ratio rvv is zero and the is zero and the

required reserve ratio is equal to 2% and the amount of cash supplied required reserve ratio is equal to 2% and the amount of cash supplied by the central bank in the year 2009 is equal to 1000 €. by the central bank in the year 2009 is equal to 1000 €. (a)(a) By how By how much must the central bank change its supply of cash, if it wants to much must the central bank change its supply of cash, if it wants to keep the monetary aggregate M (=deposit money + cash) on the level keep the monetary aggregate M (=deposit money + cash) on the level of the year 2009? of the year 2009? (b)(b) How could the same effect be reached by a How could the same effect be reached by a change of the required reserve ratio rchange of the required reserve ratio rrr??

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18.18. In country A a stock investment of 1 million € in the year 1990 has led In country A a stock investment of 1 million € in the year 1990 has led to a total return of 2 million € in the 2000. The yearly rate of inflation to a total return of 2 million € in the 2000. The yearly rate of inflation was 4%. In country B a stock investment of 1 million € in the year was 4%. In country B a stock investment of 1 million € in the year 19901990 has led to a total return of 1,6 million € in the 2000. The yearly has led to a total return of 1,6 million € in the 2000. The yearly rate of inflation was 1%. In which country was the real return on rate of inflation was 1%. In which country was the real return on investment higher?investment higher?

19.19. Explain the danger of a “deflationary spiral” in the presence of a Explain the danger of a “deflationary spiral” in the presence of a inflation target equal to zero.inflation target equal to zero.

20.20. Why can a negative real interest rate be a strong incentive to buy Why can a negative real interest rate be a strong incentive to buy goods?goods?

21.21. Give a verbal explanation, why an inflation rate above zero leads to a Give a verbal explanation, why an inflation rate above zero leads to a steady increase of the real income tax burden in the presence of a steady increase of the real income tax burden in the presence of a progressive tax scale.progressive tax scale.

© rainer maurer, pforzheim - 1 - prof. dr. rainer maure macroeconomics 6. the monetary policy of...

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