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Lecture 8
CONDUCT OF MONETARY POLICY:
OBJECTIVES AND STRATEGIES
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
1
The monetary policy goals of the ECB
• The primary objective of the European System of
Central Banks (ESCB) is to maintain price stability.
• Without prejudice to the primary objective of price
stability, the ESCB shall support the general
economic policies in the Community with a view to
contributing to the achievement of the objectives of
the Community.
• In pursuing its objectives, the ESCB shall act in
accordance with the principle of an open market
economy with free competition, favoring an efficient
allocation of resources.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
2
Transmission processes of policies
• Central banks, cannot control the price level
directly. They face a complex transmission
process from their own monetary policy actions
to changes in the general price level.
• These transmission mechanisms are
characterized by the existence of several
distinct channels, each with long, and variable
reaction lags.
• Moreover, the transmission mechanisms
themselves are continuously evolving over time
due to behavioral and institutional change.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Policy goals and targeting
• The strategy of central banks is to aim
at variables between the goals to be
achieved and the tools available:
– Intermediate targets. These can be
monetary aggregates (M1, M2, M3) or
interest rates (short, long).
– Operating targets (or “instruments”):
They can be directly adjusted (monetary
base, reserves, minimum bid rate of the
main refinancing operations).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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What instruments has a central bank?
• Open market operations.
Purchases in the open market causes the shortterm interest rate (federal funds rate) to fall.
It affects the supply of reserves
Rs
ist
Rs’
ist*
Rd
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Quantity of reserves5
What instruments has a central bank?
• Discount lending.
It also raises the quantity of reserves supplied
which causes the short-term interest rate
(federal funds rate) to fall.
Rs
ist
Rs’
ist*
Rd
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Quantity of reserves6
What instruments has a central bank?
• Reserve requirements.
It increases the quantity of reserves demanded
which causes the short-term interest rate
(federal funds rate) to increase.
Rs
ist
ist*
Rd’
Rd
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Quantity of reserves7
Advantages of OMOs
• OMOs are under the full control of a
central bank. This is not the case for
discount operations.
• OMOs can be carried out in small
quantities to “smooth” developments.
• OMOs can easily be reversed (repos).
• OMOs can be implemented without
delays.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Characteristics of discount policy
• The main advantage is that the central bank can
use it in its function as “lender of last resort”.
• But there are three main disadvantages:
– The announcement of a discount rate change can
create confusion if it contradicts the policy stance.
– If the discount rate is set at a given level,
the spread between id and the market interest rate
can vary wildly.
– Discount operations are difficult to reverse.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
9
Characteristics of reserve requirements
• The advantage is that they affect all
banks equally and have an effect on the
supply of money.
• But reserves requirements are hard to
engineer because of multiple deposit
contractions (expansions).
• Raising reserve requirements can cause
immediate liquidity problems.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Reserve requirements in the Euro area
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Should reserve requirements be reformed?
• Should they be abolished?
– Reserve requirements should be retained
to produce a more stable money multiplier,
which facilitates monetary control.
– Reserves should bear interest.
• Should the reserves be 100 percent?
– It would allow to strictly control the money
supply.
– But banks can no longer make loans.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Targeting : the NASA strategy
• By analogy, NASA’s
strategy of sending
spaceships to the moon
also works through
“operating targets”.
• The pace of spaceships
is continuously adjusted
to “intermediate targets”,
and finally to the “goal”.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Example of central bank strategy:
• Suppose the central bank’s price-level
goal is consistent with a nominal GDP
growth rate of 5%.
• The bank may then feel that this goal
can be achieved
– by a 4% growth rate for M2 (intermediate
target), and
– by a 3.5% growth rate for the monetary
base (operating target = tool).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Adjustments of central bank policy
• After implementing the policy, the central
bank may fine-tune, for instance
– because the monetary base may be
growing too slowly (which calls for an
increase of OMO purchases);
– or M2 may not grow in line with the
monetary base (which also requires an
adjustment of policy instruments such as
OMOs).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Types of target variables
• The central bank has the choice
between two different types of target
variables:
– monetary aggregates (monetary base,
reserve requirements, M1, M2, M3, etc.)
– and interest rates.
• Can a central bank pursue both targets
at the same time?
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The answer is no! Why?
• If a monetary aggregate is used, the
control of the interest rate is lost:
Ms
i*
Md
M*
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Quantity of money
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Quantity-oriented strategy: problem
• If the money demand curve shifts
unexpectedly, the interest rate will fluctuate:
Ms
iu
Mdu
i*
il
Mdl
M*
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Md*
Quantity of money
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Interest rate-oriented strategy: problem
• In order to keep the interest rate at a given level
(target), the central bank must accept variations in
monetary aggregates:
Msl
Ms
Msu
Mdu
i*
Mdl
Md*
Target
rate
Quantity of money
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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What criteria to decide on the target?
• There are three criteria for choosing an
intermediate target:
– It must be accurately measurable, and the
indicator should be available rapidly;
– it must be controllable by the central bank;
– and it must have a predictable effect on the
policy goal.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Measurability
• GDP figures and price indices become
available only after a time lag, and they
are often revised.
• Monetary aggregates are obtained
quicker (2 weeks), but are often revised.
• Interest rates are obtained instantly and
are not revised.
• Are interest rates the best target?
Be careful: What we need are real interest rates!
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Controllability and predictability
• A central bank has the ability to exercise a
powerful effect on the money supply, although
control is not perfect.
• Although it appears that the central bank can
also control interest rates, it cannot fully
control inflationary expectations.
• The linkage between intermediate targets
and the policy goal is controversial, so the
predictability issue is highly contentious.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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A historical perspective: the Fed
• When the Fed was created in 1914, the
discount rate was the primary tool.
• OMOs were not yet discovered, and the
Federal Reserve Act had no provisions
to change reserve requirements.
• The policy was based on the “real bills
doctrine” (loans only for “productive
purposes”)  which papers are ‘eligible.’
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Fed after World War I
• By the end of World War I, the (re-)discounting
of eligible papers (including Treasury bills) had
led to inflation, and the “real bills doctrine”
became discredited.
• The Fed abandoned its passive role, and it
increased the discount rate from 4.75% to 7%
in 1920, which (after a short recession
in 1920-21) brought inflation under control.
• This paved the way for the “Roaring Twenties”.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The discovery of OMOs
• The Fed discovered open market
operations by accident:
– It revenue (mainly from discount loans to
member banks) shrank during the 1920-21
recession, so the Fed was under pressure.
– It reacted by purchasing income-earning
securities to compensate for the losses.
– It then discovered that reserves in the
banking industry grew (credit multiplier).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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World War I and the Reichsbank
• In 1914, the Reichsbank had suspended
redeemability of its notes in gold.
• Much of the government borrowing was
discounted by the Reichsbank.
• At the end of the war, money in circulation had
increased four-fold.
• The consumer price index had risen 140% by
December 1918.
• Yet floating debt of the Reichsbank had
increased from 3 to 55 billion marks.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Reichsbank: After WW I
• Inflation was fueled by
– Germany’s reparation payments, which triggered a
devaluation of the mark.
– A decline in confidence in the mark.
– Hoarded savings entered the market place.
• By February 1920, the price index was 5
times as high as at armistice, but it held
almost stable for 15 months.
• This chance of monetary policy was spoiled.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The pace to hyperinflation
• During these fifteen months the government
kept issuing new money.
• The currency in circulation increased by
50% and the floating debt of the Reichsbank
by 100%, providing fuel for a new outbreak.
• In May 1921, price inflation started again
and by July 1922 prices had risen 700%.
• After July 1922 the phase of hyperinflation
began.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The German hyperinflation 1922-23
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Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Stabilization program of 1923/24
• In November 1923, a currency reform was
undertaken.
– A new bank, the (private) Rentenbank, was to
issue a new currency: the Rentenmark.
– This money was exchangeable for bonds backed
up by land and industrial plant
– A fixed amount of 2.4 billion Rentenmarks was
created, and each Rentenmark was valued at
one trillion old paper marks.
• The Rentenmarks held their value. Inflation
ceased even for the Reichsmark.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Completing the 1923 reform
• In August 1924 the reform was completed by the
introduction of a new Reichsmark, equal in value to
the Rentenmark.
• The Reichsmark had a 30% gold backing. It was not
redeemable in gold, but the government undertook
to support it by buying in the foreign exchange
markets as necessary.
• The Reichsbank became independent from the
government and government loans were limited.
• Drastic new taxes were imposed, and with the
inflation ended, tax receipts increased impressively.
In 1924-1925 the government had a surplus.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The “Roaring Twenties” and the Fed
• The stock market boom of 1928/29
created a dilemma for the Fed:
– tempering the boom would have required a
higher discount rate;
– the Fed hesitated to do that because of
“legitimate credit needs”
• When the discount rate was finally
raised (August 1929), it was too late.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Bank Panics of 1930-33
• Substantial withdrawals from banks ended in
a full-fledged panic at the end of 1930.
• One bank after the other closed, but the Fed
did not perform its role as lender of last resort.
• It did not understand the impact of bank
failures on money supply and economic
activity.
• Moreover there was political haggling that
entailed policy inactivity.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The switch to monetary targeting
• In the early 1970s (Arthur Burns), the Fed
adopted a policy of monetary targeting, but its
commitment to the new policy was weak.
• (The Bundesbank followed in 1974.)
• The policy was to pre-announce target ranges
for the growth rates of money aggregates.
• However the Fed continued to use the federal
funds rate as an operating target.
• In 1979 (Paul Volcker) the Fed officially changed
its policy, using reserves as the instrument.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Returning to interest-rate policies
• Once inflation was checked, the Fed
deemphasized monetary aggregate targets
and returned to a policy of smoothing interest
rates.
• In 1993, Alan Greenspan testified in Congress
that the Fed would no longer use monetary
targets.
• During the 1990, with strong growth and low
inflation, the Fed focused on interest rate
policies, with a defensive stance.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The ECB’s monetary policy strategy
• The ECB's stability-oriented monetary policy
strategy consists of three main elements:
a quantitative definition of price stability, and
the two "pillars" used to achieve this objective.
• These two pillars are:
– a prominent role for money, as signaled by the
announcement of a quantitative reference value for
the growth rate of a broad monetary aggregate;
– and a broadly based assessment of the outlook for
price developments and risks to price stability in
the euro area as a whole.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The definition of price stability
• The Governing Council of the ECB has
adopted the following definition:
– “Price stability shall be defined as a yearon-year increase in the Harmonized Index
of Consumer Prices (HICP) for the euro
area of below 2%”.
– Price stability according to this definition “is
to be maintained over the medium term”.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
37
Quantitative reference value
• To signal the prominent role it has assigned to
money, the Governing Council announces a
quantitative reference value for monetary
growth as one pillar of the overall stabilityoriented strategy.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
38
Reference value: problems
First, to ensure that the reference value is
consistent with the maintenance of price
stability, money must have a stable
relationship with the price level. The stability
of this relationship is typically assessed in the
context of a money demand function.
Second, substantial or prolonged deviations of
monetary growth from the reference value
signal risks to price stability over the medium
term. It requires that monetary growth is a
leading indicator of price developments.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
39
Money demand (velocity) in the Euro area
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The broadly based outlook for prices
• It is based on a large number of indicators.
• The range of indicators includes many
variables that have leading indicator
properties for future price developments.
• They include, inter alia, wages, the exchange
rate, bond prices and the yield curve, various
measures of real activity, fiscal policy
indicators, price and cost indices and
business and consumer surveys.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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