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Monetary policy in an open and unstable world

Prof. Jan Kregel
Date: From july 30 to august 10th, 2001

Synopsis

Traditional courses in money and banking present the transmission mechanism of central bank monetary policy as involving the central bank’s attempt to find an intermediate policy objective that is under its control which will impact its ultimate objective over which it may not have direct control. These intermediate goals of policy are usually some version of the supply of money or credit, or the price of money or credit: quantity or price.
Irrespective of whether the ultimate objectives of policy are price stability, full employment, growth maximisation, financial stability or foreign exchange rate stability, the intermediate objectives are the focus of monetary policy because it is usually impossible to influence the final objectives directly through actions available to the monetary authority. The transmission mechanism thus concerns the ways in which the policy instruments available to the monetary authority affect the intermediate objectives and how the changes brought about in the intermediate objectives affect the final goals.

There are two basic approaches to the transmission mechanism by which the central bank influences the economy. One approach emphasises the control of the supply of credit to the banking system, the other the control of the price of credit: money supply and interest rate control. A crucial element in the transmission mechanism assumed by both is the impact of central bank action on the balance sheets of the private banking system as a prelude to influencing the financing decisions of the private sector and thus the balance sheets of households and firms. Thus the first step in the transmission mechanism of both approaches is to influence the profitability of banks’ operations. As a result, those operations that increase bank profitability tend to overshoot while those that reduce profitability tend to undershoot. This is because banks may be led to underestimate risk and overlend in a policy induced credit expansion, while they will seek innovative products and interpretations of regulations in order to circumvent earnings reductions when policy is restricting credit growth. In some cases banks will respond by shifting some of their operations abroad if this increases profitability or market share. As a result, the impact of central bank actions is extremely variable, and will have a variable impact on the private sector and the ultimate objectives of policy depending on the response of banks to policy measures as represented by changes in the composition of their balance sheets.
Traditional analysis of monetary policy presumes either that the institutional structure of the economy does not affect the transmission mechanism or that all national financial systems are similar to the evolution of the institutional structure of the US financial system. Thus a particular structure of the balance sheets of financial institutions – this is what may be called the financial structure of the economy – is presumed. However, most national economies have developed extremely diverse financial structures. Different financial structures have usually led to the use of different policy instruments and different intermediate objectives, and thus to different transmission mechanisms for policy. Traditional analysis also presumes that all monetary authorities are similar, as is the regulatory structure that governs the permissible activities of financial institutions and the financing possibilities available to firms and households. Yet, one of the factors that has led many banks to expand their overseas operations is the difference in regulations across different national systems.
There are thus three points in which the traditional approach to the analysis of monetary policy may be improved. The first is the importance of the financial structure of the economy to the transmission mechanism. The second is the impact on the transmission mechanism of an open economy and free international financial flows on the transmission mechanism. The third is the purposive actions of banks to offset the impact of policy on their profitability. Combining these three elements leads to the conclusion that while differences in financial structure may be less important than in the past, the impact of the last two elements suggests that the traditional transmission mechanism via bank profits and bank balance sheets may be breaking down, rendering impotent the traditional description of the transmission mechanism.

The first section of the course will present the historical evolution of various national financial structures in order to highlight the different ways in which monetary policy influences the economy in different countries as well as the evolution of monetary authorities and financial regulations that govern the way financial institutions respond to policy impulses.
Since the 1970s, changes in the attitudes to fiscal policy, financial liberalisation and deregulation in the United States has had two major influences. First, it has brought about a convergence of financial structures and institutions in different national financial markets, in part through the growth and international expansion of US and other financial institutions. Secondly, the disappearance of fiscal policy and the large fiscal deficits that this produced increased the reliance on fiscal policy and made monetary continuously restrictive and thus with negative impact on bank earnings. The result was the application of new financial structures that sought to eliminate the impact of central bank policy on bank balance sheets and thus on bank profitability, largely breaking the transmission mechanism of central bank policy. The first result of these changes was the generalised acceptance that control of the money supply was no longer an efficient transmission mechanism of monetary policy as large increases in money growth took place without any impact on goods prices, and instead were transmitted onto the prices of financial assets. This led to a concentration of policy on interest rates (the inverse of asset prices) at a time when an increasing proportion of financing of the private sector was taking place outside banks in capital markets. The second was an increasingly ability of banks to offset the impact of central bank changes in the supply or price of credit on their operations through the use of innovative products such as derivatives; if these changes also allow the private sector to offset these changes, then the traditional transmission mechanism become increasingly ineffective. This means that the instruments used by the monetary authority must attempt to influence the decisions taken on the holding of various financial markets assets in capital markets, rather the banks’ decisions to lend. The location of the transmission mechanism is thus shifted from the balance sheets of banks to the balance sheets of non-bank financial institutions and corporations and the impact of policy shifts from the prices of produced goods and services to the prices of capital market assets. This requires a substantial shift in the operation of monetary policy. The second section of the course will seek to describe this process and outline the new approach to central bank policy.

Finally, the third section of the course will deal with the implications of banks operating internationally, on open capital markets and free international financial flows for the efficiency of national monetary policy.

Plan of Lectures and Suggested Readings

Week 1

1. Introduction: Monetary policy, central bank transmission mechanisms, targets and instruments, assignment problem.

Fernando Cardim de Carvalho, Francisco Pires de Sousa, João Sicsu, Luiz Fernando Rodrigues de Paula and Rogerio Studart, Economia Monetária e Financeira: Teoria e Política, Chapters 6-8.

2. Monetary and Fiscal policy - theories of money demand and money supply:

Charles Goodhart, “The Endogeneity of Money”
L. Randall Wray, Understanding Modern Money, Chapters 4-5,7.

3. Financial structures and Financial institutions – bank intermediation, market intermediation.

Kregel, "Market Form and Financial Performance," Economic Notes, Vol. 24, No. 3, 1995;

Kregel, “Instability of the Economy and Fragility of the Financial Structure”;

Studart and Hermann, “Estrutura e Operação dos Sistemas Financeiros no Mercosul: Perspectivas a Partir das Reformas Institucionais dos Anos 1990,”

4. Development of diverse financial systems and transmission mechanisms: US, UK, Germany

Kregel, Origini e sviluppo dei mercati finananziari, Chapters 3-5.

5. Development of Central Banks – the Bank of England, the Federal Reserve, the Bundesbank

Kregel, “Does the Bundesbank Fight Inflation?” ;

Martin Mayer, The Fed;

Robert Elgie and Helen Thompson, The Politics of Central Banking;

Kregel, "The Role of 1930s Regulations in the Development of Financial Markets in Post-war USA, Germany and Britain, " in Regime Changes: Macroeconomic Policy & Financial Regulation in Europe from the 1930s to the 1990s,. D. J. Forsyth and T. Notermans, eds. Boston: Berghahn Books, Inc., 1997;

Week 2

6. What banks do – what do banks do to defend their profits/markets

Kregel, The Past and Future of Banks,

Luiz Fernando Rodrigues de Paula, “Teoria da Firma Bancária,“ Chapter 7 of Gilberto Tadeu Lima, João Sicsu, Luiz Fernando de Paula, Macroeconomia Moderna;

Kregel and Burlamaqui, “Finance, Competition, Instability, and Development Microfoundations and Financial Scaffolding of The Economy;”

Studart, “Financial Opening and Deregulation in Brazil in the 1990s;”
Martin Mayer, The Bankers, Part II;

Kregel, “Margins of Safety and Weight of the Argument in Generating Financial Fragility,” Journal of Economic Issues, June, 1997;

Marcia L. Stigum and Rene O. Branch, Jr., Managing Bank Assets and Liabilities, Part II, IV.

7. The role of open international financial markets – the US in 1970s, Latin America - 1970s, Asia 1990s,

Kregel, “Capital Flows, Global Banking and Financial Crises in the post-Bretton Woods Era as A Guide to the 21st Century’s Financial Crises”, Comercio Exterior, January, 1999, pp. 7-15.

Kregel, “Riscos e implicações da globalização financeira para a autonomia de políticas nacionais,” Economia e Sociedade, No. 7, Dec. 1996,

Kregel, “A New Triffin Paradox for the Global Economy”,
Susan Strange, Mad Money, Chapters 2,5,8.

8. The role of derivatives in bank operations, in defending banks’ from monetary policy, in defending firms from the impact of monetary policy

Kregel, “Derivatives and Global Capital Flows: Applications to Asia,” Cambridge Journal of Economics, Nov., 1998, pp. 677-92,

Martin Mayer, Markets,and Stealing the Market,

David Rule, “The Credit Derivatives Market: its development and possible implications for financial stability, Financial Stability Review, June, 2001.

9 / 10. The changing transmission mechanism: from banks as the transmission belt to markets as the transmission belt; The Future of Monetary Policy in a market based transmission mechanism

Martin Mayer, The Fed.

Bibliography of Readings:

Fernando Cardim de Carvalho, Francisco Pires de Sousa, Joao Sicsu, Luiz Fernando Rodrigues de Paula and Rogerio Studart, Economia Monetaria e Financeira: Teoria e Politica, Editora Campus, 2001.

Charles Goodhart, “The Endogeneity of Money,” mimeo, London, 2001.

Robert Elgie and Helen Thompson, The Politics of Central Banking,London: Routledge, 1998.

J. Kregel, Instability of the Economy and Fragility of the Financial Structure, mimeo, Bologna, 1993.

J. Kregel, "Market Form and Financial Performance," Economic Notes, Vol. 24, No. 3, 1995.

J. Kregel, “Does the Bundesbank Fight Inflation?” mimeo, Bologna, 1995.

J. Kregel, Origini e sviluppo dei mercati finananziari, Studi e Ricerche della Banca popolare dell’Etruria e del Lazio, Arezzo, 1996.

J. Kregel, “Riscos e implicações da globliação financiera para a autonomia de politicas nacionais,” Economia e Sociedade, No. 7, Dec. 1996.

J. Kregel, "The Role of 1930s Regulations in the Development of Financial Markets in Post-war USA, Germany and Britain, " in Regime Changes: Macroeconomic Policy & Financial Regulation in Europe from the 1930s to the 1990s,. D. J. Forsyth and T. Notermans, eds. Boston: Berghahn Books, Inc., 1997.

J. Kregel, The Past and Future of Banks, Roma: Ente Einaudi, 1997.

J. Kregel, “Margins of Safety and Weight of the Argument in Generating Financial Fragility,” Journal of Economic Issues, June, 1997.

J. Kregel, “Derivatives and Global Capital Flows: Applications to Asia,” Cambridge Journal of Economics, Nov., 1998.

J. Kregel, “Capital Flows, Global Banking and Financial Crises in the post-Bretton Woods Era as A Guide to the 21st Century’s Financial Crises”,Comercio Exterior, January, 1999.

J. Kregel, “A New Triffin Paradox for the Global Economy,” mimeo UNCTAD, 1999.

J. Kregel and L. Burlamaqui, “Finance, Competition, Instability, and DevelopmentMicrofoundations and Financial Scaffolding of The Economy,” mimeo, Oslo, 2001
.
Martin Mayer, Markets, New York: Norton, 1988.

Martin Mayer, Stealing the Market, New York: Basic Books, 1992.

Martin Mayer, The Bankers, New York: Truman Talley, 1998.

Martin Mayer, The Fed: The inside Story of how the World's Most Powerful Financial Institution Drives the Markets, Free Press, 2001.

Luiz Fernando Rodrigues de Paula, “Teoria da Firma Bancaria,“ Chapter 7 of Gilberto Tadeu Lima, Joao Sicsu, Luiz Fernando de Paula, Macroeconomia Moderna , Rio: Editora Campus, 1999.

David Rule, “The Credit Derivatives Market: its development and possible implications for financial stability”, Financial Stability Review, June, 2001.

Marcia L. Stigum and Rene O. Branch, Jr., Managing Bank Assets and Liabilities, New York: Dow Jones-Irwin, 1983.

Susan Strange, Mad Money, Manchester University Press, 1998.

Rogerio Sudart and Jennifer Hermann, “Estrutura e Operação dos Sistemas Financeiros no mercosul: Perspectivas a Partir das Reformas Institucionais dos Anos 1990,” Brasilia, 2001.

Rogerio Studart, “Financial Opening and Deregulaltion in Brazil in the 1990s,” Quarterly Review of Economics and Finance, 2000.

L. Randall Wray, Understanding Modern.