Central Bank Balance Sheet and Real Business Cycles

Mustapha Akinkunmi

• Éditeur: De Gruyter
• Année: 2018
• ISBN:
  9781547400591
• Édition: 1
• Sujet: Economics
• Sous-sujet: Banks & Banking

Central Bank Balance Sheet and Real Business Cycles argues that a deeper comprehension of changes to the central bank balance sheet can lead to more effective policymaking. Any transaction engaged in by the central bank—issuing currency, conducting foreign exchange operations, investing its own funds, intervening to provide emergency liquidity assistance and carrying out monetary policy operations—influences its balance sheet. Despite this, many central banks throughout the world have largely ignored balance sheet movements, and have instead focused on implementing interest rates.

In this book, Mustapha Abiodun Akinkunmi highlights the challenges and controversies faced by central banks in the past and present when implementing policies, and analyzes the links between these policies, the central bank balance sheet, and the consequences to economies as a whole. He argues that the composition and evolution of the central bank balance sheet provides a valuable basis for understanding the needs of an economy, and is an important tool in developing strategies that would most effectively achieve policy goals. This book is an important resource for anyone interested in monetary policy or whose work is affected by the actions of the policies of central banks.

Chapter 1
Global Genesis of the Central Bank

1.1Origin of the Central Bank

The pioneering central banks were established to boost the financial capacity of governments. For instance, the Sveriges Riksbank was created in 1668 as an instrument of managing Swedish financial resources. The Bank of England was set up in 1694 by William III during a war against France. The European Central Bank (ECB) came on board in January 1999 as a result of the creation of the Eurozone. The U.S. financial crisis of 1907 led the U.S. Congress to pass the Federal Reserve Act of 1913, which mandated the creation of the Federal Reserve. The Federal Reserve was established with the understanding that the Fed would explore its balance sheet to support a currency that could respond elastically to meet the needs of a growing economy, and lessen the impact of future economic downturns. In creating the Federal Reserve System, the U.S. Congress hoped to minimize the occurrence of panics that would lead to bank runs, and maintain the stability of the U.S. financial system.

The great challenge facing the U.S. financial system was too many government constraints. It was believed then that private banking was not stable. Therefore, the result of the National Monetary Commission led to the origin of the Federal Reserve. However, the Federal Reserve failed to prevent the Great Depression of the 1930s, and there were periods of significant inflation since World War II.

Central banks, even with their technocratic expertise, could not predict the 2007–2008 global financial crisis or the euro zone’s debt crisis. In light of this, the future of central banks remains uncertain as their autonomy is not guaranteed, and because governments depend on them in a crisis and ignore their suggestions when economies recover (The Economist, 2017).

1.2Roles of the Central Bank

Central banks around the world serve as the ultimate means of settlement in an economy. For instance, balances held in commercial banks can be exchanged on-demand for banknotes; this support of direct convertibility in terms of central bank liabilities ensures some level of trust in the value of such money. Some countries—for example, the UK—allow private banks to issue banknotes, with the endorsement of the monetary authority. Prior to the establishment of the Federal Reserve System, the United States implemented various measures to regulate banks and manage the money supply at a national level. Owing to the recurring financial panics during the nineteenth and early twentieth centuries, the National Monetary Commission was set up in 1908 to investigate the problem and provide a recommended solution. The outcome of this study made the U.S. Congress pass the Federal Reserve Act in December 1913. Before 1914, the U.S. financial system was confronted with the problem of too many government restrictions.

As observed throughout history and as recently as the 2007–2008 financial crisis, central banks have explored their balance sheets and exercised their power to intervene in the financial markets, particularly when facing systemic threats arising from the failure of financial institutions.

The ECB has been tasked with the responsibility of conducting monetary policy for the euro area since its creation in January 1999. The creation of the euro area led the transfer of responsibility of monetary policy from the national central banks to the ECB.

Central banks have wielded monopoly power to issue notes and have served as a lender of last resort since their conception. In times of severe illiquidity, the central bank acts as a credible lender of last resort, and has the capacity to create the monetary liabilities needed to provide liquid assets to imperiled institutions. In addition, most central banks often have supervisory and regulatory powers to ensure financial institutions’ solvency, prevent bank runs, as well as reckless or fraudulent behavior by commercial banks.

Commercial bank reserves can be equivalent to a commercial bank’s current accounts held at the central bank. Settlement of monetary transactions between two commercial banks is accomplished by moving reserves across the central bank’s balance sheet with one commercial bank’s reserve account being debited, and the other being credited. This payment flow is always balanced by interbank transactions in order to prevent excessive withdrawals at the central bank.

Thus, the central bank creates confidence in commercial bank deposits as a means of settlement. This confidence enhances the efficiency of financial systems by freely encouraging commercial banks. Thus, it serves as intermediaries between agents in the economy and creates money by offering credit.

The central bank balance sheet presents the financial position of monetary authority in any economy. It has both an asset side and a liability side. The asset side mainly contains foreign and domestic assets, while the liability side consists of nonmonetary liabilities (such as banknotes) and monetary liabilities.

This book will specifically focus on composition and evolution of central balance sheets, and their implications on real business cycles and the macroeconomic environment.

Questions

1. What is the history of the central bank?
2. What led to the establishment of the Federal Reserve?
3. What are the roles of the central bank?
4. What is the concept of the “central bank balance sheet”?

Chapter 2
Relevance of the Central Bank Balance Sheet

2.1Understanding Relevance of Central Bank Balance Sheet in Functions of Economy

The analysis of the central bank balance sheet is important in designing and understanding the policies needed to support an economic recovery in post-financial crisis years. This book asserts that a deeper comprehension of changes to the central bank balance sheet can lead to more effective policymaking. We support this assertion by highlighting the challenges and controversies faced by central banks in the past and present when implementing policies, and analyze the links between these policies, the central bank balance sheet, and the consequences to economies as a whole.

Every country has a central bank with specific features in terms of name, organizational structure, monetary policy targets, ownership, and level of autonomy. Some countries like Nigeria, name their central bank by adding the country name to the phrase “Central Bank of” while other such as the United Kingdom and Ghana attach the phrase “Bank of” to their country name (Bank of England, Bank of Ghana). Countries such as the United States and South Africa adopt the use of “Federal Reserve.”

Most central banks have institutionalized inflation targeting. Recently, about seventy economies were regarded as inflation targeting countries. The creation of money has been considered a common feature of central banks in the world and their establishment was legally backed up.

Before the book delves deeper into its main theme, it is essential to provide readers with the fundamental information required to comprehend the content of this book. Therefore, the next subsection will be dedicated to that purpose, but this may be skipped by those readers who have a basic understanding of the balance sheet.

2.1.1Similarities and Differences between a Company’s Balance Sheet and a Central Bank Balance Sheet

A balance sheet of any organization provides information on financial status at a specific point in time. This implies that balance sheets can be created weekly, monthly, quarterly or annually. The balance sheet also provides an insight into an entity’s fiscal health, enabling stakeholders to assess previous performance and predict future trends.

However, different types of entities such as corporations and banks explore different types of information on their respective balance sheets. This creates many differences between a central bank’s balance sheet (see Figure 2.1) and a corporation’s balance sheet. These differences are as follows:

1. A central bank’s balance sheet is prepared in line with the established guideline whereas a company’s balance sheet is prepared in relation to the regulation of the International Accounting Standards Board (IASB).
2. The main objective of the central bank balance sheet is to ensure a stable financial system, while a company’s key objective is to present the accurate financial position of an organization to the stakeholders.
3. The scope of a central bank’s balance sheet covers the financial system of the whole economy whereas the counterpart’s scope is applicable for all sorts of companies.
4. A central bank’s assets and liabilities are very different from any regular company.
5. The economic situation influences the composition of the central bank’s balance sheet; however, this is insignificant in a company’s balance sheet.

Figure 2.1: Bank of Canada balance sheet

At the onset, governments set up central banks with the aim of creating reliable payment systems. Over time, the central bank’s responsibility increased to managing entire financial systems and economies. Their key method has been to influence the cost of money through a change in interest rates. This was initially applied in an effort to boost or slow the economy, and then as a means of ensuring stability.

Any transaction engaged in by the central bank—for example, issuing currency, conducting foreign exchange operations, investing its own funds, intervening to provide emergency liquidity assistance, and carrying out monetary policy operations—influences its balance sheet. Despite the relevance of the balance sheet, many central banks have largely ignored balance sheet movements, such as assets and liabilities and instead have focused on implementing price targets—establishing targets for a price index like the consumer price index. In addition, economists generally do not favor analyzing balance sheets for patterns that could inform policy decisions. However, analysis of the composition and evolution of the central bank balance sheet provides a valuable basis for understanding the needs of an economy, and is an important tool in developing strategies that would most effectively achieve policy goals.

The fundamental aim of this book is to provide a sound framework for comprehending a central bank’s balance sheet. The importance of the central bank’s balance sheet also extends to its main liabilities in the functions of the economy. The strength (or weakness) of a central bank’s balance sheet provides the trust (or lack thereof) that supports or undermines the legitimacy of most forms of money circulating in an economy.

Monetary policy can be defined as actions of central banks, which affect the size and rate of money supply growth in an economy. Its instruments for implementing these actions include interest rates, forward guidance, large scale asset purchases (QE), and additional liquidity operations such as repurchase agreements. Setting an interest rate would directly influence cost of borrowing, thus affecting economic conditions—lower borrowing cost would stimulate economic growth and vice versa.

Price level targeting is a monetary policy framework designed to ensure price stability. It establishes targets for a price index like the consumer price index. As inflation targeting is forward looking, the price-level targeting is applied to correct any short-term deviations from the target rate of inflation. For instance, in the latter half of the twentieth century, Peru experienced a long inflationary challenge. This led to the International Monetary Fund (IMF) imposition of austerity policies on the country. Its economy suffered stagflation at that time, and gave Alan Garcia the opportunity to become president in 1985. Alan’s economic reforms weakened the economy and drove Peru out of global credit markets. This condition hindered access to credit, and worsened the economic situation, and transformed high inflation into hyperinflation in Peru (http://www.businessin-sider.com/worst-hyperinflation-episodes-in-history-2013-9?IR=T#china-october-1947-may-1949-6). Deflation in the Eurozone occurred when European prices declined and imports of European goods became cheaper. This made imports into Europe more expensive and pushed inflation up in Europe.

2.2Trajectory Relevance of the Central Bank Balance Sheet

The lack of attention paid to central bank balance sheets can be attributed to the actions of central banks in moving away from quantitative targets such as money targets and moving toward price targets like inflation, using exchange rates as a means of guiding monetary policy. In the late 1970s and early 1980s, central banks used narrow measures of money supply as an operational target, thus leading to a greater focus on the central bank’s balance sheet. The status of the reserves balance, as reported on the central bank’s balance sheet, was of great interest to both practitioners and observers. Figure 2.2 indicates a long-run interest rate for G7 economies. As shown...

Table des matières

• Cover
• Title Page
• Copyright
• Dedication
• Contents
• Chapter 1: Global Genesis of the Central Bank
• Chapter 2: Relevance of the Central Bank Balance Sheet
• Chapter 3: Components of Central Bank Balance Sheets
• Chapter 4: Analytical Framework of Central Bank Balance Sheets
• Chapter 5: Evolution of Central Bank Balance Sheets and Their Heterogeneous Dimensions
• Chapter 6: Composition of Central Bank Balance Sheet Assets
• Chapter 7: Financial Ratios of the Central Bank Balance Sheet
• Chapter 8: Central Bank Operations
• Chapter 9: Real Business Cycles
• Chapter 10: Central Bank Balance Sheets and Real Business Cycles
• Chapter 11: Conclusion
• Appendix I: Central Bank Balance Sheets of Different Countries
• Appendix II: Abbreviations
• References
• Index