Question

(a) Compare the similarities and differences in terms of the structure and independence of the European System of Central Banks (ESCB) and the Federal Reserve System.

(b) What are the main problems with having a central bank that is not independent of the rest of the government?

(c) The trading desk at the Federal Reserve sold $100,000,000 in T-bills to the public. If the current reserve requirement is 8.0%, how much could the money supply change?

(d) Consider a bank policy to maintain 24% of deposits as reserves. The bank currently has $20 million in deposits and holds $800,000 in excess reserves. What is the required reserve on a new deposit of $100,000?

Answer 1

d) The bank's policy is to maintain 24% of deposits as total reserves.

Thus, from the above given problem, we have, Reserve ratio = 24% = 0.24

Therefore, Required reserve ratio + excess reserve ratio = 0.24

Amt. of deposits = $20,000,000, Excess Reserves = $800,000

Therefore, Excess reserve ratio = $ (800,000/20,000,000) = 0.04

We know, Required reserve ratio + Excess reserve ratio = 0.24

Therefore, Required reserve ratio + 0.04 = 0.24

or, Required Reserve Ratio = 0.20

Thus, the Required Reserve on a new deposit of $100,000 is :- $(100,000 × 0.20) = $20,000.

c) Reserve requirements are the amount of cash that banks must have, in their vaults or at the closest Federal Reserve bank, in line with deposits made by their customers. Set by the Fed's board of governors, reserve requirements are one of the three main tools of monetary policy, the other two tools are open market operations and the discount rate.

The money multiplier tells us the maximum amount the money supply could increase based on an increase in reserves within the banking system.
Therefore, the formula for the money multiplier is simply:-    where r = the reserve ratio.

Since, in the above given problem, the reserve requirement is 8% or, 0.08.

Therefore , the potential money multiplier as per the aforesaid formula is:- 1/0.08 = 12.5

We know, the purchase of T - bills increases the money supply, whereas, the sale of T - bills decreases the money supply.
Open market operations is the sale and purchase of government securities and treasury bills by the central bank of the country. The objective of OMO is to regulate the money supply in the economy.
When the Federal reserve bank wants to increase the money supply in the economy, it purchases the government securities (T- Bills)  from the market and it sells government securities (or, T-Bills) to suck out liquidity from the system.
OMO is one of the tools that the Fed uses to smoothen the liquidity conditions through the year and minimise its impact on the interest rate and inflation rate levels.

Hence, the contraction of money supply will be in the order of $(100,000,000 * 12.5) = $1,250,000,000.
However, if there are excess reserves in the system, it may not be that high.

b) A central bank, or reserve bank is an institution that manages the currency, money supply, and interest rates of a state or formal monetary union, and oversees their commercial banking system. A central bank possesses a monopoly on increasing the monetary base in the state, and also generally controls the printing of the national currency. Central banks in most developed nations are institutionally independent from political interference.However,some limited control by the executive and legislative bodies exists.

Ever since the 1970’s, central banks all over the world had been asking for financial independence. The OPEC shocks of the 1960’s and 1970’s had exposed the weakness of the central banks. All throughout, the 1960’s and 1970’s, inflation was running at double digits in Europe. Central banks needed greater autonomy at that time, to fix the problem. They were then given this autonomy, considering the prevailing situation. As a result, almost all the central banks in the world are free from political influence. The aim of independence is primarily to prevent short-term interference.However, this policy has its pros and cons.
For example, the Bank of England had been controlled by the government to a large extent until the year 1997. After 300 hundred years of its existence, the Bank of England was finally able to become an independent body in 1997.

Advantages of having a Central Bank independent of the government are as follows :-

• Political Cycle vs. Business Cycle: Since, the political system of any country & its politicians are mainly driven by the motive of staying in power, they become extremely generous and accommodating during the pre-election times. This over interference by the political parties may lead to economic cycles (booms & busts).
  The business,on the other hand, operates based on business cycles. It is not necessary that periods of boom and bust will coincide with the political cycles. Also, if they do, politicians may have a conflict of interest. For instance, if there is too much inflation during an election year, politicians might simply skip the necessary but unpopular decision of implementing rate hikes. Hence, it is likely that the politicians will end up jeopardizing the entire economy for political gains. This is the reason why central banks need to be independent. They can take tough decisions regardless of the election cycle. The economy and elections are not naturally correlated. Hence, it is imperative that the decisions regarding the economy be taken independently.
  Independence from government and the political process is obviously helpful when the main enemy is high inflation, as it enhances a central bank’s credibility and helps monetary policy makers do tough things without political interference.
  The main rationale for making central banks independent was to enhance the credibility of inflation-targeting monetary policy, which became the standard approach to monetary policy after the demise of the gold standard and the ensuing Great Inflation of the 1970s and early 1980s. High and volatile inflation had become the economy’s main enemy at that time, and the solution was to focus monetary policy exclusively on stabilizing inflation at low levels, with independence of Central banks making that task easier to achieve.

• Inflation:- Controlling inflation is the primary objective of any central bank. In order to do so, they need to control the money spent by the government. If decisions regarding the economy can be taken by the government, they will take only populist decisions. For instance, governments may decide to provide free health care and retirement benefits even though they don’t have the enough finances at that moment to implement such decisions. The bottom line is that if the government is given control of the economy, they might resort to indiscriminate money printing which will ultimately lead to economic collapse. This is what has happened in many ancient civilizations including Rome. Hence, to prevent this, central banks have been made independent of government authority.

• Deficit Spending: Governments inorder to pursue its populist agenda may take up such projects that are not supported by economic fundamentals. Lets, take the example of the case of sports stadiums built for the Olympics in Greece and for FIFA World Cup in Brazil. In both cases, the government should not have indulged in deficit spending, but it did. These instances would become more common if the government had full control over the monetary policy. Hence, it is important to keep the monetary policy separate from the government in order to maintain the financial health of the state.

• International organizations such as the World Bank, the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) strongly support central bank independence. The support for independence from the international organizations also derives partly from their belief that the independence of the central banks will lead to increased transparency in the policy-making process. An independent central bank will always score higher in the review of the international monetory organisations than one that is not independent.

a)

1. The Federal reseve bank is the third central banking system in the United States’ history created by the Federal Reserve Act of 1913. Its headquarter is in Washington D.C.
   European Central Bank officially established on June 1st, 1998 & its headquarter located in Frankfurt, Germany. It has 15 Member countries: Belgium, Germany, Ireland, Greece, Spain, France, Italy, Luxembourg, The Netherlands, Austria, Portugal, Slovenia, Finland, Cyprus and Malta.
2. Federal Reserve Structure comprises of the following:-
   a)The Board of Governors Seven Members Appointed by the President , who serve fourteen year terms.
   b) The Federal Open Market Committee comprising of the seven members of the Board of Governors. Five representatives from the regional Federal Reserve Banks serve one-year terms on a rotating basis. Its member banks are called Federal reserve banks.
   The 12 regional Federal Reserve Banks in the United States have a role that is similar in some respects to the NCBs in the euro area, and the Board of Governors has similarities to the ECB.
   Organization of ECB
   A) European Central Bank- The ECB was established as the core of the Euro-system and the ESCB. The ECB has legal personality under public international law.
   B)Euro-system - The Euro-system comprises the ECB and the NCBs of those countries that have adopted the euro. The Euro-system and the ESCB will co-exist as long as there are EU Member States outside the euro area.
   C) European System of Central Banks:- The ESCB comprises the ECB and the national central banks (NCBs) of all EU Member States whether they have adopted the euro or not.
3. The Board of Governors of Federal reserve Bank
   The Fed comprise of the Chairman, Vice-Chairman and five other members. All members are appointed by the President and confirmed by the Senate.
   Executive Board of the ECB
   ECB comprises of the President, Vice-President and four other members. All members are appointed by common accord of the Heads of State or Government of the euro area countries. Their responsibilities are to implement monetary policy for the euro area in accordance with the guidelines specified and decisions taken by the Governing Council.
4. The federal Reserve bank operates a Federal Open Market Committee , which consists of seven members of the Board of Governors, including President of the Federal Reserve Bank of New York. Four remaining Bank Presidents serve one year terms on a rotating basis. They hold eight meetings throughout the year. Their Responsibilities include Open Market Operations i.e. Buying and Selling of Treasury Securities.
   The Governing Council of the ECB is the main decision-making body of the ECB. It consists of six members of the Executive Board, the governors of the national central banks (NCBs) from the 13 euro area countries.
   Their responsibilities are to adopt the guidelines and take the decisions necessary to ensure the performance of the tasks entrusted to the Euro-system & to formulate monetary policy for the euro area.
5. FED's economic goals are to:- Promote Stable Prices, Sustainable Economic Growth, Maximize Employment.
   ECB Goals are to:- Maintain price stability, safeguarding the value of the euro, to maintain low positive inflation rates close to 2%, Support General Economic Policies of the European Union States, Ensure an Open-Market economy.
6. Monetary Policy of The ECB
   Price Stability is the main goal of The ECB’s Monetary Policy. Because:-
   It Leads to less fluctuation of the price level, Reduces Inflation Risk Premium, Helps eliminate the real economic costs affected by distorted inflation.
7. Powers of both of them include- To conduct Open Market Operations, Decide upon Discount Rate/Standing Facility & Reserve Requirement.
8. Independence
   FED :- Independent government agency, Reports four times a year to Congress, President can remove a member.
   ECB :- High level of independence, European Institutions have no authority over ECB which many times lead to lack of transparency.
   The Federal Reserve is relatively more centralized. In the case of the ECB, the decision-making body for all matters is the Governing Council where NCB governors have more votes than members of the Executive Board.
9. Another important difference is that in the United States no individual state has control of a Reserve Bank and each Reserve Bank represents an area that covers multiple states. This ensures better integration and makes it far more likely that Reserve Banks will be serving the interests of the United States as a whole compared to the Eurosystem where the jurisdiction of each NCB coincides with the borders of an individual state.
10. The main difference between the Fed and the ECB is that in periods of crisis the Fed buys U.S. government treasury bonds (treasuries), while the ECB lends money to governments and commercial banks in European Member States. The Fed buys treasuries that have varying maturities, and are purchased with an agreement to be repurchased at the end of the maturity period. The loans granted by the ECB are generally short term (up to three months) and are secured by collateral. When the loan period expires, the banks have to pay the money back to the ECB.