The Operational Role of the Bank of England Guo Chenzi Nov.8

The Structure of Bank System Central Bank Exchange market Money market Gilt market

Part I the objectives of Bank s market operation Part of government s overall economic strategies Fulfill the monetary of price stability

Part II The Foreign Exchange Market Question 1: What is the role of central bank under gold standard? Question 2: Question 2 What is the role of central bank under a floating exchange rate standard?

Q1 Assumption: 1.Domestic currency is maintained at a fixed rate against an external standard. 2.No government in the market could control such standard.

Q1: The market clearing condition Priority is given to maintain the ratio between par value of money and gold Increasing the money supply according to the gold reserve. Central bank loses independent monetary policy.

Q1: the role of central bank The central bank, under the gold standard in the exchange market, could do nothing but just maintain such commitment that the price of domestic currency is fixed to a particular level.

Q2: Features in the market: The price of domestic currency is basically determined by supply and demand in the market. Government can intervene the market

Q2: the role of central bank Central bank has independent monetary policy Central bank could control exchange rate to some extent by selling or buying domestic currency.

Q2: two puzzles 1.Whether could the central bank foresee the appropriate equilibrium? 2.What determine the ability of central bank to intervene exchange market, especially while they want to achieve the interest rate stability?

Part III The Money Market The Bank s operational aim is to keep very short-term interest rates within an unpublished band, which would be determined by the authority with a view to achieve their monetary objectives.

Two major questions: 1.What influence the operators in the Bank have upon money market interest rate? 2.How far these operators should concentrate their influence upon the quantity of cash in the system, rather than directly upon interest rate?

What we will discuss below about the money market. Mechanics of the present arrangements designed in 1981 Mechanics of the present arrangements designed in 1981 Problems of the 1981 s arrangements Problems of the 1981 s arrangements Relationship between cash flow and interest rate Relationship between cash flow and interest rate

Mechanics of the present arrangements designed in 1981(1) Cash flow During the day, two things happen Government the amount of people using commercial banks Bank forecasting its likely cash position maintain operation balances at the bank

Mechanics of the present arrangements designed in 1981(2) Cash flow at the end of the day Every bank settle their net difference with each other Difference is settled by debit or income at Bank

Mechanics of the present arrangements designed in 1981(3) Bank influence short- term interest rate in two ways Buy 3 months bills price of bill interest rate Policy implication, such as Green Span s secret smile

Mechanics of the present arrangements designed in 1981(4) Cash flow from government to others Discount market Call back deposits Placed with others Debt market Selling bills Commercial banks

Problems of the 1981 s arrangements (1) 1.The balances yield no interest at Bank. So, we should have to ask why banks should maintain its balance? (the incentive problem) 2.Sales of government debt cause regular and substantial shortage of cash

Problems of the 1981 s arrangements (2) 3.The influence of the authority is both visible and substantial. A sudden supply of money in the market Reluctant to increase the interest rate Open market operation to maintain the interest rate (visible effect) Change the expectation of financial institutions (substantial effect)

Relationship between cash flow and interest rate (1) The trade-off banks have to face with: Holding enough assets convertible Minimize the opportunity cost The equilibrium is determined by the attitudes of central bank

Relationship between cash flow and interest rate (2) pegged interest rate Proponents In practice, pegged interest rate is inclined to achieve monetary target. Market force in the present UK bank system could put pressure on such bias Y X Q1Q2 i Q

Relationship between cash flow and interest rate (3) Monetary Base Control Proponents 1.Money would vary pro-cyclically Demand of credit P i i is determined by market 2.In practice, there is political difficulty of raising interest rate

Relationship between cash flow and interest rate (4) Monetary Base Control Opponents 1.Inelasticity of cash demand to interest rate 2.Interest rate could be more volatile

A further discussion Which one, between pegged interest rate and monetary base control, in your opinion, is better?

Part IV Gilt Market The history of the gilt market The role of central bank in the market The problem about such operation

The history of the gilt market World War I & II massive accumulation of debt to fund government deficits After wars fund fiscal deficits monetary purposes

The role of central bank in the market when banks is over-funding the private sector, Central bank Raise medium term interest rate Selling more public sector debts Restrain bank lending Offset the immediate impact on monetary aggregate

The problem about such operation Decrease the cash in the bank system, while decreasing the deposits in banks The cooperation between Bank and Treasury in other nations

Part V something more about ECB European System Central Bank European Central Bank Central Banks of the participating EU nations Central Banks of the non-participating EU nations Independent Policy Not member in the ECB s government council Government councilExecutive board

The reason of such structure of ESCB The establishment of a single central bank for the whole euro area would not have been acceptable on political grounds. The Eurosystem approach builds on the experience of the NCBs, preserves their institutional set-up, infrastructure and operational capabilities and expertise; Given the large geographic area of the euro area, it was deemed appropriate to give credit institutions an access point to central banking in each participating Member State.

Thank you! Zhou Wei Chen Yu Xu Ting Guo Chenzi