International financial economics

International Financial Economics The European Central Bank (ECB) and the Federal Reserve (the Fed): differences and similarities in setup, operational procedure, and monetary policy Akmal Rahimov Hari Widodo Yudha Hadiyanto OUTLINE: • PART I : General Overview, Historical Background, Organizational Structure, Main Functions and Tasks of the Federal Reserve and ECB • PART II : Differences and similarities in Operational Procedures of Federal Reserve and European Central Bank • PART III : Monetary Policy PART I: General Overview, Historical Background, Organizational Structure, Main Functions and Tasks of the Federal Reserve Bank and European Central Bank (ECB) The Role of Central Bank    Issuer of the currency Controller of the money supply Lender of the Last Resort Why the US need a central bank? The United States lacked a central bank until the twentieth century Needs a money manager, to handle the nation's financial system Financial panics, the Bank Panic of 1907 convinced the public that a central bank was necessary Why the US need a central bank? (Continued) To reform the financial system to be more integrated and secure in supporting the developing economy In 1913, after considerable debate, Congress passed the Federal Reserve Act to balance the financial needs of the country Why European System of Central Bank (ESCB) is needed? Primary objective : to maintain price stability, as defined in Article of the Statute of the ESCB and of the ECB Price stability : a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2% To be maintained over the medium term The Governing Council announced that, in the pursuit of price stability, it would aim to maintain inflation rates close to 2% over the medium term Historical Background EUROPEAN CENTRAL BANK FEDERAL RESERVE  Drafted by Congress as the Federal Reserve Act in 1913  The act began in 1908, when Congress set up the National Monetary Commission to pinpoint weaknesses in the nation’s financial system    Established on June 1998, as one of the world’s youngest central banks  Triggering factors : the presence of EMU (political decision), i.e to maintain price stability  EMU: o Stage 1: Restriction on the movement of capital were abolished (1990) o Stage 2:Establishment of EMI and ECB o Stage 3:Irrevocable fixing of exchange rate Triggering Factors : Monetary panic (Bank commitment) The commission found that the United States lacked a reliable method to provide liquidity to the money supply Historical Background(Continued) ► President Woodrow Wilson signed the Federal Reserve Act into law on Dec 23, 1913, to help to maintain a stable, healthy and growing economy ◊ The legal basis : the Treaty on European Union signed on February 7, 1992 in Maastricht which established the European Community ◊The ESCB is composed of the ECB and the national central banks of all 15 EU Member States Stages to Monetary Union Maastricht Treaty Establishment of the EMU Irrevocable fixing of exchange rates 10 Three Tools of Federal Reserve Monetary Policy (Continued) Discount Rate Policy The rate of interest depository institutions pay for borrowing from the Fed  Raising the discount rate increases the cost of borrowing for needed reserve balances  Lowering the discount rate lowers the cost of bank liquidity and encourages lending and money supply expansion 51 Monetary Policy Strategy 52 53 54 55 An illustration of the transmission mechanism from interest rates to prices 56 57 58 Two Pillars of ECB’s Monetary Policy Strategy 59 First Pillar of ECB’s Monetary Policy Strategy: Economic analysis The Economic Analysis focuses mainly on the assessment of current economic and financial developments and the implied short to medium-term risks to price stability Includes:  Analysis of real economy indicators  Analysis of financial market developments  Analysis of exchange rate developments  Euro area macroeconomic projections based on technical assumptions, models and technical expertise of staf 60 Second Pillar of ECB’s Monetary Policy Strategy: Monetary analysis  Monetary analysis focuses on a longer-term horizon, exploiting the long-run link between money and prices The monetary analysis mainly serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications for monetary policy coming from the economic analysis Includes: The analysis of special factors  A comprehensive assessment of liquidity and credit conditions  Analysis of components and counterparts of M3 61 62 63 Conclusion  There is no blueprint for the structure and operations of a central bank Although the structures of the Federal Reserve System and the Eurosystem are similar, there are many differences in the way they operate  The Eurosystem is more decentralized than the Federal Reserve 64 Conclusion  There is lesson for Fed to take from ECB:  To clarify the goals of monetary policy  Disagreements remain over how to best make policy transparent while at the same time reserving the independence of the central banks  Transparency of two FED and ECB has also increased  It is harder for the ECB to forecast the monetary magnitude compared with the Fed due to the relatively limited data available from the past (only years) 65 ... the nation's financial system Financial panics, the Bank Panic of 1907 convinced the public that a central bank was necessary Why the US need a central bank? (Continued) To reform the financial. .. supervision of credit institutions and the stability of the financial system supervises and regulates a large share of the nation's banking and financial system; administers banking and finance-related... conducts the OMO through the Fed of NY and involving a fewer financial institution 35 Operational Procedure : Due to the differences in financial structure among the countries, ECB deals with more