Central Banking from theory to practice: An international comparisonÁNGEL GARCÍA

University of Siena,Pontignano Meeting03-07-2007, Siena, Italy

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(1) Are there any substantial differences among monetary practices throughout the world?

(2) If yes, what are those differences based on?

(3) How can they be observed?

(4) How are they related to the different theoretical views of money?

(5) Which economies tend to follow similar patterns?

(6) And why do such differences exist?

1. Introduction

3

ArgentinaBrazil

America and LA MexicoPeruUSAVenezuela

England Europe EU

Norway

1. Introduction (Continued): Economies Studied

ChinaJapan

Asia KuwaitIndia Saudi ArabiaUAE

√ Central bank balance sheet data: 48 months of observations from Jan 2003 to Dec 2006.

√ Overnight Interbank Interest Rate and FX data: an average of 1045 daily observations

from Jan 2003 to Dec 2006.

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The short answer is yes, there are substantial differences among monetary practices throughout the world, although these differences have been reduced as most central banks have abandoned policies based on monetary targeting in favor of those based on interest rate targeting.

The differences in monetary practices are related to international monetary asymmetries, the differences between the large and closed economy and the small open economy and between the “old” exogenous theory of money and the endogenous theory of money.

1. Introduction (Continued)

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2. The two theories of money

ConceptThe Exogenous Theory of Money The Endogenous Theory of Money

Postulate Implications Postulate Implications

Technology

Decreasing Returns to Scale. Investment highly depends on

interest rates.

Automatic adjustment

through a price mechanism

which secures a tendency

towards full employment

Increasing Returns to Scale. Investment

mostly depends on the preservation of a “normal” level of

capacity utilization.

Incomplete adjustment through variations in quantities, leading to multiplier/accelerator

effects.

Distribution of Income

Labor is a commodity. Salaries

are determined by marginal

productivity.

The distribution of

income is harmonic.

Every one gets his marginal contribution.

Salaries are negotiated and determined within a conflictive process.

The distribution of income is not harmonic and represents the major

influence over costs of production and inflation.

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2. The two theories of money

ConceptThe Exogenous Theory of Money The Endogenous Theory of Money

Postulate Implications Postulate Implications

Financial System

Savings precede Investment.

Deposits and reserves are required to extend new loans. Portfolio

adjustments are irrelevant.

Investment precedes savings.

Loans create deposits, and the availability of reserves does

not constraint the expansion of loans. Savings are just a residual which reduces

aggregate demand. Portfolio adjustments are deterministic.

Monetary System

Money is a commodity

which reduces transaction

costs.

The value of money is tied to a commodity.

Monetary reserves are physically restricted and interest rates are

determined by the market and scarcity.

Money is a fiat money which circulates by

means of coercive power

and the imposition of tax

liabilities.

The value of money has no anchor. Monetary reserves

face no restriction and interest rates are exogenously

determined by the State and the central bank.

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2. The two theories of money

ConceptThe Exogenous Theory of Money The Endogenous Theory of Money

Postulate Implications Postulate Implications

Direction of Causality

From the money supply to nominal

income.

Inflation is a demand

phenomenon and “excess money” is

its cause

From expected and actual nominal income to the money supply.

Money is an effect and not a cause. Money is demand determined, and demand is

not determined by the money supply.

Economic Policy

The role of monetary policy is emphasized. Fiscal policy is rather ineffective because it leads to “crowding out” and reduces

investment.

Monetary authorities must

reduce the output gap and control

inflation by controlling the

amount of money or the interest rate.

Monetary Policy is accommodative. Fiscal policy and Incomes Policies are effective to

stabilize inflation and output.

Monetary authorities should accommodate the demand for reserves and

stabilize the interest rate to guarantee the well

functioning of the payments and financial systems.

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In the LCE reserves face no constraint. Only expectations regarding bank profitability may restrict credit activity along the credit cycle, without having to affect the tendency towards economic growth and credit expansion.

But in the SOE, there are adverse effects arising from actual and expected variations in both the level of international reserves (as a quantity) and the foreign exchange rate (as a price) which represent in practice an indirect factor which restricts the domestic credit activity of central banks, but not that of commercial banks.

3. The complexities of the Open Economy

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In short, while the LCE is not required to build a stock of foreign currency assets and is not concerned about fluctuations in the FX rate, the SOE is.

The reason is the former supplies the international reserve currency, the latter does not – e.g. there are international monetary asymmetries. The local currency of the SOE is not accepted abroad.

3. The complexities of the Open Economy (Continued)

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3. The complexities of the Open Economy (Continued)

Exogenous factors

affecting liquidity

preference in domestic and

foreign currency:

- The structure of the

domestic the economy.

- Economic and Political uncertainty.

- Institutional arrangements and degree of

financial development, availability of

credit, liquidity

restrictions, credit

rationing, etc.

Weak Liquidity Preference in

Foreign Currency

Local currency government securities do not have to compete against foreign

currency securities.

A larger stock of gross international reserves is

not required for absorbing exogenous fiscal monetary

components.

Foreign currency assets tend to concentrate within private interbank systems,

and the exchange rate regime gains flexibility.

Portfolio adjustments in this case take place within the sphere of bank deposits, and do not require base money; hence, there is no bias towards interest rate volatility but towards two-side exchange rate volatility.

Fiscal Policy does not necessarily tend to be pro-cyclical, as its monetary absorption is secured at any time.

Two side-betting becomes the rule, reducing the preference for liquidity in foreign currency.

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3. The complexities of the Open Economy (Continued)

Exogenous factors

affecting liquidity

preference in domestic and

foreign currency:

- The structure of the

domestic the economy.

- Economic and Political uncertainty.

- Institutional arrangements and degree of

financial development, availability of

credit, liquidity

restrictions, credit

rationing, etc.

Strong Liquidity Preference in

Foreign Currency

Local currency government securities have to compete against foreign currency

securities.

Foreign currency assets tend to concentrate within the central bank, and the

exchange rate regime looses flexibility.

Portfolio adjustments in this case involve a temporary demand for base money in order to purchase foreign currency assets provided by the central bank. It requires the liquidation of (government) securities, and hence implies a bias towards interest rate volatility, unless the central bank is always ready to purchase the liquidated government securities.

Fiscal Policy tends to be pro-cyclical, as its monetary absorption is facilitated precisely in the presence of balance of payments surpluses.

One side-betting becomes the rule, reinforcing the strong preference for liquidity in foreign currency.

A larger stock of gross international reserves is required for absorbing

exogenous fiscal monetary components.

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4. Central Banks’ Balance Sheets

Assets, Liabilities and Capital

A S S E T S

Gross Intl Reserves (GRI)

Gold and Gold Certificates

Foreign Currency Assets

Other International Reserve Assets

Domestic Credit (DC=CG+CFS)

Credit to Gov (CG)

Credit to Financial Sys (CFS≈RED)

IMF

Subtotal Other Assets

Other Assets in Foreign Currency not GRI

Other Assets

TOTAL ASSETS (ASS)

Assets, Liabilities and Capital

L I A B I L I T I E S

International Reserve Liabilities

IMF

Base Money (BM =CASH+BRES)

Notes and Coins in Circulation (CASH)

Deposits of Banking Institutions (BRES)

Debt Securities (DS)

Deposits Public Adm (GD)

Other Liabilities

C A P I T A L

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4. Central Banks Stereotypes

Case

Diagnosis Symptoms

Is the Local Currency an

International

Reserve Currency?

Influence of International

Monetary Asymmetries

Influence of variations in the FX Rate

Monetary Policy and FX Rate

Regime in Place

Largest Component

of Asset Side

Largest Component of Liability Side

Quantity Effect Price Effect

(1) Yes Null Null Fully FlexibleDomestic

CreditCash

(2) No Weak Weak FlexibleDomestic

CreditTotal Base

Money

(3) No Intermediate Intermediate Flexible/FixedDomestic

CreditDebt Sec. and Gov. Deposits

(4) No Intermediate Intermediate Flexible/FixedGross Intl Reserves

Total Base Money

(5) No Strong Strong FixedGross Intl Reserves

Debt Sec. and Gov. Deposits

(6) No Strong Strong “Fully” FixedGross Intl Reserves

Cash

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5. Central Bank’s Quantitative Indexes (Continued)

(1) KGDDSBMIRLDCGIR

Variable

Flexible Exchange Rate Regime Fixed Exchange Rate Regime

Very Short-run

Short, Medium and Long-run

Very Short-run

Short, Medium and Long-run

GIR Exog Exog Endo Endo

DC Exog Endo Exog Endo

IRL Endo Exog Endo Exog

BM Exog Endo Exog Endo

DS Exog Exog Exog Exog

GD* Endo Endo Endo Endo

K Endo Endo Endo Endo* Endogenous for the Central Bank but endogenous and exogenous for the Government as it can always affect its volume of Government Deposits (GD) held at the Central Bank beyond whatever is determined through taxation by means of the issuance of Treasury Securities.

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A minimum degree of flexibility of monetary policy requires:

or equivalently in terms of equation (1):

Otherwise the ability of central banks to issue debt without having to pay an interest rate would tend to disappear – e.g. seignorage would fade away. But, overall, depending on liquidity preference, the fact that DS>BM may set out pressures leading to financial instability and interest rate volatility.

5. Central Bank’s Quantitative Indexes (Continued)

DSBM

BMKGDDCIRLGIRDS *21

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5. Central Bank’s Quantitative Indexes (Continued)

1) The ratio of the “Original Sin” – applicable when GIR>DC.

Provided BM expands with GIR and DC, should R≥1? Not necessarily, what if Gov stabilizes the FX? But, the

greater R is the more flexible the exchange rate scheme and the monetary policy of the central bank.

The minimum level so that BM>DS is:

What is the effect of Δ(GIR-IRL), ΔT, ΔGS, Fiscal Deficit not fully absorbed by T-Securities, ΔCF…?

GIR

KGDDCIRLGIRGIRBM *

21

GIRBM

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5. Central Bank’s Quantitative Indexes (Continued)

2) “Domestic Freedom” – applicable when DC>GIR.

One would expect the value of the ratio to remain somewhere around the unit.

A minimum level so that BM>DS

In the case of the large economy in charge of

supplying the international reserve currency

(GIR-IRL)≈0 ≈GD and K is always small

DC

KGDDCIRLGIRDCBM *

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DCBM

KDCBM *21

Easy to satisfy by definition

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5. Central Bank’s Quantitative Indexes (Continued)

3) The importance of the Extracting Liability Components – meaningful in all cases.

R<100%, otherwise there is a loss of flexibility.

4) The ratio of “Orthodox Favoritism” – meaningful in all cases.

R<50%, otherwise BM would tend to fade away from the monetary system.

BMGDDS

LIAGDDS

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5. Central Bank’s Quantitative Indexes (Continued)

5) “Net Extraction of Internal Liquidity” – applicable when DC>GIR.

R<100%, otherwise a net drain of BM would take place.

6) “Net Extraction of External Liquidity” – applicable when GIR>DC.

R<100%, otherwise the costs of preserving the

exchange rate regime in place would

rapidly increase.

DCGDDS

GIRGDDS

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5. Central Bank’s Quantitative Indexes (Continued)

7) “Liquidity Requirements” – applicable when DC>GIR.

R<100%, otherwise a net drain of DC would take place.DC

BRES

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6. Empirical Results

A L L C O U N T R I E S

TABLE ALL-1: PERIOD JAN 2003 TO DEC 2006-AVERAGE STRUCTURE OF (CENTRAL BANKS') MONTHLY BALANCE SHEETS

Assets, Liabilities and Capital ARG BRA MEX PERU USA VEN ENG EU NOR CHI JAP KUW IND SAU UAE

A S S E T S

Gross Intl Reserves (GIR) 39% 32% 74% 89% 2% 78% 34% 20% 56% 4% 98% 86%

Gold and Gold Certificates 1% 0% 0% 4% 1% 17% 15% 0% 0% 0% 1% 3%

Foreign Currency Assets 38% 32% 73% 83% 0% 60% 16% 19% 56% 4% 97% 83%

Other International Reserve Assets 0% 0% 1% 2% 0% 2% 3% 0% 0% 0% 0% 0%

Domestic Credit (DC=CG+CFS) 29% 65% 19% 1% 93% 7% 49% 2% 31% 94% 0% 3%

Credit to Gov (CG) 17% 61% 11% 0% 92% 7% 5% 1% 4% 92% 0% 2%

Credit to Financial Sys (CFS) 12% 4% 7% 1% 0% 0% 45% 1% 27% 2% 0% 1%

IMF (and other resources from other funds) 22% 0% 0% 0% 0% 0% 0% 75% 0% 0% 0% 0%

Subtotal Other Assets 9% 3% 7% 10% 6% 16% 17% 3% 13% 2% 2% 12%

Other Assets in Foreign Currency not GRI 4% 2% 1% 7% 0% 14% 2% 0% 1% 0% 0% 0%

Other Assets 6% 1% 6% 3% 6% 2% 15% 3% 11% 2% 2% 12%

TOTAL ASSETS (ASS)

Central Bank Stereotype (1), (2), …, (6) (4) (3) (4) (5) (1) (5)   (1) (5) (4) (1) (4) (4)    

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6. Empirical Results (Continued)

A L L C O U N T R I E S

THE EVOLUTION OF SOME KEY VARIABLES FROM YEAR-AVERAGE 2003 TO YEAR-AVERAGE 2006

Assets, Liabilities and Capital ARG BRA MEX PERU USA VEN ENG EU NOR CHI JAP KUW IND

SAU

UAE

A S S E T S

Gross Intl Reserves (GIR)

30-50% 32-32% 70-77% 87-89% 2-2% 74-74% 41-29% 22-16% 48-63% 4-4% 99-98% 78-89%

Domestic Credit (DC=CG+CFS)

26-39% 64-66% 22-19% 1-3% 92-93% 6-14% 42-51% 2-2% 40-26% 94-93% 0-1% 8-1%

IMF or Norway’s Oil Fund

37-0% 68-82%

FOREIGN EXCHANGE RATE

Foreign Exchange Rate Variation

against the US dollar

2.953.07

3.072.18

10.7910.90

3.483.28

N/A1607.602150.00

0.610.54

0.890.80

7.086.42

115.93116.29

46.5645.42

Foreign Exchange Rate Variation (%)

4.07% -29.0% 1.02% -5.75% N/A 33.74% -11.% -10.1% -9.32% 0.31% -2.45%

Central Bank Stereotype

(1), (2), …, (6)(4) (3) (4) (5) (1) (5)   (1) (5) (4) (1) (4) (4)    

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6. Empirical Results (Continued)

A L L C O U N T R I E S

TABLE ALL-1: PERIOD JAN 2003 TO DEC 2006-AVERAGE STRUCTURE OF (CENTRAL BANKS') MONTHLY BALANCE SHEETS

Assets, Liabilities and Capital ARG BRA MEX PERU USA VEN ENG EU NOR CHI JAP KUW IND SAU UAE

L I A B I L I T I E S

Reserve Liabilities (IRL) 4% 7% 5% 9% 0% 21% 2% 5% 1% 0% 2% 0%

IMF and resources from other funds or Bank Reserves in foreign currency

28% 10% 0% 45% 0% 0% 0% 81% 0% 0% 0% 0%

Base Money (BM =CASH+BRES) 39% 29% 52% 25% 95% 34% 72% 6% 66% 76% 54% 71%

Notes and Coins in Circulation (CASH) 28% 11% 30% 18% 92% 14% 55% 3% 29% 55% 29% 55%

Deposits of Banking Institutions (BRES) 11% 18% 22% 6% 3% 19% 17% 2% 37% 21% 26% 16%

Debt Securities (DS) 17% 19% 23% 13% 3% 27% 0% 0% 14% 17% 4% 5%

Deposits Public Adm (DG) 1% 34% 15% 2% 1% 15% 7% 8% 14% 4% 25% 1%

Other Liabilities 10% 1% 5% 6% 1% 4% 19% 0% 5% 3% 15% 23%

TOTAL LIABILITIES (LIA) 88% 99% 103% 99% 97% 77% 93% 93% 100% 98% 91% 100%

C A P I T A L

Capital (K) 12% 1% -3% 1% 3% 22% 7% 7% 0% 2% 9% 0%

Central Bank Stereotype (1), (2), …, (6) (4) (3) (4) (5) (1) (5)   (1) (5) (4) (1) (4) (4)    

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6. Empirical Results (Continued)A L L C O U N T R I E S

THE EVOLUTION OF SOME KEY VARIABLES FROM YEAR-AVERAGE 2003 TO YEAR-AVERAGE 2006

Assets, Liabilities and Capital

ARG BRA MEX PERU USA VEN ENG EU NOR CHI JAP KUW INDSAU

UAE

L I A B I L I T I E S

IMF or Peru’s Foreign Currency Bank Reserves and Norway’s Oil Fund

46-3% 17-0% 29-25% 76-85%

Base Money (BM =CASH+BRES)

36-49% 24-35% 51-54% 18-30% 95-95% 34-36% 68-72% 8-4% 67-56% 79-75% 66-50% 73-72%

Notes and Coins in Circulation (CASH)

22-38% 8-14% 29-30% 16-21% 92-93% 17-13% 51-56% 4-3% 35-23% 55-62% 27-25% 58-55%

Deposits of Banking Institutions (BRES)

13-11% 16-22% 22-24% 2-10% 3-2% 17-23% 18-16% 4-1% 32-33% 23-13% 38-26% 15-17%

Debt Securities (DS) 6-30% 22-19% 27-18% 8-11% 3-3% 18-42% 0-0% 0-0% 4-24% 14-19% 0-10% 0-4%

Deposits Public Adm (DG)

1-2% 27-40% 14-17% 26-20% 1-1% 14-7% 8-6% 8-6% 25-11% 5-4% 21-22% 0-2%

FOREIGN EXCHANGE RATE

Foreign Exchange Rate Variation

against the US dollar

2.953.07

3.072.18

10.7910.90

3.483.28

N/A1607.602150.00

0.610.54

0.890.80

7.086.42

115.93116.29

46.5645.42

Foreign Exchange Rate Variation (%) 4.07% -29.0% 1.02% -5.75% N/A 33.74% -11% -10.1% -9.32% 0.31% -2.45%

Central Bank Stereotype

(1), (2), …, (6)(4) (3) (4) (5) (1) (5)   (1) (5) (4) (1) (4) (4)    

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6. Empirical Results (Continued)A L L C O U N T R I E S

Graph ALL-1: Average Daily Interest Rate Volatility in the Interbank Market

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

VEN BRA ARG MEX NOR IND PERU ENG EU USA JAP CHI KUW SAU UAE

Countries

2003 2004 2005 2006

A L L C O U N T R I E S E X C E P T U S AGraph ALL-2: Average Daily Volatility over Mean in the Foreign Exchange Rate Interbank Market

0%

1%

2%

3%

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5%

6%

7%

8%

9%

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13%

BRA ARG EU JAP VEN NOR ENG MEX IND PERU CHI KUW SAU UAE

Countries

2003 2004 2005 2006

A L L C O U N T R I E S Graph ALL-3: CPI Inflation Rate

-3%

0%

3%

5%

8%

10%

13%

15%

18%

20%

23%

25%

28%

30%

VEN BRA MEX IND ARG PERU EU USA ENG NOR CHI KUW SAU UAE JAP

Countries

2003 2004 2005 2006

A L L C O U N T R I E S Graph ALL-1: Average Interest Rate in the Interbank Market

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

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22%

24%

BRA MEX IND ENG VEN PERU NOR ARG EU USA JAP CHI KUW SAU UAE

Countries

2003 2004 2005 2006

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6. Empirical Results (Continued)

−

Graph ARG-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph BRA-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph MEX-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph ARG-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%

Var FX %

Graph BRA-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%

Var FX %

Graph MEX-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%

Var FX %

Graph PERU-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph USA-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph VEN-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph PERU-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%

Var FX %

Graph VEN-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Var FX %

27

6. Empirical Results (Continued)

Graph ENG-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph EU-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph NOR-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph ENG-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%

Var FX %

Graph UE-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%

Var FX %

Graph NOR-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%

Var FX %

28

6. Empirical Results (Continued)

Graph JAP-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-3.0%-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph IND-1: Daily Interest Rate Variations during the period from Jan-2003 to Dec-2006

-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Var i %

Graph JAP-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-6%

-4%

-2%

0%

2%

4%

6%

Var FX %

Graph IND-2: Daily Exchange Rate Variations during the period from Jan-2003 to Dec-2006

-6%-5%-4%-3%-2%-1%0%1%2%3%4%5%6%

Var FX %