Central Banking

Central Banking
Theory and Practice in
Sustaining Monetary
and Financial Stability

THAMMARAK MOENJAK
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10 9 8 7 6 5 4 3 2 1
To Thamrongsak and Lugsana Moenjak,
my loving parents.
 Contents

Prefaceix

Acknowledgmentsxi

About the Author xiii

PART ONE
An Introduction to Central Banking

CHAPTER 1
A Brief Look at Central Banking History 3

CHAPTER 2
A Brief Overview of the International Monetary System 17

CHAPTER 3
Modern Central Banking Roles and Functions: What Exactly Is a Central Bank? 37

CHAPTER 4
A Brief Review of Modern Central Banking Mandates: What Are the Goals
That Modern Central Banks Try to Achieve? 59

PART TWO
Monetary Stability

CHAPTER 5
Theoretical Foundations of the Practice of Modern Monetary Policy 77

CHAPTER 6
Monetary Policy Regimes: What Monetary Policy Rules a Central Bank
Can Use to Achieve Monetary Stability 93

CHAPTER 7
Monetary Policy Implementation: Financial Market Operations 117

vii
viii CONTENTS

CHAPTER 8
The Monetary Policy Transmission Mechanism: How Changes in Interest
Rates Affect Households, Firms, Financial Institutions, Economic Activity,
and Inflation 143

CHAPTER 9
The Exchange Rate and Central Banking 161

PART THREE
Financial Stability

CHAPTER 10
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 189

CHAPTER 11
Financial Stability: Monitoring and Identifying Risks 209

CHAPTER 12
Financial Stability: Intervention Tools 229

PART FOUR
Sustaining Monetary and Financial Stability for the Next Era

CHAPTER 13
Future Challenges for Central Banking 255

CHAPTER 14
Future Central Banking Strategy and Its Execution 275

Notes287

Index307
 Preface

T his book aims to provide readers with an understanding of and insights into the
roles and functions of central banks, the theories behind their thinking, and actual
operational practices. In the wake of the global financial crisis of 2007–2010 there
has been a renewed interest in central banking on the part of academics, practition­
ers, and the general public. Many believe that central banks had a leading role in
contributing to the crisis, while others disagree. Most, however, agree that in the
future, central banks need to play a leading role in maintaining both monetary and
financial stability.
Although central banking is currently in the limelight, there are not many com­
prehensive books on the subject aimed at students or a general audience. Courses
specifically devoted to central banking at the university level are still relatively rare.
Students, investors, market and policy analysts, and even central banks’ new recruits
often have to search among different sources to piece together what central banks
actually do and what the reasons are behind their actions. The picture they arrive at,
however, can be very fragmented.
The few current books on central banking that touch on the various aspects of
the subject are mainly for expert audiences, that is, interested academics and sea­
soned central bankers. These books often assume readers have a strong background
in monetary economics, banking regulation, or other central banking operation and
thus delve deeply into subtopics such as central bank independence, monetary policy
transparency, or the Basel rules. This approach makes it difficult for nonexperts and
novices to follow the material and put it in a proper context.
While textbooks on monetary economics can offer a very rigorous theoretical
background on monetary policy, they often do not provide detailed descriptions of
actual operations. In many cases, descriptions of monetary policy operations can be
quite out of date. On the other hand, popular books about central banking intended
for a general audience often do not offer enough theoretical background in a sys­
tematic manner for the interested reader to make sense of why central banks might
choose to adopt or abandon a particular practice.
This book aims to fill in the gaps by providing an introductory overview of
central banking in a manner that is systematic, up-to-date, and accessible to a gen­
eral audience and students who have minimal background in macroeconomics.
Theoretical reviews and examples of how theories are applied in practice are done
in an easy-to-understand manner. With the background provided by the book, it is
hoped that readers will be able to investigate further the topics that interest them,
with the ultimate goal of helping them make informed judgments about a central
bank’s actions, and, hopefully, have the ability to even anticipate them in advance.
Part I provides a quick background on central banking. Chapter 1 briefly reviews
the evolution of central banking and how different functions of central banks came
about. Chapter 2 provides background on the international monetary system in

ix
x PREFACE

order to provide the context in which central banks operate. Chapter 3 reviews func­
tions of modern central banks. Although specifics do differ among modern central
banks, there are commonalities as well as diversity among their functions. Chapter 4
reviews three of the most prominent mandates for modern central banks: monetary
stability, financial stability, and (more controversially) full employment.
Part II focuses on monetary stability, the dominant central banking mandate
for the past 30 years. Chapter 5 reviews the theoretical foundations of monetary
policy, the policy that a central bank uses to regulate monetary conditions in the
economy in order to achieve monetary stability. Chapter 6 looks at different mon­
etary policy regimes (i.e., rules) that central banks might adopt in the pursuit of
monetary stability. Chapter 7 looks at the implementation of monetary policy, which
in practice is often done through operations in financial markets. Chapter 8 looks at
how monetary policy can transmit across the economy and affect monetary stabil­
ity as well as output and employment. Chapter 9 is devoted to the exchange rate,
another key variable that central banks have to keep an eye on, as it is the price of
money in terms of another currency and could also affect monetary stability as well
as financial stability.
Part III focuses on financial stability, another key central banking mandate that
started to receive attention in the 1980s and has received even more since the global
financial crisis of 2007–2010. Chapter 10 reviews various definitions of financial
­stability, an analytical framework that could be practical for central banks’ purposes,
and prominent theories related to financial stability. Chapter 11 examines various
tools that central banks might use to identify and monitor risks to financial stability.
The review of these tools uses the analytical framework proposed in Chapter 10: the
macroeconomy, financial institutions, and financial markets. Chapter 12 examines
the various tools that the central bank can use against risks to financial stability.
Part IV looks at the future challenges of central banking and how central banks
might prepare themselves to meet those challenges. Chapter 13 reviews the three
major forces that might shape the economic and financial landscape that central
banks will be operating in: the intensification of the globalization process, the con­
tinued evolution of financial activities, and unfinished business from the global
financial crisis. Chapter 14 analyzes how central banks might prepare themselves to
meet future challenges and deliver value to society. This analysis uses a public policy
analysis framework that involves improving the analytical capacity, the operational
capacity, and the political capacity of the central bank.
Ancillary materials for students and instructors can be found at wiley.com.
 Acknowledgments

In writing this book I am indebted to many people and institutions, whether directly
or indirectly.
At Wiley, I would like to express my gratitude to the many people who helped
make the book possible, and in particular to Nick Wallwork, Jules Yap, Emilie
Herman, Lia Ottaviano, Jeremy Chia, Gladys Ganaden, Chris Gage, and Tami Trask
for their constant encouragement, kind help, and earnest support throughout the
process.
At the Lee Kuan Yew School of Public Policy, National University of Singapore,
I am grateful to the wonderful faculty, staff and fellow students, particularly my
friends from the master in public management program, whose friendships are very
much treasured.
I am deeply indebted to the Bank of Thailand for giving me a chance to work in
many interesting jobs, tap into its vast institutional knowledge pool, and learn from
my many extremely dedicated and capable friends, supervisors, and colleagues.
I am very much grateful to Charles Adams, Robert J. Dixon, Charles Goodhart,
Kishore Mahbubani, Paul A. Volcker, and Christopher Worswick for kindly giving
their invaluable time to review the manuscript. Any error that might appear in the
book is, of course, mine.
I would like to also thank my parents, Thamrongsak and Lugsana Moenjak,
whose love, support, and dedication throughout the years made this book possible.

xi
 About the Author

Thammarak Moenjak has been deeply involved with various aspects of central
­banking since he started working at the Bank of Thailand (BOT) in 2000.
His work experience includes modeling and forecasting, monetary policy strat-
egy, reserves management, financial stability assessment, and corporate strategy.
Aside from being the assistant chief representative of the Bank of Thailand at its
New York Representative Office in 2008–2009, Thammarak was sent by the Bank of
Thailand, and contracted as an IMF expert, to help the Reserve Bank of Fiji develop
its own macroeconometric model for use in the conduct of monetary policy.
Thammarak recently completed a master degree in public management at the
Lee Kuan Yew School of Public Policy, the National University of Singapore, where
he was on the Dean’s List for Meritorious Performance, and was a Lee Kuan Yew
Fellow at the John F. Kennedy School of Government, Harvard University. He has
a bachelor degree in economics from the London School of Economics and a PhD
in Economics from the University of Melbourne. Thammarak could be reached at
thammarm@bot.or.th.

xiii
 PART
One
An Introduction
to Central Banking

P art I provides background on central banking.

Chapter 1 briefly reviews the evolution of central banking since its start about
400 years ago and how different functions of central banks came about.
Chapter 2 provides background on the international monetary system. Central
banking has had an international dimension since the start, and to understand cen-
tral banking it is very important to know the international monetary system that
central banks operate in.
Chapter 3 reviews the functions of modern central banks. Although specifics do
differ among central banks, there are commonalities as well as differences among
modern central bank functions.
Chapter 4 reviews modern central bank mandates, that is, their key objectives.
Again, there are commonalities and differences across central banks. Three key man-
dates are discussed: monetary stability, financial stability, and (particularly in the
case of the United States) full employment.

1
 CHAPTER 1
A Brief Look at Central Banking History

Learning Objectives
. Describe historical roles and functions of central banks.
1
2. Explain how various central banking roles and functions came
about.
3. Define money and its relation to central banking.
4. Describe key commonalities and differences of modern central
banks.

H istorically, central banking is a relatively new phenomenon, tracing its origin to

about 400 years ago. In that relatively short period of time, however, central
banks have evolved to become among the most important public institutions, which
profoundly affect everyone’s daily life. This chapter briefly reviews the evolution of
central banking in various stages, so the reader will understand the background
of how central banks rose to become what they are today.
The chapter starts with the context in which the central bank was first created.
Earlier roles of central banks—such as coin sorting, banknote issuance, banker to the
government, and banker to banks—will first be discussed. Later, the chapter looks at
newer roles of central banks, such as the lender of last resort, bank supervisor, and
the conductor of monetary policy. Lastly, the chapter looks at the current stage of
central banking, especially in the wake of the 2007–2010 global financial crisis that
led to extensive reexamination of the role of central banks around the world.

1.1 PRIOR TO CENTRAL BANKING

Prior to the creation of central banks, societies often used precious metals such as
gold or silver as the means of transaction for goods and services. In economic terms,
precious metals were deemed suitable for being money, as they possessed three inher-
ent characteristics. First, these metals were widely accepted as a medium of exchange.
People were willing to trade their goods and services for precious metals, since they
believed that they could use the metals to trade for other goods and services that
they wanted to consume. Second, these metals were a good store of value. People
who received these metals could keep them for future trading for what they might

3
4 CENTRAL BANKING

want to consume. Unlike grains or livestock, precious metals were not perishable,
nor would they easily lose their luster. Third, they could be used as units of account,
for they could be divided into uniform pieces according to the assigned value.

1.2 COIN SORTING AND STORING

When a society developed to a certain degree, the use of precious metals as money
became more formalized and standardized. The metals were made into coins, which
made them easier to transport. They were also stamped with seals or signs certifying
their weight and value, which made it easier to recognize and classify them.
In Europe, by the seventeenth century, the use of coins in commerce became
more cumbersome and required more effort for merchants. Different sovereigns
introduced different makes of coins that were of different values and different metal
content but circulated quite freely across borders. Different vintages of coins of the
same nominal value from the same sovereign could also have different metal content,
as sovereigns sometimes sought extra revenue by introducing coins of the same value
with lighter and lighter metal content—that is, coin debasement.1
Furthermore, there were also risks that the coins might be worn out because of
usage, such that the precious metal content became diminished, or they might be
intentionally clipped, as people chipped out metal content from the coins.2
To ease the problems related to coin usage, in 1609 merchants and the city of
Amsterdam, a premier global trading hub of that time, decided to set up the Bank
of Amsterdam to do the tasks of sorting, classifying, and storing the coins. The suc-
cess of the Bank of Amsterdam prompted other European cities and sovereigns to set
up banks along the lines of the Bank of Amsterdam.3

1.3 BANKNOTE ISSUANCE

In 1656, the Bank of Stockholm was established in Sweden, in the fashion of the
Bank of Amsterdam. At first, the bank simply took in copper coins and lent out
against tangible assets such as real estate.4 Five years later, however, as the Swedish
parliament decided to reduce the amount of copper in newly minted coins, older
coins of the same nominal face value became more valuable owing to their greater
copper content. The public rushed to get their hands on the older coins, and the bank
run threatened the Bank of Stockholm’s survival.
The solution by the Bank of Stockholm to prevent the threat that it might run
out of coins was to issue notes of credit (called kreditivsedlar) to those depositors
who wanted to withdraw their copper coins. With their features of having fixed face
values in round denominations, no paid interest, and being freely transferable from
one holder to another, these kreditivsedlar were considered the first banknotes in the
modern sense.5 This solution was a success for about two years until the Bank of
Stockholm could not redeem the notes at their face values and the government had
to intervene.
In 1668, the Swedish parliament approved a new bank to replace the Bank
of Stockholm. Ultimately, that new bank became the present-day Swedish central
bank, the Sveriges Riksbank, currently the world’s oldest central bank. (The Bank of
A Brief Look at Central Banking History 5

Amsterdam collapsed in 1819, suffering losses from their investments in the Dutch
East India Company, which financed wars with England.6)
Despite the demise of the Bank of Stockholm, the use of banknotes as a medium
of exchange survived and gradually became embedded in our modern economies. As
merchants who had coins deposited at the bank traded goods and services among
themselves, it was clearly easier for them to transfer their coin ownerships at the
bank without withdrawing those coins to settle their trades. Therefore, it was also
easier for the bank to just issue notes for those who owned coins held at the bank
so that they could use the notes to trade with those without accounts at the bank. In
the few centuries after the pioneer banknote issuance by the Bank of Stockholm,
banknote issuance became popular in many countries, but was not confined only
to banks established by governments or sovereigns. In many countries, privately
owned banks were also granted the right to issue their own banknotes.

1.4 BANKER TO THE GOVERNMENT

The Swedish Riksbank was chartered to not only act as a clearinghouse for mer-
chants but also to lend funds to the government. Later on, many other central banks
were also created to help finance government spending, particularly to finance wars.
These included (1) the Bank of England, which was founded in 1694 as a joint stock
company to finance the war with France and was later also given the privilege of
handling the government’s accounts;7 (2) the Bank of France, which was created
in 1800 both to help with government finances and to issue banknotes in Paris
(for which it was given a monopoly), partly to help stabilize the economy after
the French Revolution brought hyperinflation of paper money;8 and (3) the Bank
of Spain, which could trace its roots to 1782 when its predecessor was founded to
finance the country’s participation in the American War of Independence, although
it was not until 1856 that the predecessor bank was merged with another bank to
form the Bank of Spain.9
By helping to finance government spending and manage government finances,
these early central banks enjoyed close relationships with their governments, along
with good profits. As lenders to their governments, notes issued by these early cen-
tral banks gained wide acceptance, since they were implicitly backed by the promise
of repayment by their sovereigns. In the case of the early Bank of England, it could
simply issue notes to match the sum lent to the government. In such a case, the
notes (dissimilar to modern banknotes, since their face values were variable, as
the amounts were handwritten by the cashier) were not backed by precious metals,
but by the implicit promise of the government to pay.10

1.5 BANKER TO BANKS

By the nineteenth century, central banks’ close ties to their governments and the wide
acceptance of their banknotes (or in many cases, their monopoly on note issuance)
helped induce commercial banks to also open accounts and place their deposits
with the central banks, effectively becoming their clients. Consequently, the central
banks became banker to the commercial banks, in addition to being banker to the
6 CENTRAL BANKING

government. The banker-to-banks role became more and more pronounced as the
foundations of modern banking started taking shape.
In the case of nineteenth-century England, small banks proliferated in small
towns doing business such as discounting merchants’ bills. These small-town banks
often sought out larger London commercial banks as their correspondent banks, to
deposit and invest their funds and conduct other transactions. The London com-
mercial banks, in turn, often found it easier to settle claims among themselves using
Bank of England notes, as the Bank of England had a monopoly on note issuance
within a 65-mile radius of London.11
Even more conveniently, the commercial banks could open deposit accounts at
the Bank of England and use these accounts to settle claims among themselves or to
keep reserves. By being the key repository and clearinghouse for commercial banks
whose own networks of correspondent banks could be far-reaching, the Bank of
England’s function as a banker to banks became notable and helped in defining the
bank as a central bank. The Bank of England’s banker-to-banks role would become
a model for many central banks to later emulate.

1.6 PROTECTOR OF THE FINANCIAL SYSTEM: LENDER

OF LAST RESORT

Early banking systems were very prone to panics and bank failures. By nature, banks
and other financial institutions borrowed funds from depositors for short maturity, and
lent out those funds as loans for longer maturity. Diverse events such as bad harvests,
defaults, and wars could cause bank depositors to panic and rush to withdraw their
funds, putting debilitating pressures on the banks, since they might not be able to call
in loans fast enough to repay the depositors.
By the early nineteenth century, it was well recognized that financial panics and
resulting bank failures could be very disruptive and costly to commerce and the soci-
ety at large, and not just financially ruinous to those directly involved. Successfully
calming panics and rescuing banks, however, required many factors, including deep
pools of financial resources, extensive networks in the financial system, operations
know-how, and public confidence. This put central banks in a unique position to
assume the role of protector to the financial system, owing to their close ties to their
governments, large reserves, extensive networks with correspondent banks, and (in
many cases) monopoly over note issuance.12
At first the central banks were very reluctant to lend to distressed correspon-
dent banks, preferring to devote their efforts to the protection of their own gold
reserves. Central banks still regarded themselves primarily as banks, not public
institutions. Any rescue of distressed banks could thus be regarded as a rescue of
competitors.13
With major financial panics proving detrimental to everyone, however, in the
latter half of the nineteenth century the Bank of England responded to growing criti-
cism by taking on the responsibility of lender of last resort to distressed banks. To
protect itself from losses, and to prevent abuses by commercial banks, however, the
bank would lend to troubled banks only if sound collateral was posted and would
charge interest above market rates for such lending.14
A Brief Look at Central Banking History 7

Notably, it was also this need to have a central bank to respond to financial pan-
ics that led a revival of central banking in the United States. Prior to 1913, the United
States had two central banks, which were modeled after the Bank of England—that
is, the Bank of the United States (1791–1811) and the Second Bank of the United
States (1816–1836)—but their charters were not renewed owing to the public’s dis-
trust of concentrated financial power. During the 80 years that the United States
did not have a central bank, bank panics and bank failures were frequent. A severe
banking crisis in 1907 highlighted the need for a central bank in the United States
and led to the creation of the Federal Reserve System in 1913.15

1.7 BANK SUPERVISOR

By adopting the lender-of-last-resort function, central banks were taking on risks

that could damage their own capital, since they might be unable to recover all the
money they had put into the rescue of troubled banks. This was particularly true in
cases where troubled commercial banks were facing solvency problems (their debts
exceeded their assets and capital combined), as opposed to mere liquidity problems
(their debts did not exceed their assets and capital combined, but they could incur
losses as they tried to liquidate their assets to meet their liabilities). In practice, the
fact that it was not easy for the central banks to distinguish between solvency and
liquidity problems without knowing details of the troubled banks’ books also made
it very risky for the central banks to take on a bank rescue mission.
To guard against possible losses on their own balance sheets, it was natural that
central banks would seek to assess the creditworthiness of banks they were attempt-
ing to rescue. This required prior familiarity with the commercial banks’ operations
and balance sheets. Naturally, it was also in the central banks’ interests to ensure
beforehand that all commercial banks were operated in a safe and sound manner, so
that they would not easily fall into trouble.
To ensure the safety and soundness of commercial banks’ operations ex ante,
many central banks found it beneficial to have a formal authority to inspect commer-
cial banks’ operations, examine commercial banks’ books, and possibly give regula-
tory orders to the banks when deemed fit. In other words, following the assumption
of the lender-of-last-resort role, central banks started to assume formal bank regula-
tory and supervisory functions.
In practice, however, the bank supervisory role only became possible when
the central bank came to be regarded primarily as a public institution acting
in the public interest, rather than as another competitor bank acting to gain more
profits. The notion that central banks were public institutions acting in the public
interest only became widely accepted after 1914 in the wake of World War I, as
many governments resorted to using the central banks for their wartime financial
management.16
Even by then, however, not all central banks had embraced the bank supervisory
role. In countries where bank rescues were funded primarily by taxpayer money (as
opposed to the central banks’ own capital), the bank supervisory role had tradition-
ally been put under the jurisdiction of public authorities that had injected the most
money; for example, the Ministry of Finance. In such countries, notably Germany,
8 CENTRAL BANKING

bank supervision was traditionally conducted primarily by institutions other than

the central bank.17

CASE STUDY: The Debate on the Function of the Central Bank as a Bank Supervisor

By the late 1990s a number of central banks, including the Bank of England, the Bank of Japan, and
the Reserve Bank of Australia, started to relinquish their bank supervisory role to outside agencies.
Key reasons for the separation between the central bank and the role of bank supervisor included
(1) changes in the financial system, partly through the liberalization process that had begun in the
late 1970s, which were blurring the lines between banks and other nonbank financial institutions, and
(2) the fear that the bank supervisory function would be in conflict with the central banks’ other grow-
ing function, that is, that of a conductor of monetary policy.18
First, changes in the financial system that blurred the lines between different types of financial
services—for example, banking, insurance, and fund management—suggested that bank supervision
should probably be organized by the purpose of supervision—that is, systemic stability (prudential super-
vision) and consumer protection—rather than by types of market services. Therefore, bank supervision
should be housed in a separate regulator that also supervised other nonbank financial institutions.19
Second, as a conductor of monetary policy, the central banks would have to adjust money condi-
tions in the economy to ensure stability of the economy. With the bank supervisory function remaining
at the central banks, however, it was feared that the central banks might be reluctant to adjust money
conditions as required if the adjustments had the potential to jeopardize profitability and balance sheets
of commercial banks under their supervision.20
In contrast, reasons for keeping the banking supervisory function within the central bank included
(1) information sharing for the conduct of monetary policy, where microlevel information from bank
supervisors could help the conductor of monetary policy understand the state of the economy better,
thus making for better monetary policy decisions, and (2) information sharing with regard to payment
systems and market activities, since a separate bank supervisor might find it difficult to access real-
time information on the banks’ payment traffic, positions with the central bank, and their standing in
financial markets.21
The 2007–2010 global financial crisis, however, added another twist to the debate on whether
the central banks should take on a bank supervisory role. In the United Kingdom, coordination failure
among the three key regulators (the central bank, the financial supervisory agency, and the govern-
ment) was cited as one reason contributing to the emergence of bank runs in the United Kingdom,
as well as ineffectiveness in management of the runs. By 2011, the U.K. government decided to put
supervisory function (prudential regulation) of various types of financial institutions back into the
Bank of England, and create a new, separate entity responsible for consumer protection and the promo-
tion of healthy competition among financial institutions.

1.8 CONDUCTOR OF MONETARY POLICY

Given that the early central banks already had a stronger financial status than other
banks, their banknotes were very much trusted by the public. To sustain such trust,
many of them embarked on the gold standard, whereby they would fix the value
of their money to gold, and only issue an extra amount of money if they had gold
reserves to match that extra amount of money. Afterward, however, disruptions—
such as wars and the fact that the global gold supply was (and is) limited—helped
force central banks off gold as a standard. By the mid-twentieth century, central
banks had started to gradually learn that, in the short run, monetary policy could be
used actively to affect output, inflation, and employment.
A Brief Look at Central Banking History 9

The Gold Standard and Passive Monetary Policy

Following the lead by England, by the late nineteenth century the trend among exist-
ing and emerging central banks was to adopt the gold standard, which meant that
the central banks could issue money only according to the value of gold they held.
At the time, central banks were less concerned about how the amount of money
being introduced into the system might affect economic activities. The central banks
passively varied the amount of money they printed according to the amount of gold
they had, rather than actively printing money to stimulate economic activities. The
key concern of most central banks was to keep the value of money fixed to gold at
the announced level.22
During World War I the gold standard was practically discarded, as countries
abandoned the gold peg so they could print money to finance their war efforts more
freely. After World War I ended, realizing that there was not enough gold for every
central bank to hold to back their domestic currencies, the international community
embarked on the gold exchange standard. Under this system the major countries
pegged the values of their currencies to gold, and smaller countries used the curren-
cies of major countries, in addition to gold, as reserves to back their own domestic
currency.
The focus on pegging the value of currency to gold remained even during the
Great Depression in the 1930s. Even though by the end of World War I in 1919 cen-
tral banks were already starting to be more concerned about employment, economic
activity, and price levels, they still put greater focus on gold reserves.23 At the time,
understanding of the nature of the relationships between the amount of money intro-
duced, economic activity, employment, and price levels was still relatively vague.*

Bretton Woods and the Move toward Activist Monetary Policy

By the 1950s, through the influence of John Maynard Keynes, governments and cen-
tral banks became aware of the possibility of affecting economic activities through
the use of activist fiscal and monetary policy. At that time the international com-
munity had already adopted a new international monetary framework, which came
to be known as the Bretton Woods system, to replace the gold standard. Under the
Bretton Woods system the United States would peg the value of its currency, the U.S.
dollar, to gold at 35 U.S. dollars per ounce, and other countries would fix the value
of their currencies to U.S. dollars. Effectively the Bretton Woods system was a global
fixed exchange rate system, under which countries would fix their exchange rates to
the U.S. dollar, whose own value was fixed to gold.
By the 1960s the use of activist monetary policy in the United States, especially
to stimulate economic activity and reduce unemployment, became dominant. The

*Although at its start in 1913 the U.S. Federal Reserve had been given the mandate of provid-
ing a “uniform and elastic currency” (i.e., currency that could expand or contract in volume
according to the demands of business)—which meant that the Fed could increase the money
supply when there was an extra need for money, such as during banking panics, and reduce
the money supply when conditions warranted—the Fed, for various reasons, did not seriously
attempt to influence economic conditions using the money supply until at least the 1950s
(Bordo 2007).
10 CENTRAL BANKING

activist monetary policy, together with rising fiscal spending by the U.S. government,
however, also led to accelerating inflation in the United States. Investors as well as
governments of countries that pegged the value of their currency to the U.S. dollar
became concerned that inflation was fast eating away the purchasing power of the
U.S. dollar in terms of goods and services.
The tie between the U.S. dollar and gold also came to be questioned as the
United States kept issuing more and more money, despite its fixed supply of gold.
At that time, international trade and capital flow were starting to resume, as many
countries completed their rebuilding efforts after World War II and started liberal-
izing their economies. Greater international capital movements put pressure on the
currency of those countries that persistently imported more than they exported and
led to speculative attacks on many of those currencies.

Taming Inflation: Money Supply Growth Targeting

By the early 1970s the Bretton Woods system became untenable. Faced with inflation
pressure and attempts by many countries to exchange their U.S. dollar holdings into
gold from its vault, the United States decided to delink the U.S. dollar from gold.
Frequent speculative attacks also forced many countries to abandon pegging their
currencies to the U.S. dollar, instead allowing their currencies to float.24
By the late 1970s it became increasingly recognized that the use of activist mon-
etary policy to persistently stimulate the economy did more harm than good in the
long run. Theoretical developments and experience suggested that in the conduct
of monetary policy, central banks might need to follow an explicit rule, rather than
using pure discretion. It was also suggested that central banks be made operation-
ally independent from their governments, since elected politicians had the tendency
to stimulate the economy for short-term gains rather than seeking the longer-term
benefit of economic stability.25 In being operationally independent, the central bank
would still have to follow the mandates set by publicly elected officials (e.g., a coun-
try’s parliament or the U.S. Congress), but once those mandates (e.g., monetary
stability) were set the central bank would have the operational independence to
perform operations to fulfill the mandates.
To rein in inflation expectations that had been spiraling upward since the
mid-1970s, in the late 1970s and early 1980s central banks in the United States
and the United Kingdom decided to sharply tighten money supplies and expressed
determined commitment to follow an explicit money supply target rule. By adopt-
ing explicit money supply targets the central banks committed themselves not to
overprint money, such that money lost its value too fast (i.e., inflation rises exces-
sively). Despite the initial success in bringing down inflation, however, less than half
a decade later money supply targeting was abandoned in both the United States and
the United Kingdom, when the relationship between the money supply and real eco-
nomic activity was found to be unstable.26
During the latter half of the 1980s it could be said that central banks were effec-
tively in search of a nominal anchor for the conduct of monetary policy. At that time,
while many small countries still chose to fix their exchange rates to the U.S. dollar
and benefited from easy international trade facilitation as well as relatively low U.S.
dollar inflation (which also brought about low inflation for their own currencies),
A Brief Look at Central Banking History 11

macroeconomic mismanagement often later led to successive devaluations of their

currencies as well as persistently high inflation.27

Maintaining Monetary Stability: Inflation Targeting

In New Zealand, the search for a new nominal anchor for monetary policy led to the
formal adoption of inflation targeting as the monetary policy regime for the Reserve
Bank of New Zealand (RBNZ) in 1989. The regime, which has since been adopted
and modified by many other central banks worldwide, has three key elements: (1) an
announced numerical inflation target over a time horizon, (2) an implementation of
monetary policy that aims to keep inflation forecasts within the target over the time
horizon, and (3) a high degree of transparency and accountability.28
To keep inflation within the announced target in an inflation-targeting regime,
the central bank adjusts its policy interest rate over time, with the aim of influenc-
ing the cost of borrowing in the economy and thus economic activity and inflation.
Inflation targeting has become popular partly because it emphasizes transparency
and accountability in the conduct of monetary policy.29 The central bank under infla-
tion targeting will report its reasons for its decisions in the adjustments of the policy
interest rate. The public can also see for itself if the central bank is able to keep
inflation within the announced target or not. If the inflation target is not achieved,
then the governor of the central bank might be required to explain the reason to the
government or the parliament.
After RBNZ adopted inflation targeting in 1989, central banks of many advanced
and emerging market countries around the world also adopted many variations
of inflation targeting as their monetary policy regime. Central banks of advanced
economies that have adopted inflation targeting include the Bank of England, the
Reserve Bank of Australia, the Bank of Canada, and the Swedish Riksbank, among
others. Among the numerous emerging-market economy central banks, such names
as Czech National Bank, Bank of Brazil, Bank of Chile, Bank of Indonesia, Bank of
Israel, Bank of Korea, Bank of Thailand, and South African Reserve Bank reflect a
great diversity of inflation targeting countries.
After the 2007–2010 global financial crisis, the U.S. Federal Reserve and the
Bank of Japan also adopted inflation targets as a guide for their monetary policies.
At the moment, however, both of these central banks are still using quantitative
easing—a nonorthodox form of monetary policy—to aid their economic recoveries.
In the case of Japan, the inflation target can be seen as an aspiration of the country
to get out of the recurring bouts of deflation that have afflicted the economy since
the burst of its spectacular asset-price bubbles in the early 1990s.

Common Currency: The Creation of the Euro

In 2000, a notable development in central banks’ conduct of monetary policy took
place in the form of the formal introduction of a common currency, the euro, which
replaced national currencies in the 11 founding-member countries of the European
Union. In that year, the national central banks of the 11 founding-member countries
relinquished their role as the conductor of monetary policy for their countries in
favor of the European Central Bank (ECB). The ECB would now conduct monetary
policy for the member countries of the euro area.30
12 CENTRAL BANKING

1.9 THE CURRENT STAGE OF CENTRAL BANKING

Modern central banks have many commonalities, as well as differences, depend-

ing on their historical contexts and their guiding philosophies. Most modern cen-
tral banks now focus on delivering low, stable inflation and financial stability, and
are prohibited from directly financing government spending. To deliver low, stable
inflation and financial stability, however, different central banks often take different
operational approaches. Furthermore, the full-employment mandate reemphasized
by the Federal Reserve in the wake of the 2007–2010 financial crisis still remains
quite unique.

Commonalities in Modern Central Banking

Despite differences in the timing and circumstances of their origins, by the late 2000s
it could be argued that modern central banks shared a number of underlying com-
monalities: (1) the focus on the maintenance of monetary stability, (2) the focus
on the maintenance of financial stability, and (3) the prohibition on direct lending
to the government.
First, on the monetary stability front, as will be discussed more in detail in later
chapters, theoretical developments over the past four decades and various high-
inflation experiences around the world suggest that to support long-term economic
growth, the best thing a central bank can do is to deliver an environment of mon-
etary stability; that is, an environment in which inflation is low and stable. In such an
environment, households and firms are more likely to be able to optimize investment
and consumption. This stands in contrast to the call for a central bank to always
keep directly stimulating the economy. The continued stimulation of the economy
is likely to result in an upward spiral of inflation, which prevents households and
firms from making optimal decisions.
Second, on the financial stability front, experiences from various financial crises
around the world (particularly the 2007–2010 global financial crisis) suggest that to
ensure long-term economic growth, central banks should have a direct role in the
maintenance of financial stability, and that this role should apply regardless of whether
the central bank has a bank supervisory function. Central banks can help maintain
financial stability, either as regulators who help to ensure that the system is resilient
beforehand, or as lenders of last resort who help prevent the total collapse of the finan-
cial system. A smooth functioning financial system ensures that capital is distributed
efficiently, and is thus vital to the long-term, sustainable growth of an economy.
Third, although many early central banks were originally founded to help finance
their governments, direct lending by the central bank to the government is now often
prohibited in most modern economies, as it was found to lead down the dangerous
path of hyperinflation. Direct lending to the government is akin to printing money
and giving it to the government so that the government can use it to finance its pur-
chases of goods and services. Printing money and giving it directly to the government
cheapens the value of money relative to other goods and services. Under the law of
supply and demand, the more the central bank supplies money, the lower the price
(or the value) of money will be. If done in massive amounts the purchasing power of
money could fall very fast, since people will no longer trust that the money in their
hands is a good store of value, which could easily result in hyperinflation.
A Brief Look at Central Banking History 13

It should also be noted that at this current time in history, coin sorting has
largely been dissociated from modern central banking, owing to either impracticality
or principles that later emerged. In most countries coins are now issued by the mint,
which is a part of the treasury or the finance ministry, not the central bank. Banknote
issuance monopoly, on the other hand, has become deeply ingrained in the psyche of
the public and central banks, such that it has started to blend into the background
of central banking.

Diversity in Modern Central Banking

Even after the turn of the millennium, however, as the consensus on the roles of central
banks had started to coalesce around monetary and financial stability, noticeable key
underlying differences remain, including (1) the actual operations in the maintenance
of monetary stability, (2) the institutional setup with regard to the maintenance of
financial stability, and (3) the explicit role of central banks in ensuring full employment.
First, with respect to the maintenance of monetary stability, the approaches
taken by individual central banks to achieve this goal can be vastly different. As will
be discussed in more detail in Chapters 6–9, central banks can choose among dif-
ferent monetary policy and exchange rate regimes in the maintenance of monetary
stability, depending on their individual contexts and circumstances.
For example, although a growing number of central banks have begun to adopt
inflation targeting as their monetary-policy framework, a number of influential cen-
tral banks, including the Peoples’ Bank of China (PBOC) and the ECB, remain stead-
fastly without an official inflation target.
Among inflation-targeting central banks, many nuances remain, including the
nature of the target (e.g., the inflation target level and time horizon for achieving
the target). Meanwhile, noninflation-targeting central banks of small open econo-
mies, such as the Monetary Authority of Singapore and the Hong Kong Monetary
Authority, could choose to rely quite heavily on the management of the exchange
rate as a way to maintain monetary stability.
Second, on the financial stability front, there is a divergence with regard to bank
supervisory function. In the 1990s a number of central banks, including the Bank of
England, the Bank of Japan, and the Reserve Bank of Australia, delegated their bank
supervisory function to an outside regulatory agency. As discussed earlier, however,
the Bank of England, after the 2007–2010 global financial crisis, absorbed back its
(enhanced) supervisory function, a function which more than a decade earlier had
been delegated to an outside regulatory agency.
The ECB, on the other hand, did not have a supervisory function until 2014,
since after the creation of the euro the national central banks of E.U. member coun-
tries had retained that function. Only in 2013, after the height of the euro area
crisis in the early 2010s, did the push for the ECB to assume supervisory function
responsibilities get passed.31 A large number of central banks, including the Federal
Reserve, meanwhile have always retained their bank supervisory function (although
in case of the United States, bank supervisory function is also done by other regu-
latory agencies, including the Office of the Comptroller of the Currency, and the
Federal Deposit Insurance Corporation).
Third, as will be discussed in Chapter 4 in more detail, the Federal Reserve has
full employment as a legal mandate, which is quite a notable distinction among
14 CENTRAL BANKING

modern central banks. Prior to the 2007–2010 global financial crisis, the Federal
Reserve tended to tone down in its communications with regard to its role in ensur-
ing full employment, possibly for fear that it might confuse the public, since in the
short run there is a tradeoff between employment and inflation. To push unemploy-
ment down, the central bank might need to allow inflation to go up in the short
run. However, if the central bank allows inflation to go up, it might appear that the
central bank is willing to compromise on monetary stability.
To avoid such confusion, many central banks prefer to frame full employment
as being a part of long-term sustainable economic growth, which can be provided
by monetary stability. In the wake of 2007–2010 global financial crisis, however,
as the U.S. unemployment rate went up and the economy faced the threat of defla-
tion rather than inflation, the Federal Reserve again emphasized its full-employment
mandate when it needed to employ an unconventional monetary policy by injecting
massive amounts of money into the economy through quantitative-easing measures.

Self-Reexamination after the 2007–2010 Global Financial Crisis

The global financial crisis that transpired from 2007–2010 came as a shock to most
central banks. (The details of the 2007–2010 financial crisis will be reviewed briefly
in Chapter 2.) The crisis jolted the central banks to again reexamine their roles and
functions.
Many central banks whose countries were worst hit by the crisis, including the
Federal Reserve, the Bank of England, and the ECB, had all resorted to unconven-
tional monetary-policy measures, such as the purchase of government securities
and massive liquidity injections. In the United States and the United Kingdom,
unconventional monetary policy was used by the central banks to help prevent
their economies from falling into a deflationary spiral. In the case of the ECB,
unconventional monetary policy was used not only to help alleviate the economic
plight of some of their member countries, but also to preserve the existence of the
euro system itself.
With the global financial crisis, the central banks’ roles with respect to financial
stability are also being reexamined in depth by various stakeholders. A consensus
has seemed to emerge that central banks need to take a more active role in dealing
with financial stability. Relying on market forces to regulate themselves has already
proved to be quite futile, as short-term incentives of market players might be mis-
aligned with the society’s long-term interests.
There are also issues of practicality with respect to the institutional setup of
central banks. As will be discussed in later chapters in more detail, coordination
difficulties during the crisis prompted the U.K. government to return the bank
supervisory role to the Bank of England, after the role had earlier been carved out
in the 1990s.
Even half a decade after the crisis first started, the global economy is still trying
to find its footing. Reexaminations of central banking roles are still ongoing, and
reforms are still being debated worldwide (see details in Chapter 14). In the next
chapter, to provide a broad background on the context in which modern central
banks are operating in, we will review the evolution of the international monetary
system. Functions of modern central banks will then be discussed in Chapter 3.
A Brief Look at Central Banking History 15

SUMMARY
Central banking has evolved considerably since its start about 400 years ago. Starting
with coin sorting and storing, and in certain cases war financing, central banks have
taken on the functions of banknote issuers, banker to the government, banker to
banks, protector of the financial system, bank supervisor, as well as conductor of
monetary policy.
Currently, there are commonalities as well as diversity in modern central bank-
ing. Commonalities include (1) the focus on monetary stability, (2) the focus on
financial stability, and (3) the prohibition on direct lending to the government.
Differences include (1) operational differences in the pursuit of monetary stability,
(2) the institutional setup with regard to the maintenance of financial stability, and
(3) the explicit role of central bank in ensuring full employment.

KEY TERMS
activist monetary policy inflation targeting
bank supervisor lender of last resort
banker to banks medium of exchange
banker to the government monetary stability
banknote issuance money supply growth targeting
financial stability operational independence
full employment passive monetary policy
gold exchange standard store of value
gold standard units of account

QUESTIONS
1. What are the key characteristics of money?
2. What were the problems with the use of coins as a means of payment in
seventeenth-century Amsterdam?
3. How did banknote issuance first come about as a central banking role,
particularly in the case of the Bank of Stockholm?
4. What are key characteristics of banknotes, as compared to other IOUs?
5. What might be key advantages for early central banks in acting as bankers to
their governments?
6. Why might central banks be in a unique position to become protectors of the
financial system?
7. Why might a central bank emerge as a banker to commercial banks?
8. Why should a central bank supervise commercial banks?
9. Why should a central bank not supervise commercial banks?
10. Why might we perceive central banks in the gold standard era as pursuing
passive monetary policy?
11. What might activist monetary policy try to achieve?
12. What could be the reasons preventing modern central banks from directly
financing government debt?
16 CENTRAL BANKING

13. Why might we want central banks to be operationally independent from the
government?
14. What are key characteristics of inflation-targeting central banks?
15. What are some commonalities of modern central banks?
16. What are some of the key differences among modern central banks?
17. Why might we not consider livestock as money, even if it could be used to trade
for goods and services in agrarian economies?
18. The government is seeking to directly borrow money from the central bank
in order to invest in a large infrastructure project that could help improve the
livelihood of its citizens. Should the central bank agree to lend to the government?
Why or why not?
 CHAPTER 2
A Brief Overview of the International
Monetary System

Learning Objectives
1. Describe key features and explain limitations of the gold standard.
2. Describe key features and explain limitations of the gold exchange
standard.
3. Describe key features and explain limitations of the Bretton Woods
system.
4. Describe key features of the international monetary system after
the collapse of the Bretton Woods system.
5. Explain plausible causes of the global financial crisis of 2007–2010.

I n Chapter 1 we reviewed a brief history of central banking. In this chapter we

will take a brief look at the evolution of the international monetary system to
better understand the context in which central banking practices have evolved.
International elements have always been present in the history of central banking,
since the day that the Bank of Amsterdam was set up to sort out coins of different
makes by different sovereigns. With the advent of the gold standard, central banks
pegged the value of their currencies to the value of gold. As the global economy
evolves, central banking practices continue to evolve along with it.
This chapter divides the history of the international monetary system into
four sections. The first section covers the historical period before the end of World
War II, and includes specifically the gold standard, the gold exchange standard, and
the global financial turmoil of the early twentieth century resulting from World War
I and World War II.
The second section covers the period after World War II to the early 1970s (i.e.,
the period of the Bretton Woods system). Despite its demise in the early 1970s, the
Bretton Woods system was the start of the modern international monetary system as
we know it today. Two global institutions that were initiated during the creation of
the Bretton Woods system, the International Monetary Fund (IMF) and the World
Bank, are still at work and remain influential in the global economic and financial
environment today.

17
18 CENTRAL BANKING

The third section covers the period after the breakdown of the Bretton Woods
system. Here the highlights will be (1) the global inflation problem in the 1970s
which led to a rethinking of the ultimate goal in monetary policy and the role of
central banks in managing the economy; (2) the speculative attacks on emerging-
market currencies in the 1990s, which led to the abandonment of fixed exchange rate
regimes in many countries; (3) the introduction of the euro in 2000, which became
another popular currency for international trade and finance; and (4) the global
financial crisis of 2007–2010 that still has ongoing effects.

2.1 EVOLUTION OF THE INTERNATIONAL MONETARY

SYSTEM: BEFORE THE END OF WORLD WAR II

From the eighteenth century to the onset of World War I in 1914 the international
monetary system was based largely on the gold standard. World War I prompted
many countries to abandon the gold standard so that they could effectively finance
their wartime expenditures. After World War I the attempts to return to the gold
standard had never really succeeded.

The Gold Standard

From the eighteenth century and the onset of World War I in 1914, the influence of the
Bank of England on the global financial system rose with the premiere status of
the British Empire. During that period, the Bank of England pegged the value of the
pound sterling to that of gold, prompting other nations—including Germany and
Japan—to emulate it. The system whereby countries peg the value of their currencies
to gold is known as the gold standard.1
Under the gold standard, central banks have the mandate of keeping their
­currencies at announced values in terms of gold. In such a system, the amount of
money in circulation is dictated by the amount of gold the central bank has at its
disposal. The central bank can only print more money if it has enough gold to back
up that extra amount of money. It is worth noting that under the gold standard, the
amount of gold the central bank has depends in part on the size of the balance of
payment deficit or the surplus that the country is running. A country with a balance
of payment deficit has to pay out of its gold holdings, while a country with a balance of
payment surplus would receive gold payments.

The Gold Exchange Standard

During World War I many countries abandoned their gold peg and resorted to fund-
ing their war expenditures by printing money. This printing of money, together with
the scarcity resulting from war damages—whether in terms of manpower, factories
and equipment, raw materials, or reduced production capabilities—pushed inflation
up rapidly by the time the war ended in 1918.2
At the International Economic Conference held in Genoa, Italy, in 1922, many
countries showed a willingness to return to the gold standard. However, since there was
not enough gold for every central bank in the world to hold as reserves, it was agreed
A Brief Overview of the International Monetary System 19

that the smaller economies would hold currencies of the major economies as reserves,
while the major economies would hold gold against their issued currencies. The sys-
tem under which smaller countries held currencies of the major economies partially as
reserves became known as the gold exchange standard.3

The Great Depression and the 1930s: Turmoil in the International

Financial System
In 1919, even before the Genoa Conference in 1922, the United States had already
returned to the gold standard by pegging the value of its currency to gold. In 1925
England followed suit, fixing the value of its pound sterling to gold at the level it
had held prior to World War I. The decision to fix gold at the level that existed prior
to World War I was made on the basis that it would help the credibility of British
financial institutions, which were leaders during the gold standard era. By 1925,
however, prices of goods and services in England were already at levels higher than
prior to the war. The Bank of England thus had to tighten its monetary policy to
push the sterling value of the gold peg up to the prewar level. The tightening of mon-
etary policy severely pushed up British unemployment, hurt the British economy,
and undermined confidence of other countries in holding their reserves in the form
of deposits in London banks.4
In 1929, the global economy started to edge into a decade-long decline that
became known as the Great Depression. Recent research shows that the gold stan-
dard was a key contributing factor to the starting, the severity, and the spreading of
the Great Depression. By that time, most trading economies had already returned
to the gold standard. With the U.S. central bank tightening its monetary policy in
order to slow down its overheating economy, large amounts of gold started to flow
into the United States. In order to preserve their own gold reserves, other countries
also had to tighten their monetary policies and raise interest rates. This led to a
worldwide contraction of monetary policy, which also brought about a sustained
contraction in economic activity and a sustained reduction in the general price level
(i.e., deflation).5
The global economic decline also led to failures of a large number of finan-
cial institutions worldwide, which deepened and widened economic contractions
further. The confidence in the gold exchange standard also declined. As countries
started to convert their pound sterling holdings into gold, Britain was forced to
again abandon the gold standard in 1931. The decision by many countries to aban-
don the gold standard during the Great Depression badly affected countries that
chose to keep the value of their currencies fixed to gold. This also helped generate
animosity among countries, since many countries that dropped the gold standard
also devalued their currencies to curb imports and protect domestic employment.
The competitive devaluation of currencies, also known as a beggar-thy-neighbor
policy, often prompted retaliations from those affected, frequently via trade barriers.
During this turmoil, exchange rate volatility, trade restrictions, and deflation in the
major economies in North America and Europe pushed Latin American countries to
repudiate their foreign debts. The failure of the international financial system in the
1930s was something that the designers of the global financial system after World
War II kept in mind.6
20 CENTRAL BANKING

2.2 EVOLUTION OF THE INTERNATIONAL MONETARY

SYSTEM: THE BRETTON WOODS SYSTEM

After World War II, the international community agreed to embark on a new inter-
national monetary system, that is, the Bretton Woods system, which was named after
the place where the agreement initially took place. Under this system, the United
States would hold gold as reserves and fix the value of the dollar at $35 per 1 ounce
of gold. As the U.S. government started incurring heavy deficits, partly to finance the
Vietnam War, the pressures on the system mounted and the Bretton Woods system
was abandoned by the early 1970s.

The Bretton Woods System

In July 1944, delegates from 44 countries convened in Bretton Woods, New
Hampshire, to design a new international monetary system. The aim of the design
was to prevent the mistakes of the 1930s from recurring. Lessons from the 1930s
suggested that to prevent future international financial turmoil, the new interna-
tional monetary system should help countries sustain low inflation while also allow-
ing them to achieve their goals with respect to balance of payments stability and full
employment without the need to resort to trade protectionism.7
Under this new system, the value of all other currencies would be pegged to the
U.S. dollar, the currency of the most powerful country to emerge from World War II,
and also a country with long records of low inflation. The value of the U.S. dollar
itself would be pegged to gold, at 35 U.S. dollars per ounce. Members of the system
could hold reserves in terms of gold or in terms of U.S. dollar-denominated assets.
Member countries had the right to sell U.S. dollar assets to the U.S. central bank (the
Federal Reserve) and receive payments in gold at the announced exchange rate. In
other words, under this new system all other countries would peg their currencies to
the U.S. dollar, while the value of the U.S. dollar would be pegged to gold.
To help ensure long-term stability in the global economy, two new international
institutions were also proposed for creation during the Bretton Woods meeting. The
International Monetary Fund (IMF) was created to help member countries cope
with their domestic employment problems without resorting to trade protection-
ism. The World Bank was created to help with the long-term development of less
advanced countries.8

The International Monetary Fund

Experiences from the Great Depression and the turmoil in the international mone-
tary system in the 1930s showed that ultimately governments often put more empha-
sis on holding down domestic unemployment than keeping their exchange rates
at the announced fixed level. When domestic unemployment rose, countries often
resorted to trade protectionism and competitive devaluations of their currencies,
which threaten global economic stability. The goal of the IMF was to help member
countries cope with their domestic unemployment problems, without resorting to
trade protectionism and competitive devaluations of their currencies.9
To achieve its goal, the IMF relied on two main mechanisms. First, the IMF
would raise funds from the member countries in the form of currencies and gold,
A Brief Overview of the International Monetary System 21

so that the IMF could lend to member countries facing balance of payment prob-
lems. Second, although exchange rates of the member countries were pegged to U.S.
dollars at certain levels, if necessary the IMF might consent to adjustments in the
exchange rates. The IMF’s consent to exchange rate adjustments, however, would
be given only when exchange rates were deemed inconsistent with long-term funda-
mentals. For example, consent might be given when the global demand for a coun-
try’s goods and services was deemed to be permanently reduced and the country was
facing persistent serious unemployment and balance of payment deficit problems.10
Under the IMF agreement, when countries were ready they would also start to
let their currencies be freely converted to other currencies. After World War II, how-
ever, most countries were still worried about the prospects of capital outflows, and
thus restrictions were often imposed on the convertibility of their currencies. In 1945
only the United States and Canada allowed their currencies to be fully convertible.
The early free convertibility of the U.S. dollar, along with the U.S. dollar’s unique
characteristics in the Bretton Woods system, helped the popularity of the U.S. dollar
as a medium of exchange in international trade and finance.11

Pressures on the Bretton Woods System

With foreign exchange rates being anchored to the U.S. dollar and the value of the
U.S. dollar itself pegged to gold, the Bretton Woods system helped provide much
needed global economic stability from the late 1940s to the early 1960s, when coun-
tries were rebuilding their economies after World War II. By the late 1960s, however,
three major forces were already putting strain on the system: (1) freer flows of inter-
national capital and balance of payment crises; (2) the U.S. macroeconomic policy
package of 1965–1968, which led to high U.S. budget deficits and inflation, and;
(3) the availability of gold to back the value of U.S. dollar.12

Freer Flows of International Capital and Balance of Payment Crises  As countries reduced
their restrictions on international capital flows and moved toward free convertibil-
ity of their currencies, balance of payment crises became more acute and frequent.
Under the Bretton Woods system global exchange rates were fixed, so the currency
of a country with persistent current account deficits could be deemed as being out of
line with long-term fundamentals, and the exchange rate might be overvalued.13
To protect their purchasing power from being reduced by a possible currency
devaluation, investors often rushed to convert their assets from the currency of a
country that had persistent current account deficits. Speculators might also choose
to join in by borrowing in that currency and converting the borrowed money into
another currency, waiting for the borrowed currency to be devalued so they could
pocket the difference.
Under the Bretton Woods system, the central bank of the troubled country was
obliged to pay the investors and speculators wishing to convert out of the currency
by using the central bank’s international reserves, in order to keep the exchange rate
fixed at the announced level. A severe rundown in the central bank’s international
reserves, however, could threaten the country’s ability to pay for imports and foreign
debt obligations, causing a balance of payment crisis.
By the early 1960s balance of payment crises became acute and frequent, espe-
cially among Europeans who had allowed freer flows of capital and moved toward
22 CENTRAL BANKING

free convertibility of their currencies. Even mere prospects of currency devaluation

could lead to speculative attacks on the currency and tip the country into a balance
of payment crisis. In 1964 a recorded level of the United Kingdom’s trade deficit
prompted waves of speculative attacks on the pound sterling. In 1967 the United
Kingdom had to seek IMF assistance. Meanwhile, France also had to devalue its cur-
rency (the franc), while Germany had to revalue its currency (the deutsche mark).14

The U.S. Macroeconomic Policy Package of 1965–1968  It has been argued that the U.S.
macroeconomic policy package of 1965–1968 introduced considerable pressures
that led to the collapse of the Bretton Woods system. In 1965 the U.S. government
ramped up its military purchases as the Vietnam War widened, while it also increased
spending on social programs without raising taxes. Initially the Federal Reserve
tightened monetary policy as output expanded, but it had to reverse course in 1967
and 1968 as the resulting high interest rates hurt the construction industry. Given the
rising budget deficit and expansionary monetary policy, inflation in the United States
had risen to almost 6 percent a year by the end of the decade.15
With a rising budget deficit and inflation in the United States, there were con-
cerns that the real value of the U.S. dollar in terms of gold was below the announced
official rate of 35 U.S. dollars per ounce of gold. As U.S. inflation rose, the U.S. dollar
lost its purchasing power for goods and services, which meant that the U.S. dollar had
also lost its value relative to other currencies as well as to gold.
Countries that pegged their exchange rates to the U.S. dollar that wanted to
retain their exchange rates at the announced pegged levels had to buy U.S. dollars
to prop up the value of the U.S. dollar. The purchase of the U.S. dollars, however,
raised their domestic money supplies, as they needed to use their own domestic cur-
rencies to buy up U.S. dollars. In such a situation, the rise in these countries’ domestic
money supply resulted in increased inflationary pressures in their domestic economies.
Sensing that the U.S. dollar needed to be devalued, speculators started to buy
up gold in the late 1967 and early 1968, which prompted massive gold sales by the
Federal Reserve and European central banks, draining official gold reserves in these
countries. The central banks then decided to create a two-tier market for gold, with
one tier being private and another tier being official. The price of gold in the private
tier would be determined by market forces, but in the official tier central banks
would trade gold among themselves at $35 per ounce.

The Availability of Gold to Back the Value of the U.S. Dollar: The Triffin Dilemma  By the late
1960s, as the U.S. dollar became increasingly overvalued owing to rising inflation, the
U.S. current account position increasingly worsened. As U.S. balance of payment deficits
started to grow, there was also concern whether the U.S. would have enough gold to back
the value of the U.S. dollar. Apart from speculative attacks on currencies, the Bretton
Woods system also faced pressure from factors relating to the U.S. dollar’s unique status
as the world’s reserve currency. While other countries pegged their currencies to the U.S.
dollar, the U.S. pegged the value of its dollar to gold, at 35 U.S. dollars per ounce of gold.
In theory, the amount of U.S. gold holdings should have prevented the U.S. from
running excessive balance of payment deficits, since other countries could choose to
sell their U.S. dollar assets for gold from U.S. gold holdings. In practice, however,
despite growing U.S. deficits, other governments were willing to hold their wealth in
their international reserves in the form of U.S. dollar assets.
A Brief Overview of the International Monetary System 23

As the international reserves of these countries continued to grow over time,

there was a possibility that the combined U.S. dollar reserves of these other coun-
tries would exceed U.S. total gold holdings. In such a case, if all countries decided to
convert their U.S. dollar reserves into gold at the same time, the United States would
be unable to fulfill its pledge to convert U.S. dollars into gold at 35 U.S. dollars per
ounce. This situation was pointed out in 1960 by Robert Triffin, an economist at
Yale University, and the conflict described became known as the Triffin dilemma.16

The Demise of the Bretton Woods System

With the U.S. dollar still pegged to gold at $35 per ounce, rising inflation meant that
the U.S. exports kept losing their price competitiveness, which hurt the U.S. economy
further as it entered a recession in 1970.17 The United States, however, could not
devalue its currency against all other currencies on its own, since under the Bretton
Woods system other countries pegged their currencies to the U.S. dollar rather than
the other way around. If the United States wanted to devalue its currency, all other
countries would have to agree to revalue their own currencies.18
On August 15, 1971, to solve this problem, President Richard M. Nixon decided
to close the U.S. gold window—that is, stop the automatic selling of U.S. dollars for
conversion into gold by foreign central banks—and impose a 10 percent tax on all
imports to the United States until U.S. trading partners agreed to revalue their cur-
rencies against the U.S. dollar. In December of that year an international agreement
was reached at the Smithsonian Institution in Washington, DC, whereby the U.S.
dollar would be devalued to $38 per ounce of gold, which effectively implied that the
U.S. dollar was devalued against other currencies by about 8 percent. The 10 percent
tax on imports to the United States was also eliminated.
Despite the realignment of the U.S. dollar, speculative attacks on curren-
cies remained rampant, such that on March 19, 1973, Japan and many advanced
European countries decided to let the value of their currencies float against the U.S.
dollar. By letting their currencies float, these countries were allowing the value of
their currencies to be determined by the forces of demand and supply in the financial
market instead of by governments.19
In a world of floating exchange rates, central banks still held international
reserves in the form of gold and currencies of the major economies, especially the
U.S. dollar. International reserves were used for intervention in the currency market
so that movement of the exchange rate would not be too volatile. Initially, a policy of
floating exchange rates was deemed to be a temporary emergency response to massive
speculative attacks. As time passed, however, it was almost impossible to repeg the
currencies. The advanced economies thus have let their currencies float against
the U.S. dollar since then.20

2.3 AFTER BRETTON WOODS

Since the abandonment of the Bretton Woods system in 1973, the global financial
system has evolved remarkably. Since that time, there have been at least four major
developments or turning points worth mentioning. First is the global inflation prob-
lem in the 1970s, which, beginning in the early 1980s, led to the growing acceptance
24 CENTRAL BANKING

of price stability as the key goal of monetary policy and the acknowledgment that
central banks needed to follow a rule in their conduct of monetary policy. Second
are the waves of speculative attacks on the currencies of emerging-market econo-
mies in the 1990s that prompted many emerging-market economies to float their
currencies. Third is the attempt of European countries to create a monetary union,
which ultimately led to the introduction of the euro, and the European Central
Bank. And fourth is the global financial crisis of 2007–2010, which was the most
severe since the Great Depression, and that is likely to change the global financial
landscape ahead.

The Great Inflation of the 1970s

In the 1970s there were two oil crises, one in 1973 and another in 1979. Rising
oil prices during a crisis was considered a supply shock, which threatened a slow-
down in the global economy.21 During those crises of the 1970s, central banks often
deemed it necessary that monetary policy be accommodative, as a reaction to rising
unemployment and to alleviate the negative effects of an economic slowdown.
As the events turned out, however, accommodative monetary policy did not
successfully stimulate the economy and bring down unemployment, but instead led
to fast-rising inflation. This situation, in which the economy contracted yet inflation
also rose, became known as stagflation—a combination of the words stagnate and
inflation.
Rising inflation can raise uncertainty in the economy, since businesses might
try to mark up the prices of their goods and services in anticipation of inflation to
protect the purchasing power of their profits. Workers, on the other hand, might try
to negotiate for hikes in wages to protect against rising costs of living. The pricing
behavior of firms, and wage hikes, can prompt inflation to actually rise immediately
in response to anticipated inflation. Such a situation can feed on itself, and is known
as a wage-price spiral.
As the rise in prices of goods and services becomes faster, interest rates can start to
rise quickly as well, since lenders may reset their lending rates to take account of the
fast decline in the purchasing power of interest income. Fast-rising interest rates can
create uncertainty in the economy and distort consumption and investment decisions.
As the U.S. economy became seriously choked by the wage-price spiral, high
unemployment, and high inflation, the U.S. central bank, under the leadership of
Paul A. Volcker, decided that accommodative monetary policy was indeed hurting
the economy. Monetary policy stance was thus reversed to be sharply contrac-
tionary in October 1979, with the Federal Reserve hiking interest rates sharply
and tightening the money supply. The switch to a sharply contractionary mon-
etary policy helped push the U.S. economy into violent recessions in the 1980s
but also helped kill the wage-price spiral and successfully brought down inflation
expectations.
A lesson that central banks learned from the inflation problem of the late 1970s
was that during a supply shock an accommodative monetary policy might be unable
to successfully stimulate the economy, and could indeed worsen the situation by
introducing more inflationary pressures and uncertainty into the economy. Once an
accommodative monetary stance has been taken to deal with a supply shock, it may
be that to prevent inflation from spiraling out of control and to get the economy out
A Brief Overview of the International Monetary System 25

of stagflation the central bank may subsequently need to sharply contract its mon-
etary policy, putting even more severe stress on the economy.
After the experiences of the late 1970s to early 1980s, central banks often
became more cautious in using an accommodative policy stance to deal with a sup-
ply shock. Indeed, central banks increasingly started to ponder the use of a monetary
policy rule as a tool to keep inflation low and stable. In the United States, along with
the tightening of monetary conditions, the Federal Reserve, under Paul Volcker, also
showed a commitment to low and stable inflation through its emphasis on the adop-
tion of money supply growth targeting as its monetary policy rule. Theoretically,
by keeping money supply growth at a rate consistent with economic growth, there
would be no excess money that could lead to inflationary pressures in the long run
(see Chapter 6 for more details).
By the late 1980s, however, the use of monetary supply growth targeting had
practically been abandoned in both the United States and the United Kingdom. As
it happened, the relationship between money growth and economic growth became
unstable, such that the money supply growth target often was inconsistent with the
growth in economic activity.22

Speculative Attacks on Advanced European and Emerging-Market

Currencies in the 1990s
Although major advanced economies had floated their currencies against the U.S.
dollar in the early 1970s, which ended the Bretton Woods system, attempts to fix
exchange rates persisted in both advanced and emerging-market economies through-
out the 1970s and 1980s. By the early 1990s, however, the liberalization process
that had started in the advanced economies since the late 1970s started to take hold
across the world. Freer international capital mobility that came with the liberaliza-
tion process made it much more difficult for countries to maintain their exchange
rate pegs, as ultimately reflected in waves of successful speculative attacks on curren-
cies of advanced and emerging-market economies throughout the 1990s.

Speculative Attacks on Currencies in Advanced European Economies  Speculative attacks

against advanced economies were felt the most in European countries within the
European Monetary System (EMS) in the early 1990s. At the time the countries in
the EMS operated on a formal network of mutually pegged exchange rates, such
that the exchange rates of these countries would be kept within specified fluctuation
margins. By 1992, the reunification of western and eastern Germany that started in
1990 had already led to an economic boom and higher inflation in Germany, which
prompted Germany’s central bank, the Bundesbank, to raise interest rates.23
With Germany—the largest EMS economy—raising interest rates, other EMS
countries faced a dilemma. On the one hand, unless other EMS countries also raised
interest rates, the economic boom and high interest rates in Germany would keep
drawing capital out of other EMS countries into Germany, which would put depre-
ciation pressure on the currencies of these other EMS countries. On the other hand,
if they raised interest rates to match the German rate hikes they might put further
negative pressure on their already-weak domestic economies.24
Speculators, sensing that the other EMS countries would not be able to toler-
ate high domestic interest rates, started speculative attacks on a number of EMS
26 CENTRAL BANKING

countries, which forced the United Kingdom and Italy out of the EMS in 1992, and
forced the EMS to widen its exchange rate bands to +/− 15 percent in 1993 from
+/− 2.25 percent for certain member countries and +/− 15 for other member coun-
tries. Speculative attacks during the same period also forced a devaluation of Finnish
and Swedish currencies against the European Currency Unit (ECU), the precursor to
the euro.25,26 (See Concept: Speculative Attacks: Underlying Causes, Anatomy, and
Defense for more details on how speculative attacks are done.)

Speculative Attacks on Emerging-Market Currencies  In the mid-1990s, a large number of

emerging-market economies still pegged their currencies to the U.S. dollar. The main-
tenance of the peg was in part due to (1) the fact that a fixed exchange rate could
help facilitate international trade and investment, and (2) confidence that inflation
rates of countries with currencies pegged to the U.S. dollar would be more or less
in line with that of the United States, and thereby benefiting from the U.S. cen-
tral bank’s commitment to low and stable inflation.27 While inflationary pressures
in the United States could sometimes be a problem, the United States never really
experienced the kind of extreme inflation that occurred rather frequently in emerg-
ing economies that lost their fiscal and monetary discipline and deliberately printed
money to finance their deficits.
Many emerging economies in the 1980s, even when faced with balance of
payment crises, often resorted to currency devaluation rather than floating their
exchange rates. With currency devaluation troubled countries would retain the peg
to the U.S. dollar, but at a depreciated exchange rate. Later, to better reflect their
increasingly diversified international trade patterns, many emerging-market coun-
tries chose to peg their exchange rates to the value of a basket of currencies (a
portfolio of selected currencies, possibly comprising those of each country’s major
trading partners), rather than to the U.S. dollar alone. In the 1980s and the 1990s,
with the United States being the far dominant global export market, however, the
weight of U.S. dollar normally dominated the currency baskets.
With international liberalization measures yet to take full effect, the fixed
exchange rate regime in emerging markets remained robust. As the process of glo-
balization gathered momentum and countries started to open up their markets, more
international capital started to flow in and out of these economies more freely. At
first, the greater flows of capital helped finance development of the countries, par-
ticularly in export-led manufacturing industries. As more capital flowed in, however,
parts of the capital also seeped into unproductive investments, including asset-price
speculation. Finally, as exports to advanced economies slowed, emerging-market
economies started to run into large current account deficits.
The deficits, together with asset-price bubbles, prompted international investors
to speculate whether the emerging economies would be able to service their foreign
debt. With the fixed exchange rate regime, emerging economies would have to repay
their foreign debts out of their international reserves. In many cases, since foreign
debt had already been used to finance assets that were overvalued or investments
that were unproductive, investors deemed that repayments would be difficult or
impossible, and that the countries would eventually have to devalue their currencies.
With prospects of currency devaluation becoming more likely, speculative
attacks on the currencies took place (see Concept: Speculative Attacks for details).
Such attacks led to a currency crisis in Mexico in 1994 and in East Asian countries
A Brief Overview of the International Monetary System 27

in 1997 and 1998, which prompted many of the attacked countries to abandon
their fixed exchange rate regime. Later a combination of factors, including contagion
effects from the Asian financial crisis, also led to financial crises in Russia in 1998,
Brazil in 1999, and Argentina in 2002. (The Asian financial crisis is discussed in
more detail in Chapter 9.)

C O N C E P T: SPECULAT IVE AT TACKS

Speculative attacks are typically carried out against a country with a fixed
exchange rate regime. Here we discuss the underlying causes and anatomy of
speculative attacks, as well as defense against them, referencing the speculative
attacks on advanced European economies and emerging-market economies in
the 1990s.

Underlying Causes
With a fixed exchange rate regime, the central bank of a country is effectively
promising to convert the domestic currency to a foreign currency at a specified
exchange rate using its foreign reserves. Consequently, the country is prone to a
speculative attack if (1) it is in a markedly different economic cycle from that of the
country it fixes its exchange rate to (e.g., EMS countries that fixed their exchange
rates with Germany in the early 1990s), or (2) it runs a persistently large current
account deficit (e.g., emerging-market economies in the mid- and late 1990s).
If a country is in a different cycle from the country that it fixes its exchange
rate to, then that country would face a choice between using monetary policy
to address its domestic conditions or using its monetary policy to keep the
exchange rate fixed at the announced target. For example, if the country is in
a recession, the central bank might want to lower interest rates to help stimu-
late its domestic economy. If the central bank decides to lower interest rates,
however, investors might move funds abroad to receive higher interest rates
elsewhere. When investors move funds out of the country, they effectively sell
the domestic currency, which puts depreciation pressure on the exchange rate.
If enough investors sell the domestic currency, the central bank might indeed
have to devalue the exchange rate.
A large and persistent current account deficit, on the other hand, suggests
that the country has already been routinely paying out its foreign reserves
to pay for imports of goods and services from abroad. Since the amount of
a central bank’s foreign reserves is finite, such a persistent drain means that the
central bank might not be able to allow conversion of the domestic currency
into a foreign currency at the promised rate. More likely, the central bank
might need to devalue the domestic currency—that is, the public would need a
greater amount of the domestic currency in order to convert the domestic cur-
rency into a given amount of foreign currency.
If a currency devaluation occurs, those with domestic currency would lose
while those with foreign currency would gain. Therefore, investors would try to
(Continued)
28 CENTRAL BANKING

(Continued)
convert their holdings of domestic currency into foreign currency if they think
that a devaluation of the domestic currency is imminent. Speculators, meanwhile,
might force the central bank to devalue its currency through speculative attacks.

Anatomy of a Speculative Attack

In a speculative attack, speculators effectively borrow large amounts of the
domestic currency, and then use those borrowed amounts of the domestic cur-
rency to seek conversion into a foreign currency from the central bank. If the
amounts of the domestic currency that speculators use to seek conversion are
so large that the central bank does not have enough foreign reserves to allow
conversion at the fixed exchange rate, the central bank would need to devalue
the currency, or allow the exchange rate to float.
If the central bank is forced to devalue the domestic currency or allow the
exchange rate to float, speculators would gain since they would have already
obtained some foreign currency from the central bank. That foreign currency
would have appreciated in value relative to the domestic currency. Since the
speculators’ borrowings are denominated in the domestic currency, which has
by then lost in value, the speculators could convert the obtained foreign cur-
rency at a more favorable rate to repay for their domestic currency debts. The
difference between the gain in the foreign currency obtained and their domestic
currency debt repayments would be profit to the speculators.
In the attack on the British pound in 1992, Quantum Fund, a hedge fund
run by George Soros (a large speculator based in the United States), borrowed
and sold $10 billion worth of the British currency, around two and a half times
the fund’s capital. In the first two weeks of September 1992, the Bank of England
spent $27 billion worth of reserves to fend off Soros and other speculators. Finally,
when the United Kingdom left the EMS, the pound fell around 14 percent against
the deutsche mark, and Soros’s fund earned over $1 billion worth of profits.28

Defense against a Speculative Attack

To counter a speculative attack, the central bank might choose to raise domes-
tic interest rates to push up the speculators’ costs for domestic-currency bor-
rowing, and at the same time keep selling foreign currencies to the speculators
(and thus buy up domestic currency) at the announced exchange rates.
In a world of limited capital mobility, the combination of high domestic
interest rates and the ability of the central bank to keep selling foreign curren-
cies at the announced exchange rate might deter or even squeeze speculators
out of their speculative positions on the domestic currency. Speculators would
have to pay high interest rates on their domestic-currency borrowing, while the
likelihood that the central bank would run out of reserves would be low, since
in the world of limited capital mobility, the speculators cannot easily come in
and borrow so much domestic currency.
In a world of free capital mobility, however, speculators can more easily
borrow money and get hold of as much of the domestic currency as they can.
A Brief Overview of the International Monetary System 29

Consequently—as the Quantum Fund’s attack on the British currency in 1992

and the later attacks on emerging-market economy currencies have shown—
herds of large speculators can easily raise funds that match or even dwarf a
central bank’s entire foreign reserves and thus overcome the central bank’s
ability to defend its exchange rate peg.
Ultimately, if the central bank deems that it still wants to defend the
exchange rate peg, it must be noted that the central bank also has the option to
introduce capital controls to prevent easy conversion of currencies by nonresi-
dents, that is, to put limits on capital mobility. The imposition of capital con-
trols, however, also has its own costs, since it might impede access to foreign
capital that might be necessary for funding of domestic investments.

The Introduction of the Euro

After World War II, countries in Europe tried to put more emphasis on political and eco-
nomic cooperation. A long history of wars, including the two world wars, had proved
to be very destructive. The European effort toward integration was first reflected in the
Treaty of Rome, which created the European Economic Community (EEC) allowing
free trade without tariffs among member countries, which ultimately was transformed
into the European Union (EU) with a much broader political and economic integration
mandate. Although a currency union was probably not on the minds of the signatories
of the Treaty of Rome, after the creation of the EEC member countries realized that
trade among themselves would be even easier if they used a common currency.29
Up to the late 1960s, the fixed exchange rate regime offered by the Bretton
Woods system had helped facilitate international trade and finance for European
countries without much worry about exchange rate volatility. With the demise of
the Bretton Woods system, however, many European countries had to abandon their
fixed exchange rate regimes, and the benefits of a common currency became clearer.
With many stops and detours along the way, a common currency, the euro, was
introduced among a core group of European Union members in 1999.30
Despite various obstacles, in 1999 11 advanced European countries were able to
join in the creation of the euro as their common currency. These countries replaced
their old national currencies with the euro. In this newly created euro area, respon-
sibility for the conduct of monetary policy was transferred from the national central
banks (NCBs) of each member country to the newly created European Central Bank
(ECB), a supranational agency that put higher priority on the euro area rather than
any individual country. From the start, the key goal of the ECB has been the main-
tenance of price stability for the euro area as a whole. With the monetary policy
responsibility largely taken away, the NCBs, in turn, would focus on the regula-
tion of their domestic banking sector.31,* By the middle of the first decade of the

*Following the European sovereign debt crisis of in the early 2010s, however, it was deemed
important that the ECB should also take on banking supervision for the member countries.
Starting in 2014 the ECB is to also assume banking supervisory functions over large credit
institutions within the euro area.
30 CENTRAL BANKING

twenty-first century, the euro had rapidly become another popular currency of
international trade and finance. This owed partly to the fact that (1) the euro area
includes many large, advanced economies such as Germany, France, Italy, and Spain,
as well as a number of other medium-sized advanced economies, which has made
the euro area a large and important block of countries, and (2) many smaller Eastern
European economies were expected to join the euro area once they passed the tough
admissions criteria, which would strengthen the euro area even further. In the pro-
cess, the ECB became another powerful central bank whose monetary policy could
significantly affect the international monetary system.32

The Global Financial Crisis of 2007–2010

The global financial crisis of 2007–2010 showed how the international monetary
system has become globalized in nature. Although the crisis turned out to have hit
the advanced economies the hardest, it also severely disrupted global trade, brought
about a global recession, and threatened to bring down the whole global financial
system—which had by then become inextricably intertwined across boundaries.
To understand the global financial crisis more easily, it might help to break down
the complexity relating to it by focusing on the U.S. subprime crisis, which was not
only central to the story, but was also echoed by similar situations in a number of
European countries during that same period. Although the U.S. subprime crisis did
not become full blown until late 2008, we use the term global financial crisis of
2007–2010 to also encompass the U.S. subprime crisis, because by then the cracks in
the global financial system had already shown up on both sides of the Atlantic: that
is, a run on banks in the United Kingdom in 2007 and high profile failures of hedge
funds associated with the global securities firm Bear Stearns in the United States. In
the latter part of this section, we will also discuss the European sovereign debt crisis,
a related but distinct crisis that came on the heels of the U.S. subprime crisis.

The U.S. Subprime Crisis: The Run-Up  By many accounts, the U.S. subprime crisis was
caused by a combination of factors, including (1) the low interest rates that had been
kept at low levels for too long and resulted in a housing price bubble, (2) the dete-
rioration in lending standards that resulted in loans being made to borrowers with
poor credit quality, and (3) amplified risks due to the opacity surrounding the use of
new financial innovations and products.33

Low Interest Rates  Although the United States suffered a recession in the early
1990s, by the late 1990s the U.S. economy had sustained an almost decade-long
boom that came partly because of the productivity gains from the Internet revolution,
as well as a stable macroeconomic environment. Inflation had stayed low since the
mid-1980s, while the growing budget deficit that had been a problem in the 1980s
and early 1990s had reversed into a surplus by the end of the decade. The growth
in productivity and the stable macroeconomic environment helped contribute to a
boom in stock prices, particularly those of Internet-related (dot-com) companies.
The spectacular rise in the stock market in the late 1990s became known as the dot-
com bubble.
By early 2001, however, the dot-com bubble in the U.S. stock market had burst,
wiping out a lot of U.S. household wealth and severely weakening the U.S. corporate
A Brief Overview of the International Monetary System 31

sector. Later that year, terrorist attacks in the U.S. caused worldwide financial panics.
In response to these events, by the end of 2001 the U.S. central bank had lowered its
policy interest rate (the federal funds rate) to 1.75 percent, down from 6.5 percent
a year earlier.
Despite lower interest rates, the weakness in the U.S. economy, together with
other global factors—including the SARS virus scare of 2002 and 2003 and cheap
imports from China that started to flood the global economy after China had joined
WTO in 2001—helped to keep U.S. inflation down. By December 2003, the U.S.
inflation rate had fallen below 1 percent, which prompted fears of deflation.34
The deflationary scare made the Federal Reserve more cautious about subse-
quent hikes in interest rates, and it nudged the fed funds rate upward by only 0.25
percent at a time35 until it reached 5.25 percent in June 2006. The low interest rates
in the first years after 2000 were deemed a key factor that helped contribute to the
boom in the U.S. housing market, which subsequently resulted in the global financial
crisis of 2007–2010.
Between 2000 and 2006, U.S. housing prices rose by more than 80 percent.36
Low interest rates helped contribute to the boom in housing prices in a self-reinforc-
ing way because (1) low interest rates kept borrowing costs down, enabling people
to buy houses more easily; (2) low interest rates pushed people to seek investments
in assets that would yield higher returns than bank deposits, that is, stocks (which
yielded dividends as well as capital gains), housing (which could yield rents as well
as capital gains); and (3) as housing and stock prices started to rise rapidly, they also
raised U.S. household wealth, enabling and inducing households to borrow more in
order to invest in a second or third home.

Deterioration in Lending Standards  At first, financial institutions lent primar-

ily to borrowers with good credit quality (i.e., those who were more likely to be
able to repay their loans). As the pool of borrowers with good credit quality started
to become exhausted, however, lenders started to target their lending to borrowers of
lower credit quality (termed subprime borrowers). In the more notorious cases, loans
were made to borrowers without documentation requirements for income, jobs, or
assets (the so-called NINJA loans). In other cases lenders lured subprime borrowers
with complicated loans such as option-ARMs (adjustable rate mortgages that in the
initial years allowed borrowers to pay below the monthly payment owed, only to add
back the difference to the balance of the loan, and thus, through compound interest,
increasing the amount that borrowers owed once the initial years had passed).37
The deterioration in lending standards came about partly because of changes
in banks’ business models as well as financial innovations that were deemed to be
able to tame risks associated with lending. By the mid-2000s many banks in the
United States and the United Kingdom had embraced securitization as a key driver in
their business models. (Details on securitization are in the next section, which covers
financial innovations.) Rather than making loans and holding them on their books,
many banks made loans, bundled them, and sold them as a package, thereby remov-
ing the loans from their balance sheets. Since the loans were removed from their
balance sheets, the banks had less incentive to be careful about the loans they made
and were tempted to make as many loans as possible to gain lending fees and com-
missions from packaging and selling those loans. In many cases lending standards
were not strictly adhered to.38
32 CENTRAL BANKING

Opacity Surrounding New Financial Innovations  By the middle of the first decade
of the twenty-first century, new financial innovations helped make the U.S. housing
boom a global phenomenon. Securitization allowed banks to package individual
housing loans in a pool and sell securities backed by that pool of housing loans
to investors in the United States as well as abroad. The securities paid interest to
investors based on interest income pooled from individual housing loans. By putting
housing loans from diverse geographical areas into a single pool, the risk from a
default on any individual loan had been somewhat diversified away, since all bor-
rowers were not expected to default at the same time. Consequently, securitization
helped encourage banks to push for more lending, even to those who might have
poor credit history, since it would seem that the risk of such lending could be con-
tained and managed.
Securitized U.S. mortgages (housing loans) became very popular among investors
both in the U.S. and abroad because the pool of housing loans could be further sliced
into different tranches (related securities offered as part of the same transaction) that
bore different levels of risk. If any housing borrower did default, the buyers of the
most junior tranche of the pool of housing loans would be the first to absorb the loss.
In return, to compensate for such losses, the buyers of the most junior tranche would
receive the highest interest rate from that pool of housing loans.
The higher interest rates that could be earned from securitized mortgages were
deemed very attractive by investors when compared to interest rates earned on nor-
mal bank deposits. The opacity surrounding the securitization process of the pooling
and slicing of housing loans made it very difficult for investors to accurately gauge
the risks they were taking in compensation for the higher returns.
With securitization, even securities made from a pool of housing loans made to
borrowers with poor credit quality (i.e., subprime loans) were deemed rather safe
for investors, partly because credit rating agencies that were hired by the bank to
rate these securities would often rate them as being investment grade based on the
historical rise in housing prices. As demand from investors for securitized mortgages
rose, banks were induced to make loans by fees that they could earn from packaging
and selling the loans, and they became less cautious in making those loans.39

The U.S. Subprime Crisis: The Outcome  The U.S. housing bubble finally became unten-
able when inflationary pressures started to pick up, partly because of fast-rising oil
prices, and it was deemed that the Federal Reserve would need to raise interest rates
further. By the time the federal fund rate reached 5.25 percent in 2006, the U.S. hous-
ing boom had already turned into a full-blown bubble. There were fears, which later
became justified, that once mortgage interest rates started to rise, subprime borrow-
ers would be unable to repay their loans and would have to default.
By 2007 there were already signs that the global financial system was about to
crack. In June 2007, two hedge funds linked to Bear Stearns (a global securities firm)
appeared in news headlines, as they needed to be rescued following sharp falls in the
value of their investments in securitized loans. In September 2007, Northern Rock (a
British bank that had relied on fees from securitization as a part of funding) found
itself in difficulties as demand for securitized loans dried up. As the news spread,
Northern Rock depositors rushed to demand their money from the bank, resulting
in a bank run.40
A Brief Overview of the International Monetary System 33

By 2008 the crisis had become truly global: as housing bubbles in the United
States and many European countries started to burst, banks that were involved in
lending to the housing and real estate sectors suffered large losses. Uncertainty sur-
rounding the health of financial institutions also made it very difficult for banks to
get funding through borrowing in the financial markets. In March 2008 the Federal
Reserve had to facilitate the purchase of Bear Stearns by JPMorgan Chase, a large
U.S. bank, to prevent Bear Stearns from falling into bankruptcy.
The crisis reached its peak when the U.S. government decided to let Lehman
Brothers, a global securities firm, file for bankruptcy on September 15, 2008. The fail-
ure of Lehman Brother caused panic worldwide, since Lehman Brothers was a global
financial firm and counterparty to a worldwide web of global financial institutions.
By September 19, 2008, with the threat that a domino effect of bank failures would
bring a total collapse to the whole financial system, the U.S. government decided to
reverse its stance and helped rescue a number of large banks, financial securities firms,
money market mutual funds, and a large insurance company (AIG). By mid-October
2008, the governments of Ireland, Britain, France, Germany, Spain, the Netherlands,
and Austria also had to step in to rescue their own ailing banking systems.41

CASE STUDY: The European Sovereign Debt Crisis

The European sovereign debt crisis came on the heels of the global financial crisis. Despite the euro
system’s early success, by the later years of the first decade of the twenty-first century cracks began to
appear as a number of weaker member countries were hard hit by the global financial crisis. In Ireland,
which suffered from the burst of its own property bubble, the government’s decision to bail out the
whole banking system through the guarantee of all banking sector liabilities effectively turned private
debt into public debt.42 The unsustainable public-debt load ultimately pushed the Irish government to
seek outside assistance.
In Greece and Portugal, the fall in GDP growth and government revenue prompted their fiscal
deficits to rise and their already-high ratios of public debt to GDP to look unsustainable, making it dif-
ficult for the governments of these two countries to refinance their debts. Although Spain initially did
not have a high public debt-to-GDP ratio, when the global financial crisis started in 2007 the country
subsequently severely suffered from a burst in its own housing bubble, such that a sharp fall in GDP
combined with government spending to help alleviate a sharp spike in the unemployment rate made
public debt triple to more than 90 percent of GDP by 2013.43
Since euro-area members were required by their euro agreement to keep their fiscal deficits below
3 percent of GDP, the euro governments were required to cut spending, which hurt already-weak eco-
nomic activity even further. Without fiscal spending, these troubled euro countries had no tools to help
stimulate their economies during a downturn, since their conduct of monetary policy had been handed
over to the ECB, which focused primarily on the euro-wide perspective. Furthermore, in having a com-
mon currency troubled euro economies did not have the choice of a currency devaluation, which might
otherwise have helped cheapen their export prices and stimulate external demand for their goods and
services.
With their economies struggling, the risk that the governments of these countries might be unable
to repay their public debts started to rise. To compensate for the risk, investors started asking for
higher interest rates on bonds from these governments. Higher interest rates further weakened the
ability of these governments to repay their debts, and also weakened the European banking sector,
since many European banks held bonds of troubled euro governments as assets on their books. By
2012, the governments of Ireland, Greece, Portugal, and Spain all had to seek financial assistance from
the so-called troika—the IMF, the European Union, and the ECB.
34 CENTRAL BANKING

2.4 GOING FORWARD

As of 2014, the fallout from the global financial crisis of 2007–2010 was still very
much present in the global monetary system. In response to the crisis, central banks
in major advanced economies—such as the Federal Reserve, the ECB, the Bank of
Japan, and the Bank of England—lowered their interest rates to nearly 0 percent and
engaged in quantitative easing (i.e., the purchase of government securities from the
financial market) in one form or another.
One of the side effects of the low interest rate policy and the quantitative eas-
ing programs in the advanced economies was a large influx of capital flows into
emerging-market economies. Quantitative easing programs were, in effect, injec-
tions of money into the system, as the central banks that engaged in such programs
would be paying money to purchase government securities from private holders of
the securities. The extra injections of money from the quantitative easing programs
and the low interest rates in the advanced economies nudged investors to search for
higher investment returns in countries whose growth had been less affected by the
crisis. The inflow of international capital into emerging economies has caused
the currencies of emerging-market economies to appreciate in value across the board
since 2010.
Another related side effect of the low interest rate policy and quantitative easing
programs was the increasing volatility of international capital flows. Given that the
advanced economies still remained rather weak, the quantitative easing programs
were perceived more or less as a life support system, whose removal could cause a
scare and much volatility and panic in global financial markets. In mid-2013, for
example, when the Federal Reserve announced that it might taper its purchases of
government securities in the near future, stock markets dropped across the globe.
Investors rushed to draw back their capital from emerging-market economies. The
reversal of capital flows caused the exchange rates of many emerging-market econo-
mies to experience a sharp drop. Only when the Federal Reserve reversed its posi-
tion and announced that tapering might not occur until sometime in the future did
the stock markets rise again, and capital outflows from emerging-market economies
slowed or reversed.
Going forward, the international monetary system that central banks will be
operating in would likely be affected by three important forces: (1) intensification
of the globalization process, (2) continued evolution in financial activities, and
(3) unfinished businesses from global financial crisis. How these forces might inter-
act to shape the international monetary system and how central banks might adapt
to meet challenges that these forces might pose will be discussed in more detail in
Part IV of the book.

SUMMARY
International elements have always been present in central banking, ever since the
Bank of Amsterdam started sorting and storing the coins of different sovereigns. In
the centuries that followed, the international monetary system that central banks
operate has also evolved.
When the gold standard was in place, central banks pegged the value of their
currencies to gold. The main aim was to keep the value of money at the announced
A Brief Overview of the International Monetary System 35

peg level. The gold standard broke down during World War I, as countries aban-
doned their pegs so they could print more money to finance the war.
After World War I, countries adopted the gold exchange standard, whereby the
major countries would still peg their currencies to gold and hold gold as reserves.
Smaller countries, however, would hold the currencies of the major countries as
reserves instead, since there was not enough gold for all countries to hold as reserves.
In the 1930s the Great Depression emerged; as economic activities declined, a
large number of banks failed worldwide, and deflation lasted for a decade. The Great
Depression was partly attributable to the focus of central banks on maintaining their
gold pegs, which led to contractionary monetary policies worldwide.
Turmoil in the international financial system also occurred in the 1930s as coun-
tries resorted to competitive devaluation of their currencies as well as trade protec-
tionism to protect employment.
In July 1944, delegates from 44 countries decided to adopt a new interna-
tional monetary system, the Bretton Woods system. Under this system the United
States would fix the value of the U.S. dollar to gold at $35 per ounce, while other
countries would fix the value of their currencies to the U.S. dollar. The IMF was also
created to help countries deal with balance of payment and unemployment problems
without having to resort to competitive devaluation and trade protectionism.
With freer international capital flows, the macroeconomic policy package in the
United States that led to a budget deficit and high inflation, and the limitation of
gold availability to back the U.S. dollar, the pressures on the Bretton Woods system
became untenable. At first the United States stopped automatic convertibility of the
U.S. dollar into gold and devalued the U.S. dollar. With a balance of payments crisis
and speculative attacks raging on currencies, many advanced economies decided to
allow their currencies to float against the U.S. dollar.
In the 1970s, the two oil shocks and accommodative fiscal and monetary poli-
cies led to the Great Inflation problem. As inflation expectations started to spiral
out of control while the economy stagnated, many academics and central bank-
ers started to ponder the use of a monetary policy rule to ensure price stability. In
1979 the Federal Reserve decided to bring down inflation expectations by tightening
monetary policy sharply, and emphasized its commitments to money supply growth
targeting as its monetary policy rule. By the late 1980s, however, money supply tar-
geting had been practically abandoned, since the relationship between money and
output proved unstable.
In the 1990s, liberalization led to large inflows of capital into emerging-market
economies. As inflows started to seep into asset-price speculation, and emerging-
market economies started to run large current account deficits, speculative attacks
forced many of the emerging economies to devalue or float their currencies.
Since the early 1990s, many central banks in both advanced and emerging-
market economies have started to adopt a monetary policy regime known as infla-
tion targeting.
In 2000, a number of European countries decided to adopt a common currency,
the euro. The European Central Bank (ECB) was created to conduct monetary policy
for member countries of the euro area.
Between 2007 and 2010 a global financial crisis occurred, stemming from the
subprime crisis in the United States. As of this writing, the global economy has not
yet fully recovered from the global financial crisis.
36 CENTRAL BANKING

KEY TERMS
balance of payments crisis inflation targeting
Bretton Woods system money supply growth targeting
European sovereign debt crisis speculative attacks
global financial crisis stagflation
gold standard subprime crisis
gold exchange standard Triffin dilemma
the Great Depression wage-price spiral
the Great Inflation

QUESTIONS
1. What were the key features of the gold standard?
2. Why did the gold standard break down?
3. What could be key reasons preventing countries from returning to the gold
standard?
4. What were the key features of the gold exchange standard?
5. Why did the gold exchange standard break down?
6. What were the key features of the Bretton Woods system?
7. Why did the Bretton Woods system break down?
8. Why did stagflation occur in the 1970s?
9. What did the Federal Reserve do to help end stagflation in the United States?
10. Why might emerging-market economies maintain their fixed exchange rates with
major currencies, such as the U.S. dollar, after the breakdown of the Bretton
Woods system?
11. What were the causes of speculative attacks on emerging-market currencies in
the 1990s?
12. Explain intuitively how speculative attacks on currencies could be done.
13. How might low interest rates in the United States have contributed to the
subprime crisis?
14. What were the key factors contributing to the U.S. subprime crisis?
15. In the euro area, what are the main responsibilities of the ECB?
16. In the euro area, what are the main responsibilities of the NCBs?
17. What might be possible causes of the European sovereign debt crisis?
 CHAPTER 3
Modern Central Banking Roles
and Functions
What Exactly Is a Central Bank?

Learning Objectives
. Describe various roles and functions of modern central banks.
1
2. Describe the money creation process.
3. Explain the use of monetary policy to regulate monetary condi-
tions in the economy.
4. Explain the role of central banks in payment systems oversight and
provision.
5. Explain the role of central banks as lenders of last resort.
6. Explain the role of central banks as bank supervisors.

I n Chapters 1 and 2, we briefly reviewed the evolution of central banking func-

tions over the centuries and the background on international monetary systems
so we could understand the context in which central banks have become what they
are today. In this chapter we will review the main functions of modern-day central
banks. As discussed in Chapter 1, modern central banks do have both commonalities
and diversity, and thus their functions and details of institutional designs do differ.
The review presented here is thus at an overview level, where broad rationales and
mechanics of the functions are discussed, so the reader can see a broader picture of
how a modern central bank might look.
This chapter starts with an overview of modern central banking. We then review
five key functions of modern central banks: (1) money issuance, (2) the conduct
of monetary policy, (3) payment systems regulation and provision, (4) lender of
last resort, and (5) banking supervision. When reviewing each of these functions,
the chapter explains what the functions mean in the modern context and describe
relevant basic concepts, such as the money creation process, so the novice reader
understands the mechanics of how money issued by the central bank might circulate
and expand into other forms of money.

37
38 CENTRAL BANKING

3.1 MODERN CENTRAL BANKING: AN OVERVIEW

OF ROLES AND FUNCTIONS

Central banking today has evolved noticeably from its origins, owing to changes
in the economic and financial environment that central banks operate in and the
resultant changes in the roles of central banks. After many experiences and lessons
learned along the way (e.g., the Great Depression of the 1930s, the Great Inflation
of the 1970s, and the global financial crisis of 2007–2010 that were discussed
in Chapters 1 and 2), it has become generally accepted that the key role of a modern
central bank is to provide a sound and stable macroeconomic environment such that
long-term sustainable growth of the economy can be achieved.
A modern central bank can deliver a sound and stable economic environment
through (1) monetary stability, or safeguarding the value of the currency, whether
in terms of low domestic inflation or stability of the exchange rate; and (2) financial
stability, or helping the financial system to function smoothly and efficiently in the
allocation of resources in the economy.
With stability in the value of the currency and smooth and effective functioning
of the financial system, it is believed that the private sector (households and firms)
will be able to make optimal consumption and investment decisions, which are fun-
damental to the long-term growth of the economy.
Over time, to suit the modern roles of central banking, a number of the central
bank functions discussed in Chapter 2 have been dropped, and the rest have been
modified. Most notably, most central banks these days are no longer coin sorters, nor
financiers to the government. The conduct of monetary policy to achieve economic
goals has now become a key focus for most central banks. In the wake of the global
financial crisis of 2007–2010, the role of a central bank as a guardian to the financial
system has also again been a key focus.
In general, it could be said that a typical modern central bank has five key func-
tions: (1) issuance of money, (2) conduct of monetary policy, (3) payment systems
facilitation, (4) lender of last resort, and (5) banking supervision. Some of the central
banks might not have all five functions (e.g., some might not have the bank supervi-
sion function), and details of the workings of the functions might differ from one
central bank to another. Still, these five key functions represent what a typical mod-
ern central bank does. Table 3.1 illustrates how these five functions might fit with the
roles of a modern central bank.
In this chapter we briefly review what these functions are, and their underly-
ing mechanics. In Chapter 4 we will examine the goals, or mandates, of modern
central banks, which may include monetary stability, financial stability, and full
employment, and which determine the specific functions performed by modern cen-
tral banks.

The Ultimate Creator of Money: Money Issuance

In most countries these days, banknotes are issued by the central bank. Often, a
modern banknote is printed with countersignatures of the governor or the chairman
of the country’s central bank and the finance minister (or the treasury secretary in
the United States and the chancellor of the exchequer in the United Kingdom). The
Modern Central Banking Roles and Functions 39

TABLE 3.1  Roles and Functions of a Modern Central Bank: How They Fit
Monetary Stability Financial Stability

Roles Maintain stable value of the Maintain smooth and effective

currency functioning of the financial
system and guard against
financial imbalances in the
economy
Functions 1.  Money issuance 1. Payment systems supervision
and oversight
2. Regulation of money 2.  Lender of last resort
conditions (i.e., the 3.  Banking supervision*
conduct of monetary policy)

*A number of modern central banks currently do not have the banking supervision function,
while others do.

countersignatures reflect the fact that the banknotes issued by the central bank has
the backing of the sovereign.*
In this electronic age, not only can the issuance of money be done by the central
bank through banknote issuance, it can also be done through electronic means. The
central bank can choose to issue money by electronically crediting a commercial
bank’s account held at the central bank, possibly as a payment on the central bank’s
purchase of government securities from the commercial bank. In this case, the cen-
tral bank is issuing money in electronic form, and is not printing banknotes to pay
for the government securities that it bought from the commercial bank. That elec-
tronic form of money, however, could always be converted into banknotes from the
central bank if the commercial bank so desires.
Whether the central bank issues money in electronic form or in the form of
banknotes, that money goes through a process called the money creation process
when it circulates in the economy. The money creation process multiplies the initial
amount of money issued by the central bank, which results in a much larger amount.
The final amount of money that comes out of the money creation process constitutes
money supply. (See Concept: The Money Creation Process for more details.)

The Money Creation Process and Its Influences on Economic Activity and Price Levels  The
stylized money creation process described in Concept: The Money Creation Process

*In a modern economy coins are often issued by the mint, which is likely to be under the
finance ministry, not the central bank. Since in modern times banknotes account for a much
larger proportion of the money supply than coins, it is reasonable to say that it is the central
bank that is the ultimate creator of money.
40 CENTRAL BANKING

C O N C E P T: T HE M ONEY CREAT ION PR O C ES S

Banknotes and coins constitute currency. Currency plus commercial banks’
deposits in their accounts at the central bank constitute base money. Base
money is multiplied through the money creation process as it circulates through
the banking system in multiple rounds. The money creation process is essen-
tially a system of double-entry accounting.
The money creation process can be presented by the following stylized
example. In Figure 3.1, when the central bank prints new banknotes and
issues them into the system, the newly issued banknotes are considered claims
on the central bank and will be recorded as liabilities on the central bank’s
balance sheet.
To balance the central bank’s balance sheet, the new liabilities must be
supported by new assets. In the modern day, the central bank might support
the increase in banknotes (or liabilities) on its balance sheet by using those
banknotes to purchase new assets, such as government securities (e.g., Treasury
bills or government bonds), foreign currencies, foreign government securities,
or even gold.
Figure 3.1 illustrates a case in which the central bank prints and issues
new banknotes worth $100 to purchase government bonds worth $100 from
Commercial Bank A. Accordingly, the amount of money in the system first rises
by $100.
On Commercial Bank A’s balance sheet, the increase in banknotes received
from the central bank will appear on the asset side, offsetting the decrease
in government bond holdings. Since banknotes, unlike government bonds,
do not earn interest, ideally Commercial Bank A would not want to let these
banknotes sit idle in its vault. Commercial Bank A would actively seek to lend
out those banknotes.

Central Bank Commercial Bank A

Assets Liabilities
Assets Liabilities
– $100 in
+ $100 + $100 in government bonds
in government banknotes + $100 in
bonds banknotes

Gov’t
bonds
$100
Gov’t
bonds
$100

The central bank prints $100 worth of banknotes to purchase government bonds
from Commercial Bank A. At the end of this stage, the amount of money in the
economy rises by $100, as reflected by banknotes held by Commercial Bank A.

FIGURE 3.1  Stylized Money Creation Process: Step 1

Modern Central Banking Roles and Functions 41

Commercial Bank A Individual I

Assets Liabilities Firm X

– $100 in
banknotes
Firm X takes out a $100 loan The $100 worth of
+ $100 loan from Commercial Bank A banknotes is now
to Firm X and pays its supplier with Individual I.
(Individual I)

Commercial Bank A loans out $100 worth of banknotes to Firm X in order

to earn interest from the loan. To keep Commercial Bank A’s balance sheet
balanced, $100 worth of banknotes is deducted from the assets side of
Commercial Bank A’s balance sheet, while the $100 from the loan made
to Firm X would be added to the same side of the balance sheet.

FIGURE 3.2  Stylized Money Creation Process: Step 2

Figure 3.2 illustrates a case in which Commercial Bank A lends out $100
worth of banknotes to a borrower called firm X, who then uses the banknotes
to pay its supplier called Individual I. On the asset side of Commercial Bank
A’s balance sheet, that lending of $100 worth of banknotes will be recorded as
a decrease of $100 worth of banknotes, and matched by an increase of $100
on a loan made to Firm X.
When Individual I receives the $100 worth of banknotes from Firm X, if
he still does not have an urgent use for that money, then he is likely to put that
amount of money back into his bank account, possibly for safety reasons, and
possibly to also earn interest income from that money.
Figure 3.3 illustrates the case where Individual I deposits $100 worth of
banknotes that he received from Firm X into his account at Commercial Bank B.
Here, on Commercial Bank B’s balance sheet, the $100 that Individual I
deposited into his account at Commercial Bank B would be recorded as an
increase in Commercial Bank B’s liabilities. To match the increase in liabilities,
Commercial Bank B would actively seek to lend out those banknotes to earn
interest on them.
In Figure 3.3, as Commercial Bank B lends to Individual II, the loan made
to Individual II would be recorded as an increase in assets on the balance sheet
of Commercial Bank B. At this point, note that while the central bank origi-
nally issued only $100 worth of banknotes, the total amount of money by this
time has already doubled to $200, since $100 in Individual I’s deposit account
at Commercial Bank B would also be counted as money.
This process of money creation is likely to continue, since individuals or
firms will keep cash on hand only up to a certain level. Any extra cash beyond
that level would be invested or deposited to earn interest income. Once the extra

(Continued)
42 CENTRAL BANKING

(Continued)

Individual I
Commercial Bank B
Individual I deposits
Assets Liabilities $100 worth of banknotes
received from Firm X in a
+ $100 loaned + $100 deposit account held at
to deposit Commercial Bank B.
Individual II made by
Individual I
Individual II
Commercial Bank B loans
out $100 worth of
banknotes to Individual II.

At this point, the amount of money in the system has doubled to $200 (the
$100 deposited in the account of Individual I plus the $100 worth of banknotes lent
out to Individual II).

FIGURE 3.3  Stylized Money Creation Process: Step 3

cash is deposited with a commercial bank, the bank would have an incentive
to lend the extra cash out, so it can generate interest income from that lending.
The rise in the liabilities on the bank’s balance sheet in terms of an increase in
deposits would amount to an increase in the amount of money in the economy,
even though the cash is already lent out and is no longer with the bank.
In Figure 3.4, as Individual II used the borrowed money to buy gadgets
from Merchant I, and Merchant I deposited that money into his account at
Commercial Bank C, the total amount of money rises to $300 from the initial
$100 that the central bank first issued. The $300 includes the $100 worth of
banknotes that are still circulating within the economy, the $100 deposit
of Individual I at Commercial Bank B, and the $100 deposit of Merchant I at
Commercial Bank C.
From the stylized process described above, we can see that the central bank
is indeed very powerful with respect to money creation. Even at this stage, the
$100 worth of banknotes initially introduced by the central bank can turn into
$300 worth of money in the system, with the potential of going much further
as long as the process keeps repeating.

Reserves, Money Multiplier, and Money Supply

In theory, the process described could keep on repeating and thus there are no
bounds on how many times the initial $100 could be multiplied. In practice,
however, the amount of money created through this process would be limited
by the fact that (1) banks might need to keep some cash on hand or in the
Modern Central Banking Roles and Functions 43

Commercial Bank B
Merchant I
Assets Liabilities
+ $100 + $100
Individual II loaned to deposit
Individual II made by
Commercial Bank C Individual I

Assets Liabilities
+ $100 + $100
loaned to deposit
Individual III made by
Merchant I
Individual II
At this point, the amount of money in the system has increased to
$300 (the $100 deposit at Commercial Bank B plus the $100 deposit at
Commercial Bank C plus the $100 worth of banknotes at Individual III).

FIGURE 3.4  Stylized Money Creation Process: Step 4

vaults, or keep some money in their deposit accounts at the central bank, to
meet withdrawal demand from depositors or other urgencies, and (2) the num-
ber of borrowers worth lending to is limited.
The money that banks keep on hand or in the vaults and in their accounts
at the central bank constitutes what is known as bank reserves. In many coun-
tries, the central bank also sets legal reserve requirements, specifying the ratio
of reserves to deposits that the banks are legally required to maintain.
When commercial banks keep a part of deposits on hand or in the accounts
held with the central bank as reserves it is called fractional reserve banking. In
a fractional reserve banking system, if all commercial banks hold, for example,
5 percent of deposits on hand, then the money creation process has the poten-
tial to multiply the initial amount of base money by 1/0.05 = 20 times. If the
initial base money is $100, and commercial banks hold 5 percent of deposits as
reserves, then potentially the maximum amount of the money supply that can
be created from the initial $100 is $100 × 20 = $2,000. Here, 20 is called the
money multiplier. More generically, the money multiplier is 1/(reserve ratio),
where the reserve ratio is the ratio of reserves to deposits.1

suggests that money creation has a vast potential to affect economic activity. Given
that the economy is initially in equilibrium, when new money issued by the central
bank finds its way into a commercial bank’s balance sheet, the commercial bank will
actively seek to lend out that money so that it can earn interest on the loans. Money sit-
ting idle in the vault is costly to banks, whether in terms of storage, interest that must
be paid out to depositors, or foregone interest income that might be earned from lend-
ing the money out. The more money that is introduced into the system, the more banks
will aggressively loan out the money. As more money is introduced into the system,
banks become more willing to lend it out at lower interest and less stringent terms.
44 CENTRAL BANKING

Inflation  The lower costs of borrowing and less stringent borrowing terms enable
borrowers to engage in more economic activity. Firms can borrow more money to
buy raw materials, build new factories, hire employees, and generally engage in pro-
duction. Individuals can borrow more money to buy houses, cars, or other gadgets,
which will, in turn, prompt more production and investments by firms. As firms
and individuals use the money to bid up resources and goods and services, prices of
goods and services will start to rise. Indeed, if the central bank keeps on printing and
issuing new money, money will be worth less and less in terms of goods and services
that can be purchased. A situation in which there is a continuous and sustained (as
opposed to a one-time) rise in the general level of prices is called inflation.

Hyperinflation  At the extreme, if the central bank keeps issuing a lot of money,
money can very rapidly diminish in value, such that the problem of hyperinflation
ensues. With hyperinflation, the value of money can fall so fast, even minute-by-minute,
that it is not a good store of value. People in a country with hyperinflation would
rather use the money to buy goods and services right away once they get the money.
With hyperinflation, people are not able to make optimal investment decisions since
they can’t reasonably predict investment costs and revenues even in the short term.

Recession  In contrast, if too little amount of money is introduced into the system,
economic activity could very well slow down or even fall, tipping the economy into
a recession. With a scarcity of money to lend out, banks will charge higher interest
rates and impose more stringent terms on their loans. Firms will find it hard to bor-
row to buy raw materials, invest in new factories, hire employees, or expand their
production. Individuals will find it hard to borrow money to finance their purchases
of goods and services, which also affects the firms that provide those goods and ser-
vices. Indeed, as money in the system becomes scarcer, and demand for goods and
services falls, firms might have to cut their prices. As firms are unable make profits,
they might have to also cut down on their number of workers, which would further
reduce aggregate demand in the economy.

Deflation  At the extreme, if money is really scarce, economic activity could fall
so much so that a large number of firms will fail, resulting in high unemployment.
Surviving firms, meanwhile, might be forced to keep cutting prices to attract customers.
The number of the firms’ customers, meanwhile, could keep dwindling as more peo-
ple lose their jobs. The situation where the general price level continuously falls is
known as deflation.
Since the amount of money that the central bank introduces into an economy
can seriously affect economic conditions, it is very important that the amount of
money the central bank issues into the economy is appropriate for economic con-
ditions. The central bank might also need to regulate the money creation process
and money conditions in the economy through other means, a subject that we will
explore in more detail in the next section.

The Regulation of Money Conditions: The Conduct of Monetary Policy

Since the central bank is the ultimate money creator and often has the power over
the setting of reserve requirements, it falls on the central bank to be the one regu-
lating the flow and the amount of money in the economy. In modern terms, it is
Modern Central Banking Roles and Functions 45

said that the central bank is responsible for the conduct of monetary policy. As
discussed before, when a lot of money is available in the economy at low cost—
possibly through high money issuance, or from a reduction in reserve requirements,
or from cuts in interest rates—then households and firms are likely to be stimulated
to engage in more consumption and production.
When there is insufficient money in the economy or when the costs of money
are high, on the other hand, households will be less able to borrow to consume,
while firms will be less able to borrow to invest, expand production, or hire workers.
Making sure that there is just the right amount of money available at the right cost
to households and firms is something that the central bank has always aspired to as
the regulator of money.

Money Supply versus Reserve Requirements versus Policy Interest Rate  In a modern, com-
plex economy, the way the central bank regulates money has become more sophis-
ticated and indirect. As will be discussed in Part II of this book in more detail, most
modern central banks no longer attempt to set a target for the money supply in the
economy, since the relationship between the level of base money and the total level
of the money supply in the economy could be very unstable. The central bank, unless
it’s operating a tightly controlled system, also often refrains from frequently adjust-
ing reserve requirements (the percentage of deposits that banks can’t loan out), since
it might hamper the smooth functioning of the economy. For example, if the central
bank raises reserve requirements in order to slow down economic activity and the
banking system previously had been in equilibrium in the sense that there was no
existing excess reserves, commercial banks might need to call in loans from borrow-
ers in order to meet the new reserve requirements. Calling in loans can be very costly
to the banks and their borrowers, and very disruptive to economic activity.
Instead of adjusting reserve requirements, modern central banks often attempt
to regulate money conditions in the economy via the use of a policy interest rate and
financial market operations. A policy interest rate is a short-term interest rate that
a central bank chooses to directly influence, which gives a signal to the public as to
what it sees in terms of future economic conditions and future price levels. By raising
the policy interest rate, the central bank signals to the public that it wants to tone
down the acceleration of economic activity and tame the rise in the general price
level. By lowering the policy interest rate, the central bank signals to the public that
it wants economic activity to pick up and that it wants to allow a rise in the general
price level. By keeping the policy interest rate at a particular level, the central bank
signals to the public that money conditions in the economy are appropriate for a
favorable outlook of economic activity and the general price level. Financial market
operations, on the other hand, help ensure that the policy interest rate stays at or
near the level that the central bank wants to keep.

The Use of Policy Interest Rate and Financial Market Operations to Regulate Monetary Conditions
in the Economy  In a modern financial system, if the central bank deems that money con-
ditions are too loose (i.e., too much money is available at too low a cost), the central
bank might raise the policy interest rate. By raising the policy interest rate, the oppor-
tunity cost of money will increase, and thus lenders will be more discrete in their lend-
ing. In a modern system where news and information are available on a real-time basis,
once the central bank announces the hike in the policy interest rate it is conceivable
that lenders will adjust their lending behavior right away, raising the cost of their loans.
46 CENTRAL BANKING

However, in the case where there is already too much money in the system, the
central bank might back up the announcement of the policy interest rate hike with
open market operations, whereby the central bank itself takes out money from the
system by selling government bonds in the financial market. By selling government
bonds in the financial market, the central bank is effectively draining money from
the system, since payments for the bonds are made using money. Money that buyers
of bonds pay to the central bank will effectively be out of circulation.
In contrast, when the central bank deems that money conditions are too tight
(i.e., too little money is available at too high a cost), the central bank might lower the
policy interest rate. With a lower policy interest rate, the opportunity cost of money
will be lower and lenders will be more willing to lend. As with the hike in the policy
interest rate, news and information is available on a real-time basis and so the mere
announcement of a cut in the policy interest rate will lead to an adjustment in the
behavior of lenders right away.
Still, if the central bank deems it necessary, it could also back up the announce-
ment of the cut in the policy interest rate with operations in the financial market.
Most likely the central bank will decide to buy government bonds in the financial
market. By buying government bonds in the financial market the central bank will
effectively be injecting money into the system, since the government will have to pay
money to market participants for the bonds that it purchased.
The central bank’s role as a regulator of money (i.e., the conductor of monetary
policy), has become a key feature accorded much attention by the public in the past
four decades. Changes in money conditions potentially affect everyone in the econ-
omy. After many trials and errors, and a number of theoretical and practical break-
throughs, the conduct of monetary policy is now widely viewed as a composition of
both art and science. We will examine the theoretical foundations and the practice of
monetary policy in more detail in Part II of the book.

Payment Systems Oversight and Provision

Even in the earlier days of central banking, commercial banks often held accounts at
the central bank. The banks would use the accounts at the central bank to clear trans-
actions among themselves. This practice was quite logical for at least two reasons.
First, as commercial banks themselves often competed in the same line of business,
it was rare that they would hold accounts with their competitors. As central banks
started to take on the role of a public institution rather than a profit-making entity,
they became less commercial in nature and were not deemed competitors by the
commercial banks. Second, with the central bank being the ultimate money cre-
ator with close ties to the sovereign, the central bank was deemed to be safer and
more reliable for the commercial banks’ accounts. When commercial banks trans-
acted among themselves, it became easier for them to settle with each other via their
accounts held at the central bank. Accordingly, the central bank acted a banker to
commercial banks by taking in deposits and clearing funds for them.2
At present, instead of simply clearing funds for commercial banks, the modern
central bank now often takes on a more active role in national payment systems.
With regard to payments systems, the modern central bank often actively partici-
pates as (1) a regulator that ensures smooth functioning of the country’s payment
systems, and (2) a service provider of national payment systems.3
Modern Central Banking Roles and Functions 47

Payment Systems Oversight  As a payment systems regulator, the central bank sets
rules and guidelines regarding payment systems. The central bank’s main aims in
setting rules, arguably, are to (1) reduce the probability of a payment systems failure,
(2) improve efficiency in payment systems, and (3) ensure fairness and equity in the
use of payment systems.4
Payment system failures can cause ripple effects through the financial system
and the economy, as participants might rely on payments to meet their own liquidity
obligations. In extreme cases, liquidity shortages resulting from payment system fail-
ures could cause financial panics and bank runs. Consequently, failures in payment
systems have the potential to disrupt economic activity and cause financial instabil-
ity. It thus is in the central bank’s interest to reduce the probability of such failures,
which could lead to instability in both the financial system and the economy.
Apart from reducing systemic risks, the central bank also regulates the payment
system for efficiency reasons. New technology often brings improved efficiency. In
many cases, however, the private sector might not have the incentive to move to
newer technology, as it often requires major investments. To help prod the private
sector along, the mantle often falls on the public sector, particularly the central bank,
to issue guidelines and regulations to help coordinate players in the private sector to
move to the new technology on an appropriate timeline.5
Efficient payment systems are also integral to efficient monetary policy opera-
tions. Efficient payment systems can help the central bank inject and absorb liquid-
ity more quickly. Likewise, efficient payment systems will allow commercial banks
to efficiently manage their reserves. Commercial banks can borrow and lend more
quickly as needed. Consequently, to ensure maximum efficiency in monetary opera-
tions it is also in the interest of the central bank, as the conductor of monetary policy,
to get involved in designing and regulating payment systems.6
Furthermore, since payment systems are often a public good with positive exter-
nalities, the central bank might want to set rules that ensure equity and fairness in
the economy. The infrastructure of a payment system network often has economies
of scale and requires large investments that can only be made by the public sector or
large players in the private sector. When the private sector is the one making the nec-
essary investments, it might be beneficial that smaller players also be able to access
the network at a price that is affordable to them, yet fair to those large players that
made the investments.

Payment Systems Provision  The modern central bank is often the key service provider
for the large-value fund (wholesale) transfer system in the economy. For interbank
fund transfer payments, it is often most efficient for commercial banks to use a
single integrated central system, rather than relying on different, fragmented systems.
Such a single integrated central system, however, is a public good. Without public
intervention, commercial banks that initially invested in such an infrastructure are
unlikely to allow other commercial banks to join in (or free ride) the network. To
get around this problem, most central banks often become key service providers
of wholesale payments themselves. For small-value (retail) fund transfer payments,
however, central banks often get involved as a service provider only with certain
types of instruments, notably check clearing. Central banks would be unlikely to be
involved with credit card clearing, however, since private sector service providers
already provide extensive services in this area.7
48 CENTRAL BANKING

Lender of Last Resort

As discussed in Chapter 1, historically it became natural for a bank in trouble to
look to the central bank for help, if all else failed, since the central bank was the ulti-
mate creator of money with close ties to the sovereign, and a banker to banks.8 Prior
to the recent global financial crisis, however, the modern central bank often played
down this function for fear of the so-called moral hazard problem.9

Moral Hazard  In a banking context, the moral hazard problem suggests that if banks
know that they can always seek assistance from the central bank, they will be more
reckless in their behavior. Banks might lend to risky projects without adequately pre-
paring for the risks they are taking on and always assume that help will be at hand.
To discipline banks against the moral hazard problem, the central bank often urges
the banks to find other means of assistance before coming to the central bank.10
Often, the central bank will also make clear that it will not rescue any single bank
unless it would jeopardize the whole system (i.e., too-big-to-fail).
In the wake of the recent global financial crisis and the subsequent euro cri-
sis that threatened to destabilize the global economy, however, many central banks
had to again embrace the lender-of-last-resort function in a very significant man-
ner. Major central banks, including the Federal Reserve, the ECB, and the Bank of
England, all became lenders of last resort to prevent the crises from destabilizing the
financial system and the economy even more severely than it already had.

Forms of Lender-of-Last-Resort Function  Theoretically, the central bank can assume the
lender-of-last-resort function in three main forms. First, it can lend liquidity to indi-
vidual banks. Second, it can lend liquidity to the market, rather than to specific
individual financial institutions. Third, it can inject risk capital into troubled banks,
which effectively also implies a takeover of the banks by the government.11
In the first form of the lender-of-last-resort function, the central bank could pro-
vide short-term loans, possibly against collateral such as government securities, directly
to a troubled bank so that it could meet its short-term obligations first. Once the
troubled bank met its short-term obligations, it could return to normal functioning
and would be expected to repay the borrowed funds to the central bank. The fact that
the bank could return to normal functioning after meeting its short-term obligations
suggest that the bank was merely facing a liquidity problem rather than a solvency
problem.* In the second form of the lender-of-last-resort function, the central bank
could lend out liquidity to the market, rather than to specific individual financial

*A liquidity problem suggests that an entity might not be able to liquidate its assets in a timely
manner without incurring losses from the liquidation, and that those losses might hamper the
entity’s ability to meet its short-term obligations in full. If the liquidity problem is addressed in
a timely manner, the losses might not be so severe and could be covered by the entity’s existing
capital. In such a case, if the liquidity problem is addressed in a timely manner the entity is
likely to be able to return to normal functioning. A solvency problem, however, suggests that
the entity might not have enough current assets to meet its current liabilities, and the entity
might need to draw down a substantial portion (or all) of its capital to meet liabilities. With a
solvency problem, the entity thus might not be able to return to normal functioning without
a capital injection.
Modern Central Banking Roles and Functions 49

institutions, to reduce liquidity shortages that occur across the financial system in
times of extreme stress. Examples from the global financial crisis of 2007–2010
include the Federal Reserve’s Primary Dealer Credit Facility, which was set up to
ease up liquidity conditions in the repo (repurchase) market,12 as well as the Federal
Reserve’s Commercial Paper Funding Facility, which was created to ease liquidity
conditions in commercial paper market.13 In both cases the Federal Reserve was will-
ing to lend to nonbank financial institutions as well as nonfinancial firms (in many
cases against illiquid collateral) to help alleviate liquidity shortages in these markets.
With extra liquidity from the central bank, financial institutions or firms are able
to meet their short-term obligations better. The lending can also help bring down
the general level of short-term interest rates or prevent them from rising further. If
short-term interest rates are low, financial institutions will be more willing to lend
and borrow both among themselves and with other customers, which will help ease
general tightness in liquidity and allow economic activity to continue.
The third form of the lender-of-last-resort function applies to cases in which the
bank is unlikely to be able to return to normal functioning even after meeting its
short-term obligations (i.e., the bank is facing a solvency problem). In such cases the
central bank might need to inject risk capital into the bank and take over the manage-
ment of that bank. Through injecting capital the central bank would take ownership
of the bank (as opposed to merely lending) and would work to find a suitable resolu-
tion to the problem. In a way, we could view injection of risk capital into banks as
a special resolution for troubled banks, which will be discussed later in this chapter.

Bank Supervisor
As discussed in Chapter 2, if the role of lender of last resort is placed upon the cen-
tral bank, it is only fair that the central bank should be able to regularly assess the
health of commercial banks, since if any of the banks get into trouble the central
bank would have to decide if it is worth helping, and if so, pay for such help.14 In
many countries such a role has since evolved into banking supervision, under which
the central bank not only has a formal duty to inspect the soundness of commercial
banks’ operations but also to issue regulations that will ensure such soundness.
In practice, modern central banks have a number of related but diverse tasks as
bank supervisors. These tasks might include (1) licensing of new banks, (2) exami-
nation and monitoring of banks’ operations, (3) setting regulatory requirements for
banks, (4) enforcement of regulations to ensure corrective action, and (5) providing
resolution for troubled financial institutions when necessary.15 The aim of these tasks
is to reduce risk with respect to individual financial institutions as well as to the
system as a whole.

Licensing of New Banks  Many central banks undertake the task of new bank licens-
ing to ensure that banks under its supervision will start with a sound framework.*
Organizers of a new commercial bank have to submit an application to the central

*Note that in the United States, the Federal Reserve does not provide banking licenses. Rather,
states grant banking license to state banks and the Office of the Comptroller of the Currency
grants licenses to national banks. (Board of Governors of the Federal Reserve System 2005)
50 CENTRAL BANKING

bank for approval. Normally, the central bank will examine the soundness of the
business plan to see if the new bank will be profitable after a certain period of time.
Individuals proposed for the board of directors and management of the bank will
also be examined to see if they are fit and proper (i.e., they are honest and trust-
worthy, they have never declared bankruptcy, and they have not been directors or
managers of another bank that failed).16
Apart from ensuring the safety and soundness of a new bank through its policy on
new bank licensing, the central bank can also shape the financial landscape under its
jurisdiction in such a way that systemic risks are reduced and innovation and competi-
tion are encouraged. For example, if the central bank deems existing competition among
commercial banks to be already healthy and sufficient, and that more entrants will bring
in excessive competition such that the commercial banks might have to resort to riskier
activities to achieve acceptable returns, then the central bank might decide to delay new
licensing. In contrast, if the central bank deems current competition and innovation to
be insufficient in supporting economic activity, then the central bank can give licenses
to new players or allow banks to provide a wider range of financial products.

Examination and Monitoring of Commercial Banks’ Operations  Bank examination is a basic

foundation of the bank supervisory process. It is done to assess the soundness of
commercial banks’ operations, and to ensure that that commercial banks comply
with rules and regulatory requirements. In these modern days, bank examination
consists of two complementary tasks, namely on-site supervision and off-site moni-
toring. On-site examination refers to a situation in which the central bank sends its
staff to inspect the bank on site, at the bank’s offices. Off-site monitoring is done in
the period in the supervisory cycle between on-site examinations, and involves the
central bank monitoring and analyzing the commercial bank’s performance using
data from on-site examination and other relevant sources to determine the safety
and soundness of the bank’s condition and performance.17

C O N C E P T: BANK EXAM INAT ION

Bank examination has always been a foundation of the bank supervisory pro-
cess. Modern bank examination is often composed of two main elements:
on-site examination and off-site monitoring. These two elements are comple-
mentary in nature.

On-Site Examination
In a typical on-site examination, bank examiners sent by the central bank will
interview the bank’s management, inspect the bank’s written policies and pro-
cedures, determine the degree to which the policies and procedures are actually
followed, evaluate the adequacy of the bank’s capital, check the accuracy of
accounting records, check the adequacy of internal controls and the audit func-
tion, and check for compliance with laws and regulations. (See Table 3.2.)
Apart from being written up, results of an on-site examination are also
often summarized into a single composite number in what is known as the
CAMELS rating system (or its variants), where C stands for capital adequacy,
A stands for asset quality, M stands for management (which includes internal
Modern Central Banking Roles and Functions 51

TABLE 3.2  CAMELS Rating Components

CAMELS Rating System

C Capital adequacy
A Asset quality
M Management
E Earnings
L Liquidity
S Sensitivity to market risk
Source: Adapted from Board of Governor
of the Federal Reserve System, The Federal
Reserve System: Purposes and Functions
(Washington, DC: Board of Governors of
the Federal Reserve System, 2005).

controls, corporate governance, and audit), E stands for earnings (which

reflects profitability), L stands for liquidity (the ability to convert assets into
cash to meet unexpected temporary excess withdrawals), and S stands for sen-
sitivity to market risk (the sensitivity of the bank’s capital or profitability to
changes in interest rates, foreign exchange rates, or share prices, and the bank’s
measures to mitigate those risks).18
The weight given to each CAMELS component can vary, but often the
most weight is given to management. The central bank expresses its opinion
about the safety and soundness of the examined bank through the CAMELS
rating and the analysis contained in its report.19

Off-Site Monitoring
In practice, it is not cost-effective or convenient for central banks (and com-
mercial banks) to have bank examiners on-site in each bank at all times. The
supervisory central bank would thus use off-site monitoring to cover the period
in the supervisory cycle between on-site examinations. During off-site moni-
toring, the supervisory central bank will check for correction of the financial
problems revealed at the last on-site examination; plan ahead to identify areas
of emerging risk to focus on in the next examination; and analyze current con-
ditions and performance of the bank based on regulatory reports, reports of
the examiners, and publicly available information about the bank, such that,
if necessary, changes to the CAMELS rating, a targeted examination, or a full-
scope examination that takes place earlier than scheduled can be made.20

Setting Regulatory Requirements for Commercial Banks  The supervisory central bank
has the power to set rules and guidelines for commercial banks to ensure that they
operate in a safe and sound manner. Such regulations might range from the banks’
corporate governance and risk management practices to capital and reserve adequacy
requirements. For a central bank, capital requirements (the minimum capital that
each bank needs to have to buffer against unexpected losses) and reserve require-
ments (the minimum reserves that each bank needs to hold against deposits to meet
52 CENTRAL BANKING

liquidity demand) are among the key regulations it can use to ensure the safety and
soundness of commercial banks’ operations.

CASE STUDY: Capital Requirements and Reserve Requirements

Capital requirements and reserve requirements are among key regulations that the central bank can use
to ensure safety and soundness of banks under its supervision.

Capital Requirements
Since 1988, many central banks have adopted the capital requirement guidelines known as Basel I,
which were issued by the Basel Committee on Banking Supervision, an international body based in the
town of Basel, Switzerland. Basel I suggested how much capital banks should hold against different
types of assets to compensate for credit risk (risk that the bank’s debtors might be unable to repay their
debts). A central bank that had adopted Basel I would make sure that the banks under its supervision
would comply with the rules.
In 2004, the Basel Committee introduced a new version of capital guidelines called Basel II.
Basel II took account of liquidity and operation risks, in addition to credit risk, which was the focus
of Basel I. In addition, Basel II also aimed to adjust the practice of bank supervision by giving more
emphasis to off-site supervision, whereby the bank supervisor would focus less on examining the
banks’ transactions and more on the banks’ risk-management practices. Although Basel II had not yet
been widely adopted when the global financial crisis came in 2007, the crisis made its shortcomings
apparent. The Basel Committee went back to work and introduced Basel III at the end of 2010. The
details of Basel I, II, and III are discussed in Chapter 12.

Reserve Requirements
While capital requirements are primarily meant to ensure that banks have enough capital to prevent
unexpected losses in the value of their assets from directly affecting the banks’ depositors, reserve
requirements are meant to ensure that the banks have enough liquidity to meet liquidity demand.21
Reserves are traditionally held in the form of cash, or deposits at the central bank, and thus banks
can easily turn to them to meet liquidity demand. Historically, reserve requirements have also been
used as a tool of monetary policy.22 When reserve requirements are raised, banks have to keep more
reserves as cash or deposits at the central bank rather than lending them out as loans. With fewer loans
being provided in the economy—all other things being equal—economic activity will slow down. When
reserve requirements are lowered, banks are able to provide more loans, as they are required to hold
less cash and deposits at the central bank as reserves.
In modern times, not many central banks use reserve requirements as a tool of monetary policy
since frequent adjustments in reserves can entail substantial costs for both banks and customers. For
example, if the central bank decides to raise reserve requirements, then a commercial bank that already
has its reserves at the previous minimum required levels might need to convert extra assets into cash.
If the bank does not have extra assets that can be easily converted into cash, then it might need to call
in loans from customers that had previously been extended.
A small number of central banks have decided to forego reserve requirements altogether.23
Reserves can be considered extra costs imposed on banks. Cash kept as reserves do not provide
returns, and can incur a cost of safekeeping. Deposits held at the central bank might also not earn inter-
est or earn considerably less than could be gained from lending to customers. Most modern central
banks, however, still deem reserve requirements to be a crucial regulation to ensure commercial banks’
liquidity, and thus keep it as a regulatory tool.

Enforcement of Laws and Regulations to Ensure Compliance  To make sure that commercial
banks comply with laws and regulations, the central bank is often endowed with
Modern Central Banking Roles and Functions 53

enforcement power over banks. If banks are found not to be in compliance with
laws and regulations, the central bank has the power to ensure compliance from the
banks using various kinds of measures, from mild to drastic, to ensure that the banks
pursue corrective actions.24
Milder measures include moral persuasion, whereby the central bank has discus-
sions with the management of a commercial bank to persuade it to alter its gray area
actions. More drastic measures that the central bank might use to ensure compliance
with laws and regulations can include removal of directors or managers of banks for
negligence or misconduct and installation of a temporary administration, as well as
a recommendation of a forced sale or liquidation of the bank.25

Resolutions for Troubled Financial Institutions  Although the central bank may set vari-
ous rules and regulations and examine commercial banks’ operations in minute
detail, there is always a possibility that some banks might still run into trouble.
To ensure that these troubled banks do not fail in a disorderly manner, the central
bank and relevant authorities might need to impose special resolutions on these
troubled banks.
Key types of such resolutions are (1) liquidation, or the closing of banks whereby
the banks’ assets are liquidated in order to repay the banks’ liabilities; (2) conser-
vatorship, or temporary administration of the banks; (3) purchase and assumption,
under which a healthy bank purchases some or all of a failed bank’s assets and
assumes some or all of the failed bank’s liabilities; and (4) nationalization, under
which the government takes over a failed bank and assumes the bank’s assets and
liabilities.26

3.2 TO SUPERVISE BANKS OR NOT?

The global financial crisis of 2007–2010 brought a reexamination of the modern

central bank’s role as bank supervisor. In the 1990s and 2000s, many governments
decided to carve the bank supervisory role out of the central bank and give the role
to a specially created financial regulatory body. One rationale was that the central
bank’s supervisory role was inherently in conflict with its role as the conductor of
monetary policy. As a bank supervisor, the central bank knew the detailed financial
condition of banks under its supervision. As a conductor of monetary policy, the
central bank had the obligation to tighten monetary conditions if it saw inflationary
pressures building up. By tightening monetary conditions, however, business activi-
ties could slow, and firms with outsized debts might fail. Banks might have to write
down loans, making the banks’ own financial situations more precarious. Because
of its bank supervisor role, if the central bank was aware that monetary tightening
might lead to a deterioration of the banks’ balance sheets then it might hesitate to
tighten monetary conditions, even if inflationary pressures warranted a contraction.
Consequently, by the middle of the first decade of the twenty-first century a number
of central banks had already shed their bank supervisory role and relegated it to a
financial services authority, also known as a financial supervisory authority (FSA).
As the global crisis struck in 2007, the reexamination of whether the central
bank should delegate its bank supervisory role became particularly notable in the
54 CENTRAL BANKING

case of the Bank of England. Without detailed knowledge of the banking sector bal-
ance sheets, the Bank of England was caught largely unaware of financial problems
in the banking sector. When bank failures threatened to become systemic, poor coor-
dination among the FSA, the Treasury, and the Bank of England was cited as a cause.
After all, the FSA, which had details on the banks’ situations, did not have the money
or the authority to help the banks financially. The Bank of England, which had
the means to help the banks, however, did not have the details to help effectively.
As the crisis unfolded, the British government decided to eliminate the FSA and place
the bank supervisory role back with the Bank of England.

3.3 SO WHAT EXACTLY IS A MODERN CENTRAL BANK AFTER ALL?

From the discussion above, the modern central bank has retained and modified
many of the functions discussed in Chapter 2. In general, it could be said that the
modern central bank issues money, conducts monetary policy, and regulates and
provides payment systems services. When required, the modern central bank also
acts as a lender of last resort, although it often tries to play down this function for
fear of moral hazard. In many countries, the modern central bank also supervises
commercial banks (i.e., it issues new bank licenses, sets regulatory standards for
banks, examines and monitors bank operations, and enforces laws and regulations
to ensure that banks operate in a safe and sound manner).
The functions of the modern central bank discussed above can be grouped into
two broad categories that align with two of the key modern central bank mandates,
that is, monetary stability and financial stability. Those central bank functions relat-
ing to issuance of money and the conduct of monetary policy are done in such a way
that monetary stability is ensured (i.e., keeping inflation low and stable). Those func-
tions relating to payment systems regulation and provision, lender of last resort, and
bank supervision, on the other hand, are all done to ensure financial stability (i.e.,
the smooth functioning of the financial system).
In practice, many modern central banks arrange their internal organizational
structure broadly along the lines of these two mandates, with one wing dealing with
monetary stability and the other dealing with financial stability.* In the wake of the
2007–2010 global financial crisis, however, it has become increasingly recognized
that monetary stability and financial stability are intertwined, and one cannot exist
without the other. Central banks have since put increasingly more emphasis into
effective coordination between these two wings. In the next chapters, we will discuss
why monetary stability and financial stability have become key mandates for the
modern central bank, and how the central bank can act to fulfill these two mandates
in practice.

*Organizationally, the banknote issuance department is often not put under the monetary
stability wing, although determining the number of banknotes to issue is often done in con-
sultation with the monetary policy department. Operationally, the banknote issuance function
involves management of the printing press, distribution centers, and so on, which makes it too
cumbersome to place it under the monetary stability wing.
Modern Central Banking Roles and Functions 55

SUMMARY
Modern central banking functions include money issuance, the conduct of monetary
policy, payment systems oversight and provision, lender of last resort, and banking
supervision.
In modern times, the central bank issues money in the form of banknotes, as well
as in an electronic form. Money issued by the central bank goes through the money
creation process, which essentially constitutes a double-entry accounting process as
it circulates through the system. The final amount of money that comes out of the
money creation process is the money supply.
Modern central banks also aim to regulate money conditions, since the money
creation process has the potential to affect economic activity and price levels.
Theoretically the central bank can regulate money conditions through the conduct
of monetary policy, using reserve requirements, changing the policy interest rate, and
carrying out open market operations. In practice, modern central banks often avoid
using reserve requirements as a monetary policy tool, but instead use the policy
interest rate and open market operations to regulate money conditions.
Modern central banks often also perform payment systems oversight and provi-
sion functions. The central bank might want to perform payment systems oversight
to ensure a low probability of payment systems failure, to improve efficiency of the
payment systems, and to ensure equity and fairness in the use of payments systems.
The central bank is also often the provider of the wholesale payment system for the
economy.
The lender-of-last-resort role can take three key forms: (1) liquidity provision to
individual banks, (2) liquidity provision to the market as a whole, and (3) injection
of risk capital into troubled financial institutions.
Banking supervision is not a universal function for all central banks. For those
central banks that have a banking supervision function, the tasks might include
licensing of new banks, bank examination, setting regulatory requirements, enforce-
ment of laws and regulations to ensure compliance, and providing resolutions for
troubled financial institutions.
In the wake of the 2007–2010 global financial crisis, there has increasingly been
a reexamination of the debate about whether a central bank should perform a bank-
ing supervision function.

KEY TERMS
banking supervision money creation process
base money money multiplier
CAMELS money supply
capital requirement off-site monitoring
deflation on-site examination
hyperinflation open market operations
inflation payment systems oversight
lender of last resort payment systems provision
liquidity problem policy interest rate
56 CENTRAL BANKING

recession reserves
reserve ratio solvency problem
reserve requirements

QUESTIONS
1. What are main functions of modern central banks?
2. What are the key roles of modern central banks?
3. What is base money?
4. What is currency?
5. What is a money multiplier?
6. What is a reserve ratio?
7. Why does money issued by the central bank appear on the liability side of the
central bank’s balance sheet?
8. Loans made by a commercial bank would be recorded on which side of the
commercial bank’s balance sheet?
9. If a central bank issues money to a commercial bank, what does it usually take
in return?
10. If a central bank issues $100 worth of new money, and takes in $100 worth of
government securities in return, what will happen to the central bank’s balance
sheet?
11. If a central bank issues $100 of new money to a commercial bank, and the
reserve requirement on banks is 10 percent, what is the maximum change in
the amount of money in the system after the completion of the money creation
process?
12. In Question 11, if the reserve requirement is reduced to 8 percent, what is likely
to happen to the amount of money in the system?
13. What could happen if there is too little money in the system? How could the
central bank help solve this problem?
14. What would happen if there is too much money in the system? How could the
central bank help solve this problem?
15. Why might a central bank not use reserve requirements as a tool of monetary
policy?
16. What do we mean by policy interest rate?
17. How can open market operations be used in conjunction with the policy interest
rate in the conduct of monetary policy?
18. What could be key objectives of the central bank in payment systems
oversight?
19. How did the payment system provision function historically come about for
central banks?
20. Why might a central bank still need to provide payment systems infrastructure
for the banking system?
21. Explain different types of actions that a central bank might perform when
implementing the lender-of-last-resort function.
22. What are the goals of bank licensing?
Modern Central Banking Roles and Functions 57

23. What are the key differences between a liquidity problem and a solvency
problem?
24. What are key differences between capital requirements and reserve requirements?
25. How are on-site examination and off-site monitoring complementary?
26. In a banking examination, the CAMELS system or one of its variants is often
used. What are the key features of the CAMELS system?
27. Under the CAMELS system, which indicator indicates that a commercial bank is
profitable?
28. To ensure compliance of commercial banks to banking laws and regulations,
what kinds of measures can a supervisory central bank use?
 CHAPTER 4
A Brief Review of Modern Central
Banking Mandates
What Are the Goals That Modern
Central Banks Try to Achieve?

Learning Objectives
. Identify and distinguish different mandates of modern central banks.
1
2. Describe the monetary stability mandate.
3. Describe the financial stability mandate.
4. Describe the full employment mandate.
5. Explain the interlinkages among monetary, financial stability, and
employment mandates in the short and long run.

In Chapter 3 we reviewed the five key functions of the modern central bank: money
creation, the conduct of monetary policy, payment systems oversight and provision,
lender of last resort, and banking supervision. We examined how these functions fit
into two key roles of modern central banks, that is, the safeguarding of monetary
stability and the safeguarding of financial stability.
In Chapter 4 we will look at the key roles, or mandates, of modern central banks
in more detail. First, we will look at monetary stability and financial stability, the
two key mandates common to many modern central banks. Then, we will also look
at the full employment mandate of the U.S. central bank, which has regained much
attention after the recent global crisis.

4.1 AN OVERVIEW OF MODERN CENTRAL BANKING MANDATES

Before going into detail on each of the mandates, however, there are two things to
note about them. First, central banks’ roles or mandates do evolve following changes
in the economic, political, and ideological environment. Since these roles evolve over
time, not every central bank, even those in the advanced economies, are on the same
page with regard to each these roles, not the least in terms of explicit legal mandates.

59
60 CENTRAL BANKING

The Evolving Nature of Mandates

As discussed in Chapter 1, central banks’ roles in the economy evolved over time.
Although many of the earliest central banks started with a coin sorting and storing
function, or with war financing, in modern times such functions no longer belong
to a central bank. After the breakdown of the Bretton Woods system, the conduct of
monetary policy, a relatively new function, took center stage.
Only after the long accumulation of knowledge and hard experience—including
the Great Depression, hyperinflation episodes, and the Great Inflation—have central
bankers and economists come to believe that monetary stability (as defined by low
and stable inflation and confidence in the currency) should be the goal of monetary
policy, since it is believed to be a necessary ingredient for full employment in the
long run.
Meanwhile, functions such as lender of last resort, payment systems oversight,
and (in many cases) bank supervision, also put the central banks at the forefront in
preventing and dealing with a crisis. Even before the wake of the recent 2007–2010
global financial crisis, many countries had already put greater focus on the concept
of financial stability.

Monetary Stability and Price Stability  A better understanding of how a central bank
can use monetary policy to contribute to long-term sustainable economic growth
has led many countries over the past four decades to include monetary stability
or price stability as mandates for their central banks. In this book, the terms mon-
etary stability and price stability are used interchangeably. It is worth noting that the
Bank of England has monetary stability (defined as “stable prices and confidence in
the currency”) as one of its core purposes (stable prices are defined by its inflation
target).1 The U.S. Federal Reserve Act has also set stable prices as an objective for the
Federal Reserve to achieve since the late 1970s, with the term stable prices often
being expressed as the price stability objective.2 The European Central Bank (ECB)
and the Bank of Japan also have price stability as one of their objectives.3

Financial Stability  Meanwhile, since most central banks do have traditional functions
such as payment system oversight and lender of last resort, which are broadly aimed
to help safeguard stability of the financial system, it could be said that central banks
also have an inherent financial stability mandate. This inherent financial stability
mandate often holds even if the definition of financial stability varies among central
banks, or if the central bank lacks a bank supervisory function, or even if financial
stability is not explicitly stated as a legislative mandate.
For example, while it is often recognized that the Federal Reserve has had an
explicit dual mandate of price stability and full employment since the 1970s, it is
also often argued that the Federal Reserve has always had an inherent financial sta-
bility mandate as well.4 The Federal Reserve’s financial stability mandate is further
evidenced by its actions as a lender of last resort during the global financial crisis of
2007–2010.5

Maximum or Full Employment  In the wake of the recent global financial crisis, how-
ever, it is worth noting that the full employment mandate, particularly that of the
Federal Reserve, has again come into the spotlight. Although the Federal Reserve
A Brief Review of Modern Central Banking Mandates 61

TABLE 4.1  Key Central Bank Mandates

Monetary Stability Financial Stability Full Employment

■■ Refers to stability of the ■■ Still no universally agreed- ■■ Quite uniquely, the Federal
value of the currency, upon definition, but often Reserve has “price stability
whether in terms of refers to smooth function- and full employment” as its
domestic or overseas ing of the financial system mandate.
purchasing power. and robustness against ■■ Until recently, the Federal
■■ Thus encompasses price shocks. Reserve has underplayed
stability, and can be used ■■ Thus encompasses many the full employment man-
interchangeably in certain of the traditional central date, preferring to suggest
contexts. banking functions, such as that full employment can
payment system oversight, be achieved through price
lender of last resort, and stability.
banking supervision.

has been given a legal dual mandate of price stability and full employment since the
late 1970s, it seems to have been quite reluctant to mention full employment as a
separate mandate, preferring to state that maximum employment could be achieved
through the achievement of price stability.6 With the global financial crisis pushing
unemployment up to record highs while inflation remained low, however, the Federal
Reserve noted again in 2008 that its goals were “maximum employment and price
stability.”7 (See Table 4.1.)

The Intertwining Nature of Mandates

The second thing to note about central banking mandates before we discuss them
in more detail is that the three key mandates (monetary stability, financial stability,
and full employment) listed above are intertwined by nature. There could be conflicts
or complementarity among the mandates, depending on time horizon and context.

Short-Run Tradeoffs, Long-Run Synergy  With respect to time horizon, in the short run
the monetary stability mandate might be in conflict with the full employment man-
date. Sometimes, to maintain monetary or price stability, the central bank might need
to tighten money conditions, possibly by raising the policy interest rate, which could
temporarily slow down economic growth and have negative impacts on employ-
ment. In the long run, however, the conflict between monetary stability and full
employment might not exist. If anything, to the extent that monetary stability helps
economic agents plan their investment and consumption decisions more optimally,
there might be synergy between the monetary stability and full employment man-
dates. Monetary stability could help bring about full employment in the long run.
Over the long run a violation of one of the mandates can also upset the abil-
ity of the central bank to achieve the other two mandates.8 For example, if the
central bank’s financial stability mandate is compromised, a resultant financial crisis,
if severe enough, could drag the economy into a deflationary spiral in which prices
of goods and services keep falling, resulting in monetary instability. In such a case, a
severe unemployment problem could result.
62 CENTRAL BANKING

In practice, mindful of the intertwining nature of mandates, modern central

banks often need to balance their actions in achieving each of them. In general, for
monetary policy actions the overriding mandate being served is often price stability,
for reasons that will be discussed in more detail in later chapters. In recent years, cen-
tral banks have also become more mindful of the fact that monetary policy d ­ ecisions
might need to take account of longer-term financial stability issues.
Lessons from the recent global financial crisis suggest that if the central bank
keeps interest rates low for too long because it believes that price stability, as signi-
fied by low and stable consumer price inflation, has been achieved, then low interest
rates might encourage economic agents to engage in speculative activities.9 Large
asset price bubbles could build up, and once they burst could threaten financial
stability, as well as longer-term monetary stability and, for that matter, economic
growth and employment.

A Note on the Full Employment Mandate

The full employment mandate of the Federal Reserve can be considered quite contro-
versial. Upon reviewing statements by Federal Open Market Committee (FOMC)—
the committee that determines the monetary policy of the Federal Reserve—Daniel
Thornton of the Federal Reserve Bank of St. Louis suggested that before the global
financial crisis, even the FOMC had been very reluctant to state that maximum
employment was a part of its dual mandate (the second part of the mandate being
price stability).10
According to Thornton, research may suggest that although it is widely agreed
that monetary policy can directly affect economic growth the direct relationship
between monetary policy and unemployment is elusive.11 Also, there is a hypothesis
that the central bank might not be able to push unemployment down beyond a
certain point without triggering inflation.* That theory was partly confirmed by the
stagflation experience in the late 1970s and early 1980s, which suggested that by
focusing on achieving maximum employment in the short run, the central bank can
fail to satisfy both the monetary stability and full employment mandates in the lon-
ger run. Furthermore, the equilibrium unemployment rate can also shift over time,
making it difficult to specify what full employment might look like.12
Among central banks of major advanced economies, only the Federal Reserve
has emphasized full employment as its legal mandate. The Federal Reserve’s full
employment mandate dates back to a time when many mainstream economists still
believed in the power of public institutions to actively manage macroeconomic poli-
cies and stagflation had not occurred. In the wake of the stagflation experience and
more recent theoretical developments, mainstream economists and central banks
have argued for central banks to focus their monetary actions on the maintenance of
monetary stability rather than full employment. With monetary stability maintained,
it’s believed that the private sector can allocate resources more efficiently, which
would result in economic and employment growth.
In the wake of the subprime crisis in 2007–2010, however, the full employment
mandate regained much attention, since the severity of the crisis was so grave that

*This is the natural rate of employment hypothesis, which is discussed in the Chapter 6.
A Brief Review of Modern Central Banking Mandates 63

the U.S. economy was on the verge of falling into another Great Depression, and
unemployment reached record highs. With expectations that inflation would remain
low after the nadir of the crisis had passed and financial stability had been restored,
the Federal Reserve cited the full employment mandate when embarking on novel
measures of monetary policy, such as massive liquidity injections.13
Still, regardless of whether they have a full employment mandate, in prac-
tice central banks often do have to take the employment situation into consid-
eration when carrying out policy actions, since central bank monetary policy
actions ­normally have an impact on employment and thus the general welfare of
the public.

4.2 MONETARY STABILITY

The term monetary stability describes a situation in which the value of money does
not fluctuate too much, that is, money doesn’t lose or gain in value too quickly. If
money loses or gains in value too quickly, households and firms are unable to make
optimal consumption and investment decisions. When money loses its purchasing
power, we need more money just to buy the same amount of goods and services: in
other words, the price of goods and services is rising. A situation in which there is a
general rise in prices of goods and services is called inflation.
In contrast, when money gains in purchasing power, it means we need less money
to buy the same amount of goods and services. Prices of goods and services, we could
say, are falling. The general fall in prices of goods and services is called deflation. At
first glance, we as consumers might seem to benefit from such a situation, since we
can buy more goods and services with less money. In the longer run, if the situation
persists, however, we as employees or owners or firms that sell goods and services
would also lose. With falling prices, firms would make less profit, have less money
to pay employees and suppliers, and have less money to repay their debts. Economic
activity could slow down, affecting our income and employment.
Whether money would gain or lose in value depends, at least partly, on the cen-
tral bank’s actions. At the simplest level, if the central bank, the creator and ­regulator
of money, decides to loosen monetary conditions, making money more immediately
available, then money would lose its value relative to other goods and services.
Goods and services will become more expensive. In other words, prices of goods
and services will rise. In contrast, when the central bank tightens monetary condi-
tions, making money scarcer, then money gains in value relative to other goods and
services. Goods and services will become cheaper, and their prices will fall. If money
gains or loses value very quickly, there would be consequences on the economy, since
people might be unable to adjust their behavior in a timely manner. Consumption
and investment behavior could be severely distorted.

Monetary Stability versus Price Stability

The term monetary stability is very closely related to price stability. Price stability,
however, implicitly refers to stability in domestic purchasing power of the currency,
and thus has a narrower meaning, since the value of money can also be measured
in terms of overseas purchasing power via exchange rates. Monetary stability,
64 CENTRAL BANKING

which refers to the stability of the value of money in general, is a broader term.
As mentioned earlier, the Bank of England has monetary stability—defined as
“stable prices and confidence in the currency”—as one of its core purposes,
where stable prices are defined by its inflation target.14 Theoretically, however,
both price instability and monetary instability have the same root cause, and thus
­sometimes the terms are used interchangeably. In the long run, if the central bank
introduces too much money into the economy, money would lose value, whether in
terms of domestic or overseas purchasing power. A persistent rise in inflation (the
loss of domestic purchasing power) and a weakening of the exchange rate (the loss
of overseas purchasing power) often come hand in hand when too much money
is introduced.
In practice, the choice of whether to use the term monetary stability or price
stability depends on the surrounding context and what the central bank wants to
communicate to the public. In the past two decades it has become more recognized
that domestic inflation and the exchange rate are two distinct operational objec-
tives of the central bank. For a central bank that wants to emphasize that it focuses
its monetary policy actions purely on stability of domestic purchasing power of
the currency without much regard for the exchange rate, the use of the term price
stability might be appropriate. For a central bank that wants to emphasize the fact
it also cares about the stability of the exchange rate, the use of the term monetary
stability might be more apt. As will be discussed later in more detail, the choice of
a monetary policy regime will also have an impact on the choice of an exchange
rate regime.
Here, as noted earlier, the terms monetary stability and price stability are used
interchangeably to denote a situation of low and stable inflation. A more detailed
discussion of the exchange rate in the context of monetary stability takes place in
Part II of this book.

Why It Is Important
Monetary stability helps enable economic agents to make their investment and con-
sumption decisions more optimally. With inflation low and stable (and with the
exchange rate not overly volatile, for that matter), firms and households are able to
make plans for future investment and consumption more efficiently. The ability
to make efficient future plans is quite critical for long-term economic growth. With
low and stable inflation, firms and households don’t have to worry that the purchas-
ing power of their investment returns will be eaten up by hyperinflation and can
make better economic decisions.
As mentioned in the previous chapter, if the central bank prints more money
or loosens monetary conditions, individuals and firms will be more willing and
able to pursue their consumption and investment needs. Economic activity will be
stimulated. Why shouldn’t the central bank set the goal of having loose monetary
conditions so that the economy would be stimulated all the time, and both con-
sumption and investment grow indefinitely? There are at least two related answers
to this question. First, whether the economy can grow sustainably in the long run
depends on factors other than monetary conditions. These factors, such as natural
and human resources, innovation, and productivity are largely outside the central
bank’s purview. Second, things could really get out of hand if the central bank had
A Brief Review of Modern Central Banking Mandates 65

such a goal as its mandate. The central bank could be overzealous in loosening
monetary conditions, since it is its mandate, after all. If too much money is intro-
duced into the system, or monetary conditions are too loose, then two bad things
could happen. First is inflation. With more money readily available, people would
just keep bidding up prices of goods and services, which are themselves limited by
scarcity of resources. Second, as money becomes more readily and cheaply avail-
able, it could get drawn into speculative activities, as it often does under those
conditions.
In contrast, if the central bank tightens money conditions, then economic activ-
ity would likely to get slower, since money would not be as readily and cheaply avail-
able. Households and firms will be less stimulated to borrow and spend, whether on
consumption or investment. If money conditions get too tight, money becomes very
scarce and people will be much less willing to spend it. Firms might lay off workers
since there is not much prospect of selling goods and services, which means house-
hold income would be reduced, and thus result in a further reduction in demand
for goods and services. In such a case, economic activity could be reduced, and the
economy would contract.
From the arguments above, it is thus quite clear by logic that (1) too tight or
too loose money conditions are not good for the economy, and (2) the central bank
should aim to set money conditions that are just right for the economy. In practice,
however, what we mean by right money conditions could be quite a challenge to
pinpoint. Various tumultuous historical experiences have been studied and analyzed
by central bankers, academia, and other commentators, and it has been determined
that the right money conditions can be reflected best by stability in the prices of
goods and services. The general price of goods and services should not rise or fall too
quickly. In other words, the value of money should be kept relatively stable. How the
central bank can keep the value of money stable, and what stable really means, will
be discussed in detail in the Chapter 5.

4.3 FINANCIAL STABILITY

Financial stability is a relatively new concept in central banking, which began to
come into focus in the 1980s; given its multifaceted nature, its definition and mea-
sures still vary.15 At the simplest level, financial stability could be thought of as an
environment in which the financial sector can perform its intermediary function
smoothly and without disruption.16,* Disruptions, meanwhile, can come from vari-
ous sources, including the failure of financial institutions to meet their obligations
owing to weak financial conditions, as well as failures in the payment and settle-
ment system.
Looking deeper into the causes of disruptions, we can say that disruptions (and
thus financial instability) often arise with (1) severe liquidity shortages among key

*The financial sector is often defined as referring to banks, other financial institutions (broker-
age firms and insurance companies, for example), and financial markets (the money market,
the foreign exchange market, the bond market, and the equity market, for example).
66 CENTRAL BANKING

players in the financial system, or (2) widespread overindebtedness and a resulting

inability of economic agents to repay their debt obligations, or both.17

Liquidity Shortages
Severe liquidity shortages among key players in the financial system suggest that
these players might fail to meet their short-term financial obligations. When news
emerges that a financial institution is facing a severe liquidity shortage and might
have trouble meeting its short-term financial obligations, often other financial insti-
tutions will refuse to continue to lend to that financial institution, which will make
it even more certain that the particular financial institution will fail to meet its
short-term obligations. Depositors of that financial institution are also likely to with-
draw their deposits. The failure of the financial institution in question to meet its
short-term obligations can cause it to fail.
In a highly connected world, however, the failure of one particular institution
can also cause ripple effects that could bring the whole system down. If one finan-
cial institution fails to meet its short-term obligations to other financial institutions,
those other financial institutions would also face losses, and possibly a liquidity
shortage. And if a liquidity shortage occurs across the system, those other financial
institutions might be unable to meet their own obligations. Meanwhile, depositors
might be queuing up to demand their deposits back from these other financial insti-
tutions at the same time, compounding the problem further.

Overindebtedness of Economic Agents

Digging deeper, we might trace liquidity shortages, and instability in the financial
system overall, to asset price bubbles and overindebtedness of agents in the economy
(e.g., households, firms, and the government).18 When households or firms take out
loans from financial institutions to buy assets that are fast rising in price (e.g., hous-
ing, real estate, and stocks), the loans could look very safe as long as the prices of
those assets are rising. Once the bubble bursts borrowers are saddled with assets
that have a lower value than the loans that they took out to purchase them. With
economic activity likely to fall after the burst of the bubble, borrowers would find it
increasingly difficult to repay their loans.
With borrowers unable to repay their loans, lenders would also find themselves
in trouble. As will be discussed in more detail in Chapter 12, with borrowers default-
ing on their loans, financial institutions would have to write down the value of these
bad loans, which would thereby reduce their capital. With reduced capital, financial
institutions would be much more reluctant to extend new loans and might also
call in some existing loans, especially short-term ones. As more and more financial
institutions become reluctant to extend new loans and instead call in existing loans,
liquidity shortages could arise, resulting in the disruption described above.
Furthermore, in cases in which depositors sense that a bank might not have
enough capital to cushion the writing down of bad loans, there might be a run on
that bank. And such a run could be quite widespread if the public perceives that the
bad debt problem is not limited to a single institution. Runs on financial institutions
are indeed considered a major disruption, not just to the financial sector, but also to
the economy.
A Brief Review of Modern Central Banking Mandates 67

CASE STUDY: Dealing with Financial Stability Ex Post and Ex Ante

Even before the concept of financial stability rose into prominence in the 1980s, central banks always
had a role in maintaining financial stability. This is reflected by central banks’ bank supervisory and
lender-of-last-resort functions. Before the global financial crisis of 2007–2010, however, the frame-
work that central banks normally adopted to deal with financial stability put more focus on dealing
with financial stability ex post—that is, cleaning up after bubbles that had already burst—rather than
ex ante—that is, preventing bubbles and overindebtedness of economic agents in the first place.19
Before the global financial crisis, one reason for central banks’ hesitance to preempt the buildup of
overindebtedness was the fact that it was very difficult to identify the threshold beyond which over-
indebtedness violated economic fundamentals ex ante. The same applied to asset price increases.20
After the global financial crisis of 2007–2010, however, it was increasingly recognized that in
order to sustain financial stability central banks might need to step in ex ante and preempt overindebt-
edness and asset price bubbles from turning into disruptions that cause financial instability.21

Why It Is Important
Financial stability is important for at least three reasons. First, financial stability is
needed to ensure efficient allocation of funds within the economy. A smooth func-
tioning of the financial system is needed in order to channel excess funds from savers
to borrowers efficiently. Second, in the long run, financial stability is inextricably
intertwined with monetary stability. An economy facing financial instability can slip
into a deflationary spiral, as happened during the Great Depression in the 1930s and
has been true of the Japanese experience from the 1990s through the first decade of
the twenty-first century. Third, traditional central banking functions such as ­payment
systems oversight and supervision, lender of last resort, and banking supervision
already have financial stability aspects embedded in them.
The attention on the financial stability mandate began to take hold in the
1980s as frequent financial crises in both advanced and emerging market economies
brought large economic costs.22 Since then, two episodes of financial instability in
major advanced economies have reaffirmed the need for central banks to seriously
focus on their financial stability mandate: (1) the bursting of the Japanese real estate
and stock bubbles in the early 1990s that tipped Japan’s economy into deflation for
more than two decades, and (2) the global financial crisis of 2007–2010.
In the case of Japan, when massive real estate and stock market bubbles burst
in the early 1990s, banks took a large hit and the country later fell into a period of
long and painful deflation, during which prices of goods and services fell for many
consecutive years.23 Postmortem analyses suggested that the central bank of Japan
had allowed money conditions to be too loose, allowing massive bubbles to arise.24
At the time, however, the Bank of Japan was willing to run a loose monetary policy
because inflation appeared to be low enough.25 As events turned out, financial insta-
bility later turned into monetary instability and Japan fell into what became known
as the Japanese lost decades, during which the economy struggled unsuccessfully to
climb out of a deflationary spiral for over 20 years.
If anything, the global financial crisis of 2007–2010 also confirmed that ­letting
asset price bubbles to grow unchecked (in this case housing price bubbles in the United
States and in Europe) can result in financial instability that can be very costly to
society.26 With the Japanese experience and the global financial crisis of 2007–
2010 fresh in mind, central banks are starting to take a more proactive role in the
68 CENTRAL BANKING

maintenance of financial stability. As bank regulators and supervisors, central banks

now monitor risk exposures of banks from a more forward-looking perspective, and
focus more on the interlinkages among banks as well as other institutions and players.27

4.4 FULL EMPLOYMENT

Unlike monetary stability or financial stability, full employment is not a popular

mandate for central banks, at least for advanced economy central banks. Yet it is
a mandate for the most powerful central bank in the world, the Federal Reserve, so
it is worth examining in a little bit of detail. The Federal Reserve’s full employment
mandate, like that of other central banks, has been evolving through time.28
The current mandate of the Federal Reserve, which dates from 1977 when
the Congress amended the Federal Reserve Act, states that the Federal Reserve
“shall maintain long run growth of the monetary and credit aggregates com-
mensurate with the economy’s long run potential to increase production, so as to
­promote effectively the goals of maximum employment, stable prices, and moderate
long-term interest rates.”29 Since in periods of high inflation nominal interest rates
often became high, we could infer that both the terms stable prices and moderate
­long-term ­interest rates reflect a focus on price or monetary stability. Maximum
employment, then, would be another mandate of the Federal Reserve. Note that
maximum employment as a monetary policy mandate has been considered quite
controversial.30 On one side, many argue that tasking the central bank with a maxi-
mum employment mandate will bias central bankers toward providing easy money
conditions. Easy money conditions, however, as argued above, might not necessar-
ily provide the maximum employment hoped for in the long run. In the long run,
production and employment growth depends on the capacity of the economy to
generate economic activity. That capacity depends, many argue, on things such as
technology, research and development, and the rule of law—things that are largely
outside the direct influence of money conditions.31
If the central bank is too intent on easing money conditions in the hope of
achieving maximum employment, however, inflation is likely to prevail but maxi-
mum employment likely not to be attained. Lessons from the Great Inflation in the
1970s (discussed in Chapter 2) showed that without a brake, once inflation rises it
can spiral out of control, which creates uncertainty in the economy. Household con-
sumption and saving decisions will also be distorted since households will be unable
to discern accurately what the price of goods and services will be in the future. Firms
will be unable to make proper investment decisions, since they might not be able to
estimate profits correctly. If anything, the argument goes, if the central bank is biased
toward easy money conditions, in the long run the maximum employment mandate
will be self-defeating.
In practice, economists and central bankers often use the term full employment
rather than maximum employment when referring to this particular mandate. The
full employment concept corresponds to the fact the authorities can never (and
should never) aim for zero unemployment. For a start, at any given time there is
bound to be transitory unemployment, as fresh graduates start to look for jobs or
women start to get back into the job market as their children grow up. In practice,
full employment can be expressed as the unemployment rate that corresponds to
A Brief Review of Modern Central Banking Mandates 69

the economy’s natural rate of unemployment, or nonaccelerating inflation rate of

unemployment (NAIRU), which will be discussed in more detail in the Chapter 5.

Why It Is Important
The other side of the preceding argument is that without the employment man-
date, the central bank will aim only for stable prices and sacrifice other important
economic objectives. Absent acknowledgement of the employment aspect of the
dual mandate, many argue, the Federal Reserve might overlook the importance
of economic stability and employment, which at times might not correspond to
low inflation.32
In the wake of the global financial crisis of 2007–2010, the importance of the
Federal Reserve’s employment mandate also became clearer. In December 2008,
after previous hesitance until that time, the Federal Reserve explicitly communicated
its maximum employment mandate to the public in its statement of monetary pol-
icy.33 Given the severity of the crisis, it was understandable that the Federal Reserve
wanted to make sure that the public understood that it would not sit on its hands
just because inflation had been very low.
If anything, by emphasizing the maximum employment mandate after the c­ risis
hit, the Federal Reserve seemed to want to communicate to the public that it was
committed to prevent the economy from falling into a deflationary trap. The Federal
Reserve was, indeed, willing to stimulate and stabilize the economy in the face of
the crisis. That commitment was later evidenced by first introducing quantitative
­easing measures, which were introduced while inflation remained very low and
unemployment approached 10 percent (a post–World War II high). Those measures
were followed by a subsequent series of quantitative measures in the next few years
as unemployment remained high.
By December 2012 the full employment mandate had become an explicit
part of U.S. monetary policy along with price stability, with the Federal Reserve
adopting the unemployment rate as one the key forward guidance indicators of its
monetary policy.34 Specifically, the Federal Reserve announced in December 2012
that it would keep the federal funds rate between 0 and 0.25 percent as long as
(1) the unemployment rate remained above 6.5 percent, (2) inflation between one
and two years ahead was projected to be no more than 0.5 percentage points above
the 2 percent longer run goal, and (3) longer-term inflation expectations continued
to be well anchored.35

4.5 BALANCING AMONG THE THREE MANDATES

In practice, modern central banks do not focus on just a single mandate. Rather, they
try to achieve all three mandates even without explicitly saying so. For example,
while the Federal Reserve is officially tasked with a dual mandate of price stability
and full employment, it also plays a key role in sustaining financial stability, as dem-
onstrated by the recent crisis. While other central banks might not have an explicit
full employment mandate, it has often been argued that the pursuit of monetary
stability will allow economic agents to behave optimally, which is essential for full
employment in the long run.
70 CENTRAL BANKING

Stylizing the Central Bank’s Monetary Policy Actions: The Taylor Rule
While central banks often do not explicitly say exactly how they attempt to balance
price stability and employment objectives when making monetary policy, studies
along the line of one from Stanford University’s John B. Taylor in 1993 suggested
that they do, whether intentionally or not. By statistically estimating what the level
of the Federal Reserve’s policy interest rate should be were the Fed to give equal
weight to having both (1) inflation close to the target that reflected long-run price
stability and (2) output of the economy that is consistent with full employment,
Taylor found that, at least during the period of the study, the estimated policy inter-
est rate was reasonably close to the actual policy interest rate.36
In other words, Taylor’s study suggests that we can reasonably approximate
the Federal Reserve’s policy interest rate decision by assuming that the Federal
Reserve wants to achieve both actual inflation rate that is consistent with long-term
price ­stability and actual output growth rate that is consistent with the economy’s
potential (and thus full employment).
On the one hand, if actual inflation rate is higher than the rate that the Federal
Reserve deems to represent long-term price stability, then the Federal Reserve is
likely to raise the policy interest rate to slow down inflation. On the other hand, if
the actual output growth of the economy, as represented by actual GDP growth rate,
is higher than the rate of output growth that the Federal Reserve deems consistent
with the potential of the economy (and thus full employment), then the Federal
Reserve is also likely to raise the policy interest rate.
On the occasion where inflation and output growth move in opposite directions,
Taylor’s study implies that the Federal Reserve would try to balance between the
price stability and output (or employment) objectives. An example of such a situa-
tion is when an oil shock pushes inflation beyond the rate that the Federal Reserve
deems consistent with long-term price stability, but pushes economic activity down
such that output growth is below potential (and thus employment falls below full
employment). Here, the Federal Reserve is likely to take both price stability and
­output (and, implicitly, employment) objectives into consideration when making
monetary policy decisions.
Taylor’s results suggested that the Federal Reserve did indeed take both price sta-
bility and employment objectives into consideration when making monetary policy.
Later studies along this line also found that the so-called Taylor rule, which states
that central banks are supposed to care for both price stability and employment,
could explain monetary policy decisions of many other central banks, whether those
central banks had an explicit employment mandate or not.37 Specifics of the Taylor
rule are discussed in Chapter 6.

Pursuit of the Different Mandates

In practice, regardless of whether they are official mandates, central banks normally
take monetary stability, financial stability, and employment objectives into consid-
erations when making and coordinating their policies. The way that central banks
pursue these different mandates, however, differs from one central bank to another,
depending on their context. For example, central banks that do not have a bank
supervisory function would perform their financial stability role differently than
those central banks that do have a bank supervisory role. Despite the differences,
A Brief Review of Modern Central Banking Mandates 71

however, there seems to be an underlying trend with respect to how central banks
pursue the different mandates, a trend that has evolved with the arrival of the global
financial crisis in 2007–2010.38

Prior to the Global Financial Crisis  Even before global financial crisis, it was not
uncommon for a central bank to have one arm pursuing monetary stability (which
is ­supposed also to result in full employment over the long run, if monetary stabil-
ity is achieved),39 and another arm pursuing financial stability (although how work
related to achieving financial stability is defined could vary noticeably among dif-
ferent central banks).40 The arm dealing with monetary stability was responsible for
the conduct of monetary policy, that is, regulating money conditions in the economy.
The arm dealing with financial stability, meanwhile, dealt with the regulation of
banks, and also the supervision of banks if the central bank was a bank supervisor,
as well as payment systems.41
These two arms of a central bank would normally use different sets of tools to
achieve their goals. Although some of the tools can be used for multiple purposes,
prior to the global financial crisis there was normally a distinction between tools
used to fulfill the monetary stability mandate and the financial stability mandate.
The arm that dealt with monetary stability tried to influence money conditions
through tools such as interest rates, operations in financial markets, exchange rates,
and reserve requirements. The use of these tools of monetary policy affect money
conditions in general, and thus potentially everyone, through changes in the value of
money. Although monetary policy tools can also be used for financial stability pur-
poses ex ante (e.g., tightening money conditions to prevent the private sector from
overborrowing), central banks often were reluctant to do so.42
The arm that dealt with financial stability, on the other hand, normally had rules
and regulations that they could set for banks as its set of policy tools, assuming the
central bank was a bank supervisor. These rules and regulations set for banks were
more bottom-up in nature, meaning the focus was on the safety and soundness of
individual banks, with less focus on how the banking system as a whole might be
affected by developments in the macroeconomy.43
For central banks that were not bank supervisors, while the financial stability
arm might not have direct access to rules and regulations as policy tools, there was
the option of focusing more on monitoring conditions in the financial sector and
coordinating with relevant financial sector regulators as well as with the monetary
stability arm and providing input to the monetary stability arm. Examples of this
model include the Reserve Bank of Australia and, prior to the global financial crisis,
the Bank of England.

After the Global Financial Crisis  In the wake of the global financial crisis, there seems
to be a rethinking of how central banks pursue their different mandates in terms of
coordination across the two arms, the use of policy tools for different purposes, as
well as communication with the public.
Specifically, there is increasing agreement that (1) the use of monetary policy
should also take financial stability into account;44 (2) there needs to be a set of
macroprudential tools to help address financial stability using a more top-down
approach, in addition to the microprudential tools that were the primary tools before
the global financial crisis;45 and (3) the communication on the Federal Reserve’s
employment mandate might be warranted.46
72 CENTRAL BANKING

The Use of Monetary Policy to Achieve Monetary and Financial Stability  With
respect to the global financial crisis of 2007–2010, a lesson learned is that monetary
instability in one period can lead to financial instability in the next, if the central
bank becomes too complacent. Although inflation may appear low, if money con-
ditions are too loose, then firms and households may overborrow, which can lead
to asset price bubbles and financial instability.47 And if financial instability is seri-
ous enough (possibly because money conditions have been too loose for too long),
then the risk of deflation (i.e., monetary instability) will rise as the bubbles burst.48
Accordingly, it can be argued that financial stability and monetary stability are ulti-
mately linked over the long run and that central banks might need to take a longer
run view in their conduct of monetary policy. Central banks need to ensure that even
when inflation is low, money conditions are not so loose that financial instability
later arises and comes back to affect monetary stability afterward.49

The Use of Macroprudential Tools to Help Achieve Financial Stability  Prior

to the global financial crisis, central banks had just begun to shift the focus of their
bank supervisory function from the so-called microprudential framework toward a
more top-down macroprudential framework.50 In the macroprudential framework,
instead of focusing on the regulatory compliance of individual banks the focus is
on taming the buildup of risk in the system, whereby interlinkages among financial
institutions, markets, and borrowers are taken into account. The set of tools that can
be used to tame the risks of overborrowing in particular markets, such as housing or
real estate, are called macroprudential tools.51
The specifics of macroprudential tools will be discussed in more detail in Part III
of this book. At this stage, however, suffice it to say that macroprudential tools can
supplement, or at times, substitute for monetary policy tools in the pursuit of finan-
cial stability. Monetary policy tools, such as interest rate levels, reserve requirements,
and exchange rates, are broad based in the sense that their use could potentially
affect everyone in the economy directly. With a tightening of monetary policy, for
example, costs of funds are likely to rise for all individuals and firms. If overborrow-
ing and risk buildups are occurring in only a specific market within the economy,
say housing, the central bank might be hesitant to tighten overall money conditions
using monetary policy, since everyone else outside the housing market might also be
affected. As such the central bank might use macroprudential tools on banks under
its supervision to specifically squeeze lending in the housing market.

The Communication of the Employment Mandate  While full employment is still

quite controversial as an explicit mandate for most central banks, unemployment
has always been a factor that modern central banks at least implicitly consider
when pursuing their monetary stability mandate. Unemployment can be affected by
money conditions, at least indirectly in the short run, through economic growth.52
(See the discussion on the relationship between economic growth and employment
in “Case Study: The Relationship between Unemployment and Output: Okun’s Law
and the Output Gap” in Chapter 5.) Consequently, central banks whose monetary
policy decisions could be approximated by the Taylor rule are also in effect taking
employment into account in their monetary policy decisions.53
With respect to communication, however, it is still quite a delicate matter for
central banks to acknowledge full employment as an explicit mandate, since it could
create confusion among the public. In the short run, it might appear that the central
A Brief Review of Modern Central Banking Mandates 73

bank has the ability to choose between higher inflation and higher unemployment in
its use of monetary policy. Easy monetary conditions are likely to encourage more
economic activity, lower unemployment, and higher prices in the short run. In the
long run, however, historical experience and theoretical developments would sug-
gest that there is actually no tradeoff between inflation and unemployment. The
central bank that actively pursues lower unemployment over time might end up
with both higher inflation and higher unemployment. (The theoretical foundations
of ­monetary policy will be discussed in Chapter 5.)
Given the nuances inherent in the relationship between monetary policy and
unemployment, even the Federal Reserve, which has had an employment man-
date since 1977, chose to avoid explicitly communicating its mandate to consider
employment in its monetary policy decisions until December 2008, after the full
extent of the global financial crisis had been felt and the country was threatened with
a deflationary situation.54 In this particular case, the explicit communication of the
full employment mandate and the use of the unemployment number in its forward
guidance at least helped reassure the public that the Federal Reserve intended to use
an exceptionally easy monetary policy only temporarily until unemployment came
down to a more normal level.

SUMMARY
Key mandates for modern central banks include monetary stability, financial stability,
and full employment. While most central banks have monetary stability and financial
stability mandates, the Federal Reserve is rather unique in having full employment
also as another explicit mandate.
These three key mandates are intertwined and might conflict as well as have
synergy, depending on the time horizon and context. In the short run, monetary
stability might appear to be in conflict with full employment, but in the long run
monetary stability might be the foundation for full employment. Also, in the long
run, ­monetary stability cannot exist without financial stability.
Monetary stability often refers to low and stable inflation and can be used
interchangeably with price stability, although monetary stability might also suggest
“confidence in the currency,” as stated in the Bank of England’s mandate. Monetary
stability is important, since it allows for optimal investment and consumption
­decisions by economic agents.
Financial stability refers to conditions in which the financial system can perform
its function of allocating funds within the economy efficiently and smoothly. For
central banks, financial stability is important since (1) it is essential for effective
allocation of funds; (2) it is intertwined with monetary stability; and (3) it is embed-
ded into many of the traditional central banking functions such as payment systems
oversight and provision, lender of last resort, and banking supervision.
The explicit full employment mandate is rather unique to the Federal Reserve,
which has the explicit dual mandate of price stability and full employment. Prior
to the 2007–2010 crisis the Federal Reserve did not emphasize its full employment
mandate, partly because it might have created public confusion, since in the short
run there might be tradeoffs between inflation and unemployment. The emphasis
on the full employment mandate since then, however, provided assurance that the
Federal Reserve did not focus on price stability at the expense of other important
economic goals.
74 CENTRAL BANKING

Since the 2007–2010 crisis there has been a rethinking of how central banks
might pursue the different mandates. First, it has been acknowledged that the con-
duct of monetary policy might need to take account of financial stability in addition
to monetary stability. Second, macroprudential tools might be used to complement
monetary policy in sustaining financial stability. Third, with respect to the Federal
Reserve, communication on the full employment mandate might be warranted.

KEY TERMS
financial stability microprudential
full employment monetary stability
macroprudential price stability
maximum employment transitory unemployment

QUESTIONS
1. What does monetary stability mean? Is it different from price stability?
2. Why is monetary stability an important mandate for central banks?
3. How might we quantitatively measure monetary stability?
4. What could reflect the situation of financial instability?
5. Although there are many definitions of financial stability, describe key elements
that are embedded in these definitions.
6. Why is financial stability an important mandate for central banks?
7. Why might a central bank be considered to have an inherent financial stability
mandate, even though that central bank is not a bank supervisor?
8. What is the Federal Reserve’s dual mandate?
9. How might we quantitatively represent the concept of full employment?
10. Why might have the Federal Reserve underemphasized the full employment
mandate to the public until the global financial crisis of 2007–2010?
11. How might a single focus on fulfilling the monetary stability mandate result in
financial instability in the long run?
12. Why, especially prior to the global financial crisis of 2007–2010, might a central
bank hesitate to prevent the buildup of financial imbalances and asset price bubbles?
13. In the long run, is it possible to sustain monetary stability by neglecting the
financial stability mandate? Why or why not?
14. How might the focus on achieving maximum employment result in monetary
instability in the long run?
15. Why might we say that the Taylor rule was a good approximation of the Federal
Reserve’s dual mandate even in the 1980s and 1990s?
16. According to the Taylor rule, if the rate of economy’s output growth is beyond
the economy’s potential output growth rate, while inflation is above target, what
would the central bank likely do?
17. What is the forward guidance strategy of monetary policy that was used by the
Federal Reserve in the recovery period after the global financial crisis of 2007–2010?
18. What are the key characteristics of a macroprudential framework?
19. Why might central banks be hesitant to tighten monetary conditions to help
sustain financial stability?
20. How can macroprudential tools be used to help sustain financial stability?
 PART
TWO
Monetary Stability

P art II examines various aspects of monetary stability, the dominant central bank-
ing mandate for the past 30 years.
Chapter 5 reviews the theoretical foundations of monetary policy, the policy
that a central bank uses in regulating monetary conditions in the economy in order
to achieve monetary stability.
Chapter 6 looks at different monetary policy regimes (i.e., rules) that central
banks might adopt in the pursuit of monetary stability.
Chapter 7 looks at monetary policy implementation, which is often done through
operations in financial markets.
Chapter 8 looks at how monetary policy transmits across the economy and
affects monetary stability as well as output and employment.
Chapter 9 is devoted to the exchange rate, another key variable that central
banks have to watch, given that it is the price of money and that it can affect mon-
etary stability as well as financial stability.

75
 CHAPTER 5
Theoretical Foundations of the Practice
of Modern Monetary Policy

Learning Objectives
1. Describe theories that are foundational to the modern practice of
monetary policy.
2. Define and graph the short-run Phillips curve.
3. Describe the natural rate of unemployment.
4. Describe output gap.
5. Distinguish between adaptive and rational expectations.
6. Explain why operational independence of a central bank is important.

T his chapter briefly reviews five theoretical developments that guide the m ­ odern
practice of central banks in their pursuit of the monetary stability mandate.
Specifically, these five theoretical developments, when considered together, suggest
that central banks should conduct monetary policy by following a credible rule that
aims for a low and stable inflation environment. A credible rule for the central bank’s
conduct of monetary policy helps manage public expectations that the central bank
will use monetary policy to achieve only what it does best, that is, ensure long-term
price stability, as opposed to trying to push unemployment below the natural rate.

5.1 AN OVERVIEW OF THEORETICAL FOUNDATIONS

Five of the most influential theoretical developments that are foundational to the
practice of monetary policy as we know it today are (1) the quantity theory of
money, (2) the Phillips curve, (3) the natural rate of unemployment, (4) the rational
expectations hypothesis, and (5) the time inconsistency problem. These five develop-
ments led to five propositions on the design and conduct of monetary policy. These
five key theoretical developments and their propositions are described next.

1. The Quantity Theory of Money: In the long run, monetary policy can only
influence prices of goods and services in the economy and cannot influence

77
78 CENTRAL BANKING

quantity of output or level of economic activity directly. The effort by the central
bank to stimulate the economy by printing money will only result in rising prices
and inflation in the long run.
2. The Phillips Curve: There is a short-run inverse relationship between inflation
and the unemployment rate. When the inflation rate goes up, the unemployment
rate goes down, and vice versa. The central bank can attempt to use monetary
policy to fine-tune the economy by influencing these two variables.
3. The Natural Rate of Unemployment: In the long run, the inverse relationship
between inflation and unemployment disappears. There exists a rate of
unemployment that corresponds to an economy’s potential, that is, the natural
rate of unemployment. If the central bank tries to push unemployment below
that natural rate, then in the long run, after prices and inflation expectations
have fully adjusted, not only inflation but also unemployment will rise.
4. The Rational Expectations Hypothesis: Public expectations matter in the
effectiveness of economic policies. The public is rational enough to incorporate
their expectations of policy outcomes into their current behavior. Accordingly,
an expansionary monetary policy that leads to a rise in inflation expectations
could lead to an upward spiral in wages and prices. For monetary policy to
be effective in maintaining price stability, the central bank must manage the
inflation expectations of the public.
5. The Time Inconsistency Problem: Letting the central bank use pure discretion in
the conduct of monetary policy, as opposed to following an explicit rule, could
be counterproductive. Policy makers, even with the best of intentions, have an
incentive to backtrack on their policies if they believe they can improve the
welfare of the public. The backtracking, however, will defeat the future credibility
and effectiveness of policies, thereby reducing the welfare of the public instead.
For a central bank, credibility is critical if monetary policy is to work effectively
in keeping inflation low and stable.

These five theoretical developments and propositions together led to the cur-
rent mainstream belief among academics and central bankers that the conduct
of monetary policy should follow a credible rule that aims for a low and stable
inflation environment. A credible rule for the conduct of monetary policy helps
manage public expectations that the central bank will use monetary policy in the
pursuit of monetary stability, rather than trying to push unemployment below
the natural rate.

5.2 THE QUANTITY THEORY OF MONEY

The quantity theory of money describes the relationship between money, economic
activity, and the general price level in the long run. Basically, what the theory sug-
gests is that in the long run, the total output of an economy will depend on nonmon-
etary factors such as capital (factories, roads, infrastructure, etc.), labor input, and
technology. The attempt to stimulate economic activity through money creation will
be ineffective and only result in rising prices (inflation) in the long run.1
Theoretical Foundations of the Practice of Modern Monetary Policy 79

The quantity theory of money is represented by one of the most famous equa-
tions in macroeconomics, the equation of exchange, proposed by Irving Fisher in
1911.2 The equation can be expressed as

M×V=P×Q

where M stands for the quantity of money in the economy, V is the velocity of circu-
lation of the money, P is the general price level in the economy, and Q is the quantity
of products sold in the economy. In effect, we can think of the right side of the equa-
tion (P × Q) as the economy’s nominal GDP, since P (the general price level in the
economy) is being multiplied by Q (the quantity of products sold in the economy in
a given period).
Taken together, the quantity theory equation states that the amount of money
(M) would have to circulate V times to finance the nominal economy (or the total
volume of transactions within the economy) in a given period.
Under the quantity theory, the velocity of the circulation of money (V) is assumed
to depend on forces outside the equation, such as how advanced payments technology
is. The quantity of products sold is also assumed to be dependent on forces out-
side the equation, namely, the quantity and quality of labor, capital, and technology.
Accordingly, both V and Q are assumed to be constants and not determined by any
other variables in the equation.3
Under this theory an increase in the amount of money (M) leads to an increase
in the general price level (P) in the long run, since in the long run the amount of
money does not determine the quantity and quality of labor, capital, or technol-
ogy.4 Ostensibly money can be printed relatively easily, and the increase in the paper
amount of money will debase the value of money relative to that of other goods and
services in the economy, which is called inflation. The increase and improvement in
labor, capital (e.g., machines and computers), and technology cannot be directly
induced, in the long run, by an increase in paper money, or, for that matter, the
increase in money in bank accounts, or even the increase in precious metals held by
the central bank, such as gold.

The Quantity Theory of Money and Hyperinflation

In reality, numerous occasions of hyperinflation throughout modern economic
history have confirmed the hypothesis of the quantity theory of money. One of the
most famous episodes of hyperinflation was that in post-World War I Germany.
Unable to raise enough taxes or borrow to finance efforts to rebuild the economy
and pay for war reparations, the German government resorted to printing money to
pay for such endeavors.
As time passed, the flood of money did not raise output or economic activity,
but instead quickly cheapened the value of German currency. Between 1919 and
1923, as money quickly lost value, prices of goods and services rose by multiples of
billions, the German people were unwilling to hold money for more than a few hours,
instead searching for something to purchase right away. The aggressive money print-
ing caused much disruption in the German economy before the German government
decided to undertake monetary reform, negotiate for a cut in war reparations, and
aim for a balanced budget.5
80 CENTRAL BANKING

The German hyperinflation experience is often cited as strong proof of the quan-
tity theory of money. The quantity theory of money, backed by lessons learned from
hyperinflation experiences worldwide, is one key theoretical foundation against
excessively easy monetary policy and excessive money printing by central banks.6

5.3 THE PHILLIPS CURVE

While the quantity theory of money suggests that monetary policy cannot be used to
directly influence economic activity and output in the long run, the Phillips curve sug-
gests that monetary policy could be used to directly influence economic activity and
output in the short run. By the 1950s, with greater availability of macroeconomic
data, economists were starting to notice an inverse relationship between unemploy-
ment and inflation. When the inflation rate was found to be low, the unemployment
rate was found to be high, and vice versa. This inverse relationship between infla-
tion and unemployment is known as the Phillips curve, named for A. W. Phillips, an
economist who in late 1958 first noticed the relationship in British economic data.7
Figure 5.1 illustrates a stylized Phillips curve.
The presence of a Phillips curve suggests that the central bank can attempt to
lower the unemployment rate by allowing inflation to go up. The central bank could,
for example, ease money conditions to stimulate aggregate demand and economic
activity. When money conditions become easier, households and firms can borrow
more to consume or invest. With greater economic activity, firms are willing to hire
more labor, and thus the unemployment rate will go down. Meanwhile, with greater
demand for goods and services, prices and inflation will start to rise.
The Phillips curve also suggests that the central bank can also attempt to lower
inflation by allowing the unemployment rate to go up. To accomplish this, the central
bank might tighten money conditions, making money scarcer, which would slow
down aggregate demand and economic activity. Households and firms would find it
harder to borrow to consume or invest. With lower economic activity, firms would be
less willing to hire more labor, and indeed, could shed existing workers, making the
unemployment rate higher. Meanwhile, with lower demand for goods and ­services,
prices and inflation would fall.

Inflation rate

Phillips curve

Unemployment rate

FIGURE 5.1  The Phillips Curve: Short-Run Trade-Off between Inflation and Unemployment
Theoretical Foundations of the Practice of Modern Monetary Policy 81

The Phillips Curve and Economic Fine-Tuning

Given the Phillips curve, there appears to be an opportunity for the central bank
to use monetary policy to help fine-tune the economy. Whenever unemployment
is too high and there is not much inflationary pressure, the central bank might choose
to ride along the Phillips curve by easing its monetary policy stance, stimulating
economic activity, and letting inflation pick up a bit. On the other hand, whenever
inflation is too high and unemployment is not much of a problem, the central bank
might choose to tighten its monetary policy stance, which will slow down economic
activity and dampen inflationary pressures.8
As much as the quantity theory of money is a key theoretical reason for a central
bank to resist the temptation to overprint money, the Phillips curve is a key reason
for the central banks to use monetary policy to help fine-tune the economy. But why
should monetary policy be able to influence economic activity and output in the short
run (as suggested by the presence of a Phillips curve) but not the long run (as sug-
gested by the quantity theory of money)? Economists only learned to reconcile the
quantity theory of money and the Phillips curve in the late 1960s, with the introduc-
tion of the natural rate of unemployment concept.

5.4 THE NATURAL RATE OF UNEMPLOYMENT

By the mid-1960s, as more data became available, the inverse relationship between
inflation and unemployment rate seemed to weaken. Examining inflation and
­unemployment data in more detail and taking into account the role of expec-
tations, economists—notably, Edmund Phelps in 19679 and Milton Friedman
in 196810—proposed a concept that came to be known as the natural rate of
­unemployment. According to this theory, for any economy there is a rate of unem-
ployment ­corresponding to the fundamentals of that economy in such a way that
when unemployment is at that particular rate, the inflation rate will not change.
That rate of unemployment at which inflation will not change became known as
the natural rate of unemployment.

Nonaccelerating Inflation Rate of Unemployment (NAIRU)

At the natural rate of unemployment, the economy is supposed to be running at its full
capacity, given the labor, capital, and technology it has. Any unemployment that exists
at this natural rate of unemployment is likely to be transitory unemployment—for
example, batches of fresh graduates and recently arrived migrants in the process of
a job search, or women who are just recently returning to the job market after their
children have grown up. The formal name of that natural unemployment rate (the
unemployment rate for the economy at which inflation will not rise) is the nonaccel-
erating inflation rate of unemployment (NAIRU).
The concept of NAIRU became popular not only because it was theoretically
neat (it described the state of an economy in equilibrium) but because the abil-
ity of governments and central banks to actively exploit the inverse relationship
between inflation and unemployment as represented by the Phillips curve seemed
to have been lost by the late 1970s. When oil shocks hit the global economy in
82 CENTRAL BANKING

the 1970s, governments and central banks tried to limit possible negative effects
on the economy and unemployment by using stimulus policies. As time passed, how-
ever, not only did stimulus policies prove unable to bring the unemployment rate
down, but inflation also rose uncontrollably.

NAIRU and the Vertical Long-Run Phillips Curve

As lessons from the 1970s became clearer, economists were able to piece together
and synthesize the theories of the Phillips curve and NAIRU. The synthesized con-
cept is that as prices and inflation expectations adjust in the long run, the short-run
Phillips curve shifts up vertically, making the long-run Phillips curve vertical at the
natural rate of unemployment.11 (See Figure 5.2.)
In Figure 5.2, at point a on short-run Phillips curve 1, unemployment remains
at the natural rate U* as long as there are no shocks from either supply or demand.
If the central bank chooses to stimulate the economy further, at first the economy
might move from point a to point b, that is, the unemployment rate would fall below
U* while the inflation rate would pick up.
As inflation rate and wages start to pick up, firms and households would start
to adjust their inflation expectations upward. The change in inflation expectations
would build into consumption and investment decisions of firms and households,
prompting core inflation to rise, and the short-run Phillips curve to shift upward.
With the shift in inflation expectations, the inflation rate would rise, and the econ-
omy would now be at point c on the new short-run Phillips curve, Phillips curve 2.
In the longer run, however, since the economy cannot run beyond its full potential
unemployment would drift back to the natural rate U*.
At point d, which is the new equilibrium point for the economy, notice that
inflation is already above the inflation level of point a, the old equilibrium point.
Had the central bank kept on stimulating the economy, in the longer run inflation
expectations would keep rising, and the short-run Phillips curve would keep shift-
ing upward. Inflation would keep on rising, while unemployment would not remain
under the natural rate for long.

Inflation rate
Long-run Phillips curve

d
Short-run Phillips curve 2
b
a
Short-run Phillips curve 1

U* Unemployment rate
The natural rate of unemployment

FIGURE 5.2  Long-Run Phillips Curve: There Is No Trade-Off between Inflation and
Unemployment in the Long Run
Theoretical Foundations of the Practice of Modern Monetary Policy 83

CASE STUDY: How Can Unemployment Go Below the Natural Rate? The Role of Real Wages,
Incomplete Information, and Expectations

From the discussion of the long-run vertical Phillips curve framework, an interesting key question
arises: how can the economy actually run beyond its full capacity? At NAIRU, the economy is supposed
to be already running at its full potential, and labor is already willing to work at maximum hours, given
prevailing real wages. Plausible reasons why the economy might be running beyond its full potential
include incomplete information, expectations, and real wages.12
First, let us assume that if the central bank decided to ease monetary policy further when the
economy was running at its full potential, aggregate demand for goods and services would rise, and
firms would need more labor input to increase their production. To get more labor firms would have
to raise nominal wages. At first, labor would be willing to work longer hours than before. However,
as aggregate demand for goods and services in the economy rose (as a result of the easier monetary
policy), prices of goods and services would also rise. Soon enough, workers would realize that their
real wages had not increased despite the rise in their nominal wages. Once the workers realized that
their real wages did not actually rise, they would not supply labor beyond the level they had found to
be consistent with their earlier choice, that is, at NAIRU.
How could the workers not realize earlier that their real wages had not actually increased?
Information in the economy at any point in time would often be incomplete. It would normally take
time to transmit information across the economy, and it would also take time for receivers of the
information to digest the information and correctly arrive at its implications. When money conditions
became easy and economic activity started to pick up, both employers and workers might mistakenly
translate the increase in demand for their goods and services as being unique to them rather than being
a part of the general trend of an increase in demand for all goods and services for the whole economy.
This would not be too difficult to imagine, given that the firms might actually receive more orders for
their products during periods of rising economic activity.
Once the employers and workers realized that the extra hours they put in had not actually raised
their purchasing power, they would, respectively, raise the prices of their products and their wages
even higher, in anticipation of rising prices of other goods and services in the economy. With everyone
anticipating rising prices, and protecting their purchasing power by preemptively raising the prices of
their own goods and services as well as wages, inflation would start to accelerate, even without any
further increase in production or reduction in unemployment.
Note in the short run, the economy could have been running above capacity for some time. Given
that technology has not changed, factories would be operating for longer hours than would be optimal.
The same goes for labor. This cannot be sustained over the long run. At some point, the economy has
to go back to its capacity, and the unemployment rate will have go back to its natural level, that is, at
NAIRU. By that point, however, inflation would already be stuck at a higher level. Inflation, indeed, has
accelerated.

Shifting NAIRU
The natural rate of unemployment is supposed to be the one that corresponds to
long-run equilibrium in the economy, given existing capital, labor, and technology
input. (See Case Study: The Relationship between Unemployment and Output below
for more details.)
In practice, however, economists have come to believe that the natural rate of
unemployment, or NAIRU, can change as the economy evolves over time. We might
note here that in economics, the term long run simply refers to the horizon of time
in which prices (as well as wages) adjust to clear markets. Over a longer horizon
and in a broader context, however, the economy can evolve, with both quantity and
quality of capital, labor, and technology changing over time.13
84 CENTRAL BANKING

The idea of a shifting NAIRU came into focus in the late 1990s. Following
leaps in information and communication technology and the Internet revolution
in the mid-1990s, which were supposed to bring great improvements in overall
productivity, researchers found that unemployment in the United States could
be pushed down further than in previous decades without triggering spikes in the
inflation rate.14
By the early 2010s, however, follow-on effects from the global financial cri-
sis seemed to have affected the fundamentals of the U.S. economy in such a way
that rising job vacancies were not matched by a similar decline in unemployment.
As such, there have been discussions that NAIRU might have shifted up. Possible
reasons for the mismatch in labor demand and supply include the likelihood that
skills of those that were unemployed for a long time after the crisis hit might have
deteriorated so much that they did not fit the requirements of employers emerging
from the crisis.15
Figure 5.3 illustrates the possible shifts of NAIRU between the 1980s and
the 2010s.
Had NAIRU in the U.S. actually shifted up after the global financial crisis, many
observers deemed it important that the Federal Reserve be very vigilant in withdraw-
ing the quantitative easing programs that it had used in fending off deflationary
threats. As Figure 5.3 suggests, with a higher natural rate of unemployment, once
the economy recovers and unemployment starts to go down along a new short-run
Phillips curve, inflation expectations can start to rise sooner than had NAIRU been
at the previous, precrisis level.

Inflation rate
U*mid 1990s–2007 U*2010s?
U*1980s

Long-run Phillips curve

Unemployment rate

A jump in information and communications technology helped push the natural rate of
unemployment in the United States down since the mid-1990s, but have structural
changes following the global financial crisis pushed the rate up again?

FIGURE 5.3  Shifting NAIRU

Theoretical Foundations of the Practice of Modern Monetary Policy 85

CASE STUDY: The Relationship between Unemployment and Output: Okun’s Law
and the Output Gap

The concept of an output gap is closely related to the concept of the natural rate of unemployment
and can be used more readily (or as a complement to the natural rate of unemployment concept) in
monetary policy formulation.
The output gap theory can be traced back to Arthur Okun’s seminal work published in early 1962.16
In what became known as Okun’s law, unemployment is shown to have an inverse relationship with
real output.
Specifically, in the first version of Okun’s law—called the difference version—quarterly changes
in the unemployment rate, as expressed in percentage points, are related to quarterly changes in real
output (GDP growth), such that greater output growth is associated with lower unemployment.17
Another version of Okun’s law is called the gap version. Here we can think of an economy as having
a set potential level of production—given its quantity and quality of labor, capital, and technology—
known as its potential output.18 At any one time, actual real output might be above, below, or at potential
output. The difference between actual output and potential output is called the output gap.

Output gap = Actual GDP − Potential GDP

If actual GDP is at its potential, that is the output gap is zero, then we are likely to have “full
employment” in the economy. If the calculation of the output gap equation yields a positive number,
then aggregate demand has outpaced potential output, and the unemployment rate is likely to be rela-
tively low. On the contrary, if the calculation yields a negative number, aggregate demand is still below
potential output, and the unemployment rate would likely be relatively high.
In theory, we could use the concept of NAIRU to signify the natural rate of unemployment that
corresponds with potential output. In such a case, if the economy is pushed to produce beyond its
potential (and the unemployment rate is below NAIRU, or the output gap is positive), then aggregate
demand for products is outstripping potential output, such that factories, enterprises, and labor are
running overtime, resulting in accelerating inflation. In such a case the central bank might want to
tighten monetary policy in order to slow down aggregate demand and dampen inflationary pressures.
If the economy is running below its potential (unemployment rate above NAIRU, or the output
gap is negative, or there is a recessionary gap), there would be negative pressures on price levels and
inflation. A recessionary gap is one reason for the central bank to ease money conditions in order to
spur aggregate demand without having to worry too much about inflationary threats.
In practice, however, there are a number of variations of the output gap theory, and thus a number
of ways to measure the output gap.19 One way is to use an economic model to estimate the economy’s
production function, and derive the economy’s potential GDP using data on the economy’s capital stock,
labor input, and technology. This, however, could be a huge task, entailing various uncertainties about the
measures used, including the valuation of capital stock and the time lags that come with data gathering.
Another way is to look at the output gap as the deviation of output from its long-run underlying
trend. From this perspective, the long-run underlying trend of actual GDP growth could be deemed the
rate of GDP growth in the economy that is consistent with the economy’s long-term potential. The esti-
mation of this long-run underlying trend could be done by smoothing out cyclical movements in GDP
data over a long period of time, possibly a few business cycles. The deviation of actual GDP growth
for a particular time period from the potential GDP growth rate would thus represent the output gap.20
Viewed in this way, if the actual GDP growth rate is beyond the potential GDP growth rate, there is likely
to be more inflationary pressure. If the actual GDP growth rate is below the potential GDP growth rate,
however, there is likely to be less inflationary pressure.
The output gap is a variable that the central bank might look at when making monetary policy deci-
sions. Apart from looking at the current period output gap, however, the central bank might need to also
look ahead into the future and project what the output gap might look like in future periods, since it often
takes some time before monetary policy action can fully affect aggregate demand and inflation. However,
it should also be recognized that potential output, similarly to NAIRU, could also shift over time.21
86 CENTRAL BANKING

5.5 RATIONAL EXPECTATIONS

By the 1970s, as exemplified by what became known as the Lucas critique22 and the
policy ineffectiveness proposition,23 economists had succeeded in formalizing
the theoretical possibility that expectations might play in the effectiveness of eco-
nomic policies. Prior to that, with advances in the collection of macroeconomic
data and econometric techniques, policy makers had started to rely increasingly on
historical relationships among economic variables when making policy decisions.
For example, policy makers might rely on the historical relationship between unem-
ployment and inflation, as reflected by the (short-run) Phillips curve, when deciding
on whether to rein or stimulate aggregate demand. However, the view of many econ-
omists was that policy actions based on historical relationships might be ineffective,
since the public would anticipate the consequences of such policy actions and might
alter their behaviors in ways not anticipated by the policy makers.
Broadly speaking, it could be said that the rational expectations hypothesis
was developed to address the shortcomings in economic theories (or applications
of theories) that were based on adaptive expectations. Under an adaptive expecta-
tions framework, the expectation of the future value of an economic variable is
based on its past values. For example, operating under adaptive expectations, people
would assume that inflation for any one year would be the same as the previous year.
If the economy indeed suffers from constantly rising inflation, then operating under
adaptive expectations, people would constantly underestimate inflation. Assuming a
framework of adaptive expectations is thus quite unrealistic, since rational peo-
ple would soon notice this type of trend and take it into account in forming their
expectations.
The rational expectations hypothesis addresses the shortcomings of adaptive
expectations by assuming that individuals take all available information into account
in forming expectations. By doing so, the hypothesis suggests that an individual’s
expectations are correct on average. Although the future is not fully predictable, by
using all relevant information when forming expectations of the future values of
economic variables, the individual’s or the public’s expectations pertaining to those
variables would not be systematically biased.

The Lucas Critique

The rational expectations hypothesis has two important implications for the conduct
of monetary policy because of the Lucas critique (and its close relative, Goodhart’s
law, described in the next chapter in more detail) and the policy ineffectiveness
proposition.
The Lucas critique proposes that the effort to conduct economic policy entirely
on the basis of relationships observed in highly aggregated historical data is futile,
as individuals change their decisions in response to the introduction of the policy.
For ­example, if the central bank attempts to exploit the historical inverse correlation
between inflation and unemployment (as represented by the Phillips curve) by intro-
ducing policies that persistently raise inflation in the hope that unemployment will also
be persistently lower, that inverse correlation between inflation and unemployment will
eventually break down. Firms and individuals will raise their inflation e­ xpectations
and meanwhile alter their decisions with regard to hiring and employment.
Theoretical Foundations of the Practice of Modern Monetary Policy 87

One implication of the Lucas critique is that to predict the effect of a mac-
roeconomic policy experiment, it be better to model the parameters that govern
individual behavior at the microeconomic level (as opposed to aggregated macro-
data). Indeed, the latest cutting-edge macroeconomic models—such as the dynamic
stochastic general equilibrium (DSGE) models—used at modern central banks for
economic forecasts and monetary policy decisions these days are often built with
the Lucas critique in mind. Rather than relying on the historical relationship of
aggregated macrodata, these models attempt to model the behavior of a rational
representative economic agent (a representative consumer, for example) at the
­
microeconomic level.
A concept related to the Lucas critique, but which is more directly associated
with the use of a monetary policy rule, is Goodhart’s law, which states that “any
observed statistical regularity will tend to collapse once pressure is placed upon it
for control purposes.”24 Goodhart’s law is often ascribed as an apt description of
the breakdown of the relationship between the money supply and nominal income
following the failure of money supply targeting in the United States and the United
Kingdom in the early 1980s.

The Policy Ineffectiveness Proposition

The rational expectations hypothesis also had very profound implications for the
conduct of monetary policy through the policy ineffectiveness proposition devel-
oped by economists Thomas Sargent and Neil Wallace in 1976 (cited earlier). The
proposition suggests that if the Federal Reserve attempts to lower unemployment
through an expansionary monetary policy, the effects of the change in policy stance
would be fully anticipated by economic agents, who would raise their expectations
of future inflation accordingly. This will counteract the expansionary effect of the
change in the policy stance. At the extreme, the inflation rate will adjust but not
unemployment.
The policy ineffectiveness proposition gained a lot of attention in the late 1970s
and early 1980s, partly because of its neat logical deduction and probably partly
because it coincided with the rise of the stagflation situation of the time. In the late
1970s the Federal Reserve had tried to cushion the effects of the second oil shock
with relatively easy monetary policy, yet unemployment remained high while infla-
tion kept rising. Since then, however, other economists have shown that if wages are
sticky (i.e., nominal wage contracts do not change continuously), then macroeco-
nomic policy will have nontrivial effects on the economy.25 Despite the debate on
the applicability of the proposition, however, it can be argued that the proposition at
least made central bankers more aware of the role of expectations and the possibil-
ity of the danger of using monetary policy to actively pursue lower unemployment.

Irrationality and Other Technical Matters

While the rational expectations hypothesis has made a deep imprint on the way
that policy makers have implemented macroeconomic policy since the introduction
of the hypothesis in the late 1970s, it has also drawn its fair share of criticism, as
with any other influential economic theory. In general, recent advances in the field of
behavioral economics have suggested that, for example, individuals might not be as
88 CENTRAL BANKING

rational in their actions as the rational expectations hypothesis suggests. Experiments

in behavioral economics have shown that rather than basing their actions purely on
optimal economic outcomes, the actions of individuals can be biased by noneco-
nomic factors, such as perception and emotion.
At a more technical level, in terms of the central banks’ effort in modeling pol-
icy responses, it has been argued that the behavior of an individual representative
agent does not necessarily correspond to aggregated results, owing to interactions
among individuals that could lead to extreme herd behavior, such as speculation in
asset prices. This implies that the sophisticated dynamic stochastic general equilib-
rium (DSGE) models used by central banks for economic forecasts might not be so
effective, since these models often rely on modeling the behaviors of an individual
representative agent.
Despite the various criticisms, however, the rational expectations hypothesis still
provides useful guidelines in the formulation of monetary policy. First, the idea of
rational expectations can be used to address the shortcomings of adaptive expec-
tations when the central bank models monetary policy effects. Under the rational
expectations hypothesis, economic agents are not supposed to make systemic expec-
tational errors, thus the central bank should not expect to reliably exploit the tradeoff
between inflation and employment without triggering changes in the agents’ expecta-
tions.26 Second, despite recent arguments that biases can influence rational behavior,
many behavioral economists have also found that so-called irrational behaviors are
actually fairly predictable, such that appropriate economic policies can be designed
to take advantage of those seemingly irrational behaviors.

5.6 TIME INCONSISTENCY PROBLEM

While the NAIRU and rational expectations theories pointed out the shortcomings
of using monetary policy to actively manipulate unemployment beyond the natural
level, they did not exactly prescribe how the central banks should best conduct their
monetary policy. A 1977 work by economists Finn Kydland and Edward Prescott27
on the time consistency problem helped complete the picture by pointing out that
without a binding rule, policy makers, through their best intentions for the public,
would tend to retreat from their announced policies. Such retreats create a credibility
problem for future policies. Once the rational public knows that the authority can
always retreat from a policy, that policy and any subsequent policy change aimed to
improve the public welfare will not be effective, since the public will have altered its
behavior since the first policy was announced.
In terms of monetary policy, if the central bank announces that it will reduce
inflation (and thus probably create unemployment along the way, given that the
economy moves along a short-run Phillips curve), unless the central bank demon-
strates a credible binding commitment to deliver on that announcement, the public
will not trust such an announcement. The public will know that once inflation seems
to have stabilized, the central bank will have many incentives to start easing its
monetary policy and squeezing unemployment even further at the expense of higher
inflation. (One such incentive for the central bank might simply be desire on the
part of central bankers to further boost society’s welfare!) Without a binding com-
mitment against policy retreats, the central bank’s announcement about reducing
Theoretical Foundations of the Practice of Modern Monetary Policy 89

inflation will not be credible from the start. Inflation expectations of the public will
remain high, and the central bank therefore will be unable to reduce inflation, let
alone reduce unemployment.

Monetary Policy Rules

Research on the time inconsistency problem suggests that policy makers should
not be allowed pure discretion in policy making. Instead, policy makers should be
bound by policy rules. Policy rules make policy actions more credible and effec-
tive, since the public knows that policy makers do not have the discretion to easily
retreat from their policy actions. In terms of monetary policy, the time inconsistency
problem also suggests that central bankers should also be bound by rules when
making policy actions. Given the current understanding of what monetary policy
can actually achieve, monetary policy rules often should be those that aim to keep
inflation low and stable in the long run, as opposed to getting unemployment below
the natural rate.
Monetary policy rules that central banks have used to ensure price stability
include exchange rate targeting, monetary targeting, and inflation targeting, as well
as other implicit rules. We will look at these rules in more detail in Chapter 6. It
should be noted here, however, that although monetary policy rules are meant to
ensure central banks make policy actions that best support price stability, they are
not necessarily straightjackets. Central banks often have a certain degree of flexibil-
ity in using discretion to act within rules. In other words, monetary policy rules help
ensure that central banks act with constrained discretion.

The Central Bank’s Operational Independence

Another important implication of the time inconsistency problem is the need for the
central bank to be operationally independent from political interference, so it can
follow its chosen monetary policy rule effectively. Politicians, concerned with short-
term gains, especially reelection, often have the incentive to coerce the central bank
to reduce unemployment prior to an election. As we learned from the NAIRU argu-
ment, pushing unemployment below the natural rate will allow inflation to creep up
in the long run, while unemployment will move back to the natural rate. By then,
politicians might have been reelected but the economy will be left with higher infla-
tion as well as higher inflation expectations. The price stability mandate could thus
be compromised along with the credibility and effectiveness of the central bank’s
future monetary policy actions.
To help guard the credibility and effectiveness of the central bank’s monetary
policy actions, and to ensure that the central bank will not easily succumb to poli-
ticians’ short-term needs, it has been deemed preferable to grant the central bank
operational independence. Operational independence does not mean that the cen-
tral bank is accountable to no one. Rather, it means that the central bank is free to
undertake monetary policy actions without undue political inference, assuming it is
acting within broad guidelines to achieve operational targets approved or set by the
government or the parliament, who themselves answer to the general public. Even
with operational independence, the central bank can still be held accountable if it does
not comply with broad guidelines or fails to achieve its approved operational targets.
90 CENTRAL BANKING

5.7 TAKING THEM ALL TOGETHER

The quantity theory of money, the Phillips curve, the natural rate of unemploy-
ment, the rational expectations hypothesis, and the time consistency problem are key
theoretical foundations of the modern design and practice of monetary policy and
the pursuit of the monetary stability mandate by central banks, as well as the dual
mandate of the Federal Reserve.

■■ The quantity theory of money explains why the central bank should refrain
from overprinting the money in the long run. Given the economy’s capital, labor,
and technology input, an increase in money supply will in the long run lead to
rising prices, but not output.
■■ The Phillips curve provides a basis for using monetary policy to help fine-tune
the economy, or at least to trade off between inflation and unemployment in the
short run.
■■ In the long run (the period over which prices and wages can fully adjust), the
natural rate of unemployment concept and the rational expectations hypothesis
suggest that monetary policy cannot be used to trade off between inflation and
unemployment. Monetary policy will not be able to bring unemployment down
below the natural rate in the long run. Were the central bank to attempt to bring
unemployment down below the natural rate, in the long run, not only it will fail
to bring unemployment down, but inflation would also rise.
■■ The time inconsistency concept suggests that to help the credibility and effective-
ness of monetary policy, monetary policy should be conducted under an explicit
rule, so that the central bank does not have the discretion to easily retreat from a
monetary policy action. Furthermore, to help shield the central bank from
being subjected to short-term political pressures, which could jeopardize the
credibility of monetary policy, the central bank should be granted operational
independence.

In Chapter 6 we will explore in more detail the rules, or regimes, of monetary

policy adopted by modern central banks.

SUMMARY
Theoretical developments that have influenced the modern conduct of monetary
policy include (1) the quantity theory of money, (2) the Phillips curve, (3) the natural
rate of unemployment concept, (4) the rational expectations hypothesis, and (5) the
time inconsistency problem.
The Quantity Theory of Money: The government should refrain from overprint-
ing money. In the long run, monetary policy can only influence prices of goods and
services in the economy, and cannot influence the quantity of output or level of eco-
nomic activity directly. The efforts by the central bank to stimulate the economy by
printing money will only result in rising prices and inflation in the long run.
The Phillips Curve: The government can attempt to fine-tune the economy in
the short run by trading off unemployment and inflation. There is a short-run nega-
tive relationship between inflation and the unemployment rate. When the inflation
rate goes up, the unemployment rate goes down, and vice versa.
Theoretical Foundations of the Practice of Modern Monetary Policy 91

The Natural Rate of Unemployment: The central bank should not attempt to
push unemployment below the natural rate of unemployment, since this will lead
to higher inflation expectations in the long run, without lowering unemployment.
In the long run, the inverse relationship between inflation and unemployment disap-
pears. There is a rate of unemployment, called the natural rate of unemployment,
that corresponds to the economy’s potential. In practice, the concept of an output
gap can also be used to capture the concept of the natural rate of unemployment.
The Rational Expectations Hypothesis: Public expectations matter in the
effectiveness of economic policies. The public is rational enough to incorporate
their expectations of policy outcomes into their current behavior. As such, an
expansionary monetary policy that leads to a rise in inflation expectations could
lead to an upward spiral in wages and prices. For monetary policy to be effective
in maintaining price stability, the central bank must manage the inflation expecta-
tions of the public.
The rational expectations hypothesis has important implications for the con-
duct of monetary policy because of the Lucas critique and the policy ineffectiveness
proposition.
The Time Inconsistency Problem: To raise the credibility of the central bank
with respect to its commitment to low and stable inflation, and to anchor infla-
tion expectations, the central bank needs to conduct monetary policy by following
an explicit rule rather than using pure discretion. Policy makers, even with the best
of intentions, have an incentive to backtrack on their policies if they believe they can
improve welfare of the public. The backtracking, however, will damage the future
credibility and effectiveness of its policies, thereby reducing the welfare of the public
instead. For a central bank, credibility is critical if monetary policy is to work effec-
tively in keeping inflation low and stable.

KEY TERMS
adaptive expectations output gap
equation of exchange Phillips curve
long-run Phillips curve policy ineffectiveness proposition
Lucas critique quantity theory of money
natural rate of unemployment rational expectations
nonaccelerating inflation rate of time-inconsistency problem
­unemployment (NAIRU) velocity of circulation
Okun’s law

QUESTIONS
1. What is the equation representing the quantity theory of money?
2. What are the key assumptions used in the equation representing the quantity
theory of money?
3. According to the quantity theory of money, if the amount of money in the
economy rises, what would happen in the long run?
4. According to the quantity theory of money, why can’t we expect monetary policy
to help directly stimulate output growth in a sustainable manner in the long run?
92 CENTRAL BANKING

5. Keeping in mind historical episodes of hyperinflation, is the quantity theory of

money justified?
6. What is the relationship between inflation and unemployment in the short run?
7. How does the Phillips curve represent the relationship between inflation and
unemployment graphically? Please draw a short-run Phillips curve.
8. If the short-run Phillips curve exists, what would happen to unemployment
when the central bank attempts to reduce inflation?
9. If the short-run Phillips curve exists, what would happen to inflation when the
central bank attempts to reduce unemployment?
10. What is NAIRU? Why might it represent the natural rate of unemployment?
11. How might we reconcile the Phillips curve with the concept of the natural rate
of unemployment?
12. If the Phillips curve is vertical in the long run, what will happen if the central
bank tries to push unemployment rate below its natural rate?
13. What are the reasons that unemployment could be pushed below its natural rate
in the short run?
14. Why might the natural rate of unemployment shift over time?
15. After the global financial crisis of 2007–2010, how might the natural rate of
unemployment in the U.S. have shifted, and why?
16. What might we mean by potential GDP?
17. What is an output gap?
18. If there is a large positive output gap, what can the central bank do using
monetary policy?
19. What do we mean by adaptive expectations? With adaptive expectations, if
inflation is rising, are individual’s inflation expectations likely to be correct or
not? Why or why not?
20. What are the key differences between adaptive expectations and rational
expectations?
21. According to the policy ineffectiveness proposition, if people have rational
expectations why might monetary policy be ineffective?
22. Why might the policy ineffectiveness proposition not be realized in the real
world?
23. What do we often mean by the operational independence of a central bank?
24. In the world of accountability, why might one want to advocate a central bank’s
operational independence?
 CHAPTER 6
Monetary Policy Regimes
What Monetary Policy Rules a Central
Bank Can Use to Achieve Monetary Stability

Learning Objectives
1. Describe various monetary policy regimes that central banks have
adopted since the end of the Bretton Woods system.
2. Explain the pros and cons of adopting an exchange rate targeting
regime.
3. Explain the pros and cons of adopting a money supply targeting
regime.
4. Explain the pros and cons of adopting an inflation-targeting regime.
5. Explain the pros and cons of unconventional monetary policy in
the case of quantitative easing.

A s discussed in Chapter 5, the concept of the time inconsistency problem ­suggests

that without a monetary policy rule guiding how the central bank regulates money
conditions in the economy, the conduct of monetary policy would not be credible nor
effective. Without a monetary policy rule constraining the central bank on monetary-
policy decisions, the public might not believe that the central bank would ultimately
keep the promise of price stability, since there are always incentives for the central
bank to backtrack on the policy and try to push unemployment down further, possi-
bly at the cost of price stability. Without a monetary policy rule, the public’s inflation
expectations might thus not be properly anchored, and the central bank, for all its
good intentions, might be unable to successfully control inflation and deliver price
stability as promised. To effectively conduct monetary policy, the central bank thus
needs to follow a monetary policy rule that will assure a rational public that a policy
action will contribute positively to the overall welfare of the economy.
But exactly what monetary policy rule should the central bank follow?
Theoretical developments discussed in Chapter 5, as well as historical experience
discussed in earlier chapters, suggest that, in the conduct of monetary policy, the
central bank should follow a monetary policy rule that ensures price (or monetary)
stability. In following a particular monetary policy rule, the central bank has to

93
94 CENTRAL BANKING

design its operational processes and organizational structure to best help it achieve
the objective of that rule.

6.1 AN OVERVIEW OF MONETARY POLICY RULES

OR MONETARY POLICY REGIMES

In modern monetary policy jargon, to follow a particular monetary policy rule is

to adopt a monetary policy regime. It is often called a regime because the adop-
tion of a monetary policy rule involves various aspects of institutional design that
the central bank needs in order to achieve the objectives of the rule. Specifics of
modern institutional design might include legislation or statute to institutionalize
and legitimize the rule and empower the monetary-policy decision-making body; the
central bank’s organizational structure that is appropriate for implementing mon-
etary policy actions under such rule; and other supporting infrastructures, such as
the existence of interbank markets, secondary government bond markets, relevant
statistical database, and public communication tools.
Broadly speaking, given modern theoretical developments and historical expe-
riences, a credible monetary policy rule (monetary policy regime) is one that aims
to keep inflation low and stable and that provides the price and economic stability
needed for long-run economic growth, rather than one that aims to reduce unem-
ployment below the natural rate to reap short-term gains.*
In practice, the five key monetary policy rules, or monetary policy regimes, that
have been used among central banks since the breakdown of the Bretton Woods
system in the early 1970s include (1) exchange rate targeting, (2) money growth rate
targeting, (3) the so-called risk management approach, (4) inflation targeting, and, in
the wake of the recent global financial crisis, (5) unconventional monetary policy.1
The first four of these monetary policy rules, or regimes, can be thought of as
being conventional monetary policy rules, which have the common goal of provid-
ing the central bank with guidance on how to conduct monetary policy to achieve
monetary stability.2 This chapter will also address unconventional monetary policy,
which a number of major advanced economies decided to use as a separate regime in
the wake of their crises. This chapter will review briefly the basic ideas behind all of
these monetary policy regimes. In later chapters, operational details of these regimes
will be discussed when appropriate.

6.2 EXCHANGE RATE TARGETING

Exchange rate targeting is a monetary policy rule under which the central bank
promises to keep the exchange rate within an announced target for a given period.
Under exchange rate targeting the central bank cannot change the money supply at

*
Note here that the gold standard and the gold exchange standard are, by definition, also mon-
etary policy rules. The gold standard, for example, was a monetary policy rule that limited the
central bank to printing money only up to the amount that could be backed by the value of its
gold reserves. The gold standard (as well as the gold exchange standard) as a monetary policy
rule did not allow central banks to actually fine-tune the economy. To be fair, theoretical
understanding at the time of the gold standard did not allow for the possibility of fine-tuning
the economy (Bordo 2007).
Monetary Policy Regimes 95

will, lest the exchange rate move away from the announced target level.3 Generally
speaking, exchange rate targeting as a monetary policy rule can help the central bank
achieve credibility and price stability if the central bank pegs the value of its currency
to that of a large country that has a good record of price stability.4
Historically, following the breakdown of the Bretton Woods system and until
the late 1990s, the currency of choice for a central bank to peg its currency to has
often been the U.S. dollar for emerging-market economies and the German mark
for advanced economies in Europe.5 Despite blips during the great inflation period
in the late 1970s, the United States had always had a good record of price stability,
and even to this day, the U.S. dollar remains the dominant currency used in inter-
national trade and finance. Fixing the level of its exchange rate to the U.S. dollar
would enable easy international transactions for the country that chooses to do so.
Germany, meanwhile, after the hyperinflation episode of the 1920s, has always been
very vigilant in keeping its inflation rate low. By the 1970s France and the United
Kingdom had started to peg their exchange rates to the German mark as German
economic prominence grew, a prelude to the creation of the euro.6
Later on, as countries started to diversify their trade and investment, many cen-
tral banks also started to fix the value of their domestic currencies to a basket of
currencies of their main trading partners.7 To do this, the central bank might create
an index representing the weighted value of the basket of currencies of their major
trading partner countries and target the exchange rate at a certain level of the index.8
Also, rather than fixing the exchange rate at a particular level, the central bank
could also choose to allow the exchange rate to fluctuate within a (narrow) target
band, or to adopt a crawling peg—that is a system under which the exchange rate
might be allowed to gradually depreciate against the pegged country, thus allowing
inflation in the country in question to be higher than that in the pegged country.9
Whether the central bank targets the value of its currency to another currency
(such as the U.S. dollar) or to a basket of currencies, or in terms of a particular
exchange rate level, a target band, or a crawling peg, however, the essential mechan-
ics can be illustrated by the following simple stylized model.

A Stylized Model of Exchange Rate Targeting

Figure 6.1 illustrates a stylized model of foreign exchange market equilibrium in a coun-
try where the central bank adopts exchange rate targeting as its monetary policy rule.

Pesos per USD

S'
S
d
1.5
Exchange rate
2 c a
target = 2 pesos
per USD
2.5
b
D
D'

Q2 Q1 Quantity of pesos

FIGURE 6.1  A Stylized Model of Exchange Rate Targeting

96 CENTRAL BANKING

Initial Equilibrium  In Figure 6.1, let us say that the central bank of Country A decides
to peg the value of its currency, the peso, at an exchange rate of 2 pesos per 1 U.S.
dollar (USD). Initially, the foreign exchange market for the peso is in equilibrium at
point a. At point a, demand for pesos is matched by the supply of pesos (Q1 on the
x-axis).

The Case of a Fall in Demand for the Domestic Currency  Assume that importers in Country
A later want to convert their pesos into U.S. dollars so that they can use U.S. dollars
to import goods from abroad. In that case, the demand curve for pesos would shift
to the left, with point b potentially as the new equilibrium point.
At point b, however, the peso exchange rate would have dropped to 2.5 pesos
per 1 U.S. dollar, which is less than the announced target level of 2 pesos per 1 U.S.
dollar. To keep the exchange rate at the target level, the central bank of Country A
would have to sell U.S. dollars from its foreign-exchange reserve holdings to import-
ers and buy up pesos from them. By buying up pesos from importers, the central
bank would be drawing out pesos that currently reside in private hands and in the
economy at large. In effect, through its sale of U.S. dollars and purchase of pesos
from importers, the central bank would be reducing the supply of pesos to match
the fall in demand for pesos. The supply curve for pesos would shift to the left (from
supply curve S to supply curve S'). At point c, which is the new equilibrium point,
the exchange rate would be back at 2 pesos per dollar, the central bank’s announced
exchange target level.

The Case of a Rise in Demand for the Domestic Currency  In contrast to the importer exam-
ple above, let us say that the initial equilibrium is at point c. When exporters in
Country A want to convert their U.S. dollar earnings into pesos, demand for pesos
rises. The demand curve for pesos would shift to the right (from demand curve D
to demand curve D'), with the new equilibrium at point d, a point at which there
are appreciation pressures on the peso. To prevent the peso from rising above the
announced target level, the central bank would have to buy up U.S. dollars from
exporters and sell pesos to them, thereby raising the supply of pesos in the economy.
The supply curve for pesos would then shift to the right (from supply curve S to sup-
ply curve S'). To keep the exchange rate at the announced 2 pesos per dollar target,
the central bank would have to expand supply of pesos until the supply curve for
pesos intersects with the demand curve for pesos at point a, which would be the new
equilibrium point.
In practice, the central bank with exchange rate targeting has to constantly adjust
the money supply to meet changes in demand for the domestic currency. From the
examples above, we can see that (1) demand for foreign currencies rises (and demand
for domestic currency falls) when importers need foreign currencies to import goods
and services from abroad, and (2) demand for foreign currencies falls (and demand
for domestic currency rises) when exporters need to convert their export earnings
into domestic currency. To keep the exchange rate fixed at the announced target
level, the central bank has to adjust the domestic money supply to meet changes in
demand for the domestic currency.

The Effects of Capital Inflows  In a country that is open to international capital flows,
changes in demand for domestic currency would come not only from importers and
Monetary Policy Regimes 97

exporters of goods and services, but also from international investors. If interna-
tional investors deem that the country is a good investment prospect, then capital
would flow into the domestic economy. In order to invest in the country, interna-
tional investors would first have to convert their foreign currencies into the domestic
currency. This would raise demand for the domestic currency. To meet the demand
from international investors, and to keep the exchange rate fixed at the announced
target, the central bank would have to buy up foreign currencies from international
investors and supply them with domestic currency.

The Effects of Capital Outflows  In contrast, if international investors deem that the
country is not a good investment prospect and want to divest from the country, then
there would be a flight of capital out of the country. International investors would
want to convert their domestic currency into foreign currencies. Demand for domes-
tic currency would fall. To meet the demand of international investors and to keep
the exchange rate fixed at the announced target, the central bank would have to buy
up domestic currency from international investors and sell its foreign currencies to
them as demanded. Through the purchase of domestic currency, the central bank
would effectively be withdrawing a portion of the domestic money supply from the
economy, thereby reducing the domestic money supply.

Exchange Rate Targeting in the Real World

In the real world, in a small, open economy, large and volatile flows of international
capital can easily overwhelm the central bank’s ability to keep the exchange rate
at the fixed target. For example, if suddenly international investors no longer see
the country as an investment destination and decide to convert their domestic cur-
rency holdings into foreign currencies, the central bank must have enough foreign
exchange reserves in order to meet the demand of international investors if it wants
to keep the exchange rate fixed at the announced target. If currency speculators
deem that the central bank might not have enough foreign exchange reserves to hold
the exchange rate at the announced level, they could prompt a speculative attack on
the currency, forcing the central bank to devalue the currency or let the exchange
rate move from the announced target. In a more globalized world, international
investors and currency speculators can command larger sums of capital than the
foreign exchange reserves of central banks, making it difficult for a central bank to
keep its exchange rate fixed at any given level.

Exchange Rate Targeting and Monetary Policy Independence  From Figure 6.1 and the pre-
ceding discussion, we can see that the central bank does not truly have the inde-
pendence to conduct monetary policy and fine-tune the economy as it sees fit. If
there is a requirement to keep the exchange rate at the announced target level, the
central bank will have to vary the money supply to match changes in the demand for
domestic currency by importers and exporters, as well as international investors and
speculators, rather than adjusting domestic money conditions to directly influence
domestic aggregate demand.
An extreme form of exchange rate targeting is the use of a currency board,
whereby the exchange rate is fixed at a particular level and the domestic currency is
legally required to be fully backed up by foreign currencies held by the central bank.
98 CENTRAL BANKING

The central bank is legally obliged to exchange domestic currency for a foreign cur-
rency at the specified exchange rate, and thus can only issue additional domestic
currency if it has extra foreign currencies to fully back it up. A central bank in a
currency board system (e.g., the Hong Kong Monetary Authority, which fixes the
Hong Kong dollar at the rate of HK$ 7.8 to USD 1) cannot thus independently alter
money supply as it wishes to.10
In general, even for those that are not on the currency board system, it could
be said that the central bank under an exchange rate targeting regime must keep
domestic money conditions aligned with money conditions in the country that it
fixes the value of its domestic currency to. Otherwise, divergences in money condi-
tions between the two countries will not allow the central bank to keep the exchange
rate at the announced target level.
For example, let us say that Country A fixes the value of its currency to the
U.S. dollar. If Country A’s domestic unemployment is very high, the central bank of
Country A cannot simply ease money conditions to stimulate domestic aggregate
demand unless the U.S. central bank also eases U.S. money conditions. Otherwise,
Country A’s domestic inflation could rise much faster than that of the United States
and there will be immense depreciation pressures on the value of Country A’s cur-
rency. In the world of free capital flows, these depreciation pressures could simply
overwhelm the ability of Country A’s central bank to keep the exchange rate fixed
at the target level. As will be discussed in more detail in later chapters, a currency
with a higher inflation rate is likely to depreciate in value—both in terms of domestic
purchasing power and overseas purchasing power—which would put downward
pressure on the exchange rate.

The Impossible Trinity: Exchange Rate Targeting, Free Capital Flows, and Independent Monetary
Policy  From the preceding discussion, we can see that the success of using exchange
rate targeting as a monetary policy rule depends on both the degree of capital flows
and the degree of monetary policy independence. The impossibility of having (1) a
fixed exchange rate, (2) free capital flows, and (3) an independent monetary policy
all at the same time is known among economists and central bankers as the impos-
sible trinity. The impossible trinity has been one key reason why numerous central
banks in Europe, Asia, and Latin America have been abandoning exchange rate tar-
geting as their monetary policy rule. In a world of freer international capital flows
and diverging economic cycles, many of these central banks often find it hard to
maintain a fixed exchange rate and fine-tune the domestic economy at the same time.
We discuss issues relating to the exchange rate in more detail in Chapters 8 to 10.

6.3 MONEY SUPPLY GROWTH TARGETING

As the name suggests, a money growth targeting rule requires that the central bank
set a target rate for growth of the money supply. According to this rule, if the central
bank keeps money supply growth at a target rate that is consistent with that of real
economic activity, then inflation should be relatively low and stable. In the 1970s,
central banks around the world had to grapple with the effects of the breakdown of
the Bretton Woods system. While many central banks decided to keep their exchange
rates fixed to the U.S. dollar or the German mark,11 by the 1980s a number of
Monetary Policy Regimes 99

advanced economy central banks, including those of the United States and Germany,
had adopted money growth targets as a guide for their monetary policy actions.12

A Stylized Model of Money Supply Growth Targeting

Money supply growth targeting is based mainly on the quantity theory of money
discussed in Chapter 5. Recall the equation of exchange

M×V=P×Q (6.1)

where M stands for the quantity of money in the economy, V is the velocity of circu-
lation of the money, P is the general price level in the economy, and Q is the quantity
of products sold in the economy.
Rearrange to get
M ×Q
P= (6.2)
V

Given that V and Q are exogenous to the equation, and thus assumed constant,
then a change in P must be equal to a change in M.
dP dM
= (6.3)
p M

In differentiating with respect to time (t), changes in P over time will be equal to
changes in M over time.
dP / P dM / M
= (6.4)
dt dt

The preceding calculation means that the rate of change in the general price
level of the economy, or the rate of inflation, is equal to the rate of change in money
supply over time.
Given Equation 6.4, if the central bank allows the money supply to grow at a
rate that is markedly faster than the growth rate of economic activity, inflation will
accelerate. In other words, with so much money, money will soon lose its purchasing
power. If the central bank pushes the money supply growth rate below the growth
rate of economic activity, on the other hand, money conditions will be tight and
inflation will decelerate. In extreme cases, if money becomes extremely scarce, prices
of goods and services might fall, and deflation could set in.

Money Supply Growth Targeting in the Real World

In the real world, money supply growth targeting experiences are quite complicated.
In the 1970s many advanced economies, including the United States, the United
Kingdom, Germany, and Switzerland, adopted money supply growth targeting as
their monetary policy regime, partly as a response to growing inflation, and partly
because of the need to search for a nominal regime after the collapse of the Bretton
Woods system.13
100 CENTRAL BANKING

In the United States, in a response to a congressional resolution, the Federal

Reserve started to publicly announce it targets for money supply growth in 1975.
In practice, however, the Federal Reserve did not place high priority on meeting the
supply growth target, but focused more on reducing unemployment and smoothing
interest rates.14 Without a strict commitment to money supply growth targets and
with the primary focus on reducing unemployment, together with events such as oil
shocks, inflation was spiraling out of control.
Only in late 1979, when the Federal Reserve (under the new leadership of Paul
Volcker) decided to (1) emphasize its commitments to money supply targets (2)
adjust its operating procedures to focus on setting a desired path for bank reserves
and an associated range for the federal funds rate, which allowed the interest rates
fluctuate more widely; and (3) push up interest rates to underscore its resolve to
discourage excessive money growth, did inflation expectations started to come
down.15
By 1982, however, the relationship between money supply growth and nominal
income was found to be unstable, and the Federal Reserve began to deemphasize
money supply targets.16

The U.S. and U.K. Experiences  Monetary growth targeting became popular as a mon-
etary policy rule in the advanced economies including the United States, the United
Kingdom, Canada, Germany, and Switzerland in the 1970s.17 In practice, however,
despite the announced money growth targets, many of these central banks also pur-
sued other objectives, including the stability of exchange rates and the financial mar-
ket. They often also attempted to fine-tune the economy based on the immediate
conditions, that is, moving along the short-run Phillips curve.18 When two major oil
shocks hit the world economy in the mid- and late 1970s, central banks—notably
those of the United States and the United Kingdom—tried to ease monetary condi-
tions, and along the way overshot their money supply growth targets in order to
push unemployment down.19
The unwillingness of U.S. and U.K. central banks to strictly adhere to their
announced money supply growth targets and to actually let the targets be consis-
tently overshot led to sharp increases in inflation.20 As public inflation expectations
rose upward in response to easy monetary policy, however, both unemployment and
inflation accelerated, resulting by the late 1970s in a situation known as stagfla-
tion (stagnation plus inflation). As discussed in Chapter 5 in the context of the time
inconsistency problem, the stagflation experience reflected the cost of using mon-
etary policy in a discretionary manner, as opposed to following a credible monetary
policy rule.
To get inflation back down, in October 1979 the Federal Reserve (under the new
chairmanship of Paul A. Volcker) decided to publicly emphasize its commitments to
money growth targets and allowed interest rates to shoot up to very high levels.21
While the policy resulted in deep economic contractions in the short term, it had the
effect of driving inflation expectations downward in the longer term, since it showed
the willingness of the Federal Reserve to commit to price stability even at steep
short-term costs. In any case, by the early 1980s both the Federal Reserve and the
Bank of England ran into a technical problem in pursuing money supply growth tar-
gets: the relationship between targeted money supply growth and nominal income
growth became very unstable, making it impossible to target money supply growth
Monetary Policy Regimes 101

properly.22 (See Case Study: The Breakdown of the Relationship between Money
Supply Growth, Nominal Income, and Inflation in the United States and the United
Kingdom, and the Role of Goodhart’s Law for more details.)
With inflation expectations already tamped down by a tight monetary policy,
the breakdown in the relationship between the growth in the money supply and
nominal income growth prompted the Federal Reserve to start deemphasizing
money supply growth targets by late 1982.23 By July 1993, the Federal Reserve
had completely phased out monetary targeting as a monetary policy rule, and
had effectively adopted what became known as a just-do-it, or a risk manage-
ment, approach to its monetary framework.24 The United Kingdom, meanwhile,
also dropped money growth targeting in the late 1980s and started pegging the
value of its currency to the deutsche mark in anticipation of joining the European
monetary union.25

The German Experience  In contrast to the U.S. and U.K. experiences, however, money
supply growth targeting in Germany was quite successful from the 1970s through
the 1990s.26 Apart from using a money supply growth target as a communication
tool to anchor expectations, the German central bank also announced a numerical
inflation goal and used that inflation goal to calculate the necessary money sup-
ply growth rate from the quantity theory of money equation.27 In this respect the
German central bank was also flexible enough to adjust a numerical inflation goal
over time to make it consistent with long-term price stability.
Furthermore, while the German central bank allowed monetary growth to some-
time overshoot the target in response to shocks, it also reversed those overages later
to get money supply growth back to the target over time.28 The German’s success
with money supply growth targeting as monetary policy rule to maintain price sta-
bility also depended heavily on the manner in which it communicated its monetary
policy strategy to the public. Although the central bank might miss its money supply
growth targets by large margins, the central bank also spent a lot effort in explain-
ing to the public how monetary policy was being directed to achieve its inflation
goal.29 This successful strategy was later adopted by the ECB through the use of the
two-pillar strategy of monetary policy, under which ECB concerned itself with both
money supply growth and inflation rates.

CASE STUDY: The Breakdown of the Relationship between Money Supply Growth, Nominal Income,
and Inflation in the United States and the United Kingdom, and the Role of Goodhart’s Law

By the early 1980s, as the Federal Reserve and the Bank of England had started to show more seri-
ous commitment to the rule of money supply growth targeting, the relationship between money sup-
ply, nominal income, and inflation started to break down in both the United States and the United
Kingdom.30 In terms of the quantity theory of money equation, the variable V in the M × V = P × Q
equation had become unstable, such that the central banks were having a hard time setting a growth of
M variable that would rightly correspond to the growth of P × Q (or growth of nominal GDP).31
The instability of V could have owed to factors that altered the cost of holding money (including
changes in inflation expectations and real interest rates), financial innovations (such as the introduc-
tion of money market accounts), and credit cards.32 With velocity of circulation (V ) being unstable, the
central banks found it increasingly difficult to calibrate their money supply growth targets in a way that
was consistent with nominal GDP.33
102 CENTRAL BANKING

Goodhart’s Law
This breakdown in the relationship between money and nominal income has also often been ascribed
partly to Goodhart’s law, named after the economist Charles Goodhart of the London School of
Economics. The law is a close relative to the Lucas critique discussed in Chapter 5.34 Specifically,
Goodhart’s law states that “any observed statistical regularity will tend to collapse once pressure is
placed upon it for control purposes.”35 With money supply growth becoming a control target, this
caused greater variation in nominal and real interest rates, as well as inflation, which helped increase
pressure for deregulation and competition.36 Ultimately the pressure for competition and deregula-
tion, coupled with the speed of the evolution in information technology, helped bring about financial
innovations that effectively caused instability in the velocity of circulation and destroyed the observed
relationship between money and nominal income.37

6.4 THE RISK MANAGEMENT APPROACH

From the mid 1980s until the onset of the global financial crisis in 2007, the Federal
Reserve had adopted a monetary-policy framework that became known as the just-
do-it, or the risk management, approach to monetary policy.38 In this framework,
there were no announced specific targets for money supply growth or the inflation
rate. Instead, the Federal Reserve closely monitored various economic data and acted
in a forward-looking manner, in order to maintain price stability and minimize risks
to employment and economic growth.39
Under the risk management approach, the Federal Reserve used a short-term
interest rate as its policy interest rate and adjusted the policy interest rate to preempt
risks that might lead to inflation and threaten economic stability. A famous example
is when Alan Greenspan, then chairman of the Federal Reserve, famously tightened
the Federal Reserve’s monetary policy stance in 1996, explicitly to temper down
“irrational exuberance” in the U.S. stock markets.40 Despite adjusting monetary pol-
icy based on factors such as asset prices and the state of the stock market, however,
when economists actually traced out monetary policy actions during the period of
risk management approach, it was found that the Federal Reserve monetary-policy
decisions at the time could be expressed as minimization of risks to both output
growth and price stability.

A Stylized Model of the Risk Management Approach: The Taylor Rule

Despite the lack of announced monetary policy targets on the part of the Federal
Reserve in the late 1980s and early 1990s, John B. Taylor, a prominent academic,
deduced statistically from the Federal Reserve’s monetary policy actions that the
Federal Reserve had, intentionally or not, tried to keep inflation at some equilibrium
level and the rate of GDP growth around inflation’s potential growth rate.41
The hypothesis made by Taylor received popular attention because it seemed
to approximate the Federal Reserve’s monetary policy actions reasonably well. The
hypothesis became known as the Taylor rule, which can be expressed as the formula

it = rt*+ πt + aπ (πt − πt*) + ay (yt − yt*) (6.5)

where it is the policy interest rate at time t, πt is the inflation rate, πt* is the desired
rate of inflation, rt* is the assumed equilibrium real interest rate, yt is the actual GDP
Monetary Policy Regimes 103

growth rate, yt* is the GDP growth rate at full potential, and aπ and ay are the rela-
tive weights that the central bank assigns to keeping inflation at the target rate and
getting the actual GDP growth rate to its full potential. In his 1993 paper, Taylor
suggested that aπ = ay = 0.5.
According to Equation 6.5, the Federal Reserve would raise the policy interest
rate when inflation is above the desired rate or when GDP growth rate is beyond its
full potential. When inflation is below the desired rate or when GDP growth rate is
below its full potential, then the Federal Reserve would lower the policy interest rate.
At times when inflation and output goals turn out to be in conflict—for example,
when an oil shock causes inflation to rise beyond the desired rate and at the same
time causes GDP growth to be below potential—the central bank might tilt the rela-
tive weights according to what it sees fit. In this case, if the central bank wants to
drive down inflation expectations it might put more weight toward keeping inflation
at the target rate.

The Risk Management Approach in the Real World

When the Federal Reserve quietly abandoned its money supply targeting regime in
the mid-1980s it did not explicitly announce a nominal target to replace its money
supply growth target. Rather, Alan Greenspan, who became the Federal Reserve
chairman in 1987, conducted monetary policy by closely monitoring changes in
eclectic sets of economic and financial variables and adjusting the policy interest rate
to forestall inflation and prevent problems with economic stability.42
The Federal Reserve, under Greenspan’s leadership, tried to actively conduct
monetary policy to contain various shocks that risked economic and financial system
stability. To mitigate the effects of the 1987 stock market crash and the 2001 terror-
ist attacks, the Federal Reserve injected massive amounts of liquidity into the system.
The Federal Reserve also lowered interest rates markedly in response to economic
slowdowns that led to recessions in the early 1990s and in the first decade of the
twenty-first century.
After each recession was over, the Federal Reserve tightened its monetary policy
stance by raising interest rates, notably in 1994 (which led to a crash in bond mar-
kets), 1996 (in response to “irrational exuberance” in the stock market), in the late
1990s (in response to the dot-com boom), and again in the middle of the first decade
of the twenty-first century (in response to rising oil prices and inflation).
Despite the lack of a nominal target for monetary policy, monetary policy con-
ducted under the risk management approach was approximated reasonably well by
the Taylor rule from the early 1980s onwards to very early in the first decade of the
twenty-first century.43 This suggests that at the time the Federal Reserve was con-
cerned with both inflation and unemployment, that is, the dual mandate discussed
in Chapter 4.

6.5 INFLATION TARGETING

Inflation targeting is a monetary policy regime under which the central bank aims
to keep the inflation rate within a specified target over a specified time frame. An
inflation-targeting central bank often uses a short-term interest rate (known as the
policy interest rate) as the key tool to adjust monetary conditions in the economy
104 CENTRAL BANKING

in a forward-looking manner, so that inflation, or more specifically the forecast for

inflation, is kept within target.44,*
Inflation targeting as a monetary policy regime rests upon two pillars: transpar-
ency and accountability.45 Transparency is conveyed through the public announce-
ment of the inflation target that the central bank tries to achieve, as well as the
reasons behind each of the central bank’s monetary-policy decisions with respect
to achieving the target. Accountability is conveyed through the fact that the cen-
tral bank is accountable if the inflation target is missed.46 With transparency and
accountability, the credibility of the central bank in maintaining monetary stability
through its conduct of monetary policy is enhanced.47
Note here that unlike money supply growth targets, an inflation target is more
transparent, both because the inflation rate is often collected by a government agency
(or agencies) outside the central bank and because the public can understand and
have a feel for the implications of an inflation rate much better than for a money-
supply growth rate.
Although there may be concern that an inflation-targeting central bank might
be too narrowly focused on inflation, in practice inflation targeting as a monetary
policy rule often allows the central bank discretion in dealing with unemployment
and output, but in a more transparent and appropriate longer-term context.48

A Stylized Model of Inflation Targeting

Figure 6.2 illustrates a stylized model of using inflation targeting as a monetary policy
rule. An inflation-targeting central bank would announce its target for inflation in
advance, along with the time frame for which inflation is to remain within target.

Consumption
behavior

Policy Investment Aggregate

Output gap Inflation
interest rate behavior demand

Export/Import
behavior

t 18 to 24 months

FIGURE 6.2  A Stylized Model of Inflation Targeting

*
Technically it is more precise to say that under inflation targeting the central bank’s forecast
of inflation, rather than current actual inflation, is to be kept within target, because there is
normally a time lag between a monetary policy action and a rise in prices. In the conduct of
monetary policy under inflation targeting, the central bank thus acts today in response to its
forecast of future inflation. In practice, however, the central bank is judged on its ability to
keep actual inflation within target.
Monetary Policy Regimes 105

If the central bank deems that current money conditions are stimulating consumption
and investment demand, as well as economic activity, too much, such that inflation
may rise beyond its target in the future, the central bank might raise the policy interest
rate to help tighten money conditions.
As will be discussed in more detail in later chapters, a rise in the policy inter-
est rate could lead to a rise in other short-term and long-term interest rates and
tightened money conditions, and thus a slowdown in consumption and investment
demand in the economy. The slowdown in consumption and investment demand
means that there would be less competition for goods and services, and thus also a
slowdown in the rise in prices of goods and services in the economy; in other words,
a slowdown in inflation.
It has long been recognized that before monetary policy actions can affect eco-
nomic activity and inflation, however, that there would be time lags that are both
long and variable.49 It could take anywhere from 12 months to more than 24 months
for a change in the policy interest rate to work through aggregate demand and fully
affect inflation.50 An inflation-targeting central bank would thus have to make an
inflation forecast over that time horizon and adjust the policy interest rate to make
sure that the inflation forecast would remain within target.51 This will be a rolling
exercise; that is, an inflation-targeting central bank would normally schedule mon-
etary policy meetings on a regular basis (possibly every six weeks) to assess new
information, make its inflation forecast two years out, and adjust its policy interest
rate accordingly.
As will be discussed in later chapters in more detail, apart from affecting con-
sumption and investment demand, a rise in short-term interest rates could also lead
to appreciation pressures on the exchange rate, and thus net exports, all else being
equal. With an appreciating exchange rate, the economy’s exports would be priced
higher in terms of a foreign currency, and thus demand for exports from the country
would also fall, leading to a slowdown in domestic economic activity and lower
inflationary pressures. On the other hand, with an appreciating currency, imports
of foreign goods and services would be cheaper in terms of domestic currency. As
such, there will be more imports to substitute for locally produced products. On the
whole, a rise in short-term interest rates is likely to lead to lower net exports and
thus a slowdown in economic activity, other things being equal. Along with weak-
ened domestic demand, the fall in net exports would help further weaken inflation-
ary pressures in the economy.
In contrast, if an inflation-targeting central bank deems that monetary condi-
tions are already too tight or economic activity too slow, such that inflation might
fall below its target, the central bank might choose to stimulate economic activity
and demand in the economy by lowering the policy interest rate. In such a case, as
other interest rates in the economy start to fall in line with the lower policy interest
rate, consumption and investment demand will rise. Competing demand for goods
and services will thus lead to higher inflationary pressures.
Also, as interest rates start to fall, all else being equal, the exchange rate will
likely depreciate, making exports cheaper in terms of a foreign currency. Demand for
the country’s exports will rise, leading to more economic activity and more competi-
tion for goods and services. With a depreciating currency, imports will become more
expensive in domestic currency terms and more likely to be substituted for by locally
produced products. Competition for domestic resources to increase production for
106 CENTRAL BANKING

these import substitutions will help spur economic activity, and also inflationary
pressures, going forward.

Inflation Targeting in the Real World

As discussed in Chapter 1, in 1990 the Reserve Bank of New Zealand (RBNZ)
became the first central bank to adopt inflation targeting as its monetary policy
regime. In designing its inflation-targeting regime, RBNZ put great emphasis on
transparency and accountability in monetary-policy decisions, in line with the over-
all public-sector reform being carried out in New Zealand at the time. Inflation
targeting emphasizes transparency in the form of a publicly announced inflation
target and the reasons behind the central bank’s monetary policy stance, that is, why
the central bank raised, lowered, or maintained the level of the policy interest rate.52
Accountability is conveyed through the fact that if the inflation target is missed
without a good explanation, the RBNZ governor could be removed. It could be said
that the emphasis on transparency and accountability helped enhance the credibility
of RBNZ’s commitment to price stability in its conduct of monetary policy in New
Zealand.
Later on, when many central banks of both advanced and emerging economies
were forced to find a credible monetary policy regime to replace exchange rate tar-
geting and money supply growth targeting, inflation targeting became the regime
of choice. Central banks that currently have inflation targeting as their monetary
policy regimes are diverse, and include the Bank of Canada, the Bank of England,
the Reserve Bank of Australia, the Bank of Korea, the Bank of Thailand, the Bank of
Indonesia, the Central Bank of the Philippines, the Czech National Bank, the Central
Bank of Brazil, and the Central Bank of Chile, among others.
In case of the United States, after Ben Bernanke succeeded Alan Greenspan as
chairman of the Federal Reserve System, the Federal Reserve gradually modified
certain procedures of their monetary policy practices so that they were more along
the lines of inflation-targeting central banks. In 2009, to increase transparency the
Federal Reserve started releasing its own forecast of inflation and output to the
public and acknowledged that a 2 percent rise in inflation represented the Federal
Reserve’s definition of price stability.53
Later, in January 2012, the Federal Reserve officially adopted an inflation target
rate, specifying that an inflation rate of 2 percent was best aligned with the mandates
of price stability and full employment.54 The Fed’s announcement of an inflation
target was expected to help keep longer-term inflation expectations firmly anchored,
which was expected to enhance the Fed’s ability to keep stimulating the economy in
the wake of 2007–2010 financial crisis. The adoption of an official inflation target
finally made the Federal Reserve another inflation-targeting central bank, although
as of this writing the Federal Reserve is still using quantitative easing, an unorthodox
monetary-policy framework that will be discussed in the next section.

CASE STUDY: Dealing with Challenges: Flexible Inflation Targeting

Despite its popularity and relative success, an inflation-targeting regime is not without challenges.
Indeed, two key major challenges of an inflation-targeting regime have already actually happened:
(1) the possibility that inflation might come from a supply shock (such as an oil shock) rather than
Monetary Policy Regimes 107

a demand shock, and (2) the possibility that asset-price bubbles could occur even in a low inflation
environment.55
Both of these challenges point favorably toward the adoption of what has become known as a
flexible inflation regime, under which long-term price stability remains supreme but the central bank
has the flexibility to deal with different sources of shocks to the economy.56
One of the novel approaches that a central bank with flexible inflation targeting might adopt is the
Bank of Canada’s program that adjusts the time horizon for it to bring inflation within target, so as to
minimize the economic and financial volatility that its actions may cause. The Bank of Canada lengthens
or shortens the typical two-year time horizon that it needs to bring inflation back to the target depend-
ing on the nature and persistence of the risks facing the economy. Specifically, the Bank of Canada is
willing to sacrifice inflation performance over the two-year horizon if by doing so it can achieve greater
economic, financial, and price stability over the longer run.57

Supply Shocks
In an inflation-targeting regime, the central bank is supposed to adjust the policy interest rate to influ-
ence aggregate demand in the economy. When a supply shock (such as an oil shock) occurs, economic
activity can slow down owing to rising costs of production, yet inflation can also accelerate. If the
central bank responds to an oil shock by being too accommodative in its monetary policy stance, then
inflation expectations might rise and inflation could accelerate, as happened during the Great Inflation
of the1970s. If the central bank simply raises the policy interest rate in order to bring down inflation,
however, aggregate demand can weaken, hurting economic activity further.
For the central bank with flexible inflation targeting that is dealing with a supply shock, if the
record of transparency, accountability, and credibility is strong (such that inflation expectations are
low), then rather than quickly raising the policy interest rate and further aggravating the contraction
of output, the central bank might be able to allow for a more gradual convergence of inflation with the
target, given that output stabilization might also be important when facing a supply shock.
More formally, it has been suggested that the central bank with flexible inflation-targeting regime
might try to minimize the social loss function using the equation

Lt = (1/2)[(πt − π*)2 + λxt2 ]

where πt is the actual inflation rate in period t, π* is the inflation target, xt is the output gap in period
t, and λ > 0 is the relative weight on output-gap stabilization. Rather than being entirely oblivious to
output fluctuation, and given that λ = 0, inflation-targeting central banks that are not so-called inflation
nutters are likely to want to give some weight (sometimes substantial) to λ.58

Asset-price bubbles
Even before the global financial crisis in 2007, the possibility existed that asset-price bubbles might
occur in the calm environment of low consumer price inflation.59 Usually, inflation-targeting central
banks would use one measure or another of consumer price inflation as their inflation target, since
consumer price inflation seems to best reflect the cost of living and is more readily understandable.
However, the experiences from Japan in the late 1980s and the United States in the middle of the first
decade of the twenty-first century suggest that asset-price bubbles can form when consumer price
inflation is low.60 Indeed, low consumer price inflation might allow asset-price bubbles to emerge,
since the central bank would be more likely to keep interest rates low, making asset-price speculation
easier.61
To deal with the possibility of asset-price bubbles, it has been suggested that an inflation-targeting
central bank might need to look beyond the traditional 18-to-24-month time horizon when making
monetary-policy decisions.62 Asset-price bubbles that form during periods of low inflation might keep
building up beyond the 24-month horizon, only to spectacularly burst later.63 A notable example of a
central bank using a longer horizon is the Reserve Bank of Australia, which—being cognizant of the
108 CENTRAL BANKING

possibility of asset-price bubbles building up and threatening price stability beyond the usual two-year
forecast horizon—adopted an inflation target whose time horizon is “over the [business] cycle.”64
More recently, central banks (whether inflation-targeting or not) have also started to look at
another set of tools called macroprudential measures, to help address specific buildups of asset-price
bubbles. For an inflation-targeting central bank, macroprudential measures are tools that can comple-
ment the use of the policy interest rate, since they can be applied more specifically to different areas
of the economy, unlike the policy interest rate, which normally affects all sectors of the economy.65

6.6 UNCONVENTIONAL MONETARY POLICY

Unconventional monetary policy became the policy mode of choice among central
banks of four of the major advanced economies—the United States, the euro area,
the United Kingdom, and Japan—after these economies experienced a large shock
in the form of a financial crisis (the global financial crisis of 2007–2010), and, for
Japan, a shock in the early 1990s in the form of bursting Japanese asset-price bub-
bles.66 Although the actual policy specifics differ, a common feature of the use of
unconventional monetary policy is that the central bank has already pushed the
policy interest rate down to zero, or almost zero, but the economy still needs further
stimulus lest it fall into a deflationary spiral (or fall further into a deflationary spiral
as in the case of Japan).
To complement the zero, or near-zero, interest rate policy that was implemented
in response to the global financial crisis, these central banks instituted an unconven-
tional policy response through three sets of tools, including (1) lending to financial
institutions, (2) providing liquidity to key credit markets, and (3) purchasing long-
term securities.67 As noted by Ben Bernanke, the chairman of the Federal Reserve
who used these tools, one common element that these tools have is that they rely on
the central bank’s authority to extend credit or to purchase securities.68
Given that the first two sets of tools (lending to financial institutions and provid-
ing liquidity to key credit markets) are more closely tied to the lender-of-last-resort
function and were discontinued once the crisis was past its peak, we can consider
the last set of tools (purchase of long-term securities)—which became popularly
known as quantitative easing and was still being used as of the time of this writing in
December 2013, five years after the peak of the crisis—as a form of monetary policy,
albeit an unconventional one.

A Stylized Model of Quantitative Easing

After the policy interest rate is near or at 0 percent, to further stimulate the economy
the central bank might choose to buy up long-term (or long-maturity, or long-dated)
government securities from the private sector, with the aim of (1) lowering long-term
borrowing costs, since government securities are often used as a benchmark for pri-
vate sector lending, and (2) restoring liquidity to financial institutions and key credit
markets so that further lending can be done to induce more economic activity.

Lowering Long-Term Borrowing Costs  Large purchases of long-maturity government

securities by the central bank is often known as quantitative easing, or QE, since
rather than purely adjusting the price of money (in terms of the policy interest rate),
Monetary Policy Regimes 109

Yield
(Percent per year)

Yield curve before the central bank buys up

long maturity securities.

4
Yield curve after the central bank buys up
long maturity securities.

0
Overnight 10 years 30 years Maturity

FIGURE 6.3  A Stylized Model of Unconventional Monetary Policy

the central bank is also easing shortages of liquidity in the economy by injecting a
quantity of money into the hands of the private sector.
Figure 6.3 illustrates a stylized model of unconventional monetary policy in
which the central bank decides to buy up long-maturity government securities from
the private sector. In Figure 6.3 the horizontal axis shows the maturity of govern-
ment securities (measured in time t), while the vertical axis shows the yield (interest)
paid to those holding government securities (measured in percent per year). When
we plot the yield of government securities at different maturities and draw a line
across the plots, we have what is known as the government yield curve. (Details of
the yield curve will be discussed in Chapter 7.)
Normally the yield curve is upward sloping, that is, yields of short-maturity
securities would be lower than yields of those with a longer maturity. For example,
the yield of a one-year government bond will normally be lower than the yield of a
five-year government bond, the yield of a ten-year government bond will normally
be lower than the yield of a thirty-year government bond, and so on. (Reasons for
this will be discussed in more detail in Chapter 7.)
In practice, the private sector uses the government yield curve as a benchmark
when calculating interest rates for borrowing and lending. Government securities
are considered risk-free assets, since the government is very unlikely to default on
its own securities. When the private sector lends funds among themselves, they often
compare the interest from such lending with what they could get from investing in
government securities (which is equivalent to lending to the government). Since lend-
ing to the government is risk free, while lending to the private sector involves risks,
the lender would normally charge interest rates on private loans that are higher than
yields of government securities of comparable maturities.
Figure 6.3 shows that when the central bank has already lowered its policy
interest rate (a short-term interest rate, possibly an overnight interest rate) to zero,
or near-zero, then the yield from holding government securities of overnight matu-
rity will also be at or near zero, but the yield of government securities of longer
maturity could still be much higher. For example, in Figure 6.3 the ten-year yield
could still be at 6 percent per year even though the overnight yield is at 0 percent.
110 CENTRAL BANKING

High long-term interest rates, however, could be a serious impediment to eco-

nomic activity when the economy is already weak. Commercial loans and mortgages
are often made based on long-term interest rates rather than short-term interest
rates, since these loans are repaid over a long maturity. When the policy interest rate
is already at or near 0 percent, to stimulate the economy further the central bank
might buy up long-maturity government securities directly from the private sector in
order to drive down long-term interest rates, as reflected by the yields on long-term
government securities.
The price of a government security and the yield of that government security are
inversely related. As the central bank starts buying up more government securities,
the price of the securities rises and thus the yield of the securities falls. In Figure 6.3,
as the central bank buys up more 10-year government securities, the 10-year
yield falls from 6 percent to 4 percent. With the 10-year yield of government securi-
ties falling from 6 percent to 4 percent, the private sector would benchmark their
interest rates for 10-year loans among themselves to this lower yield.

Restoring Liquidity  Apart from driving down long-maturity government yields, which
are benchmarks for private sector lending and borrowing, the purchase of govern-
ment securities from the private sector will also put more money in the hands of
the private sector, especially banks. During times of crisis, private agents are often
reluctant to borrow and lend among themselves. Instead, they might hoard risk-free
assets, such as government securities. This leads to shortages of liquidity, which ham-
pers economic activity.
Under quantitative easing, the central bank buys up government securities from
the private sector, which amounts to putting money in the hands of the private sector,
especially banks, which are often large holders of government securities. With more
cash on hand, banks would have a better ability to lend to private agents and spur
economic activity.

Unconventional Monetary Policy in the United States

In addition to buying up long-term government securities, which helped bring down
the government yield curve and restore liquidity as described in the preceding para-
graphs, the U.S. central bank also decided to buy up private sector securities, notably
mortgage-backed securities, in its response to the global financial crisis.69

Credit Easing plus Quantitative Easing  The purchase of private sector securities is
known as credit easing, to distinguish it from the purchase of government securities
(quantitative easing), although both are essentially large-scale asset purchases by
the central bank.70 The purchase of mortgage-backed securities in the United States
was intended to directly address problems relating to the bursting of the U.S. hous-
ing bubble, which threatened to drag the U.S. economy into a deflationary spiral.
Broadly speaking, rising housing prices during the bubble buildup had helped raise
household wealth and consumption spending prior to the crisis. The financial sector
had helped the fast growth of housing prices by providing mortgage financing to
U.S. households, and by packaging those mortgages into tradable securities known
as mortgage-backed securities. When the housing bubble finally burst, the financial
sector experienced great losses on unsold mortgage-backed securities that were still
Monetary Policy Regimes 111

on their books, and had to cut down on lending. The household sector, on the other
hand, faced with falling housing prices and huge mortgage debts, was experiencing
a fast decline in wealth, and had to cut down on spending.

Credit Easing and the Help for the Financial Sector  By buying up mortgage-backed securi-
ties, the U.S. central bank took some of the pressure off the financial sector.71 The
purchase of securities helped prevent the price of the securities held by many finan-
cial institutions from further falling and putting the financial sector at even greater
losses. Indeed, by doing its job of financial intermediation by purchasing mortgage-
backed securities, the U.S. central bank provided liquidity for the financial sector and
helped the financial sector to regain its capacity.72

Credit Easing and Help for the Housing Market  The purchase of mortgage-backed securi-
ties also helped alleviate pressures on the household sector. The willingness of the
U.S. central bank to buy up mortgage-backed securities indirectly helped slow the
fall in housing prices. The purchase of mortgage-backed securities helped prevent the
price of these securities from spiraling downward. With the price of these securities
stabilized and money being put back into lenders’ hands, lenders were able to finance
new housing purchases and thus help slow the fall in housing demand and prices, as
well as household wealth.

Credit and Quantitative Easing and Help for the Labor Market  Although initially the focus
of credit easing and quantitative easing was primarily to ease tension in the financial
sector and the housing market, as financial markets and the housing market stabi-
lized, the Federal Reserve deemed it appropriate to use both credit easing and quan-
titative easing as tools to help alleviate pressures in the labor market. In September
2012, for example, the Federal Reserve announced that it would buy an additional
$40 billion a month in mortgage securities and that it would reinvest principal pay-
ments of the mortgage securities it held to help put downward pressure on long-term
interest rates and foster economic growth in order to help to “generate sustained
improvements in labor market conditions.”73

CASE STUDY: Dealing with the European Sovereign Debt Crisis: Not Yet a QE in 2013

In the euro area, although the ECB also engaged in lending to financial institutions and providing liquid-
ity to key credit markets, it initially did not buy up long-term government securities in response to the
global financial crisis of 2007–2010, in contrast to the Federal Reserve and the Bank of England.74 By
the early 2010s, however, as economic activity in the euro area started to slow down in wake of the
global financial crisis, there were fears that governments of a number of smaller, uncompetitive euro
area countries that had high levels of public debt might have troubles repaying that debt.
With the debt repayment ability of these governments in doubt, securities issued by these gov-
ernments started to lose in value. International investors started demanding higher yields for holding
these securities, to compensate for the risk that these governments might default on these supposedly
risk-free securities. The higher yields demanded by the investors placed an additional burden on these
governments to find money to pay for the higher yields demanded. The situation threatened to become
self-fulfilling, since the higher yields demanded by investors would further cripple the ability of govern-
ments to repay their debt and actually push the governments into default.
Since a default by a government of a euro area member country would raise doubt on credibility of
the euro as a currency and the euro area as a monetary union, the ECB announced that it was willing to
112 CENTRAL BANKING

buy up securities issued by governments of the troubled euro area countries. The purchase would help
allay investor fears and also help bring down yields of securities issued by the troubled governments,
enabling the governments in question to sort out their finances in the meantime. Also, in offering to
buy up these securities, the ECB would in effect be letting the banking sector offload their vast holdings
of troubled government securities from their books, limiting the chance that the sovereign debt crisis
would also transform into a banking crisis.
In September 2012 Mario Draghi, the new leader of the ECB, proposed a plan to buy an unlimited
amount of government securities of the member countries as a measure to stem the European sov-
ereign debt crisis.75 The ECB’s purchase of government securities, however, would not be exactly the
quantitative easing of the type conducted by the Federal Reserve or the Bank of England. Specifically,
the ECB would sterilize its purchases of the government securities from the private sector, meaning
that it would also sell its own securities to the markets to drain out the extra money it paid for the bond
purchases.76 Accordingly, government securities of the troubled economies would be replaced by ECB
securities, and there would be no net effect on the quantity of money from the operation.

Challenges to Unconventional Monetary Policy

While unconventional monetary policy might have helped prevent the global econ-
omy from falling into a deflationary spiral and economic chaos, there has been criti-
cism about the continued use of such a policy.
First, at a fundamental level, large, sustained purchases of government securi-
ties by central banks threaten to move central banks into the realm of fiscal policy.
The purchase of government securities, even from the private sector, had a similar
effect to that of central bank funding of government deficits. A sustained pursuit of
quantitative easing could make it look like the central banks were printing money to
finance government spending, which would jeopardize the central bank’s credibility
and political independence.
Second, a sustained pursuit of quantitative easing could end up encouraging
asset-price speculation. This was partly reflected in the large run-ups in equity prices
in advanced economies, even at a time that their general economic activity remained
weak. The quantitative easing policy helped put liquidity into the system, but as the
economies were still in the process of deleveraging (i.e., reducing debt overhangs
from the crisis), much of the liquidity was channeled into asset markets (particularly
the equity markets, but also emerging-market economies) to chase higher returns,
rather than into real economic activity in the crisis-hit economies.
Third, timing the exit from quantitative easing is another challenge for cen-
tral banks. If inflation starts to kick in when quantitative easing is still being used,
it could make the central banks’ commitment to price stability seem less credible.
As such, when their economies start to recover and inflation starts to pick up, the
central banks will need to sell the securities and absorb liquidity from the economy
fast enough, while at the same time not creating panic in the financial markets. The
timing of the exit could be quite a challenge, as demonstrated in mid-2013 when the
Federal Reserve’s mere announcement of the possibility of a tapering of quantitative
easing policy caused so much disruption in global financial markets that the Federal
Reserve had to reassure investors that the tapering would be gradual.
Fourth, the purchase of private sector securities (such as mortgage-backed secu-
rities) has been criticized on the grounds that it is “picking winners” and is “dis-
tortionary,” since the central bank is effectively helping those institutions that held
Monetary Policy Regimes 113

assets that were falling in value, while other economic sectors were left out, with no
assistance from the authorities.
Despite these criticisms and challenges, however, it can be argued that the
recent global financial crisis was so grave that the use of unconventional monetary
policy by the central banks might have been warranted. In using unconventional
monetary policy, however, central banks need to carefully assure the public that
they are not becoming subordinate to their governments. Furthermore, central
banks will need to be very vigilant about threats of inflation once their economies
have recovered.

SUMMARY
Theoretical foundations of monetary policy conduct discussed in Chapter 5 sug-
gested that, for monetary policy to be credible, a monetary policy rule (also called a
monetary policy regime) should be adopted by the central bank.
The key monetary policy regimes that modern central banks have adopted are
(1) exchange rate targeting, (2) money supply growth targeting, (3) the risk man-
agement approach, (4) inflation targeting, and (5) unconventional monetary policy.
Under an exchange rate targeting regime, the central bank aims to keep the
exchange rate within the announced target. In such a regime, the exchange rate is
often pegged to the currency of a large country that has a good record of monetary
stability.
Under a money supply growth targeting regime, the central bank aims to keep
money supply growth at a target that is consistent with nominal income growth in
the economy.
Under the risk management approach, adopted by the Federal Reserve from the
mid-1980s to the middle of the first decade of the twenty-first century, the central
bank adjusts the policy interest rate to preempt risks that might threaten monetary
and economic stability.
Under an inflation-targeting regime, the central bank adjusts the policy interest
rate to keep inflation within its announced target over a prespecified time horizon.
The central bank is held accountable if inflation misses the target.
Unconventional monetary policy was adopted by various central banks of
advanced economies to deal with the aftermath of the 2007–2010 global financial
crisis, after the policy interest rate had been reduced to or near 0 percent. At the core,
such policy involves large-scale purchases of long-term securities in order to bring
down long-term interest rates and ease money and credit conditions.

KEY TERMS
basket of currencies money supply growth targeting
credit easing quantitative easing
exchange rate targeting risk management approach
flexible inflation targeting the Taylor rule
Goodhart’s law unconventional monetary
inflation targeting policy
114 CENTRAL BANKING

QUESTIONS
1. What is a monetary policy regime, and why is it important?
2. How can a central bank with an exchange rate targeting regime aim to achieve
price stability?
3. What is a currency board?
4. If there are large inflows of capital, what is likely to happen to the country’s
exchange rate? Why?
5. If there are large inflows of capital, conceptually how can the central bank under
an exchange rate targeting regime keep the exchange rate within its announced
target?
6. If a large number of importers need large amounts of foreign currencies to pay
for their import purchases at the same time, what would happen to the exchange
rate?
7. How can the central bank keep the exchange rate at the announced target if a
large number of importers need large amounts of foreign currencies to pay for
their import purchases at the same time?
8. What might be the reason to say that those countries that have an exchange rate
targeting regime do not have monetary policy independence?
9. Why is it impossible for a central bank to achieve an exchange rate target, allow
free flows of capital, and maintain monetary policy independence simultane-
ously in the long run?
10. What is the underlying theoretical underpinning of money supply growth
targeting?
11. What are the pros of adopting money supply growth targeting as the monetary
policy regime?
12. Why did the United States and United Kingdom abandon money supply growth
targeting in the mid-1980s even though money supply growth targeting helped
manage inflation expectations downward in the early 1980s?
13. What does Goodhart’s law state and how does it apply to the practice of mon-
etary policy?
14. In the risk management approach practice of monetary policy in the United
States during Alan Greenspan’s era, what were examples of key variables that
the Federal Reserve took into consideration when making monetary-policy
decisions?
15. What are the pros of the risk management approach to monetary policy?
16. What are the cons of the risk management approach to monetary policy?
17. What are the features of and rationale for inflation targeting?
18. Under inflation targeting, how do transparency, accountability, and credibility of
the central bank come into play?
19. What is the key monetary policy instrument that a central bank with an
­inflation-targeting regime normally uses to achieve its inflation target? How can
the central bank use that instrument to maintain monetary stability, if there seems
to be a risk that projected inflation might overshoot its target?
20. Should an inflation-targeting central bank raise its policy interest rate if infla-
tionary pressures come from a supply shock (e.g., an oil shock) as opposed to a
demand shock?
Monetary Policy Regimes 115

21. Given that inflation is likely to remain low, how could an asset-price bubble
be a challenge for the central bank in the conduct of monetary policy under an
inflation-targeting regime?
22. What are the pros of inflation targeting?
23. What are the cons of inflation targeting?
24. How might a central bank deal with the cons of inflation targeting?
25. What are the three key elements of the policy that the Federal Reserve used to
deal with the U.S. subprime crisis?
26. What might be immediate goals of quantitative easing programs?
27. In terms of their influences on the yield curve, how might quantitative easing
differ from conventional monetary policy?
28. How could quantitative easing help the housing market and the labor market in
the United States?
29. What are the pros of quantitative easing programs?
30. What are the cons of quantitative easing programs?
 CHAPTER 7
Monetary Policy Implementation
Financial Market Operations

Learning Objectives
. Distinguish between the financial sector and the real sector.
1
2. Define money market.
3. Describe how central banks can influence conditions and interest
rates in the money market.
4. Explain how changes in money market interest rates can affect
long-term interest rates.

M onetary policy implementation refers to ways in which the central bank could
act to influence money conditions in the economy in order to achieve its
mandate, whether the mandate is monetary stability, financial stability, or employ-
ment (the latter applies particularly to the case of the United States). In the previous
chapter, we have discussed monetary policy rules, or monetary policy regimes, which
modern central banks might choose to adopt. The regime that the central bank has
chosen to adopt would dictate how the central bank might implement its monetary
policy decisions in the pursuit of its mandate.
In practice, modern monetary policy is often conducted through operations in
the financial markets.1 Such operations often involve transactions with financial
institutions, which will affect money conditions before affecting real economic activ-
ity such as consumption, investment, and net exports, which are components of
aggregate demand. Generally speaking, changes in aggregate demand will then affect
the output gap and inflation. In practice, however, changes in expectations following
an announcement of the central bank’s monetary policy decision might also have a
prompt impact in financial markets even before the central bank embarks on any
financial market operations, as market players adjust their portfolios in response
to the monetary policy decision. Economic agents, meanwhile, might also adjust
their economic behavior in line with changes in their expectations following the
announcement of the central bank’s monetary policy decisions.2
Figure 7.1 illustrates the link between monetary policy, the financial sector, the
real sector, expectations, and inflation.

117
118 CENTRAL BANKING

Expectations

Financial sector Real economy

Consumption
Financial
markets
Monetary Aggregate Output
policy Investment Inflation
demand gap
Financial
institutions
Export/Import

Expectations

FIGURE 7.1  The Financial Sector and the Role of Expectations

The financial sector is the initial contact point of monetary policy implementation, although
expectations can also have an immediate impact.

In this chapter, we will look at how monetary policy could affect the financial
sector, which primarily is composed of financial markets and financial institutions.
In particular, we will focus on central bank operations in the financial markets by
looking at the nature of financial markets and the tools that the central bank can
use to influence interest rates in those markets. In Chapter 8 we will look at how
the effects of monetary policy on interest rates in the financial markets work their
way through the real economy (the part of the economy concerned with producing
goods and services, also termed the real sector) via various channels of transmission
mechanisms to affect economic activity and inflation.

7.1 CENTRAL BANK OPERATIONS IN THE

FINANCIAL MARKET: AN OVERVIEW

The first link between the central bank’s monetary policy action and real economic
activity is the financial markets. The definition of the term financial market, how-
ever, is often quite loose. Broadly speaking, a financial market is one in which those
in need of funds and those with excess funds come to transact with each other. The
transaction could be simple borrowing and lending (with or without collateral), or
sales and purchases of securities or currencies. As such, the term financial market
actually encompasses many markets, which are distinguished by the nature of under-
lying transactions.
Table 7.1 lists a number of key financial markets in which central banks often
conduct their monetary policy operations.
Under normal circumstances, central banks conduct their monetary policy
operations through transactions in the money market, the foreign exchange market,
the government securities (bond) market. The preferred market(s) for operations
depends on the monetary policy regime, as well as surrounding circumstances. For
many central banks, the money market, which is the market for short-term (normally
Monetary Policy Implementation 119

TABLE 7.1  Key Financial Markets in Which Central Banks Conduct Their Monetary
Policy Operations

Central Bank Operations or

Type of Financial Market Transactions Handled Involvement
Money market Short-term (less than Operations in the money market are
one year) liquidity done to manage the policy interest
funding rate, which is a key reference rate for
other short-term interest rates.
Foreign exchange market Foreign exchange Foreign exchange interventions are
funding done to smooth out excess exchange
rate volatility, or to keep the
exchange rate within target.
Government securities Government funding Transactions in the (secondary)
market government securities market are
done to inject or absorb liquidity in
the longer term.
Credit market Corporate funding, Part of unconventional monetary pol-
housing market icy used in the United States, under
funding which the central bank targets spe-
cific liquidity shortages in the system.

less than one year) funding, is often the preferred venue for the conduct of monetary
policy operations. Another main venue for monetary policy operations, especially
for those central banks that are concerned with the exchange rate, is the foreign
exchange market, which generally refers to the market for foreign exchange funding.
The government bond market, on the other hand, is an important venue for central
banks to occasionally influence longer-term interest rates.3
Additionally, during times of financial crisis, the central bank might extend its
operations and carry out transactions in nontraditional markets such as the credit
market.4 The credit market is a market for debt securities and includes securities
issued by banks, nonbank financial institutions, and corporations outside the finan-
cial industry. As discussed in Chapter 6, in response to the global financial crisis, the
U.S. central bank decided to conduct unconventional monetary policy by buying
up mortgage-backed securities and commercial paper from players in the financial
market. The operations were deemed unconventional since in normal times central
banks would certainly not be directly involved in corporate funding.*
It must be noted that, in a world where financial markets are closely connected,
no matter what particular market the central bank chooses to operate in, the effects

*Another example of crisis operations would be operations of the central bank in the equity
market. In the midst of the Asian financial crisis in the late 1990s, the Hong Kong Monetary
Authority decided to directly purchase vast amounts of shares in the Hong Kong stock mar-
ket in order to fend off foreign speculators who were trying to break its exchange rate target
through short selling on the Hong Kong stock market. Such operations, however, have rarely
been done even during stressful times, since they could be easily misinterpreted as central bank
funding of the corporate sector.
120 CENTRAL BANKING

of its operations are likely to spill out to all other markets. The magnitude of the
effects in other markets, however, could vary, depending on market infrastructure as
well as surrounding circumstances. By tightening conditions in the money market,
for example, commercial banks would face higher short-term funding costs, which
they might pass on to their operations in other markets, such as the foreign exchange
market, that they themselves also operate in.
In practice, even a mere announcement of monetary policy operations in one
market could affect conditions in other markets through the expectations effect.
Players in other markets would anticipate the ultimate effects of such operations, and
accordingly adjust their behavior even before the central bank actually backs up its
announcement with actions. Indeed, in a world of fast information, it can be more
profitable for market players to act in advance of a monetary policy announcement,
such that the anticipation of a future policy announcement itself could drive the play-
ers’ actions and actually move markets before the central bank actually does anything.

The Money Market

The money market is the market in which participants borrow or lend funds for the
short term, which normally means less than one year.5 Participants in the money
market often consist of institutions that need to borrow or lend funds among them-
selves over the short term. At the core of the money market is interbank lending,
where commercial banks lend and borrow among themselves. Also involved in the
money market are nonbank financial companies and corporations outside the finan-
cial sector that come in to tap short-term funds by issuing commercial paper.6 The
government could also come in and tap short-term funding needs by issuing Treasury
bills (government securities with less than one year maturity).
When the central bank conducts operations in the money market, it is effectively
trying to influence the tightness or looseness of funding (i.e., borrowing and lend-
ing) conditions in the money market. By tightening lending conditions in the money
market, liquidity, or availability of funds, for lending becomes scarcer. Once lending
conditions in the money market become tight (as often reflected by rising money
market interest rates), borrowers and lenders of funds in the money market factor in
the higher opportunity costs of short-term funding into their other operations.
Tightness in short-term funding conditions could also lead to tightness in other
markets and in long-term funding conditions, since borrowers could scramble to
seek cheaper funding elsewhere, if possible. In the same spirit, by loosening short-
term funding conditions in the money market, the central bank could also indirectly
loosen funding conditions in other markets and in long-term funding.
In practice, the central bank is just another participant in the money market, but
with its special status as the ultimate money creator and the setter of regulations for
the banking system, the central bank has particular influences over borrowing and
lending conditions in the money market. To understand how the central bank could
influence the money market, it is helpful to first understand the interaction between
supply and demand for funds in the money market.

Demand for Funds in the Money Market  Normally commercial banks want to hold the
minimum amount of cash possible, since cash does not yield any interest, unlike
loans. In practice, however, banks would not lend out all the deposits that they took
Monetary Policy Implementation 121

in, owing to their need to hold reserves to meet (1) reserve requirements, whereby
the central bank requires commercial banks to set aside a certain percentage of the
deposits they took in from depositors as reserves to be held in accounts at the central
bank, and (2) contractual clearing balances, or settlement balances, whereby com-
mercial banks might keep funds in their accounts at the central bank to clear or settle
transactions that are done through the central bank’s payments system.7
Commercial banks would normally want to minimize their holdings in settle-
ment balances and excess reserves (the amount of reserves over and above those
required by reserve requirements or settlement balances), since money deposited at
the central bank might not be paid interest, or be paid at a rate lower than the pre-
vailing market rates.8 If unexpected large settlement needs arise, then banks might
be forced to borrow funds from the central bank at a penalty rate, or go borrow in
the money market. Such a need to borrow funds constitutes a large portion of the
demand for funds in the money market.9
Apart from banks’ need for short-term funds, demand for funds in the money
market could also come from nonbank private players, such as nonbank financial
institutions, large corporations, and the government. These nonbank private play-
ers might have short-term funding needs, possibly for short-term financing of their
investments or as working capital (to pay suppliers, or even employee payrolls). To
fund their short-term financing needs, these players could issue commercial paper to
tap short-term funds. Government, on the other hand, might issue government bills
to tap short-term funds to finance their own short-term obligations.

Supply of Funds in the Money Market  If banks find that they have been holding more
reserves than would be needed to meet their reserve requirements and settlement obli-
gations, they would normally want to lend out at least part of their excess funds in
order to earn interest. The desire to lend out funds short-term would constitute the
supply of funds in the money market. In practice, in places where financial markets are
relatively developed, nonbank players (e.g., money market mutual funds) have also
become increasingly important suppliers of funds in the money market.10 Investors
put their money into money market mutual funds, and the funds then seek to invest
the money by putting it into money market securities such as commercial paper or
government bills. The money invested by these mutual funds to fund commercial
paper or government bills also constitute short-term lending in the money market.11

Theoretical Equilibrium in the Money Market  In theory, at any given time, some of the
players in the money market would be short of funds and need to borrow, while oth-
ers would have excess funds that they want to lend out. Equilibrium in the money
market would be achieved when the amount players wish to borrow matches the
amount other players wish to lend. Interest rates, which are the prices of funds, help
clear the market. If there is a large demand for funds relative to supply, interest rates
would likely rise. In contrast, if there is a small demand for funds relative to supply, then
interest rates would fall. In a case in which there is an unexpected demand shock such
that there is net shortage of funds in the system, then interest rates could really spike up.
If the money market as a whole is extremely short of funds, however, mar-
ket participants might be unable to lend among themselves and the central bank
might need to step in and provide funding to market participants. In other words,
sometimes movements in interest rates might be unable to clear the money market
122 CENTRAL BANKING

effectively, and the central bank, being the regulator, might need to step in and lead
the market into equilibrium.

Central Bank’s Influences in the Money Market

Without the central bank’s presence, conditions in the money market could be quite
volatile, as demand and supply of funds could be subjected to numerous external
forces. The central bank’s presence in the money market helps facilitate smooth func-
tioning of the money market, not the least through its funding provision when there
is a net shortage of funds in the system.

Influencing Reserve Balances  In practice, as a part of its normal monetary policy imple-
mentation, the central bank routinely uses its special position in the money market to
influence money market conditions, specifically through its ability to meet demand for
reserve balances held at the central bank by commercial banks to meet their reserve
requirements or settlement obligations (as previously discussed).12
In the United States, when the Federal Reserve wants to ease conditions in the
money market it can announce a lower target rate for the federal funds rate, which is
the interest rate commercial banks charge one another when lending reserve balances
(the funds held by commercial banks in accounts at the Federal Reserve). If there is a
net shortage of reserve balances, however, commercial banks might be unwilling or
unable to lend to each other at or near a rate that is consistent with this new (lower)
target rate announced by the Federal Reserve. To make sure that commercial banks
could and would lend at each other at the lower announced federal funds rate target
rate, the Federal Reserve might back up its announcement by providing liquidity to
help reduce the net shortage of reserve balances, thus enabling the banks to lend funds
to each other at or near the announced federal funds target rate.13

Tools for Monetary Implementation  In general, we can classify tools that the central
bank can use to influence conditions in the money market into four groups.
First, the central bank can use the level of the policy interest rate as a signal
to indicate the tightness or looseness of money market conditions that it deems to
be appropriate for the general economy. Second, the central bank could use open
market operations, that is, direct transactions with money market participants to
actually influence liquidity conditions in the money market. Third, the central bank
can set up lending and deposit facilities (standing facilities) for money market par-
ticipants to access, in order to help keep money market interest rates consistent
with the policy interest rate without too much reliance on open market operations.
Fourth, the central bank could use reserve requirements to directly regulate commer-
cial banks’ liquidity needs, and thus money market conditions.14
When used together, the first three of the channels listed above (i.e., the pol-
icy interest rate, open market operations, and standing facilities) constitute what
is known as the interest rate corridor, which has become increasingly popular as
a framework for central banks to guide money market conditions, especially in an
environment in which financial markets have become liberalized and interest rates
are allowed to move relatively freely. The fourth channel (reserve requirements)
remains useful for central banks to regulate money market conditions, especially in
cases in which financial markets have yet to be liberalized.15
Monetary Policy Implementation 123

Policy Interest Rate  The policy interest rate refers to a short term interest rate that
the central bank uses to indicate its monetary policy stance. By announcing its inten-
tion to keep the policy interest rate at a particular level, the central bank can induce
participants in the money market to borrow and lend among themselves at rates that
are not too far off from the policy interest rate. Normally, market participants are
encouraged to borrow and lend among themselves first before turning to the central
bank. Competition among market participants would normally ensure that they bor-
row and lend among themselves at rates that are not too extreme.16 Yet, if it seems
that shortages or surpluses of funds would not be cleared easily at rates of interest
near the policy interest rate, then the central bank can always step in and inject or
drain out funds from market participants directly, through open market operations.
With the knowledge that the central bank can always step in to ensure that rates do
not go much out of line with the policy interest rate, market participants would nor-
mally borrow and lend near or at the policy rate anyhow. This, of course, is unless
there is a large systemic shortage or surplus of funds that drives market participants
to borrow and lend at rates far removed from the policy rate.17

Open Market Operations  When conducting open market operations, central bank
injects or absorbs funds from the money market at the margin, so as to prevent
excessive net shortages or surpluses of funds from driving a large wedge between
prevailing interest rates and the policy rate.18 Open market operations normally
means purchasing and selling of securities (normally government securities and cen-
tral bank bills) to market participants. With a purchase of securities, the central bank
is effectively injecting funds into the system, since the central bank has to pay for
those securities with money. With a sale of securities, in contrast, the central bank
is effectively draining funds out of the system, as market participants who buy the
securities have to pay the central bank with money.19

C O N C E P T: VARIOUS T YPES OF OPEN MA R K ET OP ER ATI ONS

Open market operations can be broadly separated into two types, according to
the nature of the transaction.

Outright Transactions
The first type of transaction is the buying or selling of securities whose rights
are permanently transferred to the buyer. In such a case, the securities are said
to be bought or sold outright.20
Figure 7.2a illustrates a case in which the central bank tightens money mar-
ket conditions by draining out liquidity through an outright purchase of securi-
ties from a financial institution, one of its counterparties in the money market.
In contrast, Figure 7.2b illustrates a case in which the central bank eases
money market conditions by injecting liquidity through the sale of securities to
a financial institution, one of its counterparties in the money market.

(Continued)
124 CENTRAL BANKING

(Continued)
Gov’t 1. Central bank sells government Gov’t
bonds securities to Financial Institution A. bonds

Central Financial
bank Institution A

2. Financial Institution A pays the

central bank with cash.
3. Money is now with the
central bank and out of
circulation.

FIGURE 7.2a  Liquidity Absorption by the Central Bank: Tightening Money Market
Conditions

Gov’t 1. Financial Institution A sells government Gov’t

bonds securities to the central bank. bonds

Financial
Central
Institution A
bank

2. The central bank pays Financial Institution A

with cash.
3. Money is now with
Financial Institution A and is
ready to circulate further
into system.

FIGURE 7.2b  Liquidity Injection by the Central Bank: Easing Money Market
Conditions

Repo and Reverse-Repo Transactions

The other main type of open market operations is the buying or selling of secu-
rities whose rights are only temporarily transferred to the buyer. An example of
this type of transaction is a repurchase agreement or a repo, whereby the seller
of securities would have to buy those securities back in a future date and at a
specified price. In this case, of course, funds are drained out of the system only
temporarily. If the central bank wants to inject funds into the system temporar-
ily, on the other hand, it could do a reverse-repo. In this case, the central bank
buys securities from a market participant with an agreement to sell back those
Monetary Policy Implementation 125

securities to the market participant at a future date and at a specified price. In

a reverse-repo, the central bank temporarily injects funds into the system.
Figures 7.3a illustrates a case in which the central bank enters into a repo
transaction in order to temporarily tighten money market conditions.
Figures 7.3b illustrates a case in which the central bank enters into a
reverse-repo transaction in order to temporarily ease money market conditions.
1. At time t = 0, the central bank absorbs liquidity
from the system, by selling government securities
to Financial Institution A, with an agreement to
purchase the securities back from Financial
Financial Institution A at time t = 1. Central
Institution A $
bank
At time
t=0 Government 2. Money is now with
IOU the central bank and
out of circulation.

3. At time t = 1, the central bank injects liquidity

back into the system by buying government
At time securities back from Financial Institution A.
t=1
$
Financial
Institution A Central
bank
Government
IOU
4. Money is now back with
Financial Institution A and is ready
to circulate further into the system.

FIGURE 7.3a  Repurchase Agreement by the Central Bank: Temporarily Absorbing

Liquidity

1. At time t = 0, the central bank injects liquidity into the

system by buying government securities from Financial
$ Institution A with the agreement to sell the securities
Financial back to Financial Institution A at time t = 1.
Institution A
At time Central
t=0 bank
2. Money is now with
Financial Institution A and
Government
ready to circulate further
IOU
into the system.

At time 3. At time t = 1, the central bank withdraws liquidity

t=1 back from the system by selling government
securities back to Financial Institution A. $ Central
Financial bank
Institution A
Government 4. Money is back with
IOU the central bank and
out of circulation.

FIGURE 7.3b  Reverse Repurchase Agreement by the Central Bank: Temporarily

Injecting Liquidity

(Continued)
126 CENTRAL BANKING

(Continued)
A repo-type transaction is often popular in the money market, since the
same securities could be used many times over. A repo could also be thought
of as a loan of funds, whereby securities are used as collateral. The seller of
securities would get money for her securities, with an agreement that she
would have to buy back those securities in a future date. The price at buy-
back would be higher than the price at which the securities were first sold.
The difference in the buyback price and the price for which the securities
were first sold reflects the interest charged on the lending of funds for the
period of the repo. A repo (as well as a reverse-repo), with its temporary
nature, is more suitable for a central bank wishing to manage temporary fluc-
tuations in the money market. The central bank does not need to keep issuing
bills or finding government securities to sell to market participants every time
it wishes to drain liquidity from the system.

Federal Reserve’s Use of the Terms Repo and Reverse-Repo

It should be noted that the Federal Reserve describes its own repo and reverse-
repo operations from its counterparty’s viewpoint rather than from its own
viewpoint. As such, when the Federal Reserve said it was conducting what
it described as a “reverse-repo” exercise in September 2013 as a part of the
preparation plan of its future exit from its quantitative easing programs,
the Fed was actually exercising draining out liquidity from the system by
selling out securities to market players with an agreement to buy them back at
a specified future period at a specified price.

FX Swaps
Another open market operations tool that the central bank can use in influenc-
ing conditions in the money market is foreign exchange swaps, or FX swaps.21
Like a repo, an FX swap can be considered lending, but with foreign currency as
collateral instead of securities. The borrower of local currency funds would sell
its foreign currency holdings to the lender, with an agreement to buy those for-
eign currency holdings back at a future date and at a prespecified price. When
the central bank wants to absorb funds from the money market, it can thus
offer to borrow (local currency) funds from market participants and provide
foreign currency as collateral on those borrowed funds. In a prespecified future
period, the central bank would repay local currency funds back to market par-
ticipants and take back foreign currency that had been placed as collateral.
Normally, if terms are favorable enough, market participants would have
already been willing to lend local currency to the central bank this way. Still,
in many cases, market participants might also have legitimate needs for foreign
exchange funds, whether for their own or their customers’ use. For example,
corporate customers of money market participants might need to pay for
imports or to repay their foreign currency debt. With the central bank willing
to borrow local currency and provide foreign currency as collateral, money
market participants would have another way to access foreign currencies.
Monetary Policy Implementation 127

On the other hand, the central bank could inject local currency funds into
the money market by lending out local currency funds to market participants
and take in foreign currency as collateral. In this case, market participants might
be short of local currency but have a surplus of foreign currencies. This might be
the case, for example, when exporters sell their export receipts to money
market participants for local currency funds.

Standing Facilities  Broadly speaking, standing facilities refer to facilities at which

money market participants can come to borrow and lend funds directly with the
central bank. While the central bank can do open market operations to drain or
inject funds into the money market, these days a modern central bank often aims
not to intervene in the market too often or too much. The central bank would rather
have money market participants efficiently manage their own funding needs and let
market forces allocate funds among the participants. In such a case, the central bank
can set up standing facilities as passive tools that help smooth out volatility in money
market interest rates.
When market participants are in need of short-term funds and they cannot find
a lender among themselves, the participants can borrow directly from the central
bank’s lending facility. When market participants have excess funds that they cannot
lend out among themselves, they can put the funds into the central bank’s deposit
facility. Of course, the central bank prefers that the interest rates money market par-
ticipants charge among themselves remain in line with the announced level of policy
interest rate, since the policy rate signals the central bank’s monetary policy stance.22
Figure 7.4 provides a stylized model of how the central bank can use standing
facilities to help regulate money market conditions, especially when some financial
institutions might be short of funds while others have excess funds.

Financial Institution A deposits

part of its excess liquidity in the Financial Institution D
central bank’s deposit facility. Central
deposits part of its excess
bank
liquidity in the central
bank’s deposit facility.
The central bank lends
liquidity to Financial
Financial Institution C through
Institution A the lending facility.
Financial Institution A
lends part of its excess Financial
liquidity to Financial Institution D
Institution B.

Financial Financial
Institution B Institution D lends
Financial part of its excess
Institution C liquidity to
Financial
Institution C.

FIGURE 7.4  Use of Central Bank’s Standing Facilities to Help Manage Liquidity in the
Money Market
128 CENTRAL BANKING

C O N C E P T: T HE INT EREST RAT E CORR I D O R

In practice, market movements can indeed be very volatile, and net shortages
or surpluses in the market can push market participants to borrow and lend
among themselves at rates far different from the level of the policy interest
rate. The use of standing facilities along with the policy interest rate and open
market operations constitutes the so-called interest rate corridor, whereby bor-
rowing and lending in the money market are kept within the corridor and
consistent with the policy interest rate.
Lately, many central banks in advanced and emerging-market economies
have decided to use an interest rate corridor system, with standing facilities
that help put a ceiling and a floor on how far the rates that market par-
ticipants charge among themselves can diverge from the policy interest rate.
Central banks that have adopted an interest rate corridor system include
the Federal Reserve, the Bank of England, the ECB, the Reserve Bank of
Australia, the Reserve Bank of New Zealand, the Bank of Korea, the Bank
Negara Malaysia, the Bangko Sentral ng Pilipinas, and the Bank of Thailand,
among others.23
Figure 7.5 provides a stylized illustration of interest rate corridor mechanics.
In Figure 7.5 we can see that the interest rate that the central bank charges
for its lending through the lending facility would be noticeably higher than
the policy interest rate, to encourage market participants to first find lenders
among themselves before turning to the central bank’s lending facility. The rate
charged at the central bank’s lending facility, however, will not be significantly
higher than the policy interest rate (usually it is the policy interest rate plus half
a percentage point). This is to encourage market participants to charge each

Annual interest rate

(percent)

The central bank announces a cut

in the policy interest rate at time t1.

The interest rate that the central bank will charge

at its lending facility (ceiling of the corridor)

The announced
level of policy
interest rate
The actual interest rate
charged among private
players The interest rate that the central bank offers to
pay at its deposit facility (floor of the corridor)

t1 t

FIGURE 7.5  Illustration of an Interest Rate Corridor

Monetary Policy Implementation 129

other rates not much higher than the policy rate—otherwise, market partici-
pants can always turn to the central bank’s lending facility. The interest rate
charged at the central bank’s lending facility is thus effectively the ceiling for
interest rates charged by money market participants when lending and bor-
rowing among themselves.
In contrast, when money market participants have excess short-term funds
that they cannot lend among themselves, they can deposit those funds at the
central bank’s deposit facility. The interest rate given at the central bank’s
deposit facility will be noticeably lower than the policy interest rate, in order
to encourage market participants to first find borrowers of funds among them-
selves before turning to the central bank’s deposit facility. The interest rate paid
at the central bank’s deposit facility is unlikely to be significantly lower than
the policy interest rate, however (usually the policy rate minus half a percent-
age point). The interest rate paid at the central bank’s deposit facility is thus
effectively a floor on rates in the money market.

Reserve Requirements  Theoretically, reserve requirements can be another tool that

the central bank can use to influence conditions in the money market. When the
central bank raises reserve requirements, banks that are money market participants
have to reserve more cash per dollar they take in as deposits. With a hike in reserve
requirements, conditions in the money market would be tighter since money market
participants would have to designate more funds as reserves, and thus would be able
to lend out less. Those who were initially short of funds would have to scramble
harder to find funds to meet the stricter requirements.
In practice, however, reserve requirements are not very popular as an active
tool to influence the money market in a system in which the financial market has
been liberalized and interest rates are allowed to float.24 In such a system, the cen-
tral bank often prefers to have market forces allocate funds in the money market
and would be more likely to use a policy interest rate to signal its monetary stance.
Frequent changes in reserve requirements can have profound effects on bank credit
extension.25 Theoretically, in the case of a bank that had been efficiently lending out
its deposits such that its reserves are already at the existing requirement, a hike in
reserve requirements might prompt the bank to call in its callable loans from firms
and households in order to meet the stricter reserve requirements. Firms and house-
holds who are denied loans or having their loans called in would have a very hard
time adjusting.
In contrast, had the policy rate been used as the policy tool, a hike in the policy
interest rate would only have a gradual effect on firms and households. As money
market conditions are tightened, the bank might raise interest rates on its new loans
or on its floating rate loans rather than calling in loans that have already been
extended to meet its own reserve requirements. In such a case, firms and households
would have time to adjust their behavior accordingly, which would be less traumatic
than having their loans called in.
130 CENTRAL BANKING

7.2 TRANSMISSION OF MONEY MARKET INTEREST RATES

TO OTHER INTEREST RATES IN THE ECONOMY

The earlier discussion suggested how central banks can influence conditions in the
money market and thus money market interest rates. For changes in money mar-
ket conditions to affect real economic activity and price levels, however, conditions
and interest rates in other segments of the financial market must first also respond
to changes in money market conditions and money market interest rates. For the
central bank’s conduct of monetary policy to affect the real economy, interest rates
charged on corporate loans, personal loans, and mortgages (which are long-term
interest rates, or long rates), as well as deposit rates and expectations of players in
the economy, must first change.

The Yield Curve

In practice, how changes in money market conditions might affect long-term inter-
est rates are partly reflected by movements in the government bond yield curve.
A government bond yield curve plots yields (or interest rates) on different maturities
of government securities. Figure 7.6 illustrates a government bond yield curve. The
vertical axis represents the yield on government securities in percentage per year.
The horizontal axis represents maturity, or the time that government securities have
left before they actually become due (have matured). Yields on government securities
with the shortest maturities would be nearest to the vertical axis.
In Figure 7.6, the short maturity end of the yield curve at zero is overnight matu-
rity. This represents the yield of government securities that are maturing overnight.
If the policy interest rate is an overnight interest rate, then the yield of government
securities maturing overnight must be equal or very close to the level of the policy
interest rate. Otherwise, there could be arbitrage opportunities, whereby economic
agents could make riskless profits by borrowing funds from a lower rate source and
lending those funds at a higher rate.
For example, if the overnight yield of government securities is much higher
than the policy interest rate, then market participants could borrow funds
from the money market for overnight at, or very near, the policy interest rate, and
invest the borrowed funds into government securities that are also maturing over-
night, earning riskless profits. The opportunity to earn riskless profits will draw a
large number of participants into such an activity, such that the yield will converge
to the policy interest rate. In a financial market that is efficient, market forces will
keep the yield of government securities at very short maturity very close to the
policy interest rate.*

*In contrast, had the yield for overnight government securities been much lower than the pol-
icy interest rate, investors would dump the securities and lend overnight funds in the money
market in order to earn interest very near or at the policy interest rate. The dumping of over-
night securities will have the effect of pushing the price of the securities down (and the yield
up). Again, in a reasonably efficient market, market forces will drive the overnight yield very
close to the policy interest rate, if the policy interest rate is an overnight rate.
Monetary Policy Implementation 131

Yield
(percent per year)

Level of the
policy
interest rate
0
Overnight 1 year 3 years 5 years 10 years 30 years Maturity

FIGURE 7.6  Illustration of a Government Bond Yield Curve

Possible Shapes of the Yield Curve  In theory, although the very short end of the yield
curve will be anchored by the policy interest rate, the yield curve can take any
shape. Normally there are three general shapes used to describe yield curves, namely
upward-sloping (normal), flat, and downward-sloping (inverted). Figure 7.7 illus-
trates what a normal, a flat, an inverted, and a humped yield curve might look like.
An upward sloping (normal) yield curve means that the short-term yields are
lower than the longer-term yields. A flat yield curve means that the yields are equal, or
almost equal, at every maturity (debt securities of shorter maturities will have lower
yields than longer-term debt securities). A downward sloping (inverted) yield curve
means that the short-term yields are higher than the longer-term yields (debt securi-
ties of shorter maturities will have higher yields than longer-term debt securities). An
upward-then-downward (humped) yield curve means that yields of medium-term
maturities are higher than those with shorter or longer maturities.

The Government Bond Yield Curve as a Benchmark for Setting Other Interest Rates  Banks and
other financial institutions often use the government bond yield curve as a bench-
mark when they set interest rates on loans and deposits. Interest rates on loans and
deposits at short maturities are benchmarked against the yields of government secu-
rities with short maturities (i.e., the short end of the government bond yield curve).
Interest rates on loans and deposits at longer maturities are benchmarked against the
yields of government securities with long maturities (i.e., the long end of the govern-
ment bond yield curve).
The reason the government bond yield curve is normally used as a benchmark
is that yields on government bonds represent risk-free interest rates. Lending to the
government is normally assumed to be risk free, particularly in terms of domestic
currency lending, since the government can always impose taxes to repay its debt.
When setting interest rates to be charged on corporate and household borrowers,
banks and other financial institutions would thus just add a risk premium to risk-free
132 CENTRAL BANKING

Yield Yield
(percent per year) (percent per year)

0 0
Overnight 30 years Overnight 30 years
A normal yield curve A flat yield curve

Yield Yield
(percent per year) (percent per year)

0 0
Overnight 30 years Overnight 30 years
An inverted yield curve A humped yield curve

FIGURE 7.7  Illustration of Normal, Flat, Inverted, and Humped Yield Curves

rates at corresponding maturities, to compensate for the possibility that borrowers

would be unable to pay back the loans.

The Central Bank’s Influence on the Yield Curve  In the normal conduct of monetary policy
(as opposed to the unconventional conduct of monetary policy; see Chapter 6) the
central bank usually tries to influence the short end of the yield curve and let market
forces determine longer-term yields and interest rates. Consequently, the reaction of
long-term interest rates to changes in the policy interest rate are not so straightfor-
ward. Although the central bank can use the policy interest rate to tightly anchor
interest rates at the very short end of the yield curve, long-term interest rates are gener-
ally allowed to float in places where financial markets are liberalized (see Figure 7.8).
How changes in short-term interest rates might affect long-term interest rates
involves many forces, and the results are indeed not entirely predictable. A hike in
the policy interest rate, while likely to push up other short-term interest rates, does
not necessarily always translate to a rise in long-term interest rates.
In practice, the effect of changes in short-term rates on long-term rates depends
on the interplay of various factors, including the initial levels of long-term and short-
term rates, expectations about future central bank actions, and liquidity conditions
of players in the financial markets. The complexity of the relationship between short-
term rates and long-term rates is reflected partly by the fact that there are at least
three competing theories of yield curve. All of the theories are consistent with any
shape of the yield curve but propose different reasons for why the yield curve might
take a particular shape. The details of the theories are discussed next in Concept:
Term Structure Theories and the Shape of the Yield Curve.
Monetary Policy Implementation 133

Yield
(percent per year)

Long-term yields are normally

allowed to float and
are also affected by factors
The central bank’s money
other than the central bank’s
market operations are normally
open market operations.
done to anchor short-term
yields and interest rates.

Level of
policy
interest
rate
0
Overnight 1 year 3 years 5 years 10 years 30 years Maturity

FIGURE 7.8  In Normal Times, the Central Bank Operates Primarily at the Short Maturity
End of the Yield Curve

C O N C E P T: T ERM ST RUCT URE T HEOR I ES AND THE SH A P E

O F T H E YIELD CURVE
Theories of the yield curve, or theories describing the term structure of inter-
est rates, attempt to explain the relationship between short-term interest rates
and long-term interest rates, thatis, why a yield curve might take a particular
shape. The three competing theories of the yield curve are (1) the pure expec-
tations theory, (2) the liquidity preference theory, and (3) the market seg-
mentation theory.26 The fact that all of these theories could offer different
explanations that are consistent with any shape of a yield curve suggests the
complexity of transmission mechanisms from a change in the policy interest
rate to changes in interest rates at longer maturities.

Pure Expectations Theory

The pure expectations theory assumes that the various maturities on the yield
curve are perfect substitutes, and thus the shape of the yield curve depends
on market participants’ expectations of future short-term rates. According to
the pure expectations theory, when short-term rates are expected to rise in the
future, the yield curve would be upward sloping. When short-term rates are
expected to fall, the yield curve would be downward sloping. When short-
term rates are expected to remain constant, the yield curve would be flat. (See
Figures 7.9a and 7.9b.)

(Continued)
134 CENTRAL BANKING

(Continued)

Yield Yield
(percent per year) (percent per year)

0 0
Overnight 30 years Overnight 30 years

A normal yield curve A flat yield curve

Short-term rates are expected Short-term rates are expected to
to rise in the future. remain the same in the future.

FIGURE 7.9a  Pure Expectations Theory: Normal and Flat Yield Curves

Yield Yield
(percent per year) (percent per year)

0 0
Overnight 30 years Overnight 30 years

An inverted yield curve A humped yield curve

Short-term rates are expected Short-term rates are expected to
to fall in the future. rise and then fall in the future.

FIGURE 7.9b  Pure Expectations Theory: Inverted and Humped Yield Curves

To illustrate the point, think of the three-month rate being the short rate,
and the three-year rate being the long rate. Within the space of three years,
there is a series of 12 consecutive three-month rates. If the short rate (i.e.,
the three-month rate, is expected to rise within that three-year period, obvi-
ously the rate charged for lending long term for three years starting today
would be higher than the current three-month rate. Thus when we plot the
yield curve, it would be upward sloping, since the three-month rate is lower
Monetary Policy Implementation 135

than the three-year rate.* The humped yield curve, in contrast, would occur
when short rates are expected to rise, then fall.

Liquidity Preference Theory

The liquidity preference theory suggests that investors require additional com-
pensation (i.e., a liquidity premium) to hold longer-term securities, and thus
yields on longer-term maturity securities are higher than shorter-term maturity
securities. This is because holding on to longer-term securities involve greater
risk than holding on to shorter-term securities. Shorter-term securities would
be redeemable for cash sooner rather than later, and thus investors will have a
greater choice with what to do with the money. Holders of longer-term maturity
securities will have to wait for a longer time before securities can be redeemed
for cash, and in the meantime there are many things that could go wrong.
According to the liquidity preference theory, an upward sloping yield
curve could still be consistent with expectation of declining short-term rates
in the future, if the liquidity premium more than compensates for the expected
fall in future short-term rates. If rates are expected to fall sharply, however,
even adding in a liquidity premium would not prevent the yield curve from
being downward sloping. A humped yield curve, on the other hand, could also
be humped even with a liquidity premium added to yields in all maturities. (See
Figures 7.10 and 7.11.)

Market Segmentation and Preferred Habitat Theories

In contrast to the pure expectations theory, the market segmentation theory sug-
gests that the various maturities of the yield curve are not exactly close substitutes,
and thus it is the supply and the demand for securities at each maturity range that
determine the yields of securities within that maturity range (see Figure 7.12).
According to this theory, different types of investors have different preferences
for maturity range. Investors with longer-term liabilities, such as life insurance
companies and pension funds, often prefer holding securities in a longer-term
maturity range. Investors with shorter-term liabilities, such as commercial banks,
may have a preference for holding securities with a shorter maturity. This theory
fits quite well in a situation where there are legal or institutional policy restric-
tions that prohibit investors from purchasing securities with maturities outside
a particular maturity range. Money market mutual funds, for example, are nor-
mally required to invest only in securities with maturities of less than one year.

*The current three-month rate would also be known as the 3-month spot rate, while the
current three-year rate would also be known as three-year spot rate. The three-month
rates for the subsequent periods after the initial three months are known as three-
month forward rates. Note that the average (not the simple average) of the three-month
rates for the three-year period would be equal to the three-year spot rate.

(Continued)
136 CENTRAL BANKING

(Continued)

Yield
(percent per year)

Liquidity preference yield curve

Liquidity premium, or extra

yields, demanded by investors for
holding longer-term securities

Yield curve without liquidity

preference (pure expectations)

0
Overnight 1 3 5 10 30 Maturity
year years years years years

FIGURE 7.10  Liquidity Preference Theory: Liquidity Premium

Yield
(percent per year)

Liquidity preference yield curve

Liquidity premium

Pure expectations yield curve

0
Overnight 1 3 5 10 30 Maturity
year years years years years

FIGURE 7.11  Reconciling Pure Expectations Theory and Liquidity Preference

Theory: Liquidity Premium Added to Decreasing Expected Rates
Monetary Policy Implementation 137

Yield
(percent per year)

Life insurers and

pension funds

Money market mutual funds

and commercial banks

Demand
Demand Supply curve
Supply curve curve
Supply Demand curve
curve curve

0 Maturity
Overnight 1 3 5 10 30
year years years years years

FIGURE 7.12  Market Segmentation Theory: Different Types of Players Dominate

Different Segments of the Yield Curve

A weaker form of the market segmentation theory is the preferred habitat

theory. According to this theory, although different types of investors have
their preferred maturity ranges for their investments, investors can still move to
other maturity ranges if the yields in those other maturity ranges are attractive
enough for them. Similar to the market segmentation theory, however, the pre-
ferred habitat theory also takes the view that yields are determined by supply
and demand for various maturity ranges.

7.3 MONETARY POLICY AND THE YIELD CURVE

As mentioned previously, the reactions of long-term yields to changes in the policy

interest rate depend on many factors. A change in the policy interest rate could
produce different results on longer-term rates depending on various factors, includ-
ing the initial level of interest rates, expectations, and the interactions of different
market players.

The Effects of the Policy Interest Rate on the Long End

of the Yield Curve
Broadly speaking, changes in the policy interest rate may alter expectations for future
movements of short-term rates (pure expectations theory), as well as expectations for
138 CENTRAL BANKING

economic conditions and inflation, and thus affect the liquidity premium needed for
holding long-term securities (liquidity preference theory). Such changes in expec-
tations could affect expectations of various types of players differently, and thus
demand and supply for different maturity ranges (market segmentation and pre-
ferred habitat theories). In practice, how a change in the policy interest rate will
ultimately affect long-term yields will depend on the interplay of all these factors and
the surrounding circumstances.
A hike in the policy interest rate could, for example, prompt long-term yields to
rise proportionately to the hike such that the yield curve shifts upward in parallel. In
other circumstances, such as when long-term rates are already quite high, or when
long-term rates are low but inflation expectations are quite well anchored, a hike
in the policy interest rate might result in a flattening of the yield curve (long-term
yields do not rise proportionately to the hike in the policy interest rate).
At the extreme, a hike in the policy interest rate might actually prompt long-term
yields to fall and the yield curve to become inverted. This last instance might happen
when the hike in policy interest rate is expected to slow down economic activity and
dampen inflation expectations so much that rates are expected to subsequently fall
in the future. (See Figure 7.13.)
A cut in the policy interest rate, meanwhile, could also lead to different responses
in long-term yields. For example, long-term yields might fall proportionately to the
cut in the policy interest rate, resulting in a parallel downward shift of the yield
curve. In contrast, long-term yields might fall less than proportionately than the cut
in policy interest rate, resulting in a steepened yield curve. At the extreme, long-term
yields might actually rise in response to a cut in the policy interest rate, had the cut
been expected to boost up economic activity so much so that long-term inflation is
expected to accelerate. (See Figure 7.14.)

The yield curve after the hike in the policy interest rate.
The yield curve before the hike in the policy interest rate.

Yield Yield Yield

(percent per year) (percent per year) (percent per year)

0 0 0
Overnight 30 years Overnight 30 years Overnight 30 years

A hike in the policy interest A hike in the policy A hike in the policy
rate leads to a parallel interest rate leads to a interest rate leads to an
upward shift in the yield flattening of the yield inverted yield curve.
curve. curve, with long-term
yields hardly moving.

FIGURE 7.13  Examples of How a Hike in the Policy Interest Rate Could Affect Long-Term
Yields in Different Ways
Monetary Policy Implementation 139

The yield curve after the cut in the policy interest rate.
The yield curve before the cut in the policy interest rate.

Yield Yield Yield

(percent per year) (percent per year) (percent per year)

0 0
Overnight 30 years Overnight 30 years Overnight 30 years
A cut in the policy A cut in the policy interest A cut in the policy
interest rate leads to a rate leads to a steepening interest rate leads to a
parallel downward shift of the yield curve, with a steepening of the yield
of the yield curve. relatively slight fall in long- curve, with a slight rise
term yields. in long-term yields.

FIGURE 7.14  Examples of How a Cut in the Policy Interest Rate Could Affect Long-Term
Yields in Different Ways

The Yield Curve as a Leading Economic Indicator

In practice, since the yield curve could be influenced by multitudes of forward-looking
expectations, it is deemed to also contain valuable information for policy making.
Modern central banks routinely monitor movements in the yield curve to gauge not
only what is happening in the financial markets, but also what market players might
be expecting about the general economy.
A downward-sloping, or inverted, yield curve suggests that interest rates are
more likely to fall than not in the future. In the United States, since it has been found
that short-term rates exceeded longer-term rates in each of seven recessions since
1970, an inverted yield curve is often deemed as a good predictor of a coming reces-
sion.27 An economic explanation of why an inverted yield curve might be a good
predictor of a recession is that an inverted yield curve suggests that economic agents
do not see economic opportunities that might offer high rates of return in the future,
compared to what they could earn now.

Unconventional Monetary Policy and the Yield Curve

As discussed earlier, in the normal conduct of monetary policy, the central bank tries
to influence only the short end of the yield curve and lets long-term rates be deter-
mined by market forces. In the wake of the recent global financial crisis, however,
many central banks of economies affected by the crisis decided to embark upon
quantitative easing, which is an unconventional monetary policy. As discussed in
Chapter 6, quantitative easing is done with the central bank directly purchasing
long-term securities and influencing the long end of the yield curve.
The use of quantitative easing is likely to have three complementary objectives.
First, by directly purchasing long-term government securities, the central bank would
140 CENTRAL BANKING

help push down long-term government yields. Since yields on government securities
are usually used as a benchmark for private sector lending, the pushdown of long-
term yields on government securities could translate into lower long-term lending
(and borrowing) rates among the private sector.
Second, by purchasing other long-term securities, such as mortgage-backed
securities, from market players, such as banks, the central bank would be effec-
tively providing much needed liquidity to those players during the time of crisis.
The liquidity provided will help the players meet short-term obligations, and enable
financial markets to continue functioning in a smooth manner, which is essential
for financial stability.
Third, with large enough purchases of securities, the central bank would in effect
be injecting money into the economy. Players in the financial markets, such as banks,
will have enough excess liquidity to finance economic activity by households and
firms. Since the policy interest rate will normally be at or near 0 percent by the time
unconventional monetary policy is used, the central bank uses the option of easing
monetary conditions further through such purchases of securities.

SUMMARY
Monetary policy implementation refers to the ways in which the central bank can
act to influence money conditions in the economy in order to achieve its mandate.
To influence money conditions, the central bank might operate in various types of
financial markets, including (among others) the money market, the foreign exchange
market, the government securities market, and the credit market. The money market
is the key market in which modern central banks operate to influence money condi-
tions in the economy. The money market is the market in which participants borrow
or lend funds for maturities of less than one year.
The central bank typically influences conditions in the money market by influ-
encing reserve balances held by commercial banks at the central bank, using tools
such as the policy interest rate, open market operations, and standing facilities.
The use of the policy interest rate, open market operations, and standing facilities
together constitutes the interest rate corridor system, which keeps money market
interest rates near the desired policy interest rate.
Transmission of money market interest rates to other interest rates in the econ-
omy can be seen through the movements of the yield curve. The yield curve shows
yields (interest rates) at different maturities; the policy interest rate (which is often
an overnight interest rate) is at the very short-maturity end of the yield curve. The
government yield curve, which shows yields of government securities at different
maturities, is often used by financial market players to benchmark rates for risk-free
lending.
The yield curve is normally upward sloping, but could also be downward slop-
ing (inverted), as well as flat. Theories explaining the shape of the yield curve include
pure expectations, liquidity preference, and the market segmentation or preferred
habitat theories.
Normally, the central bank tries to influence the short end of the yield curve. In the
wake of the 2007–2010 crisis, after major central banks had cut their policy interest
rates to or near 0 percent, many of them decided to also use unconventional monetary
policy (e.g., quantitative easing) to influence the longer end of the yield curve.
Monetary Policy Implementation 141

KEY TERMS
credit market money market
deposit facility open market operations
financial market outright transaction
foreign exchange market policy interest rate
FX swap preferred habitat theory
government securities market pure expectations theory
government securities yield curve repos
interest rate corridor repurchase agreement
inverted yield curve reserve balance
lending facility reverse repurchase agreement
liquidity preference theory reverse-repo
liquidity premium standing facility
market segmentation theory yield curve

QUESTIONS
1. What are the key differences between the financial sector and the real sector?
2. Please give examples of the key financial markets in which central banks conduct
their operations.
3. What is a money market?
4. How can a central bank tighten conditions in the money market?
5. How can a central bank ease conditions in the money market?
6. In open market operations, what is an outright transaction?
7. In open market operations, what is a repo transaction?
8. Does the central bank always need to conduct open market operations to
influence money market interest rates? Why or why not?
9. How does an interest rate corridor system work?
10. How might reserve requirements be used to influence conditions in the money
market?
11. Why might the central bank not want to use reserve requirements to influence
money market conditions?
12. What is a yield curve?
13. When the central bank adjusts the policy interest rate, it is trying to directly
influence which end of the yield curve?
14. According to expectations theory, why might a yield curve be upward sloping?
15. According to expectations theory, why might a yield curve be downward sloping?
16. According to expectations theory, what does a humped yield curve imply?
17. According to liquidity preference theory, why might a yield curve be upward
sloping?
18. According to liquidity preference theory, could an expectation of a falling short-
term interest rate be consistent with an upward sloping yield curve?
19. According to market segmentation theory, why might the yield curve be upward
sloping?
142 CENTRAL BANKING

20. What is the likely implication of a downward sloping yield curve on the state of
the economy going forward?
21. If the central bank raises its policy interest rate, which is an overnight rate,
by 0.25 percent, what is likely to happen to the 10-year yield of government
securities?
22. Theoretically, is it possible that the yield curve could become inverted after a
hike in the policy interest rate?
23. What is the difference between the normal conduct of monetary policy and
quantitative easing in terms of the intention to influence the yield curve?
 CHAPTER 8
The Monetary Policy
Transmission Mechanism
How Changes in Interest Rates Affect
Households, Firms, Financial Institutions,
Economic Activity, and Inflation

Learning Objectives
1. Describe how changes in interest rates can affect unemployment
and inflation through households’ behavior.
2. Describe how changes in interest rates can affect unemployment
and inflation through firms’ behavior.
3. Describe how changes in interest rates can affect unemployment
and inflation through behavior of financial institutions.
4. Explain why might there be uncertainty and time lags in the mon-
etary policy transmission mechanism.

C hapter 7 discussed how the central bank’s conduct of monetary policy opera-
tions could affect interest rates in the financial markets. This section will discuss
how changes in interest rates might affect the behavior of households, businesses,
and financial institutions, and thus aggregate demand and general price levels in the
economy. The transmission of effects to economic activity and inflation from
the implementation of monetary policy is often known as the monetary policy trans-
mission mechanism (see Figure 8.1).
Through its conduct of monetary policy, the central bank uses the policy inter-
est rate to signal its monetary policy stance and to try to influence interest rates
and money conditions within the economy, and ultimately GDP, employment, and
monetary stability. Changes in monetary conditions and interest rates will then affect
lending behavior of financial institutions, as well as the spending, saving, and invest-
ment behaviors of households and businesses, which, in turn, will affect aggregate
demand and inflation.

143
144 CENTRAL BANKING

Expectations effect

Financial sector Second-round effects Real sector

Consumption
Households

Monetary Financial Financial Aggregate Output

Inflation
policy markets institutions demand gap

Investment
Firms
Money market
interest rates Net exports

Second-round effects

Expectations effect

FIGURE 8.1  Transmission of Monetary Policy through Households, Firms, and Financial
Institutions

This chapter will examine the monetary policy transmission mechanism by looking
at how behaviors of households, firms, and financial institutions are likely to react to
changes in money conditions, which can be typified by changes in prevailing borrowing
and lending rates within the economy. It must be noted, however, that although it’s called
a mechanism, monetary policy does not necessarily transmit in a mechanistic way, and
the transmission itself can be viewed from different perspectives.1 If anything, monetary
policy transmission has inherent uncertainty, whether in terms of timing or the relative
importance of the different channels through which monetary policy is transmitted.2

C O N C E P T: A NOT E ON NOM INAL AND REA L I NTER ES T RATES: TH E

F I S H E R E QUAT ION AND INFLAT ION EX P EC TATI ONS
While the central bank can directly influence short-term interest rates through
adjustments in the policy interest rate through normal policy operations, and
directly influence longer-term interest rates by unconventional monetary policy,
such as quantitative easing, such interest rates discussed in previous chapters
so far have been expressed in nominal terms, that is, not deflated by inflation
expectations.

The Fisher Equation

Economists, however, believe that households’ and firms’ consumption and
investment decisions are influenced by real interest rates, or nominal interest
The Monetary Policy Transmission Mechanism 145

rates deflated by inflation expectations. This concept is expressed in what is

known as the Fisher equation (named for Irving Fisher, an American econo-
mist), or

r = i − πe

where r is the real interest rate, i is the nominal interest rate, and πe are inflation
expectations.
When economic agents decide to save or invest an amount of money,
intuitively they compare the nominal interest rate with what they expect infla-
tion will be over the time horizon being considered. If the nominal interest
rate is below what they think inflation would be over that period (i.e., the real
interest rate is negative), then they might be better off spending their money
now, since they are not expecting interest earned on the money to keep up
with inflation.
For our discussions on monetary transmission mechanism that follow, we
are referring to real interest rates, although the term real is sometimes omitted
for conciseness. Indeed, if inflation expectations are stable in the short run, we
can safely say that a rise in nominal interest rates implies a rise in real short-
term interest rates.

Inflation Expectations
In practice, there are three main ways that a central bank can gauge the infla-
tion expectations of the public. First is through surveys. A typical question
asked of the public in a survey might ask respondents what they think the
inflation rate will be over the next year, the next 5 years, and the next 10 years.
Inflation expectations for each time horizon would then be calculated from the
mean value of the surveys’ answers.
Second would be looking at breakeven inflation, which is the difference
between the yield of a nominal government security and the yield of an inflation-
protected government security. Unlike most government securities, which are
nominal securities, inflation-protected government securities have their princi-
pal adjusted by the inflation rate.3
For example, if a five-year nominal government security has a yield of
5 percent, while a five-year inflation-protected government security has a
yield of 2 percent, then the breakeven yield would be 3 percent. In this case,
we could say that inflation expectations of the public over the five-year hori-
zon are also 5 percent minus 2 percent = 3 percent. In other words, given the
yield difference of 3 percent, the public would be indifferent between hold-
ing the five-year nominal government security and the five-year inflation-
protected security.
Third, the central bank could use economic models to estimate inflation
expectations.4
146 CENTRAL BANKING

8.1 MONETARY POLICY AND HOUSEHOLDS’ BEHAVIOR

Generally speaking, changes in interest rates can affect households’ spending and
saving decisions via six main effects, namely (1) the intertemporal substitution effect,
(2) the income effect, (3) the wealth effect, (4) the exchange rate effect, (5) the expec-
tations effect, and (6) second-round effects.
In this section, we will discuss the first four effects, namely the intertempo-
ral substitution effect, the income effect, the wealth effect, and the exchange rate
effect (see Figure 8.2). The final two effects, that is, the expectations effect and
second-round effects, will be discussed later in the chapter in the context of both
households’ and firms’ behavior.

The Intertemporal Substitution Effect: Consumption Today versus

Consumption Tomorrow
The intertemporal substitution effect refers to the effect that changes in interest rates
might have on the decision of households to substitute current consumption for
future consumption, and vice versa. If households raise their consumption today,
they will have lower savings available for consumption in the future. In contrast, if
households cut their consumption today, they will have higher savings available for
future consumption.
Higher interest rates imply greater opportunity costs for current consumption
and thus tend to encourage households to delay their consumption into the future.
With higher interest rates households can receive higher returns on their savings,
and thus are likely to save more and spend less. In other words, with higher inter-
est rates, household can have more future consumption if they delay their current
consumption.5

Intertemporal
substitution effect

Income
effect
Output gap
Monetary Interest Households’ Aggregate and
policy rates consumption demand Inflation
Wealth
effect

Exchange
rate effect
Second-
round effects

Expectations
effect

FIGURE 8.2  Effects of Changes in Interest Rates on Households’ Consumption Behavior

The Monetary Policy Transmission Mechanism 147

Accordingly, with higher interest rates households are likely to substitute future
consumption for current consumption. In contrast, lower interest rates imply lower
opportunity costs for current consumption, which would encourage households to
raise their current consumption relative to future consumption.

C O N C E P T: SAVERS VERSUS BORRO W ER S , A ND DU R A B LE GO O D S

V E R S U S NONDURABLE GOODS
Intertemporal substitution works in the same way whether households are savers
or borrowers. Whether consumption of a product could be very much delayed into
the future, however, would also depend on the nature of the product in question.

Savers versus Borrowers

The intertemporal substitution effect works in the same way whether the
households are savers or borrowers. For savers, higher interest rates mean that
any withdrawal for spending purposes would incur higher opportunity costs
owing to the higher interest income that is given up. For borrowers, higher
interest rates mean that the funding cost of any current purchase of goods and
services would be higher and thus they are more likely to be discouraged from
borrowing to finance consumption.
According to the intertemporal substitution effect, then, higher interest
rates tend to slow down household consumption spending whether those
households are savers or borrowers. Both depositors and borrowers might
delay their purchases until interest rates have come down or until they really
need to make their purchases.6

Durable Goods, Big-Ticket Items, Nondurable Goods, Luxuries,

and Essentials
The intertemporal substitution effect is especially noticeable with consumption
of durable goods and big-ticket items.7 Consumption of durable goods, such
as cars and appliances, can be postponed relatively easily, since these goods
do not need to be replaced very often. Consequently, if interest rates are rising
households may find it easier to delay the purchase of such goods. Similarly,
when interest rates are rising, consumption of luxury goods and services could
also be relatively easily delayed. In contrast, purchases of nondurable goods,
such as food and essential services (e.g., utilities), cannot be as easily delayed,
and thus are less sensitive to changes in interest rates.

The Income Effect

Household consumption spending tends to rise and fall with household disposable
income.* When disposable income is high, a household is likely to consume more,

*Income that is available after taxes.

148 CENTRAL BANKING

and vice versa. Rising interest rates, however, could add to or subtract from house-
hold disposable income, depending on whether the household is a net borrower, or
a net lender.
For a household that is a net borrower with an initial level of debt (which could
be composed of anything from mortgages to personal loans to credit card debt), a
rise in interest rates is likely to raise the household’s interest burden and reduce its
disposable income. There will be less flow of funds available for these households to
spend on goods and services.
To maintain the old level of consumption spending, these households would
either need to borrow more (and incur even more debt) or cut their spending. In
contrast, for a household that is a net saver, rising interest rates will result in higher
interest income, which will augment household disposable income, encouraging the
household to consume more.8
Despite the opposing effects that higher interest rates might have on disposable
income of net borrowers and net savers, in general the view is often that higher inter-
est rates are more likely to reduce aggregate consumption. One underlying reason
is that higher interest rates essentially have the effect of redistributing income from
net borrowers toward net savers. In most countries, income distribution is such that
there are fewer net savers than net borrowers.9
Furthermore, compared to net borrowers, net savers tend to have a lower mar-
ginal propensity to consume; that is, for every dollar increase in disposable income,
a net saver tends to spend less on consumption than a net borrower. Redistributing
income from net borrowers to net savers would thus suggest a fall in aggregate con-
sumption spending.10

The Wealth Effect

Changes in interest rates affect asset valuation. Consumption spending also rises and
falls with household wealth. With greater household wealth, a household is likely to
consume more, and vice versa. Household wealth can be held in the form of finan-
cial assets (stocks and bonds, and also possibly pension and mutual funds) and real
assets (particularly housing). Since rising interest rates tend to have negative effects
on the valuation of both financial assets and real assets, they are likely to reduce
household wealth and thus household consumption spending.11
When interest rates rise, financial assets tend to drop in value. Bond prices are
inversely related to interest rates, not the least since bond coupon payments are
often fixed at a nominal value. When interest rates rise compared to the fixed value
coupon payments, existing bondholders are foregoing the possibility that they could
actually receive higher interest rates elsewhere, or from new bonds that have yet to
be issued.
Stock prices are also inversely related to interest rates. Higher interest rates
mean that future income streams of businesses are discounted with a larger dis-
count factor, making stock prices and the present value of the firms themselves lower.
Furthermore, with higher interest rates feedback between consumption spending
and stock prices also occurs, since firms’ expected revenues (and thus stock prices)
are likely to fall along with lower consumption spending.12
The Monetary Policy Transmission Mechanism 149

Households often also hold a significant portion of their wealth in the form of
housing. Rising interest rates, however, tend to slow down the rise in house prices or
even push prices down. With higher interest rates, the financing of a house purchase
becomes more difficult, dampening demand and housing prices. As house prices fall,
households may perceive themselves as being poorer and thus restrict their con-
sumption. In the worse cases (especially after the burst of a housing bubble), since
home purchases are often financed by mortgage loans, if the value of a house falls
so much that it is below the value of the mortgage owed, household wealth in the
form of housing could be negative, and household consumption could be seriously
affected.13

The Exchange Rate Effect

Higher interest rates tend to strengthen the exchange rate, other things being equal.
A strengthening of the exchange rate is likely to shift demand of consumers more
toward imported goods and services and away from domestically produced goods
and services, since imported goods and services will be cheaper than before.
Furthermore, in a country that has a significant level of household wealth held
in foreign-currency denominated assets (foreign stocks and bonds, and foreign real
estate, for example), an exchange rate change that is significant enough to affect net
wealth could also affect household consumption.14

Taking the Four Effects Together: The Effect on Household Consumption

and Savings
In the aggregate, other things being equal, higher interest rates are likely to reduce
household consumption spending overall. If the exchange rate is stronger following
the rise in interest rates, consumption spending will likely shift away from domesti-
cally produced goods and services and toward foreign produced goods and services.
In essence, the central bank’s decision to tighten its monetary policy stance is likely
to reduce household consumption spending and increase imports, other things being
equal. The central bank’s decision to loosen its monetary policy stance, on the other
hand, is likely to encourage more consumption spending and more consumption of
domestically produced goods and services.15

8.2 MONETARY POLICY AND FIRMS’ BEHAVIOR

Firms are entities created to combine labor and other inputs in a production process,
such that they can sell resulting products for profit, which can then be distributed
to the firms’ shareholders or retained within the firms. Monetary policy could affect
firms’ spending, saving, and investment behavior through five key effects, namely
(1) the funding costs effect, (2) the asset price effect, (3) the exchange rate effect,
(4) the expectations effect, and (5) second-round effects.
This section will focus on how changes in money conditions and interest rates
could affect firms’ behavior through the first three effects, that is, the funding costs
150 CENTRAL BANKING

Funding
costs

Output gap
Monetary Interest Asset Corporate Aggregate
and
policy rates prices investment demand
Inflation

Exchange
rate

Second-
round effects

Expectations
effect

FIGURE 8.3  Effect of Changes in Interest Rates on Firms’ Behavior

effect, the asset price effect, and the exchange rate effect. (See Figure 8.3.) The final
two effects (the expectations effect and second-round effects) will be the focus of
the next section, where we will look at expectations and second-round effects in the
context of both households’ and firms’ behaviors.

The Funding Costs Effect

For indebted firms, higher interest rates can raise interest expenses and worsen cash
flows. In response firms might attempt to cut costs or delay other expenses, for
example, by cutting down workers’ hours of work or delaying workforce expan-
sion. Furthermore, since higher interest rates raise funding costs for new investment
projects and make the projects less profitable, firms might also choose to delay their
new investments, for example, purchases of new equipment.16
For firms that are debt free or have funds in the money market or bank deposit
accounts, higher interest rates imply higher interest income. For these firms, higher
interest income suggests greater cash flows available for new investment projects
or workforce expansion. However, even if new investment projects or workforce
expansion could be funded entirely by the extra interest income, firms have to take
into account that higher interest rates also suggest greater opportunity costs for
the use of funds, as well as a higher discount factor to be used for their new invest-
ment projects. If new investment projects cannot be entirely funded by the extra inter-
est income then these firms will also have to take into account higher funding costs.17
Given the aggregate effects on both interest expenses and income, the funding
costs effect suggests that higher interest rates are more likely to slow down firms’
spending and investment.18

The Asset Price Effect

Higher interest rates lower the value of firms’ assets, not the least because a higher
discount factor and a lower income stream are used in the valuation of assets. In the
The Monetary Policy Transmission Mechanism 151

simplest terms, the value of an asset can be approximated by the net present value
formula
N
Rt
NPV = ∑
t =0 (1+ i)t

where NPV is net present value of the asset, t is the time period, N is the number of
periods, Rt is the difference between cash inflow and cash outflow generated by the
asset at time t, and i is the discount factor. Generally, the discount factor i is corre-
lated with the expected prevailing interest rates at time t. Accordingly, higher interest
rates are likely to result in a higher discount factor, which will lower the net present
value, and thus the current price, of the asset.
Lower asset prices make firms’ applications for bank credit more difficult, since bank
loans are often secured by assets that are posted as collateral. Also, with lower assets
values, and thus lower net worth, publicly listed firms will find it more difficult to issue
new shares to finance new investments. Furthermore, since the valuation of a new invest-
ment project is often done using a NPV-based formula, rising interest rates are likely to
decrease net present value of the project, both because of the projected reduced income
stream and the higher discount factor, and there is thus likely to be fewer new investment
projects approved. Consequently, given the asset price effect, higher interest rates are thus
also likely to reduce firms’ spending on expansion and new investment projects.19

The Exchange Rate Effect

Higher interest rates can draw capital inflows into the domestic economy and lead to
a strengthening of the exchange rate (see Chapter 9 for more details). A strengthen-
ing of the exchange rate is likely to affect both costs and revenues of domestic firms,
especially those that produce exports, or those competing with imports.20
On the cost side, a strengthening of the exchange rate could raise the domestic
cost of production relative to the foreign cost of production. In effect, firms that
produce domestically would become less price competitive, as they would need to
charge higher prices than their competitors to just break even.
On the revenue side, a strengthening of the exchange rate could make domesti-
cally produced products become more expensive than before, when compared to
foreign produced products. Foreign imports would become cheaper compared
to domestically produced products. Similarly, the country’s exports would become
more expensive compared to foreign produced products. With higher prices, cus-
tomers are more likely to switch from domestically produced to foreign produced
products. Revenue of firms that rely on domestic production is thus likely to decline.
With higher costs and lower revenues, firms’ profits would tend to fall. The
exchange rate effect is likely to be felt more acutely by manufacturing firms. They
would be thus less likely to spend to expand their domestic workforce, and indeed
might shift their plants and factories overseas. In addition to manufacturing firms,
the agricultural sector and parts of the service sector (such as tourism) are also likely
to be affected by the exchange rate effect.
Overall, the exchange rate effect suggests that higher interest rates will result
in a slowdown in domestic economic activity, as domestic production of goods and
services become less competitive compared to foreign production.
152 CENTRAL BANKING

8.3 EXPECTATIONS AND SECOND-ROUND EFFECTS

ON HOUSEHOLD AND FIRM BEHAVIOR

In this section we will discuss how changes in interest rates could affect households’
and firms’ behavior through the expectations effect and second-round effects. (See
Figure 8.4.)
According to the expectations effect, rational and forward-looking households
and firms are likely to adjust their behaviors immediately after—or even before—a
change in monetary policy stance is announced, in anticipation of things to come.
The expectations effect could thus affect economic activity even before a monetary
policy action actually starts to affect interest rates for deposits and loans.21
Second-round effects, on the other hand, suggest that changes in households’ and
firms’ spending behaviors are likely to affect aggregate demand, which, in turn, will
introduce feedback loops back to household and firm spending behaviors. Second-
round effects are thus likely to further amplify the initial impact of a monetary
policy action on household and firm behaviors.22

The Expectations Effect

One significant way that a change in the central bank’s monetary policy stance might
affect behavior of households and firms is through expectations. A tightening of the
monetary policy stance might signal that future economic activity will slow down
and money might be harder to come by. Consequently, households might start to
cut down their consumption (and thus raise their savings) even before they actually
experience changes in their interest burden or interest income. Firms, on the other
hand, anticipating slower consumption demand, might choose to slow down their
activities, buy less input materials, schedule fewer hours of work, and postpone
their investment plans.23

Second-round effects
Expectations effects

Household
consumption
Monetary Interest Aggregate Output gap
policy rates demand and inflation

Corporate
investment

Expectations effect
Second-round effects

FIGURE 8.4  Expectations and Second-Round Effects on Household and Firm Behavior
The Monetary Policy Transmission Mechanism 153

The expectations effect involves a lot of uncertainty. If a significant tightening

of the monetary policy stance is unexpected, for example, the response of house-
holds and firms is likely to differ quite a bit from a case in which the tightening is
fully anticipated, or in the case of a less drastic tightening. The strength of the feed-
back loop between expectations and the actual behavior of households and firms is
also very difficult to gauge, not the least because each household and each firm are
different.

Second-Round Effects
Previously we discussed how changes in monetary policy stance could affect the
behavior of households and firms, not the least through direct changes in house-
holds’ disposable income, firms’ cash flows, asset prices, the exchange rate, and
expectations, and so on. In practice, however, the so-called second-round effects also
play a significant role in monetary policy transmission.
Second-round effects can be thought of as a feedback loop between induced
changes in aggregate demand and further changes in the spending behavior of house-
holds and firms. With greater aggregate demand, firms are more likely to expand their
production. The firms’ suppliers along the supply chain will also benefit. Demand for
labor in the economy will rise and households’ disposable income is likely to rise along
with it. This would lead back to a further rise in demand for all goods and services in
general. In a downturn, a fall in aggregate demand would lead to cuts in labor demand,
a fall in households’ disposable income, and a further fall in aggregate spending.24
The feedback loop of second-round effects, indeed, mimics the nature of busi-
ness cycles. Once a change in monetary policy stance starts to affect households’
and firms’ behavior, the feedback loop kicks in. With the presence of second round-
effects, indeed, a change in monetary policy stance is likely to also transmit widely
throughout all sectors of the economy and affect everyone.

8.4 MONETARY POLICY AND FINANCIAL INSTITUTIONS

In the previous section we discussed the monetary policy transmission mechanism,
focusing on the effects that a change in monetary policy might have on households
and firms, the ultimate agents that make consumption, saving, and investment deci-
sions. Another way to describe the monetary policy transmission mechanism is
through financial intermediaries such as commercial banks, which often play impor-
tant roles as conduits of monetary policy transmission, since households and firms
borrow and save through them.
The ultimate effects of monetary policy transmission on output and inflation will
be the same whether expressed through changes in households’ and firms’ behavior
or through the effects on financial intermediaries. Indeed, these two channels are two
sides of the same coin, as the following discussion makes clear.
Broadly speaking, we can see that monetary policy transmits through finan-
cial institutions via (1) the credit channel, whereby lenders pass on changes in the
policy interest rate and money market rates to customers through retail deposit and
lending rates, which then prompts changes in the external financing costs of firms
and households (as opposed to internal costs incurred through financing spending
154 CENTRAL BANKING

With higher interest

rates, households will be Household
able to obtain less consumption
credit.

Aggregate
Monetary Financial Financial demand
policy markets institutions

Corporate
With higher interest investment
rates, firms will be able
Short-term funding to obtain less credit.
costs of financial
institutions in the
financial market

FIGURE 8.5  Credit Channel: Higher Interest Rates Make Financial Institutions More Wary
in Lending to Households and Firms

using retained earnings or savings)25 and (2) the balance sheet channel, whereby mon-
etary policy affects households’ and firms’ balance sheets, net worth, and liquid assets,
and thus the willingness of financial intermediaries to lend to them.26 These two
channels often work in tandem, and are indeed quite intertwined in certain aspects.27

The Credit Channel

When the policy interest rate is raised, money market interest rates are also likely
to rise. Short-term funding costs of financial intermediaries will rise, and ultimately
financial intermediaries are likely to pass on their higher funding costs to their bor-
rowers through higher lending rates.
Rising lending rates could lower the borrowers’ ability to repay their debts (e.g.,
borrowers would be faced with higher monthly debt repayments while their revenue
might slow in line with an economy that is facing higher interest rates). Consequently,
banks and other lenders might add a higher premium to their lending rates to com-
pensate for rising credit risk when interest rates are rising, or they might extend
credit more cautiously in general (see Figure 8.5). On the whole, lenders might be
more cautious in extending credit in an environment of rising interest rates.28

The Balance Sheet Channel

The balance sheet channel, on the other hand, is the corollary to wealth and asset
price effects through which changes in interest rates affect households and firms.
With higher interest rates, households’ and firms’ assets are likely to fall in value,
making the assets less valuable as collateral for loans. Higher interest rates are also
likely to result in lower wealth and net worth for borrowers since discount rates will
now be higher for their wealth and future income. Overall, this would lower cred-
itworthiness of households and firms, and nudge financial institutions to reduce the
supply of credit to them.29 (See Figure 8.6.) The reduced supply of credit will then
help contribute to a slowdown in aggregate demand.
The Monetary Policy Transmission Mechanism 155

Income prospects

Consumption
Credit is granted
Households
based partly on households’
wealth and income
prospects. Valuation of households’ wealth

Aggregate
Monetary Financial Financial Interest rates demand
policy markets institutions

Valuation of firms’ asset value

Short-term funding Credit is
costs of financial granted based partly Firms Investment
institutions in the on firms’ asset
financial market valuation and income
prospects.
Income prospects

FIGURE 8.6  Balance Sheet Channel: Higher Interest Rates Lower the Collateral Value
of Assets

8.5 TIME LAGS AND UNCERTAINTY IN MONETARY

POLICY TRANSMISSION

From the discussions above, it can be seen that changes in monetary policy
stance take some time to have their full effects play out. There are at least five iden-
tifiable steps before a change in monetary policy fully affects price levels in the
economy: (1) the transmission from the implementation of monetary policy oper-
ations to money market interest rates; (2) the pass-through from money market
interest rates to borrowing and lending rates for households and firms; (3) the
adjustments in households’ and firms’ spending behavior; (4) second-round effects,
which comprise feedback loops between households’ and firms’ spending behavior
and aggregate demand; and (5) the expectations effect, which can be a wild card that
hastens or slows the transmission of monetary policy. (See Figure 8.7.)
First, the change in monetary policy stance affects money market interest rates.
This stage is likely to be very short, since money market rates are likely to adjust
immediately in response to changes in liquidity conditions. Indeed, financial asset
prices could change even before there is an actual shift in the monetary policy stance
if that shift is anticipated by market participants. Such changes might be reflected in
changes to the shape of the yield curve.
Second, changes in money market interest rates would be translated into changes
in borrowing and lending rates charged to households and firms. Changes in money
market rates will likely affect financial institutions’ short-term funding costs imme-
diately, but it could take time before financial institutions adjust their retail deposit
and lending rates since they will have to consider many other factors, including the
shape of the government yield curve (which would partly dictate the level of longer-
term interest rates), peer competition, and profit margins. Adjustments in retail inter-
est rates are likely to be gradual and could take months. Furthermore, adjustments in
156 CENTRAL BANKING

Expectations effect Second-round effects

Households Consumption

Monetary Financial Financial Aggregate Output

Inflation
policy markets institutions demand gap

Investment
Firms
Money market
interest rates Net exports

Expectations effect Second-round effects

Elapsed time is between 1.5 and 2 years.

FIGURE 8.7  Time Lags and Uncertainty in Monetary Policy Transmission

lending and deposit rates might not be perfectly synchronized depending on various
factors, including the initial levels of the rates, the stage of business cycles, etc.
Third, households and firms are also likely to take time to adjust their spending
behavior in response to changes in retail borrowing and lending rates. Of course, as
discussed earlier, changes in expectations could make households and firms promptly
adjust their behaviors. The full effects, however, are unlikely to come from changes
in expectations alone. Certain spending habits will need time to adjust. The full
response of firms to changes in household spending will also take time, whether in
terms of volume of production or alterations in spending for previously planned
investment projects.30
Fourth, it will take time for feedback loops, or second-round effects, to take
place. There will be chain reactions through firms’ suppliers. These changes by firms
will affect employment and income of the labor force, which would feed back into
household consumption spending, all affecting aggregate output of the economy.
Meanwhile, pricing of firms’ goods and services will also likely change in response to
changes in household demand, and the feedback loop will also lead to wage negotia-
tions and adjustments.
Fifth, expectations of households and firms could hasten the transmission
of monetary policy to changes in output and inflation, but in a nonlinear way. If
households and firms expect that the central bank is fully committed to monetary
stability, even a small hike in the policy interest rate might prompt them to adjust
their behavior quickly. Otherwise, the central bank might need to hike the policy
interest rate many times before the public adjusts their behavior.
From the outline above, we can see that changes in monetary policy stance take
time to fully affect the economy’s output and prices. Such time lags can be quite
long, and the exact timing can vary, depending on many outside factors including
expectations, confidence, the stage of business cycles, etc. Empirically, studies have
The Monetary Policy Transmission Mechanism 157

shown that it could take up to a year for a change in monetary policy to reach its
peak effect on demand and output, and another year for the effect on inflation to be
fully realized, although estimates vary.31

The Conduct of Monetary Policy Given Time Lags and Uncertainty

Given the time lags and uncertainty involved with the transmission mechanism of
monetary policy, the central bank needs to be quite cautious and forward-looking
when considering a policy action. A change in monetary policy stance today will
only be fully felt about one to two years later, and by that time surrounding cir-
cumstances might have already changed.32 Despite the time lags and uncertainty,
however, it is still the central bank’s job to conduct monetary policy in such a way
that stability and growth of the economy is promoted.
To do its job properly, the central bank needs to understand the intricacies of and
linkages within the economy. It also needs to be adept at forecasting future economic
and inflation outcomes so that it can decide on an appropriate monetary policy action
today. In practice, many modern central banks rely on a suite of macroeconomic mod-
els to forecast the future outlook for the economy and inflation. Such macroeconomic
models often capture key relationships and linkages within the economy.
In a modern central bank there are likely to be a number of competing macro-
economic models based on different mathematical and statistical techniques, so that
the bank can cross-check the consistency of the forecasts. Such models can range
from a spreadsheet model with more mechanistic linkages of macroeconomic vari-
ables to a macroeconometric model that relies on econometric estimates of historical
macroeconomic data to the so-called dynamic stochastic general equilibrium (DSGE)
model that is based more on theoretical microeconomic principles and interactions
among key agents (such as households and firms) within the economy.
Given the time lags and uncertainty involved, the central bank will often make
projections based on different possible scenarios. For example, the central bank
might try to project GDP growth and inflation rates based on different estimates of
future oil prices. The final forecasts that are used as a basis for monetary policy deci-
sions, or baseline forecasts, are often expressed as the range of values (as opposed to
a single value) that key economic variables (such as GDP growth and inflation rates)
are most likely to be over the forecast horizon.
In practice, if inflation and GDP growth forecasts are projected to diverge much
from a so-called acceptable (or target) range, it would be a signal for the central
bank to reconsider its monetary policy stance. Whether the central bank will actually
change monetary policy stance will also depend on the policy makers’ judgment, as it
is usually accepted that even the most sophisticated macroeconomic models cannot
capture the full complexity of the economy, and thus forecasts from the models can
have a certain degree of error.

SUMMARY
Changes in real interest rates can affect saving and investment decisions of house-
holds and firms, and thus economic activity, inflation, and employment.
Monetary policy can affect household spending and saving decisions via six
main effects, namely (1) the intertemporal substitution effect, (2) the income effect,
158 CENTRAL BANKING

(3) the wealth effect, (4) the exchange rate effect, (5) the expectations effect, and
(6) second-round effects.
Monetary policy can affect firms’ spending, saving, and investment behavior
through five key effects, namely (1) the funding costs effect, (2) the asset price effect,
(3) the exchange rate effect, (4) the expectations effect, and (5) second-round effects.
The effects of monetary policy on households’ and firms’ consumption and
investment decisions can transmit through the credit channel and the balance sheet
channel, which themselves work through financial institutions.
Since there are many steps through which monetary policy transmits through
the economy, the ultimate effects on output, inflation, and employment will have
long and variable time lags.

KEY TERMS
asset price effect of monetary policy income effect of monetary policy
transmission transmission
balance sheet channel inflation-protected security
breakeven yield intertemporal substitution
credit channel macroeconometric model
dynamic stochastic general equilibrium nominal interest rate
model (DSGE) real interest rate
exchange rate effect of monetary policy second-round effects of monetary policy
transmission transmission
expectations effect of monetary policy time lags of monetary policy transmission
transmission uncertainty of monetary policy
feedback loop transmission
funding costs effect of monetary policy wealth effect of monetary policy
transmission transmission

QUESTIONS
1. Households’ and firms’ investment and savings decisions are influenced by real
or nominal interest rates?
2. If the expectation is that inflation will be 2 percent per year and the nominal
interest rate is 5 percent per year, what is the real interest rate?
3. If the yield on a five-year nominal government security is 5 percent and the yield
on a five-year inflation-protected government security is 3 percent, what are
breakeven inflation expectations and the breakeven yield?
4. How does an increase in interest rates affect aggregate household spending
through the intertemporal substitution effect?
5. How might the effects of an increase in interest rates be different for wealthier
households and less wealthy households?
6. Since a rise in interest rates can raise income for savers, why might we think that
in the aggregate a rise in interest rates is likely to cause a fall in consumption?
7. How is an increase in interest rates likely to affect consumption of durable goods
compared to nondurable goods?
The Monetary Policy Transmission Mechanism 159

8. How would an increase in interest rates be likely to affect aggregate household

spending through the income effect?
9. How would an increase in interest rates be likely to affect aggregate household
spending through the wealth effect?
10. Why might a household reduce its consumption even before a change in the
policy interest rate actually starts to work through the intertemporal substitution,
income, and wealth effects?
11. What do we mean by second-round effects of the transmission mechanism?
12. How does an increase in interest rates affect business spending through the
funding cost effect?
13. How might rising interest rates affect firms’ spending and investment behavior
through the funding cost effect?
14. Why are rising interest rates likely to reduce the value of firms’ assets?
15. How might rising interest rates affect firms’ spending and investment behavior
through the exchange rate effect?
16. How would a change in interest rates likely affect financial institutions?
17. How does a rise in the policy interest rate work through the credit channel?
18. How does a rise in the policy interest rate work through the balance sheet
channel?
19. What are the reasons that the length of the time lag associated with the monetary
policy transmission mechanism is uncertain?
20. What is the usual time lag between the time the policy interest rate is changed
and the time the change has an effect on the economy’s output and inflation?
21. When conducting monetary policy, how can a central bank deal with the
uncertainty of the time lag for monetary policy transmission?
 CHAPTER 9
The Exchange Rate and Central Banking

Learning Objectives
1. Explain how movements in the exchange rate can affect monetary
stability, financial stability, and unemployment.
2. Distinguish between a rigid peg, a free-float, and a managed float
exchange rate regimes.
3. Explain key theories that attempt to explain exchange rate
determination.
4. Identify key factors that can affect the exchange rate.
5. Describe the way in which the central bank can influence the
exchange rate.

A t its core, the exchange rate is the price of money expressed in terms of another
currency. Accordingly, the exchange rate is an important variable that the central
bank must watch, even if the regime of that central bank does not involve exchange
targeting. In Chapter 9 we will examine issues relating to the exchange rate in
­relation to central banking in more detail.
This chapter starts with a brief review of how the exchange rate might affect
price stability, financial stability, and the real economy in theory and in practice. The
­chapter will then review the alternative exchange rate regimes, or frameworks, that
a modern central bank can adopt. The exchange rate regimes that will be reviewed
include the rigid peg regime, the free-float regime, and the managed float regime. Later
on the chapter will review exchange rate theories so that the reader can see the funda-
mental forces that would influence the exchange rate in the absence of direct central
bank intervention. The chapter will then review how the central bank can deal with the
exchange rate using various instruments. Lastly, the chapter will discuss the manage-
ment of official foreign reserves, which are a key tool in exchange rate management.

9.1 THE EXCHANGE RATE, MONETARY STABILITY, FINANCIAL

STABILITY, AND MACROECONOMIC STABILITY

The exchange rate is an important variable that the central bank has to watch, regard-
less of whether the central bank uses an exchange rate targeting regime. Apart from

161
162 CENTRAL BANKING

being the price of money in terms of another currency, movements in the exchange
rate can affect monetary stability as well as financial stability.

In Theory
Theoretically, movements in the exchange rate can have implications for the central
bank’s pursuit of monetary stability as well as financial stability. In terms of mon-
etary stability, if a country depends heavily on energy imports, for example, a fast
depreciating exchange rate implies a fast rise in energy prices in terms of the domes-
tic currency, which could translate into a fast rise in consumer price inflation and
affect inflation expectations. In such a case, if inflation expectations have not been
well managed, then monetary stability could be compromised, as witnessed during
the great inflation period of the 1970s, when oil shocks helped contribute to a sharp
and sustained rise in inflation.
In terms of financial stability, if a country has a high proportion of public or
private debt denominated in foreign currencies, a sharp depreciation in the exchange
rate could prove troublesome. With a sharp depreciation in the value of domestic
currency, debt denominated in foreign currency could balloon when measured in
terms of domestic currency. If the country does not have a reliable source of foreign
income, this will affect the country’s ability to repay its debt, which could lead to
a financial crisis, as occurred among emerging-market economies in Asia and Latin
America in the 1990s.
For many emerging-market economies, an excessively volatile exchange rate
could also have direct implications not only on monetary stability and financial
stability, but on the real economy, as reflected by output and employment. For those
emerging-market economies that rely heavily on exports, for example, a fast appreci-
ating exchange rate implies a fast rise in the price of the country’s exports in terms of
foreign currencies. This could lead to a fast fall in demand for the country’s exports
and the country’s domestically produced products, which could lead to a sharp fall
in production and a jump in unemployment.

In Practice
In practice, how the exchange rate affects monetary stability, financial stability,
and macroeconomic stability would depend on the context and could be quite
complicated.
A review of research from different central banks by the Bank for International
Settlements, for example, found that the pass-through effect on inflation by exchange
rates over the 1990s was small and had declined over the period studied.1 The
decline owed partly to the greater availability of hedging instruments to deal with
short-term exchange rate risks, and partly to the trend toward the adoption of more
flexible exchange rate regimes, which familiarized importers with exchange rate vol-
atility and thus prompted them to change prices less frequently.2 Furthermore, the
pass-through effects of the exchange rate on inflation also varied among different
sectors of the economy, as well as among exporters and importers.3
These studies further showed that the effect of exchange rate movements on cur-
rent account balances (as with their effects on the real economy) was also declining.
The Exchange Rate and Central Banking 163

A depreciating currency, for example, was not found to always lead to an expansion
in output.4 In other cases, while the exchange rate was found to historically play a
crucial role in the adjustment of current account balances, changes in the economic
environment meant that this might not necessarily be the case in the future.5
Despite the complicated picture with regard to the effects of the exchange rate
on monetary stability, financial stability, and the real economy, however, the central
bank often does keep a close watch on it by the virtue of the fact that the exchange
rate is the price of money in terms of another currency and that it is a key economic
variable in a globalized economy. Whether the central bank does anything to influ-
ence the exchange rate, however, depends on the context and the exchange rate
regime it has adopted for its currency.

9.2 EXCHANGE RATE REGIMES

An exchange rate regime refers to the operational rule and related institutional mech-
anisms that the central bank adopts for the management of the exchange rate of its
currency. In modern times, exchange rate regimes could range from rigid exchange
rate pegs to completely free-floating exchange rates.

A Spectrum of Exchange Rate Regimes

With the end of the Bretton Woods system, currencies no longer had a universal
peg that tied them to the value of gold. In theory, the exchange rates of currencies
were now determined by market forces. In practice, after the Bretton Woods sys-
tem had ended, a number of Western European countries at first used a system of
exchange rate bands and capital controls that helped limit the movement of their
currencies against one another, and which was a precursor to introduction of the
euro.6 Many emerging-market countries, meanwhile, decided unilaterally to main-
tain their exchange rate pegs with the U.S. dollar, to facilitate international trade and
investment.7
As time went by, the increasingly connected nature of global economies and
financial markets made rigid controls over currencies untenable and countries had
to seek ways to manage their exchange rates in the way that best suited their needs.
In the decades after the demise of the Bretton Woods system, various exchange rate
regimes have been tried, adopted, and abandoned.
In practice we might view exchange rate regimes as constituting a spectrum,
with a hard or rigid peg system (e.g., with either a common currency—where an
independent currency is abandoned, while some other currency is adopted—or a
currency board) on one end, and a free float (a type of flexible exchange rate regime
whereby the exchange rate is purely determined by market forces) on the other end.8
In between these two extreme ends, there are a range of regimes under which the
central bank influences the exchange rate to temper pure market forces.9
The differences among these exchange rate regimes range from a slight shading
to stark contrast. For our purposes, it’s useful to look at exchange rate regimes as
being on a continuum, with a rigid peg system at one end and a free-float system at
the other. Figure 9.1 presents a spectrum of exchange rate regimes.
164 CENTRAL BANKING

Exchange rate regimes

Rigid peg Free float

Currency board: Free float:

The central bank The central bank
can only issue Fixed exchange Managed float: does not intervene
Crawling peg:
domestic rate: The central The central bank in the currency
The central bank market at all,
currency to the bank regularly intervenes in
allows the letting the
extent that intervenes in the the currency
exchange rate to
there is enough currency market market mainly to exchange rate be
move along a completely
foreign currency to keep the smooth out
specified path. determined by
to fully back the exchange rate at excess volatility
issuance at the the announced in the exchange market forces.
legally specified target level or rate.
exchange rate. within a target
band.

FIGURE 9.1  A Spectrum of Exchange Rate Regimes

The Rigid Peg End

Theoretically, rigid exchange rate pegs could take the form of a common currency or
a currency board.10 In a common currency area, the central bank replaces its national
currency with a currency commonly used within a specified economic area (e.g., the
euro in the euro area). In practice, of course, a common currency such as the euro
can float against other currencies outside the common currency area.
Under a currency board system, the central bank can only issue domestic
currency to the extent that it is fully backed by foreign reserves at the specified
exchange rate.

A Common Currency  A common currency constitutes the most extreme form of a rigid
peg system.11 Under this system, as is the case in the euro area, member countries
abandon their own currencies and adopted a common one (e.g., the euro). The euro
area member countries do not have monetary policy independence; instead mon-
etary policy is conducted by the ECB, which aims to sustain monetary stability for
the euro area as a whole rather than for any individual member country.
In practice, however, as a currency the euro is classified as a free-floating cur-
rency by the IMF, since the ECB allows the value of the euro to be largely determined
by market forces.12

A Currency Board  A currency board is another extreme form of a rigid peg system,
whereby each unit of the local currency issued by the central bank is required by
law to be fully backed by foreign currency reserves. Under a currency board, local
currency notes and coins are fully convertible into a specified foreign currency at a
specified exchange rate. Accordingly, the central bank does not have the indepen-
dence to just issue whatever amount of money it sees fit for the country’s prevailing
economic conditions. If the central bank wants to issue an extra unit of local cur-
rency, it is legally required to have enough foreign currency to back that extra unit
of local currency.
The Exchange Rate and Central Banking 165

An example of a government that uses a currency board is the special adminis-

trative region of Hong Kong; the Hong Kong Monetary Authority fixes the Hong
Kong dollar at the rate of HK$ 7.8 to USD 1, and cannot independently depart from
that ratio even if it wishes to.13

The Rationale for a Rigid Peg  A country may adopt a common currency for both politi-
cal and economic reasons. A common currency such as the euro is part of the larger
goal of political and economic union. Having a common currency helps to eliminate
exchange rate risk and encourage cross-border investment and trade among member
countries.
Meanwhile, one reason a country might choose to adopt a currency board sys-
tem is that it helps enhance the credibility of the local currency. Holders of local
notes and coins are assured that the central bank has enough of the foreign currency
to allow them to convert their local notes and coins into it at prevailing exchange
rates. This guarantee of currency conversion at the prevailing exchange rates under
a currency board system is particularly useful to boost confidence in the local econ-
omy, since otherwise the holders of local currency might be tempted to rush out of it
at the first sign of trouble, creating a self-fulfilling prophecy.
Furthermore, as with the case of a common currency, a currency board could
also be quite helpful in facilitating international trade and investment for a small
open economy (or an international trading hub such as Hong Kong) since it elimi-
nates exchange rate risk for traders and investors.

The Free-Float End

At the other end of the exchange rate spectrum from the rigid peg is the free-float
regime. In contrast to an exchange rate peg, in a free-float regime the central bank
allows exchange rate to be completely determined by market forces.
Other things being equal, whenever the demand for local currency rises the
exchange rate will appreciate, and whenever the demand for local currency falls
the exchange rate will depreciate. Under this regime the central bank is not supposed
to intervene in the foreign exchange market, and thus movements in the exchange
rate can be quite volatile, since demand and supply of a currency are normally influ-
enced by many factors, particularly expectations of market players, which can be
quite fickle.

Rationale for a Free Float  One key reason why the central bank might adopt a free-
float regime is that monetary policy could then be freely used to address domestic
concerns. Accordingly, we can say that a central bank that chooses to adopt a free-
float regime does not see a particular need to manage the value of its currency with
the exchange rate to order to achieve monetary stability.
In contrast to a rigid peg regime, under a free-float regime the central bank has
the independence to freely use monetary policy to achieve a monetary stability man-
date in a way that is in accord with particular conditions in the economy, without
having to be too concerned about the implications for the exchange rate. For exam-
ple, if the domestic economy is in a severe recession the central bank could choose
to lower interest rates and ease money conditions to help decrease funding costs and
166 CENTRAL BANKING

boost domestic demand, even though lower interest rates and easy money conditions
might put downward pressures on the exchange rate (all other things being equal).
Furthermore, in a world of greater capital flows it could be difficult for the
central bank to keep the exchange rate fixed at any particular level for a sustained
period of time. For the central bank to successfully resist depreciation pressures on
the exchange rate, for example, it might need to have large amounts of foreign cur-
rencies on hand and use those foreign currencies to buy up domestic currency to
shore up the value of the exchange rate (see the section on exchange rate targeting
regimes in Chapter 6).
In any case, in a world in which economies are continually evolving, an equi­
librium exchange rate that suits the country’s economic fundamentals could be quite
­elusive, as will be discussed later in the chapter.14 Consequently, the central bank
might want to let the exchange rate be moved by market forces rather than attempt-
ing to keep it fixed at a particular level.
Also, for many economies, the development of financial markets is so advanced
that economic agents can hedge against exchange rate volatility rather readily and
cheaply. In these cases the central bank does not need to bear exchange rate risks for
private agents, as private agents can already efficiently protect themselves.
In 2013 the following countries were among those classified by the IMF as
­having a free-floating exchange rate regime: euro area member countries, Australia,
Canada, Chile, the Czech Republic, Israel, Japan, Mexico, Norway, Poland, Sweden,
Israel, Japan, Mexico, Norway, Poland, Sweden, the United Kingdom, and the
United States.15

The Middle Options

In between a rigid peg, such as the currency board system, and a free float there are
exchange rate regimes under which a central bank intervenes against market forces
to varying degrees. Note here that the definitions of exchange rate regimes can vary,
and that what the central bank might say about its regime de jure might differ from
what it actually practices de facto.

Traditional Fixed Exchange Rate  A fixed exchange rate regime traditionally refers to
those that are similar to the Bretton Woods system, whereby the central bank might
allow the exchange rate to fluctuate within 1 percent on either side of the announced
target.16

Fixed Exchange Rate with a Horizontal Band  Under a fixed exchange rate system with a
horizontal band, the exchange rate is allowed to fluctuate within a horizontal band
around the announced exchange rate target. The width of the band could range from
2.5 to 15 percent, such as was the case under the European Monetary System that
was a precursor to the euro.17

Crawling Peg  Under a crawling peg regime, the central bank allows the level of the
exchange rate to gradually appreciate or depreciate along a controlled path that it
deems consistent with the economic fundamentals of the economy. In 2013, the IMF
classified China’s exchange rate regime as being a crawl-like arrangement.18
The Exchange Rate and Central Banking 167

Managed Float  Under a managed float exchange rate regime, the central bank allows
market forces to largely determine the exchange rate, but intervenes to smooth out
fluctuations and excessive volatility in the exchange rate.19

Rationale for the Middle Options  The reasons why a central bank might want to adopt
an exchange rate regime that is neither a rigid peg nor a free float could depend
on the circumstances that it finds itself in. For a central bank that leans more toward
the fixed exchange rate regime, a key reason to adopt such a system could be that it
needs to anchor the value of its currency to that of another low-inflation country in
order to achieve credibility and low inflation for its own economy.
On the other hand, a central bank that chooses to adopt a crawling peg regime
(or, as with China, some variation of it) may be one whose country depends heav-
ily on international trade and investment with a financial market that is in an early
stage of liberalization, meaning that private agents would not have much access to or
experience with hedging instruments. In this instance, the central bank would partly
bear the exchange rate risk for private agents (such as exporters) while the agents are
adapting to the new economic environment.
Finally, in a country that depends a lot on exports with a financial market that
has been very much liberalized with international capital flowing in and out rela-
tively freely, a central bank might choose to adopt a managed float regime, whereby
it would intervene only to smooth out excessive fluctuations in the exchange rate,
rather than trying to keep the exchange rate at a particular level or on a particular
path. In this case the central bank might also encourage the development of hedging
instruments that private agents can readily use to hedge against exchange rate risk.

CASE STUDY: The Interesting Case of Singapore: Basket, Band, Crawl

Singapore’s exchange rate management framework is an interesting case. While embracing free flows
of capital, the country has used an exchange rate targeting regime since the 1980s and has success-
fully maintained long-term monetary stability despite its heavy dependence on the external sector.
In using the exchange rate as an instrument to sustain monetary stability, rather than adopting
a rigid peg or allowing a free float, the Monetary Authority of Singapore (MAS), Singapore’s central
bank, has adopted a framework for exchange rate management known as basket, band, crawl, or BBC.
According to the 2011 MAS publication Sustaining Stability, Serving Singapore, the basket feature
of the MAS framework refers to the fact that the MAS pegs the value of the Singapore dollar to a bas-
ket of currencies belonging to Singapore’s major trading partners and competitors, thereby creating
a trade-weighted index for the Singapore dollar. (Currencies of countries with a higher value of trade
with Singapore would be given higher weights in the index.) The band feature refers to the fact that
the MAS allows the trade-weighted Singapore dollar to float within a policy band, the width of which
is undisclosed. The crawl feature of the framework refers to the fact that the MAS regularly reviews
the exchange rate band, and adjusts the band over time to ensure that it is aligned with the underlying
fundamentals of the economy. The trade-weighted Singapore dollar would thus crawl along the path of
the exchange rate band over time.
Given the nature of the BBC regime, MAS sees itself as having three levers to adjust its monetary
policy: the slope, the width, and the level of the band. The slope can be adjusted to allow the currency
to appreciate faster or slower in response to changes in the economic situation that are expected to
persist for some time. The width of the band can be widened to accommodate market-driven move-
ments that result in the strengthening or weakening of the currency that are expected to be temporary,
and narrowed after markets have stabilized. The level of the entire band can also be adjusted upward or
downward in response to more significant, sharp, sustained shocks, such as a financial crisis.
168 CENTRAL BANKING

At the same time, MAS sees three key reasons why the exchange rate should be used as its mon-
etary policy tool to maintain monetary stability. First, Singapore was (and is) a small, open economy
whose domestic prices are largely determined by world prices, and whose domestic prices of factor
inputs (such as labor) are influenced largely by external demand. This is reflected partly in the fact that
the value of both imports and exports each almost doubled Singapore’s GDP.28 Second, unlike larger
economies in which investment would be sensitive to changes in interest rates, Singapore relies mainly
on direct foreign investment, which is not very sensitive to Singapore’s own interest rates. Third, to
promote Singapore as an international financial center, MAS has allowed free flows of capital and has
willingly ceded control over domestic interest rates and the money supply.
Given Singapore’s heavy reliance on the external sector and the potentially huge implications of
free capital flows on domestic prices, using the exchange rate to achieve monetary stability is not an
easy task. According to MAS, Singapore’s success in maintaining price stability using the BBC frame-
work rests on two key unique conditions.
The first condition involves the automatic drain on Singapore’s liquidity in the form of persistent
fiscal surpluses and the mandatory contributions of firms and households to Central Provident Fund
savings accounts, both of which continuously take Singapore dollars out of the system. Consequently,
MAS has to keep making up for the drain on liquidity by injecting Singapore dollars into the economy,
in the process buying up U.S. dollars. This has resulted in the accumulation of international reserves at
MAS, which augments its ability to manage the exchange rate over time.
The second condition involves the high credibility of MAS in maintaining the regime, which has
lessened the prospect of speculative attacks on the currency. This credibility itself rests on the huge
reserves available to defend the system; the persistent fiscal surpluses that keep on draining Singapore
dollar liquidity; and a flexible labor market, which implies that the labor market can clear relatively eas-
ily, meaning monetary policy can be used to maintain long-term price stability without undue strain on
employment and the economy.20

9.3 EXCHANGE RATE THEORIES

In the previous section we saw that unless the central bank puts the exchange rate on
a rigid peg, the level of the exchange rate will be determined at least partly by market
forces. Even with a rigid peg exchange rate regime, however, the central bank will
still need to counter market forces if it wants the exchange rate to remain pegged at
the announced level. This section reviews theories that attempt to explain the forces
behind exchange rate movements, so the reader can understand the context in which
the central bank deals with issues relating to the exchange rate.
It should be noted, however, that at the moment there is no one single
theory that can satisfactorily explain exchange rate behavior in a unified manner.
One exchange rate theory that might seem to readily fit exchange rate behavior
in one context might be completely irrelevant in another. To understand why the
exchange rate might move in a certain manner in any given context, it is extremely
useful to have at least some grasp of all key variations of exchange rate theory.
Broadly speaking, exchange rate theories can be classified into four main categories,
namely (1) purchasing power parity (PPP), (2) monetary approach, (3) portfolio bal-
ance models, and (4) exchange rate market microstructure.

Purchasing Power Parity

Purchasing power parity (PPP) provides a key building block in our understanding
of the exchange rate. PPP is based on the notion of the law of one price, whereby if
The Exchange Rate and Central Banking 169

markets are perfectly efficient and goods can be transported freely at no costs, then
the price of identical goods should be the same everywhere in the world, after adjust-
ing for exchange rates.

An Illustrative Example of PPP  The following is a simple but effective example that can
help in the understanding of PPP. Assume that a particular make of pen is the only
product in the world. If such a pen costs, say, 1.5 U.S. dollars in the United States and
1 euro in Germany, then according to PPP the exchange rate between the U.S. dollar
and the euro should be 1.5 U.S. dollar per 1 euro.
If the exchange rate was not at 1.5 U.S. dollar per 1 euro, and was instead at
2 U.S. dollars per euro, then a German trader could bring 1 euro to the U.S. and
exchange it for 2 U.S. dollars. He could then buy the pen at the cost of 1.5 U.S. dol-
lars and bring the pen back to Germany in order to sell it for 1 euro. That German
trader, or indeed any investor who embarks on such a scheme, would then pocket a
risk-free profit of 0.5 U.S. dollars, or 0.25 euros.
In the preceding example, as long as that profit opportunity exists, profit seekers
will keep exchanging euros for U.S. dollars to exploit the opportunity. As demand
for the U.S. dollar rises, however, the value of the U.S. dollar cannot stay at 2 U.S.
dollars per euro sustainably. The U.S. dollar exchange rate will keep strengthening
against the euro until it reaches 1.5 U.S. dollars per euro, consistent with the price of
the pen. In that case, there is no more riskless profit opportunity and the exchange
rate reaches its equilibrium.

Absolute PPP: The Law of One Price  There are two forms of the PPP concept, namely
absolute PPP and relative PPP. The pen example above corresponds to absolute
PPP, which corresponds directly to the law of one price. Absolute PPP suggests
that a basket of identical goods will have the same price in any two countries after
adjusting for the exchange rate. If the price is not the same, then the exchange
rate is not in equilibrium and international investors could arbitrage in a scheme
similar to the pen example above, which would then pressure the exchange rate to
move to its equilibrium. In real life, given that transportation costs and obstacles in
trade between countries do exist, as do differences in customs and tax rates,
in the short-run, and the fact that investors cannot arbitrage between the price of
certain location-specific services (e.g., the price of getting a haircut) in two coun-
tries, the exchange rate could remain quite different from the equilibrium suggested
by absolute PPP.

Relative PPP: A Change in the Exchange Rate Reflects Inflation Differential  Whereas the
­absolute PPP concept focuses on the level of the equilibrium exchange rate, the rela-
tive PPP concept focuses on the changes in the exchange rate. Given a basket of
­identical goods in two countries, if the price of the basket in country A rises faster
than the price in country B, the exchange rate of country A should depreciate relative
to the exchange rate of country B. Specifically, according to relative PPP, a change in
the exchange rate between the currencies of two countries should equal the differ-
ence in the countries’ domestic inflation rates.
To use our earlier pen example, if over the year the price of the pen in the
United States has risen by 10 percent to 1.65 U.S. dollars while the price of the pen
in Germany has remained flat at 1 euro, then the exchange rate at the end of that
170 CENTRAL BANKING

one year period would be 1.65 U.S. dollars per euro. Indeed, the 10 percent drop in
the U.S. dollar against the euro over that one-year period would be a result of the
difference between U.S. inflation (10 percent) and German inflation (0 percent) over
that same period.

Usefulness of PPP as a Theory  The concept of PPP is useful in the understanding of

long-run exchange rate behavior.21 Data often show that the actual exchange rate
can diverge quite a bit from the equilibrium exchange rate implied by absolute PPP,
at least in the short run. The reasons why the actual exchange rate might diverge
from the absolute PPP equilibrium could range from taxes and structures of the
labor market to menu costs—costs related to the frequent changing of prices, as with
printing costs for restaurant menus. Over the long run, as relevant adjustments in the
economy started taking hold, the exchange rate will be more likely to behave in line
with behavior described by the PPP concept.

The Big Mac Index  A well-known attempt to gauge exchange rate equilibrium as sug-
gested by absolute PPP is the Big Mac index published annually by the Economist
magazine. This index compares the price of a Big Mac being sold in McDonald’s
restaurants worldwide. A key advantage of the Big Mac index is that Big Macs are
being sold globally in the same manner with largely the same ingredients, and yet
are locally produced, so there is no international transportation costs involved. With
such characteristics, according to absolute PPP, the price of a Big Mac should be the
same anywhere, after adjusting for the exchange rate. In practice, however, this is
often not the case. The reason for this could be that the cost of producing a Big Mac
might not really be identical worldwide (wages and rent could be different across
countries), or that the exchange rate is over- or undervalued, or both.

Uncovered Interest Parity (UIP)

Another key building block in the understanding of exchange rate behavior is the
concept of uncovered interest parity (UIP). Unlike PPP, the concept of UIP takes into
account investor expectations and the role of asset prices in the determination of
exchange rates. UIP assumes that domestic and foreign assets are perfectly substitut-
able and the exchange rate would move to help equalize international investment
returns such that there would be no riskless arbitrage opportunity.

An Illustrative Example of UIP  Suppose that we have an international investor who

can choose between investing in a U.S. government bond or a German government
bond. Let us assume that the bonds in question have the same risk profile and are
of the same maturity. If the investor can switch between these two bonds promptly
and seamlessly, then the only remaining differences between them are the cur-
rencies they are denominated in (U.S. dollar and the euro) and the interest rates
they offer.
In order to maximize total returns on investment, the investor would thus only
need to consider two factors, namely the interest rate differential between the two
bonds and the likelihood of adjustments in the exchange rate between the U.S. dollar
and the euro, the two currencies that these two bonds are denominated in.
The Exchange Rate and Central Banking 171

For this example, at equilibrium the differential between U.S. and German inter-
est rates would have to be matched by the expected percentage of depreciation of the
U.S. dollar against the euro. This could be expressed as the equation

rus − reur = es

where rus is the interest rate on the U.S. government bond, reur is the interest rate
on the German government bond, and es is the expected percentage of depreciation
of the U.S. dollar per euro.
According to UIP, as long as the expected percentage of depreciation of the U.S.
dollar relative to the euro differs from the interest differential on the otherwise identical
U.S. and German government bonds, investors would expect the returns from invest-
ment from these two bonds to be different. Investors would seek to invest in the bond
that is expected to provide higher total returns and shift away from investing in the
bond that is expected to give lower total returns. As investors switch toward the more
lucrative investment, the expected total returns of these two bonds would be equated.
To further illustrate this point, let’s say that the annual yield on the U.S. govern-
ment bond is at 10 percent and the annual yield on the German government bond is
at 5 percent. If, however, the expected depreciation of the U.S. dollar per euro were
only 2 percent per year, the expected return from an investment in the U.S. bond
would be greater than that from the German bond. Investors would continuously
switch their investments from the German bond to the U.S. bond, thereby reducing
yield on the U.S. bond. Investors would stop switching between these two bonds
only when the expected returns from these two bonds are equal, that is, when the
interest rate differential between the U.S. and German bonds declined to 2 percent,
equivalent to the expected percent of depreciation of the U.S. dollar against the euro.

Usefulness of the UIP  From the illustration above we can see that UIP pins down the
expected change in exchange rates, but not the level. In practice, however, while UIP
provides a very important conceptual framework, accounting for the UIP relationship
might be complicated by many factors.22 The assumption of perfect substitutability
between assets used in UIP, for example, might not necessarily always hold. Even
bonds with the same credit rating might differ in terms of liquidity. Consequently,
investors might not rush to switch between them as UIP would predict.
Also, investors might not be as rational as the theory assumes. Investors could
have a bias toward investments in their home country and be less willing to switch
to foreign bonds, for example. Furthermore, the long-run equilibrium exchange rate
itself can change, thus affecting expected exchange rate depreciation. Despite these
real-life limitations, however, UIP remains a key building block in our understanding
of the exchange rate since it offers a theoretical baseline that could later be adjusted
to different situations.

Portfolio Balance Models

Portfolio balance models refer to a large class of exchange rate models that attempt
to address real-life limitations of the PPP and UIP concepts by taking into account
relevant factors that might influence the exchange rate, including differences in the
riskiness of domestic and foreign assets as well as the country’s current account.23
172 CENTRAL BANKING

Implications of Riskiness and Diversification of Bond Holdings on the Exchange Rate  In contrast
to UIP, which assumes domestic and foreign assets are perfect substitutes, portfolio
balance theories recognize that domestic and foreign assets are not perfect substi-
tutes since there are often differences in their riskiness.24 In practice, differences in
the riskiness of bonds could come from many sources. For example, a country that
issues a larger supply of bonds is more at risk of being unable to repay bondholders
when the bonds mature, other things being equal. A country with lower productivity
is also more likely to default on it bonds.25
Under portfolio balance theories, since domestic and foreign bonds are not
perfect substitutes, investors would hold both domestic and foreign bonds to
diversify their risks and maximize their investment returns.26 Unlike the world
of UIP, according to portfolio balance theories, investors will not rush to entirely
switch from domestic to foreign bonds whenever the interest rate differential
on the bonds does not match the expected depreciation of the exchange rate, or
vice versa. Instead, investors would want to diversify their portfolios by holding
both domestic and foreign bonds at the same time (but more likely in different
proportions).
To compensate for holding a riskier bond, however, investors will also likely
demand that the riskier bond pays a higher interest rate. In other words, a risk pre-
mium would have to be paid for investors to hold the riskier bond. According to
portfolio balance theories, the interest differential on domestic and foreign bonds
thus reflects not only the expected exchange rate depreciation as prescribed by UIP,
but also the risk premium paid to compensate investors for holding the riskier bond.
Persistent or large deviations from UIP (i.e., cases in which the interest rate differen-
tial is not matched by the expected depreciation of the exchange rate), could thus be
at least partly explained by the existence of risk premiums.

Role of the Current Account  Aside from differences in the riskiness of investments, port-
folio balance theories also put emphasis on the role of a country’s current account as
a factor determining the country’s exchange rate.27 A country’s current account sur-
plus suggests that the country exports more than it imports. Accumulation of export
proceeds over import payments implies a rise in a country’s foreign assets. However,
since foreign and domestic assets are not perfect substitutes, and portfolio balance
theories suggest that investors often want to hold both foreign and domestic assets
in their portfolios, parts of the country’s net export proceeds would be repatri-
ated back to invest in domestic assets. The repatriation of those export proceeds
would drive up the value of domestic currency relative to that of foreign curren-
cies. Therefore, the country’s current account could play a role in determination
of the exchange rate. Over time, however, the strengthening of domestic currency
could reduce the country’s current account surplus since it would make the country’s
exports more expensive than before.
From the preceding discussion we can conclude that large and persistent devia-
tions from UIP are thus also possible for the country’s current account position. If
we examine this further, then we see that since current account dynamics and the
country’s growth prospects are intertwined, portfolio balance theories would seem
to also suggest that factors affecting the country’s growth prospects would also play
a role in the determination of the exchange rate. The final result, however, could
be rather complex since it depends on wide-ranging factors, including the nature
The Exchange Rate and Central Banking 173

of factors affecting the country’s growth prospects and the corresponding current
account dynamics.
For example, if the country is experiencing higher productivity growth (possibly,
say, from a burst of new innovations), then the higher income growth that comes
with higher productivity could encourage the country to start to consume more
and run current account deficits. On the other hand, the rise in productivity might
enable the country to produce and export more, and run current account surpluses.
Whichever path the country follows, however, the exchange rate would likely be
affected. Furthermore, higher productivity and higher potential growth would likely
lead to higher expected returns from investment in that country’s domestic assets,
which would then alter its exchange rate dynamics.

Exchange Rate Market Microstructure

The preceding exchange rate theories focus mainly on the longer-term macroeco-
nomic determinants of exchange rate behaviors. In practice, however, it has been
observed that the exchange rate can change in almost a continuous manner, even if
there has not been a change in inflation, the current account, or potential growth
data.* Research has thus increasingly put more focus on the interaction among play-
ers in the foreign exchange market as a key determinant of the exchange rate.28 This
focus gives rise to the microstructure theory of the exchange rate market.
Under the exchange rate microstructure theory, attention is paid to how play-
ers in the exchange rate market (individuals, firms, and financial institutions) use
information available to them when trading currencies in the market. Often players
have to aggregate a wide range of dispersed information, including that on macro
variables such as future inflation and economic growth, as well as that on actions
of other players in the market. Owing to information asymmetry and the fact that
players might aggregate dispersed information differently, different players are likely
to have different views on the intrinsic value of a currency.
With numerous players in the market at any given moment, and with news and
information being introduced throughout the day, it is conceivable that the exchange
rate would adjust almost moment-by-moment, depending on how players in the for-
eign exchange market decide to trade, given their interpretation of available informa-
tion. Research on market microstructure is also starting to provide more insight into
the understanding of how the central bank’s announcement of monetary decisions
might affect the exchange rate. By examining exchange rate behaviors in periods
following a monetary policy announcement, researchers will be able to gauge how a
hike in the policy interest rate, for example, might influence exchange rate movement.

Implications of Exchange Rate Theories for Exchange Rate Policy

Although there is no one single unified theory that can explain exchange rate behav-
ior at all times, existing theories do offer many useful insights that are pertinent to
central banking. Here we discuss four of them.

*For most countries, inflation data are updated monthly while current account data and
­economic growth projections are updated only quarterly.
174 CENTRAL BANKING

First, from PPP we know that if the central bank allows inflation to rise persis-
tently, then ultimately the exchange rate is likely to be weakened, other things being
constant. Indeed, according to the concept of relative PPP, for any pair of countries, if
inflation in one country rises persistently beyond that of the other, then its exchange
rate would likely depreciate vis-à-vis that of the other country. If the central bank of
a country runs an easy monetary policy stance, then, other things being equal, the
currency of that country is likely to depreciate in the long run.
Second, from UIP we know that if a country’s interest rate is higher than that
of another country, then its exchange rate will have to depreciate over time such
that total returns from investments in these two countries would be equal. If a
country unexpectedly raises its interest rates, then its exchange rate will have to
instantaneously appreciate in response so that over time the exchange rate can then
­depreciate, other things being equal.
Third, from the portfolio balance theory we know that assets of different coun-
tries differ in riskiness and thus are not perfectly substitutable, as UIP assumes. An
interest rate differential between any pair of countries might thus not necessarily
lead to pressure on the exchange rate. Furthermore, if a country’s economy grows
then the country might be perceived as getting stronger, and thus the perception of
risk associated with investing in that country might fall. Accordingly, if monetary
policy is conducted in a way that is conducive to increasing economic growth, then
the exchange rate might also strengthen, other things being equal.
Fourth, from the exchange rate microstructure theory we know that the exchange
rate can fluctuate on an almost continuous basis, owing to changes in expectations
of players in the financial markets. Therefore, the central bank will have to take
into account that their actions and nonactions relating to monetary policy could
drive the expectations of players in the foreign exchange market, induce them to
adjust their exchange rate positions, and thus affect the exchange rate.

9.4 DEALING WITH THE EXCHANGE RATE IN PRACTICE

In practice, the central bank has to deal with the exchange rate at both the macro
level and at the operational level. At the macro level, the central bank would have to
be aware of how its policy on the exchange rate fit with its overall monetary policy
framework. The exchange rate, interest rates, and the inflation rate are inextricably
intertwined in the long run, as they all represent various aspects of the cost of money.
At the operational level, the central bank would have to figure out how, if
it wants to do so, to best influence the exchange rate. The central bank might want
to intervene in the foreign exchange market, or to regulate flows of capital. These
actions, however, do have costs that the central bank will need to consider.

Dealing with the Exchange Rate: The Macro Concepts

At the macro level (as opposed to at the operational level), the central bank has to
take into account that the exchange rate, inflation, and interest rates are interre-
lated. The central bank’s action to influence one variable could affect the other two
variables.
The Exchange Rate and Central Banking 175

Lower domestic interest

According to relative PPP,
rates that lead to capital Exchange rate
higher inflation will lead to
outflow will bring about
a depreciation pressure on
a depreciation pressure
the exchange rate.
on the exchange rate.

Interest rate Inflation rate

Lower domestic interest

rates could lead to
higher inflation.

FIGURE 9.2  The Exchange Rate, Inflation, and Interest Rates Are All Intertwined

The Relationship between the Exchange Rate, Inflation, and Interest Rates  As is implicit in
the various exchange rate theories discussed above, inflation, interest rates, and the
exchange rate are related. The central bank’s action to influence any one of the vari-
ables is likely to affect the other two, at least over the long run (see Figure 9.2).
For example, other things being equal, a loosened monetary policy stance could
raise inflation, according to the monetary theories discussed in Chapter 5. With higher
inflation, according to relative PPP, the exchange rate of the country with respect to
an anchor country would over time depreciate proportionately in relation to the infla-
tion differential between the two countries. On the other hand, according to UIP, the
loosening of monetary policy that resulted in lower interest rates would also result in
an exchange rate depreciation, other things being equal.

Congruence in the Central Bank’s Actions toward the Three Variables  As the exchange rate,
inflation, and interest rates are all intrinsically intertwined, any policy action to affect
one of these three variables will affect not only the variable in question but will also
indirectly affect the other two. Any attempt to move any two pairs of variables in
opposing directions will be likely to prove unsustainable in the long run.
For example, say a central bank wants to hike interest rates to keep inflation
down, but at the same time wants to keep exchange rates weak in order to stimulate
exports. Specifically, let’s also say that the central bank wants to fix the exchange
rate at a level it deems favorable to the country’s exports. In such a case, by raising
interest rates to tame inflation but keeping the exchange rates fixed, the central bank
is essentially creating a profit opportunity for investors to bring in foreign capital to
invest in that country (in order to gain from interest differentials), since if the fixing
of the exchange rate holds, the expected depreciation of the currency will be zero.
In other words, in this particular case, the central bank is violating UIP. Such
a scheme would be self-defeating for the central bank, since the higher interest
rates will attract more foreign capital, driving up the demand for domestic cur-
rency. However, since the central bank wants to fix the exchange rate, the central
bank will have to intervene in the foreign exchange market by injecting money into
the economy to satisfy the greater demand for domestic currency. The injection of
money will, of course, defeat the initial purpose of the hike in interest rates, that is,
the taming of inflation.
176 CENTRAL BANKING

At the extreme, if the public realizes at the start that the central bank has both
low inflation and fixed exchange rate objectives, the public might be skeptical about
the effect that the hike in the policy interest rate might have on inflation. Monetary
policy and the central bank itself might lose their credibility. Even without the fixed
exchange rate objective, any large scale foreign exchange intervention without
“sterilization” (the central bank’s absorption of liquidity from the system through its
selling of securities to financial market players) could jeopardize the central bank’s
price stability objective credibility.
In theory, the central bank has many options to deal with the exchange rate.
At one extreme, it could focus solely in keeping the exchange rate at a predetermined
fixed level through exchange rate targeting. At another extreme, it could choose to
let the exchange rate float freely so that it is completely determined by market forces
(although this is very unlikely in practice). In between these two extremes, the central
bank would choose the degree of exchange flexibility that it deems most suitable to
economic conditions or the central bank’s objectives, or both.

CASE STUDY: Exchange Rate Policy and the Asian Financial Crisis

As discussed above, since interest rates, exchange rates, and inflation are all interrelated, any attempt
to influence interest rates and inflation rates in an inconsistent way will be self-defeating. The situation
can be seen most clearly in a currency crisis when a country is forced to massively devalue its currency
or abruptly abandon a fixed exchange rate regime.

Fixed Exchange Rate Regime

Prior to the Asian financial crisis in the late 1990s, many of the currencies in the region were on a
de facto fixed exchange rate regime. In such a situation, if the central bank is to maintain the fixed
exchange rate regime it cannot freely implement independent monetary policy to manage domestic
demand, since to keep the exchange rate fixed domestic interest rates must be in line with those of the
anchor economies, predominantly the United States in this instance.

Liberalization: The Arrival of Foreign Capital

As countries such as Thailand, South Korea, and Indonesia started to liberalize their economies in the
1980s, foreign capital started to pour in, partly attracted by the high growth potential of the economies
and the cheap labor that could be used for export-based manufacturing. While some of the foreign
capital came in to finance export-oriented manufacturing, as the Asian economies heated up, some of
the capital started to seep into asset price speculation (e.g., on stocks and real estate markets).
Note here during that time, foreign capital that poured into the Asian economy came in the form of
foreign loans as well as foreign direct investment and portfolio investment. Foreign direct investment
means that foreign investors set up their operations in the domestic economy, or buy domestic firms,
or jointly invest with domestic firms. Portfolio investment means that foreign investors invest in the
domestic bond and the stock markets. In this case, foreign capital also poured into Asian economies in
the form of foreign loans, as foreign banks lent to Asian banks and the Asian corporate sector to take
advantage of interest rate differentials between advanced economies and emerging-market economies.

Interest Rate Differentials and Implicit Guarantee on Exchange Rate Risk

Theoretically, domestic interest rates in Asia were kept in line with those of the anchor economies to
which their exchange rates were fixed. However, given that loans in emerging economies had higher
risks than loans in advanced economies, and given that there was also a huge demand for funds in
Asian economies, Asian domestic interest rates were considerably higher than those in the advanced
The Exchange Rate and Central Banking 177

economies, in other words, owing to both the risk premium demanded by foreign lenders and the
demand for funds by Asian borrowers.
Also, with their fixed exchange rate regimes, Asian central banks were essentially protecting
investors and borrowers from exchange rate risk in such cross-border lending and borrowing transac-
tions. Consequently, foreign commercial banks were willing to lend to Asian commercial banks and the
corporate sector to take advantage of the interest rate differentials that came with an implicit central
bank guarantee against exchange rate risk.

The Outcome
Ultimately, as Asian exports slowed in line with their advanced economy export markets, the current
account deficits of many Asian economies grew larger, creating a dilemma. On the one hand, interest
rate cuts by central banks could help stimulate domestic demand in these Asian economies and a deval-
uation of their currencies could help stimulate exports and reduce current account deficits. On the other
hand, interest rate cuts by central banks would put pressure on the exchange rates and a devaluation
of the currencies could bring financial instability, since domestic Asian banks and the corporate sector
had borrowed heavily from overseas without hedging the exchange rate risk, and at the same time a
huge chunk of the money had already either seeped into projects that could not be liquidated quickly or
seeped into asset price speculation.
As discussed in Chapter 2, when such dilemma became apparent, international investors and
speculators have incentives to engage in speculative attacks against central banks with fixed exchange
rate regimes. In this case, a series of massive speculative attacks forced the Bank of Thailand to float
the Thai baht on July 2, 1997, which started the Asian financial crisis since other Asian currencies
(including the Korean won and the Indonesian rupiah) were also forced to float. As a result, countries
around the region suffered massive economic instability. It should be noted that prior to the crisis
the fixed exchange rate regime had helped push inflation expectations down and had also helped
facilitate international trade and investment for many Asian countries. As the economies of these
countries became liberalized and foreign capital started to pour in, however, the countries entered
into an impossible trinity situation, since they could not independently use monetary policy to man-
age domestic demand in their economies and at the same time kept their exchange rates fixed.

Equilibrium Exchange Rates  When a central bank intervenes to keep exchange rates at
a certain level, it is often legitimate to ask if the central bank thinks such a level is
an equilibrium exchange rate for the economy. (Otherwise, why would the central
bank do so?) In a world where information is incomplete and prices are inflexible,
however, determining an equilibrium exchange rate is rather elusive.29
In practice, there have been many definitions of an equilibrium exchange rate.
Some of them are (1) the exchange rate that balances the current account, (2) the
fundamental equilibrium exchange rate, (3) the exchange rate that is consistent with
PPP, (4) the exchange rate that equates one’s export prices with those of the trading
partners, and (5) the exchange rate that equates domestic costs to foreign costs.30
As we shall see, these definitions are not exactly congruent among themselves.
A level of exchange rate that seems to suggest equilibrium in one sense does not
necessarily suggest equilibrium in another. Table 9.1 summarizes the pros and cons
of these different definitions of equilibrium exchange rate.

Exchange Rate That Balances the Current Account  In theory, a sustained bal-
anced current account should imply that the economy has achieved equilibrium with
respect to external trade. An exchange rate that balances the current account could
thus be deemed an equilibrium exchange rate.
178 CENTRAL BANKING

TABLE 9.1  Different Concepts of Equilibrium Rate: Examples and Their Pros and Cons

Exchange rate that Exchange rate that

Exchange rate Exchange rate that equates export prices equates domestic
that balances the is consistent with with those of trading costs to foreign
current account PPP partners costs
Pros A sustained cur- Popular for com- Theoretically reflects Bypasses the
rent account bal- paring standards the equilibrium ­problem of profit
ance implies that of living. exchange rate, if margin measure-
the economy is in countries have the ment that comes
equilibrium. same profit margin. with the measure
of export prices.
Cons Certain stages of Does not reflect Countries do not Other measure-
development may external balances. have the same profit ment problems:
need a current Not all goods margin for their goods are not
account that is not and services can exports. identical, ­different
balanced. be traded across labor market
border. structures, etc.
Source: Adapted from Tony Latter, The Choice of Exchange Rate Regime, Handbooks in
Central Banking No. 2 (London: Centre for Central Banking Studies, Bank of England, 1996).

In practice, however, there are at least two reasons that the exchange rate that
ensures a balanced current account might not represent an equilibrium exchange
rate. First, the feedback loop between the exchange rate and the current account is
often uncertain and is subject to time lags. The balanced current account that we see
today does not necessarily correspond to the exchange rate that we see today.
Second, countries in different stages of development and investment opportu-
nities might need a current account that is not balanced, which would result in
accompanying structural capital inflows or outflows. For example, a country that
needs foreign investment might be better off having a current account deficit, which
would be financed by capital inflows. On the other hand, a country that does not
have enough local productive investment opportunities might be better off having a
current account surplus and invest its surplus (capital) abroad.31

Fundamental Equilibrium Exchange Rate  The fundamental equilibrium exchange

rate can be defined as one that produces the optimal current account plus normal
capital flows.32 This definition allows for the needs of a current account that is
not balanced and structural net capital inflows or outflows. In practice, however,
this definition also suffers from the uncertainty and time lags of the feedback loop
between the exchange rate and the current account (and the accompanying capital
flows). Furthermore, it is difficult to determine the optimal level for the country’s
current account and capital flows.

Exchange Rate That Is Consistent with PPP  The exchange rate that equates overall
domestic price levels with international price levels, or the exchange rate that reflects
PPP, is another candidate for the concept of an equilibrium exchange rate.33 The PPP
exchange rate would reflect the value of the domestic currency in its ability to pur-
chase an identical basket of goods and services across borders.
The Exchange Rate and Central Banking 179

In practice, however, many goods and services cannot be traded across borders,
and thus arbitrage activities that are supposed to equate domestic and international
prices and ensure that the exchange rate accurately reflects PPP might not exist.
Furthermore, while PPP is useful in comparing international standards of living, it
does not reflect the country’s external balance.

Exchange Rate That Equates Export Prices with Those of Trading Partners’  Another
candidate for the equilibrium exchange rate is one that equates one country’s export
prices with those of its trading partners.34 Theoretically, this rate should ensure a
level-playing field among countries in the global market. In practice, however, the
same export prices do not necessarily translate into the same profit margins in dif-
ferent countries. Thus, such an exchange rate would still not necessarily represent an
equilibrium exchange rate.

Exchange Rate That Equates Domestic Costs to Foreign Costs  Although an

exchange rate that equates per unit cost of domestic goods to those of the trad-
ing partner countries could solve some of the problems associated with differences
in profit margins that were a problem for the exchange rate that equates export
prices, problems of measurement remain.35 Goods that are exported from different
countries are not necessarily identical, although they might be of the same type (e.g.,
different varieties of rice). Differences in labor market structures across countries
could also complicate measurements of wage costs.

Implications of the Elusiveness of an Equilibrium Exchange Rate for the Central

Bank  The discussion above suggests that a universally accepted notion of equilib-
rium exchange rate might not exist in practice. When trying the influence the level of
the exchange rate, the central bank will have to decide which concept of the equilib-
rium exchange rate would best fit its context.
In practice, since economic data often involve time lags, the central bank’s deci-
sion to intervene in the foreign exchange market to keep the exchange rate at an equi-
librium defined based on any definition discussed also risks being untimely. Owing to
time lags, by the time statistics on current account data, profit margins, or labor and
material costs come out, the inherent equilibrium exchange rate might have already
changed.
The elusiveness of an equilibrium exchange rate is also the reason that, unless a
fixed exchange rate regime is adopted, central banks in a managed float regime often
choose to intervene to smooth out excess volatilities in the exchange rates rather
than to intervene to sustain the exchange rate at a particular level, while those that
are in a free-float regime might simply let the exchange rate be determined purely by
market forces.

Dealing with the Exchange Rate: The Operations Level

At the operations level, the central bank can influence the behavior of the exchange
rate in three major ways. First, the central bank’s implementation of monetary ­policy
could influence the exchange rate, both indirectly through changes in pertinent
­macroeconomic variables and directly through expectations of participants in the
foreign exchange market. Second, the central bank could attempt to directly temper
180 CENTRAL BANKING

or alter exchange rate movements through intervention in the foreign exchange

market. Third, the central bank could influence the exchange rate through regula-
tions regarding capital flows.

The Direct and Indirect Effects of Monetary Policy  From the exchange rate theories
­discussed above, it is possible to broadly distinguish the channels through which
monetary policy affects the exchange rate into those that are long term and those
that are short term. In the long term, monetary policy affects the exchange rate indi-
rectly through changes in relevant macroeconomic variables, which might include
inflation, productivity, and the current account, among others. In the short term,
monetary policy can have effects on conditions and expectations in the foreign
exchange market microstructure.
By affecting the behavior of inflation and growth, monetary policy can influence
the exchange rate in the long run, as PPP and the portfolio balance models predict.
This channel of influence would work relatively slowly, as it takes time for mone-
tary policy to first influence macroeconomic variables, and later, for macroeconomic
variables to affect the exchange rate. In the short run, monetary policy announce-
ments can influence expectations of foreign exchange market players and thus the
exchange rate right away, as UIP and the market microstructure predict.

Foreign Exchange Intervention  Apart from influencing the exchange rate through the
conduct of monetary policy, the central bank can directly influence the exchange
rate through direct intervention in the foreign exchange market. The term foreign
exchange market intervention often refers to the central bank’s act of buying and
selling foreign currencies in the foreign exchange market.36
By buying up foreign currencies and paying for them using domestic currency,
the central bank is effectively raising the supply of domestic currency in the sys-
tem, thus putting downward pressures on the price of domestic currency, (i.e., the
exchange rate). In contrast, by selling out its holdings of foreign currencies and tak-
ing in domestic currency instead, the central bank is effectively draining domestic
currency from the system, thus putting upward pressures on the exchange rate. If
the scale of such purchases or sales of foreign currencies is large enough, the central
bank can indeed directly influence the exchange rate.

Sterilized Foreign Exchange Market Intervention  In the act of a foreign exchange

intervention, the central bank is effectively changing the supply of domestic currency.
A change in the supply of domestic currency resulting from a foreign exchange inter-
vention, however, has the potential of introducing unwanted side effects, since such
a change would directly affect money conditions in the economy. For example, an
increase in the supply of domestic currency resulting from a foreign currency pur-
chase can put downward pressures on interest rates in the domestic money market.
Unless the central bank wants to also lower interest rates in the money market, the
central bank would need to sterilize the foreign currency purchase to eliminate poten-
tial unwanted side effects on money market interest rates.
In the example above, the central bank might choose to sterilize the foreign cur-
rency purchase by absorbing the extra supply of domestic money through the sales
of domestic securities, such as government bonds and securities issued by the central
bank to players in the money market. By selling its government bond holdings, or
The Exchange Rate and Central Banking 181

issuing its own securities for sales to money market participants, the central bank is
effectively draining domestic money from the system. Such acts of buying up foreign
currencies and at the same time selling or issuing domestic securities to drain out the
resulting extra supply of domestic currency is known as a sterilized foreign exchange
intervention.
For an emerging-market country, a sterilized foreign exchange intervention of
capital inflows could be costly to the central bank, often because the central bank
would be purchasing low yielding foreign currency assets (e.g., U.S. Treasuries) while
issuing higher yielding domestic securities.37

Regulations of Capital Flows  Another possible way to influence movement of the

exchange rate is through the use of regulation on capital flows. As we discussed
earlier in the section on exchange rate theories, the decision by international inves-
tors to invest or not invest in a country can affect that country’s exchange rate. If
international investors perceive that investment in a country would yield a good
total return, they would likely pour capital into that country. As foreign capital starts
to flow in, the country’s exchange rate is likely to appreciate, since international
investors would have to convert their foreign currencies into that country’s domestic
currency to make an investment.
Normally, inflows of foreign capital are often welcome in a country with an
open economy, since they could be used to finance domestic investment projects.
However, if many investors decide to pour capital into the country at the same time,
the influx of capital could put a lot of upward pressure on the exchange rate. This is
especially a problem with a small emerging-market country that does not have much
capacity to accommodate large inflows of capital.
With a fast appreciating currency, the country’s exports are likely to become
less competitive as they become more expensive, while the domestic economy is
also likely to experience many distortions, especially if its internal prices and wages
cannot change quickly in response. On the other hand, if local prices and wages can
respond very quickly to changes in the exchange rate, the economy would still be
experiencing problems if exchange rate movements are fast or volatile.
Economic distortions resulting from capital inflows could be worse if a large
portion of capital inflows is the so-called hot money that aims to capture quick
returns, possibly through speculation in the stock and real estate markets. Apart
from causing a fast appreciation in the exchange rate that often results in economic
distortions, such flows of hot money could lead to nonproductive investments and
bubbles. Since large and fast inflows of capital potentially have great adverse effects
on the economy, the central bank always has an option to impose regulations to
temper the magnitude and the velocity of such flows.
Regulation of capital flows, or capital controls, can take various forms. Among
the best known are the Tobin tax and unremunerated reserve requirements (URRs) on
capital inflows. A Tobin tax refers to a tax charged on spot foreign exchange transac-
tions. This has the effect of imposing extra costs on currency conversion and thereby
lowering potential total returns from cross-border investment. Unremunerated
reserve requirements on capital inflows, on the other hand, require that a certain
percentage of the capital that investors bring into the economy be deducted and held
in special accounts that pay no interest for a specified period. This also has the effect
of lowering potential total returns from cross-border investment.
182 CENTRAL BANKING

In practice, although the central bank always has the option of imposing capital
controls to temper pressures on the exchange rate, it rarely exercises such options.
The introduction of regulations on capital flows could discourage all types of capital,
not just hot money, since it translates into uncertainty for international investors. In
the real world it is very difficult to discriminate between speculative and productive
inflows. Also, over time, speculators often find loopholes even in a well-designed
regulation that aims squarely at hot money.

Management of Official Foreign Reserves: The Other Side

of the Central Bank’s Balance Sheet
The central bank’s intervention in the foreign exchange market entails selling and
buying of domestic currency, which directly affects the central bank’s liabilities. Such
selling and buying of the domestic currency, however, would often be financed by
official foreign reserves (OFRs), which are assets on the central bank’s balance sheet.
Accordingly, central banks often also have the duty of managing their portfolios of
OFRs as a byproduct of their exchange rate management.

Official Foreign Reserves and the Exchange Rate Policy  According to the IMF, official
foreign exchange reserves are official public sector assets that are readily available
to and controlled by the monetary authorities for a range of objectives including to
“support and maintain confidence in the policies for monetary and exchange rate
management, including the capacity to intervene in support of the national or union
currency; limit external vulnerability by maintaining foreign currency liquidity to
absorb shocks during times of crisis or when access to borrowing is curtailed, and in
doing so provide a level of confidence to markets that a country can meet its external
obligations; demonstrate the backing of domestic currency by external assets; assist
the government in meeting its foreign exchange needs and external debt obligations;
and maintain a reserve for national disasters or emergencies.”38
In practice, OFRs could include gold, foreign currencies, foreign government
securities, foreign government guaranteed securities (such as mortgage backed secu-
rities), as well as foreign corporate bonds and foreign equities, depending on the
statute governing the particular central bank.
When the central bank wants to dampen exchange rate appreciation, it could
intervene in the foreign exchange market by selling out domestic currency and buy-
ing up foreign currencies. The sales of domestic currency will raise supply of the
domestic currency and dampen the appreciation pressures on the currency. The pur-
chase of foreign currencies will contribute to the buildup in OFRs.
When the central bank wants to temper exchange rate depreciation, it can buy
up domestic currency by selling parts of its OFRs in the foreign exchange market.
The purchase of domestic currency will reduce its supply of domestic currency and
temper depreciation pressures on the currency. The sales of foreign assets out of
OFRs will reduce the amount of OFRs under the control of the central bank.

OFRs and the Central Bank’s Balance Sheet  The use of OFRs in foreign exchange market
intervention will have implications for the central bank’s balance sheet. OFRs can be
considered assets on the central bank’s balance sheet that are financed by liabilities
such as domestic currency (e.g., money issued to buy up foreign currencies during
The Exchange Rate and Central Banking 183

foreign exchange market interventions), and central bank securities (e.g., securities
issued by the central bank when sterilizing the effects of foreign currency purchases).
The purchase of foreign currencies to temper appreciation pressures on domes-
tic currency will have the effect of enlarging the central bank’s balance sheet by
raising both assets and liabilities, if such a purchase is done without sterilization, or
is being sterilized by the issuance of central bank securities. Foreign currencies pur-
chased will now be considered as a part of OFRs and thus the central bank’s assets.
If the central bank uses domestic currency to buy foreign currencies without
sterilization, then the domestic currency used in that operation would contribute to
the rise in the liabilities of the central bank. If the central bank uses the domestic cur-
rency to buy the foreign currencies but then sterilizes the operation by issuing central
bank securities to drain out the extra domestic currency from the system, then OFRs
(assets) would rise, while liabilities would also rise, but ultimately in the form of the
central bank’s issued securities, rather than the domestic currency.
If the central bank uses the domestic currency to buy foreign currencies but
sterilizes the operation by selling domestic government securities to drain the extra
domestic currency from the system, then the size of the central bank’s balance sheet
will remain the same as that before the purchase of foreign currencies. The composi-
tion of the asset side of the balance sheet, however, will be different from before, as
the central bank would have effectively substituted its government securities hold-
ings with the foreign currencies purchased.

Management of OFRs  When the central bank buys up foreign currencies to temper
appreciation pressures on the domestic currency, it normally does not want to simply
keep the purchased foreign currencies in its vault. Rather, it would prefer to pre-
serve the purchasing power of those foreign currencies it has, and possibly earn some
investment returns. As such, the central bank would often diversify foreign currencies
it has into various financial instruments, making it into an investment portfolio.
In managing its portfolio of OFRs, the central bank often aims for safety,
liquidity, and appropriate returns. Traditionally, central banks invest their OFRs in
safe, highly liquid instruments, such as foreign currency deposits at reputable finan-
cial institutions, as well as highly rated foreign government securities, particularly
U.S. government securities.
In the past decade, however, OFRs of many emerging-market economies have
grown very quickly, owing partly to the central banks’ need to purchase foreign
currencies in response to appreciation pressures on the domestic currency that came
from the growth in their export earnings and capital inflows from advanced econo-
mies. In the wake of the 2007–2010 financial crisis, the large balances of OFRs,
often financed by issuance of central bank securities, have become a concern from a
balance sheet perspective.
In the wake of the crisis, returns from investment in traditional reserves assets,
such as foreign currency deposits and government securities of advanced economies,
fell to historical lows. Meanwhile, to sterilize their foreign currency purchases, the
emerging-market central banks often had to issue securities that pay higher inter-
est rates than could they receive on their investment in OFRs. Furthermore, as
­emerging-market currencies kept appreciating, emerging-market central banks were
also experiencing huge valuation losses on their holdings of foreign assets when
measured in terms of their domestic currencies.
184 CENTRAL BANKING

In response to carry losses (the difference between the low yields of investment
in traditional reserves assets—such as short-term deposits and advanced economies
government securities—and the high interest rates that emerging-market central
banks had to pay on their sterilization securities), as well as valuation losses, many
emerging-market central banks started to diversify into other classes of assets.
These new asset classes often included emerging-market government securities,
mortgage-backed securities guaranteed by advanced market governments, corpo-
rate bonds from both advanced economies and emerging-market countries, and
equities. The specific classes included in the mix depend on what the central banks’
own statutes allow.

SUMMARY
The exchange rate is a key variable that the central bank must watch, since it is the
price of money in terms of another currency and could affect monetary stability as
well as financial stability. Exchange rate regimes can range from rigid pegs on one
end of the spectrum to free floats on the other. In the middle, regimes include the
traditional fixed exchange rate, the fixed exchange rate with a horizontal band,
the crawling peg, and the managed float.
Major exchange rate theories include purchasing power parity, uncovered inter-
est parity, portfolio balance models, and exchange rate market microstructure theory.
At the macro level, the central bank must be aware of the interrelationship
among the exchange rate, inflation, and interest rates. Also, the central bank must be
aware that a free-float exchange rate regime, free-capital flows, and an independent
monetary policy cannot coexist in the long run. Furthermore, the determination of
an equilibrium exchange rate can be quite elusive.
At the micro level, the central bank can influence the exchange rate by interven-
tions in the foreign exchange market, as well as by regulations on capital flows.
Foreign exchange market intervention entails the management of official foreign
reserves by the central bank.

KEY TERMS
absolute purchasing power parity foreign direct investment
Big Mac index foreign exchange intervention
common currency foreign loans
crawling peg free float
currency board impossible trinity
equilibrium exchange rate managed float
exchange rate market microstructure official foreign reserves
theory portfolio balance model of the exchange
exchange rate regime rate
exchange rate risk portfolio investment
fixed exchange rate with a horizontal purchasing power parity
band relative purchasing power parity
The Exchange Rate and Central Banking 185

rigid peg traditional fixed exchange rate regime

risk premium uncovered interest parity
sterilized foreign exchange intervention unremunerated reserve requirements
Tobin tax

QUESTIONS
1. Provide an example of the way that the exchange rate can affect monetary
stability.
2. Provide an example of the way that the exchange rate can affect employment.
3. Provide an example of the way that the exchange rate can affect financial
stability.
4. In a rigid peg exchange rate regime, can the central bank independently print
money to stimulate the economy without regard to money conditions in the
country that it pegs its exchange rate to? Why or why not?
5. Why might a central bank choose a currency board for its exchange rate regime?
6. What are the drawbacks of a currency board system?
7. Why might a central bank choose to adopt a free-float exchange rate regime?
8. What are the problems with a freely floating exchange rate?
9. What are key differences between a managed float exchange rate regime and a
crawling peg exchange rate regime?
10. According to relative purchasing power parity, if inflation goes up, what is likely
to happen to the exchange rate?
11. Why might an exchange rate deviate from purchasing power parity in practice?
12. According to uncovered interest parity, what is the relationship between the
interest rate differential between two countries and their corresponding exchange
rate?
13. According to uncovered interest parity, if the interest rate in one country is hiked
unexpectedly, what would happen to the exchange rate of that country? Why?
14. According to portfolio balance models of exchange rates, why might uncovered
interest rate parity (UIP) not hold?
15. According to portfolio balance models of exchange rates, if a country’s
productivity improves what is likely to happen to the exchange rate?
16. Why might the exchange rate move continuously, almost second-by-second,
given that important economic data are released only monthly or quarterly?
17. Why can’t the central bank aim to have an exchange rate target, free capital
mobility, and independent monetary policy at the same time? What is this
concept called?
18. How useful is the concept of equilibrium exchange rates? Please discuss using at
least three examples.
19. What is sterilized foreign exchange intervention?
20. Why might sterilized foreign exchange interventions be costly for emerging-
market central banks to undertake?
21. What might be the reasons for the central bank to impose capital controls?
22. What might be the reasons for the central bank to not impose capital controls?
 PART
Three
Financial Stability

P art III focuses on financial stability, another key central banking mandate. The
financial stability mandate started receiving attention in the 1980s but has
received even more since the global financial crisis of 2007–2010.
Chapter 10 reviews various definitions of financial stability, provides an ana-
lytical framework that could be practical for central banks as they consider how
to fulfill this mandate, and reviews the theoretical foundations of financial stability.
Chapter 11 examines various tools that central banks might use to identify and
monitor risks to financial stability. This review is done using the analytical frame-
work proposed in Chapter 10, and prospective tools are examined from three key
overlapping areas, namely the macroeconomy, financial institutions, and financial
markets.
Chapter 12 looks at various tools that the central bank could use to intervene
to address risks to financial stability. Review of these tools also uses the analytical
framework proposed in Chapter 10.

187
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 189

CHAPTER 10
Financial Stability
Definition, Analytical Framework,
and Theoretical Foundation

Learning Objectives
. Define financial stability.
1
2. Explain why financial stability is important as a central banking
mandate.
3. Explain how weaknesses in the balance sheets of households, firms,
and the government could affect financial stability.
4. Describe the risks facing a financial institution.
5. Describe the risks facing a network of financial institutions.
6. Explain why information asymmetry could lead to instability in
financial markets.

A s discussed in Chapter 4, financial stability has increasingly been recognized as a

key mandate of central banks, in addition to monetary stability (and, in the case
of the United States, full employment). Given the relative newness of the focus on
financial stability, which started in the 1980s,1 the definition, analytical framework,
and operational framework for financial stability are all still very much at the early
development stages when compared to monetary stability.2
This chapter first reviews issues surrounding the definition of financial stability.
The chapter then proposes an analytical framework that a central bank could use to
view financial stability from a practical perspective. The chapter ends with a review
of theoretical principles that will be helpful in understanding probable causes of
financial instability and how the central bank might deal with them.

10.1 DEFINITIONS OF FINANCIAL STABILITY

Among the three widely cited central bank mandates, financial stability is arguably
the only one that does not yet have a single, quantifiable, operational definition
that is widely agreed upon.3 For price stability, one could argue that low and stable

189
190 CENTRAL BANKING

­inflation is often the agreed-upon operational definition. For employment, despite

various complications one can think of the unemployment rate as a measure that
can be used, possibly against the natural rate of unemployment as a benchmark. This
lack of an agreed-upon, quantifiable definition of financial stability reflects both the
relative newness and the complexity of the issues involved.
Although central banks have been involved with financial stability functions
since their early days,* financial liberalization in the last few decades has brought
about rapid changes in the financial system globally. The complexity and intercon-
nectedness of global financial systems have grown more than most would have
expected prior to the crisis of 2007–2010. Although many central banks started to
put more emphasis on developing tools and a framework for financial stability func-
tions in the late 1990s, partly in response to the delegation of the bank supervision
role to outside regulators, the framework and the tools developed for the main-
tenance of financial stability were still relatively immature when compared to the
rapid changes in global financial systems.
The complexity of the issues involved have led to many different definitions of
financial stability being proposed, oftentimes with different emphases. A 1990 paper
by Ben Bernanke (now former Federal Reserve chairman) and economist Mark
Gertler focused on the balance sheets of economic agents and suggested that finan-
cial stability depended on the net-worth positions of potential borrowers.4 The paper
argued that if the net-worth positions of potential borrowers were low enough, there
could be collapse in investment and thus economic activity.
Meanwhile, a 2006 paper by economists Oriol Aspachs, Charles Goodhart,
Miguel Segoviano, Demetrios Tsomocos, and Lea Zicchino suggested that credit
risk—that is, the ability of borrowers to repay their debts in full—is central to finan-
cial stability, and thus low probability of default by borrowers is a key metric for
financial stability.5 This followed a 2005 paper by Charles Goodhart that stated,
“If everyone always fully paid their debts, with certainty, there would be no credit
risk, probably no money (since everyone’s IOUs could be used in trade), and no need
for financial intermediaries.”6
A 2009 paper from Claudio Borio and Mathias Drehmann focused more on the
performance of financial institutions, defining financial stability as the converse of
financial instability, with instability occurring because of “a set of conditions that is
sufficient to result in the emergence of financial distress/crises in response to normal-
sized shocks.”7
Gary Schinasi’s 2004 paper looked at the broader financial system rather than
financial institutions, and defined financial stability as the ability of the financial
system to (1) facilitate both the efficient allocation of economic resources and the
effectiveness of other economic processes, (2) assess, price, allocate, and manage
financial risks, and (3) maintain its ability to perform these key function primarily
through self-correcting mechanisms.8
These diverse emphases in defining financial stability suggest that financial sta-
bility is indeed multifaceted in nature, and that one has to look at the interaction of
various facets to get a more complete picture.

*As a lender of last resort, and thus as a bank supervisor, as well as a guardian of the payment
system, for example.
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 191

10.2 A PRACTICAL ANALYTICAL FRAMEWORK: THE MACROECONOMY,

FINANCIAL INSTITUTIONS, AND FINANCIAL MARKETS

It might be helpful to recognize that financial stability encompasses three key interre-
lated elements for central banks: (1) a macroeconomy that is free of major financial
imbalances, (2) a system of financial institutions that is sound and stable, and (3)
financial markets that are smoothly functioning. These three elements of financial
stability normally interact with each other in a state of flux, and the absence of any
one element can lead to financial instability as well as the failure of the other two
elements.* Figure 10.1 illustrates the overlapping dimensions of the three key ele-
ments of financial stability.
An analytical framework based on recognizing the three key elements and their
interrelationships is practical from the central bank’s vantage point for at least three
reasons. First, it helps disentangle the inherent complexity of the interrelationships
among the key elements of financial stability into more tractable and manageable
parts. Second, it corresponds well with the institutional setup of most modern cen-
tral banks, even those without supervisory function. Third, it corresponds well to the
disparate body of theoretical and empirical research on the issues related to financial
stability that can also be grouped roughly into these three specific areas (see Gertler’s
1988 paper, for example).9 The body of research on financial stability will be dis-
cussed in more detail later in the chapter.

The Inherent Interrelationships between the Macroeconomy,

Financial Institutions, and Financial Markets
The interrelationships of the macroeconomy, financial institutions, and financial
markets are inherent in nature. One can see that for financial institutions to be sound

Macroeconomy

Area of
Areas of concern for
concern for financial
financial stability
stability Financial Financial
institutions markets

Area of concern for

financial stability

FIGURE 10.1  Overlapping Dimensions of Financial Stability: The

Macroeconomy, Financial Institutions, and Financial Markets

*In such a framework, a stable payments system helps stitch the three elements seamlessly
together.
192 CENTRAL BANKING

and stable, or for financial markets to continue to function smoothly, it is often a

prerequisite that the macroeconomy be free from major financial imbalances—that
is, households, firms, and the government are free from excessive indebtedness.10
If they are not free from excessive indebtedness, and their debts cannot be repaid in
full, then their lenders (financial institutions), and ultimately savers in the economy,
would have to bear financial losses.
If the losses of financial institutions are (or believed to be) large enough, then the
financial intermediation process in the macroeconomy could be at risk (this process
is described in section 10.3). Depositors could rush in to withdraw their money,
while creditors of the financial institutions might call in their loans. Disruptions in
investment and consumption could ensue. Furthermore, troubles among financial
institutions could freeze lending in the money market and also usher in panics in
other financial markets. As such, the financial system as a whole would be unstable
and unable to function smoothly or effectively.
On the other hand, panics in financial markets* could bring a negative feedback
loop to financial institutions and the macroeconomy. Firms that rely on financial
markets might find themselves short of funds during dire times, while households
could be hit with both income and financial losses (from job cuts, and the fall in the
value of their financial asset holdings, for example), dampening their demand for
goods and services. In the case of severe financial instability, economic activity could
sharply contract and price stability would be threatened.
By grouping the issues into these three separate categories, we can often identify
issues that crosscut these three key interrelated areas. Accordingly, once the issues
are identified, they could be more effectively dealt with, knowing how they might fit
in the big picture. Coordination using information and tools from different units of
the central bank will often facilitate effective solutions to problems.

Financial Stability and the Organization of Central Banks

Through their conduct of monetary policy, most central banks already have a unit to
monitor, assess, and forecast inflation and output in the macroeconomy. The mon-
etary policy unit of these central banks is often already tasked with assessing the
behavior of households, corporations, the government, and external sectors, as well
as monitoring developments in asset prices. The central banks can thus easily lever-
age the existing capability of such a monetary policy unit to monitor and assess risks
to financial stability that might arise in the macroeconomy.
Meanwhile, through their conduct of routine financial market operations, most
central banks also have a unit that interacts actively with the financial markets. This
unit of the central banks often has extensive contact with players in the financial
markets and has experience in using the various tools at its disposal to influence
financial markets. The central banks can thus leverage the existing capability of such
a financial market operations unit to monitor and assess risks to financial stability
that might arise from financial markets.

*Financial markets are markets where market players with excess funds and market players
in need of funds transact with each other. Market players might include banks, nonbank
­financial institutions, and large and retail investors. The term financial markets, in fact, is
a generic term that encompasses a great variety of specific markets, including money mar-
kets (for short-term lending), capital markets (for long-term funding, which include both
equity and bond markets), and other markets, such as foreign exchange markets (for foreign
exchange funding), derivatives markets (for hedging activities), etc.
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 193

As for monitoring financial institutions, those central banks that have a bank
supervisory unit can use it to provide timely and detailed assessments on the banking
sector’s financial health. For central banks with a bank supervisory function, such
a unit also often has experience and tools to influence banks on issues related to
financial stability. Even central banks without a banking supervisory role often have
a unit that assesses and monitors developments in financial institutions, and those
central banks could utilize such a unit in monitoring and assessing risks that might
come from financial institutions, and to coordinate with relevant banking supervi-
sory agency outside the central banks.
In any case, it is well recognized that close coordination and data-sharing among
these three units, as well as with outside agencies, is vital if a central bank is to
­effectively deal with financial instability risks.

10.3 FINANCIAL STABILITY: THEORETICAL FOUNDATIONS

Unlike the body of research on price stability and employment, the theoretical under-
pinnings of financial stability practices remained in the relatively early stages of
development and are still quite fragmented. To make the review of relevant theoreti-
cal knowledge more tractable, it might be useful to group it into the three key areas
of financial stability mentioned above: the macroeconomy, financial institutions, and
financial markets (see Table 10.1).

TABLE 10.1  Grouping of Key Theories Relating to Financial Stability

Key studies and
Area of focus theories Key hypotheses Key implications
Macroeconomy Fisher (1933), Financial activities Moderation of finan-
Gurley and Shaw and economic activi- cial activities to prevent
(1955), Kindleberger ties could feed on each excessive risk buildups
(1978), Minsky other. The macro- that could threaten the
(1986), Bernanke economy is thus prone macroeconomy might
and Gertler (1990) toward instability. be needed.
Financial Diamond and Individual financial Deposit insurance,
institutions Dybvig (1983), intermediaries are effective supervision of
Rochet and Tirole prone toward bank both individual banks
(1996), Allen and runs. Linkages among and the ­banking sys-
Gale (2000), Freixas, financial institutions tem as a whole, as
Paragi, and Rochet also make the sys- well as resolutions
(2000) tem prone toward to stop a run, are
instability. needed.
Financial Akerloff (1970), The existence of infor- Mitigation of informa-
markets Stiglitz and Weiss mation asymmetry tion asymmetry and
(1981) in financial markets related problems (e.g.,
suggests that market moral hazard, adverse
prices do not necessar- selection, principal
ily reflect underlying agent problems) will be
risks. needed to reduce unin-
tended risk buildups.
194 CENTRAL BANKING

First, at the macroeconomy level, key theories focus on interaction between

financial activities of economic agents and their real economic activity. Acceleration
in financial activities, as reflected by fast growth in credit and asset prices, for exam-
ple, could induce more consumption and investment, which would then bring about
more increases in credit and asset prices. Once the increases in credit and asset prices
turned into a bubble and burst, however, the resulting declines in credit and asset
prices would amplify the contraction in real economic activity. Theories focusing on
this interaction were disseminated in 1933 by Irving Fisher11, in 1955 by John Gurley
and E. S. Shaw,12 in 1986 by Hyman Minsky,13 in 1978 by Charles Kindleberger,14
in 1990 by Ben Bernanke and Mark Gertler,15 and in 2004 by Claudio Borio and
William White (2004).16 Later research, including a 2002 paper by Claudio Borio
and Philip Lowe17 and a 2009 paper by Borio and Mathias Drehmann,18 found
­evidence to support such theories.
Second, with respect to financial institutions, relevant theories include models
of bank runs, such as those pioneered by Douglas Diamond and Philip Dybvig in
1983,19 which suggested that financial intermediation generally has a smooth func-
tioning equilibrium, but is also inherently prone to instability. Banks often make
long-term, illiquid loans, using funds raised from deposits that have a short-maturity
or can be called back by depositors at will. A bank run can occur whenever there
is a panic among depositors, since the bank will not be able to call back loans and
repay depositors as demanded. Looking at the banking system as a whole, as banks
themselves are often linked with each other (whether through direct exposures such
as interbank lending or through indirect exposure where they are similarly exposed
to the price swings in assets that they hold, e.g. loans, and government securities), the
effects of a shock to one bank would be distributed throughout the system. We can
include later work related to systemic bank runs, such as 1996 research from J.C.
Rochet and J. Tirole,20 2000 research from F. Allen and D. Gale21 and research the
same year from X. Freixas, B. Parigi, and J. C. Rochet,22 and work on the resiliency
and fragility of financial network, such as that from Andrew Haldane in 2009,23 in
this group of theories as well.
Third, with respect to financial markets, are theories relating to market f­ ailures
based on information asymmetry, as pioneered and applied to financial markets by
George Akerloff in 1970,24 which suggested that financial markets are not com-
pletely efficient and conditions such as adverse selection can occur (e.g., see the
1981 paper by Joseph Stiglitz and Andrew Weiss, “Credit Rationing in Markets with
Imperfection”25). With information asymmetry, prices of financial assets might not
reflect the true underlying risks. With distorted risk-reward profiles, investors thus
might accumulate excessive positions in certain financial assets, which could lead to
financial imbalances and financial instability. Furthermore, during times of financial
stress, information asymmetry might exacerbate the situation: for example, through
coordination failures, whereby financial firms either refuse to lend to each other or
charge prohibitively high interest rates in order to insure against risk.

The Macroeconomy: Interaction between Financial

and Economic Cycles
The influence of financial activities (e.g., borrowing and lending) on real economic
activity (e.g., consumption and investment) has been recognized since at least the
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 195

time of the Great Depression, when Irving Fisher26 argued that poorly perform-
ing financial markets contributed to the severity of the economic downturn (see
Mark Gertler’s 1988 paper27). Since then, studies such as one by Gurley and Shaw
in 1955,28 Kindleberger in 1978,29 Minsky in 1986,30 Bernanke and Gertler in
1990,31 Borio and Lowe in 2002,32 Borio and White in 2004,33 and Borio and
Drehman in 200934—as well as papers by Borio in 201135 and 2012,36 have noted
how financial activities and real economic activity can interact to reinforce boom-
and-bust cycles.
To make a review of theoretical foundation in this area more tractable, it
might also be helpful to delineate related issues into (1) the behavior of economic
agents, (2) the role of nonmoney financial assets, and (3) the behavior of financial
intermediaries.

The Behavior of Economic Agents  Work along the line of the research cited above by
Gurley and Shaw in 1955, Kindleberger in 1978, Minsky in 1986, and Bernanke
and Gertler in 1990 pointed out that the balance sheets or net-worth positions of
economic agents (e.g., households and firms) can influence their spending and invest-
ment behavior, and thus business cycles.
Theoretically, a strong net-worth position of an agent would imply greater
resources available for spending or for use as collateral for borrowing. With a strong
balance sheet (probably supported by a strong prices for assets), an agent can spend
more (which would help generate more economic activity). Robust economic activ-
ity, meanwhile, could also support a further rise in asset prices and the agent’s bal-
ance sheet in a self-reinforcing manner.
A fall in asset prices, in contrast, could weaken the balance sheet of agents
and their ability to spend or borrow, which would slow down economic activ-
ity. If agents have heavy debt burdens relative to net worth, possibly as a result
of prior borrowing to purchase or invest in assets when asset prices were rising,
then the fall in asset prices could weaken their balance sheets and suppress their
ability to spend. Note that if agents had financed asset purchases largely by using
borrowed funds, then even a small fall in asset prices can severely harm their bal-
ance sheets.
If asset prices fall far enough, many agents in the economy might find their
net worth to be very low or negative, which would not only affect their ability
to spend and, by extension, general economic activity, but could also hamper
their ability to repay their debts This could result in both a banking crisis and a
collapse in general spending. Work by Borio and Lowe in 2002 and Borio and
Drehmann in 2009 showed that unusually strong increases in credit and asset
prices could indeed lead to banking crises in advanced as well as emerging-mar-
ket economies.
Given that governments can also be considered economic agents, the strengths
and weaknesses in governments’ balance sheets can influence real economic activity.
Using data from both advanced and emerging-market economies that spans about
200 years, in 2010 Carmen Reinhart and Kenneth Rogoff showed that countries
whose governments have weak balance sheet positions (i.e., heavy debt loads that
represent more than 90 percent of GDP) were likely to have lower GDP growth rates
than otherwise.37
196 CENTRAL BANKING

C O N C E P T: FINANCIAL INSTABILIT Y I N MI NSK Y ’ S FRA MEW OR K

The work of the late Hyman P. Minsky has received much attention in the
wake of the 2007–2010 crisis, partly because it aptly describes how the interac-
tion between activities in the macroeconomy and financing activities can bring
about financial instability.
In his book Stabilizing an Unstable Economy, first published in 1986,
Minsky touched on various aspects of financial instability, from macroeco-
nomic theories to the practices of bankers.
Here we focus on how the interaction between activities in the macro-
economy and financing activities might contribute to financial instability
(see Figure 10.2).
According to Minsky, financing activities can be categorized into three
­distinct types. The first is hedge finance, which dominates during an economic
recovery phase. During this period lenders focus on repairing their balance
sheets, and thus focus on loans to projects whose cash flows from operations
are more than sufficient to meet contractual payment commitments.
Second, speculative finance emerges as the economy recovers and starts to
grow. Lenders focus on projects that might have income shortfalls in the near
term but will likely have positive returns over the long run. Examples of such
projects might include capital-intensive investment projects, as well as ordinary
fixed-rate mortgages.
Third, Ponzi finance becomes more prevalent after the economy has been
in a protracted growth period. Borrowers, focusing on capital gains on assets

Hedge Speculative Ponzi Crisis

financing financing financing

1 2 3 4

After an economic As the economy recovers After a protracted Crisis

downturn, banks and starts to grow, growth period in the
focus on repairing their financing activities economy, financing
balance sheets; turn more toward projects activities turn to projects
financing activities that might have some whose financing costs
focus on projects income shortfall in the might actually exceed
whose operating cash near term, but will likely income from the projects,
flows are more than have positive returns over since borrowers are
sufficient to meet the long run. focusing mainly on the
contractual payment projects’ capital appreciation
commitments. potential.

FIGURE 10.2  Minsky’s Instability Hypothesis

Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 197

rather than how a projects’ income might cover operational and financing
costs, are more willing to invest in projects whose financing costs might actu-
ally exceed total income over the life of the project. We can think of variable
rate subprime mortgages as being an example of Ponzi finance.
As Ponzi finance becomes pervasive, any hiccup (e.g., rising interest rates)
can lead to financial instability, since under Ponzi finance, lenders are already
lending to projects that are not viable in the long run.
At any one time, the economy might have a mix of these three types of
financing activities. But as the economy keeps growing, incentives in the econ-
omy lead to a transition from hedge finance to speculative finance, and then to
Ponzi finance.
For example, initially after a crisis interest rates are often low and liquidity
plentiful, and banks themselves might shy away from speculative and Ponzi
finance. As the economy starts to recover, but short-term interest rates are still
relatively low, firms and households might find it profitable to engage in specu-
lative financing, that is, to borrow at the low short-term rates and invest in
capital-intensive long-term projects that offer higher long-term yields. As the
economy enters the boom phase and asset prices start to rise, then households
and firms might start to engage in Ponzi finance, that is, borrowing to invest
in projects for the purpose of asset price appreciation, even if cash inflows
from the projects might not cover operational costs and debt repayment com-
mitments for the projects. Adding to this, Minsky points out, are the inherent
incentives of bankers to use leverage to expand their lending operations, which
can easily tip the whole system into instability.38

The Role of Nonmoney Financial Assets  The research of both Gurley and Shaw in
195539 and Kindleberger in 197840 pointed toward to the importance of nonmoney
financial assets; that is, those financial securities issued by intermediaries that
can contribute to acceleration and crashes in economic activity. In their research
Gurley and Shaw pointed out that if the central bank were to effectively maintain
economic stability, there would be a needs for financial control—controls on the
proliferation of nonmoney financial assets—in addition to monetary control, or
control of money.
Meanwhile, Kindleberger pointed out that throughout history, booms and
resulting crashes could be traced to an introduction of new asset classes, whether
the asset was tulips in early sixteenth-century Holland or dot-com shares in the
late twentieth-century United States.41 Kindleberger passed away in 2003, before
the global financial crisis of 2007–2010, but securities backed by subprime mort-
gages come to mind as another new asset class that led to a boom and a resulting
crisis. The role of nonmoney financial assets in a financial crisis has gained much
attention in the wake of the 2007–2010 crises, although prior to that mainstream
research in macroeconomics has tended to neglect it. See “Concept: Money versus
Nonmoney Financial Assets in Macroeconomics” for more details.
198 CENTRAL BANKING

C O N C E P T: M ONEY VERSUS NONMONEY FI NANCI A L AS S ETS

IN M A C R OECONOM ICS
Most mainstream macroeconomic research from the 1950s to the period prior to
the global financial crisis of 2007–2010 ignored the impact that financial assets
could have on real economic activity and often treated financial intermediaries as
passive agents who collected funds from lenders and distributed them to borrow-
ers (see, for example, the work of Gertler in 1988 and Borio in 201242).
According to Gertler’s 1988 work,43 the lack of emphasis on nonmoney
financial assets and financial structures among mainstream macroeconomists
was attributable to at least the three factors that follow.

1. The influence of work by Franco Modigliani and Merton Miller in 1958,44

which “derived the formal proposition that real economic decisions were
independent of financial structure,” and thus it did not matter to the value
of the firm whether the firm borrowed or issued equity to finance its
investment.
2. The publication of Milton Friedman’s and Anna Schwartz’s 1963 book,45
which emphasized the role of the money supply (as opposed to nonmoney
financial assets) as a key contributing factors to the severity of the Great
Depression.
3. The popular use of reduced-form econometric techniques, particularly
vector auto regression (VAR) models that aim to capture the dynamics
among key macroeconomic forces by using the fewest number of variables
possible in the modeling process. As such, money often ends up being the
main variable representing other (non-money) financial variables as well.

Later on, even when macroeconomists in central banks and in academia

started to develop macroeconometric and general equilibrium macroeconomic
models for use in monetary policy, the influence of mainstream macroeconom-
ics and the difficulties of incorporating complex financial structures into these
types of models still prompted macroeconomists to emphasize money as the
only key financial variable. When financial intermediaries are treated as passive
agents, the only monetary variable(s) in a macroeconomic model are interest
rates (or the money supply), which do not necessarily capture developments in
financial activities that might later have implications for real economic activity
(see the previously cited work of Gertler in 1988 and Borio in 201146 and 2012
for examples).

The Behavior of Financial Intermediaries  Hyman Minsky’s 1986 book emphasized that
managers of financial intermediaries indeed were active profit maximizers, and
that their profit maximizing behavior would lead them to fund projects that were
progressively more speculative (projects that relied progressively more on capi-
tal appreciation, as opposed to income flows), driving the economy further into a
boom period.47
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 199

To keep profits and their bonuses growing, managers of financial intermediaries

will also likely need to engage in higher leveraging (i.e., borrowing more funds to
invest in more projects). When the economy inevitably slows and these projects do
not generate as much income as expected, the failures of the speculative projects and
the highly leveraged position of financial intermediaries leads to a financial collapse.
How a financial collapse feeds back to the real economy was also captured by
Ben Bernanke’s 1983 work, which pointed out that the collapse of the financial sys-
tem was a key determinant of the Great Depression’s depth and length.48 The break-
down of banking activity and the crisis in security markets choked off financial flows
to borrowers, who did not have easy access to other forms of credit, which further
weakened borrowers’ balance sheets.

Financial Institutions: Intermediation, Bank Runs,

and Banking System Resiliency
In their influential 1983 study, Douglas Diamond and Philip Dybvig presented a
model that formalized the act of financial intermediation and how financial inter-
mediation might inherently be prone to instability in the form of bank runs.49 While
Diamond and Dybvig focused on runs involving a single bank, later work, such
as that by J.C. Rochet and J. Tirole in 1996, F. Allen and D. Gale in 200050 and X.
Freixas, B. Paragi, and J. C. Rochet the same year,51 investigated contagion and
systemic effects of a bank run.

Financial Intermediation  According to Diamond and Dybvig, the act of intermediation

can be thought of as liquidity creation by banks. Savers are often reluctant to lend
directly to businesses or households, since those loans are illiquid; that is, they can-
not be converted into cash quickly without incurring substantial losses. By taking in
funds from savers and promising that savers can withdraw their funds easily, with
very low or no costs, banks are in fact creating liquidity in the system. If savers deem
liquidity to be important to them, they will be more likely to deposit some of their
funds in banks. Banks then pool these funds together and lend them out to borrow-
ers under long-term contracts. In a sense, by pooling deposits banks are providing
depositors with an insurance arrangement in which depositors share the risk of
liquidating an asset early at a loss.52
By pooling deposits from a large number of depositors who normally have
uncorrelated expenditure needs, a bank needs to keep only a small fraction of funds
on hand to meet demand for withdrawals at any given point in time. The bank can
then lend most of the rest of the funds out to its borrowers so that the funds can earn
interest. The interest earned can be applied to deposits or used to cover the bank’s
operating costs, and, if possible, pay dividends to the bank’s shareholders. At any
given point in time a bank can function smoothly as long as only a small fraction of
depositors want to withdraw their deposits. Normally depositors would be expected
to have uncorrelated expenditure needs and thus would be unlikely to withdraw
their deposits at the same time. (See Figure 10.3.)

The Diamond-Dybvig Model: The Switch from Normal Functioning to a Bank Run  If at any given
point in time the bank’s depositors demand withdrawals in excess of the funds that
the bank has on hand, then the bank could get into serious trouble. As Diamond and
200 CENTRAL BANKING

Factories
Bank A
Depositors

Banks create liquidity for

Depositors do not want to depositors by allowing
lend directly to businesses depositors to withdraw
or households, since such money at any given time.
lending would be illiquid. Real estate
The process works since
depositors normally have
uncorrelated expenditure
needs.

FIGURE 10.3  A Stylized Diamond-Dybvig Model: A Normal

Functioning Equilibrium

Dybvig point out in their 1983 work cited above, a bank cannot easily call in their
loans in order to raise funds to meet depositors’ demands without incurring signifi-
cant losses, since those loans are long-term.
Indeed, if a large enough portion of depositors demand withdrawal of their
funds at the same time, the bank could simply run out of money and go bankrupt.
Depositors would then have to litigate to recover their funds from the liquidation of
the bank’s assets. In practice, the recovery of funds through litigation could take a
long time, and depositors would have to contend with the possibility that they might
be unable to recover all their funds.
Consequently, if depositors expect that a large proportion of depositors would
want to withdraw their money at the same time, it is rational for all depositors to rush
in and try to withdraw their money. Depositors know that those who withdraw their
money early are likely to have an advantage, since at that time, the bank might still
have enough money on hand to repay depositors. This situation creates a self-fulfilling
prophecy, with all depositors rushing in to be the first to withdraw. (See Figure 10.4.)
According to Diamond and Dybvig, there are thus two equilibriums in financial
intermediation: one is normal functioning, and the other is a bank run. The normal
functioning case would occur as long as depositors expect most other depositors to
withdraw money only when they have real expenditure needs. In such a case, it is ratio-
nal for all depositors to also withdraw only when they have real expenditure needs.53
A bank run, however, can occur whenever depositors expect most other deposi-
tors to rush in and close their accounts. In such a case, it is rational for all depositors
to rush in and close their accounts. The switch from the normal functioning equi-
librium to a bank run could be triggered by multitudes of tangible and intangible
things, including, notably, expectations.

The Banking System as a Network  The groundbreaking model of a bank run proposed
by Diamond and Dybvig in 1983 focused mainly on the case of a run on an individual
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 201

Banks cannot recall loans to businesses

and households easily, since the loan
is often used up in purchasing illiquid
assets or for consumption.

Factories
Bank A
Depositors

If depositors expect that a large proportion of them

would want to withdraw their money at the same time, it is
rational for all depositors to rush in and try to be the first to
withdraw their money, since they know that the bank Real estate
cannot recall loans to repay all of them.

Only those who come while the bank still has money on hand
will likely be repaid on time and in full.

FIGURE 10.4  A Stylized Diamond-Dybvig Model: A Bank Run

bank. Later, researchers started to look at the possibility of a systemic bank run, in
which distress in one bank could be transmitted to other banks through direct and
indirect linkages.
Most prominent among the direct financial linkages are interbank loans, where
banks lend to each other, possibly to meet liquidity needs. Payment systems are also
direct linkages, albeit of a more physical type. With these direct linkages among
banks, the banking system can be examined as a network. A hiccup that affects the
ability of one bank to meet its obligations to another could lead to ripple effects
through the network.
Indirect linkages are also a factor, because banks do often hold similar types of
assets in their portfolios and thus the value of their portfolios will also be affected
by each other’s actions. For example, during a panic, once a troubled bank starts a
fire sale of its short-term assets to raise funds, prices of those assets could fall very
sharply, causing losses in other banks’ portfolios. Other banks might then be forced
to have their own fire sales, which would affect everyone further.
The work of Rochet and Tirole in 1996,54 Allen and Gale in 2000,55 and Freixas,
Parigi, and Rochet56 the same year examined cases where the failure of one bank
or the payment systems triggered a chain of subsequent failures. In 2009, Andrew
Haldane looked at how the financial network had become more fragile in the p ­ eriods
leading up to the 2007–2010 financial crisis.57

Network Resiliency and Network Fragility  Theoretically, connections between banks can
make the banking network more resilient as well as more fragile, depending partly
on linkage structures, diversity of institutions, and the density of activities or concen-
tration of risks in the banking system.
According to Allen and Gale’s 2000 work, in a better connected network—that
is, where the interbank market is complete, meaning that banks of different types
(e.g., commercial banks, investment banks, banks that focus on wholesale lending,
and banks that focus on attracting deposits from savers) are all connected to one
202 CENTRAL BANKING

another—then potentially risks could be better distributed throughout the network.

The proportion of the losses in one bank’s portfolio can be shared by more banks
through interbank agreements.58
In contrast, if the linkages between the banks in the network are incomplete—
that is, banks of different types are not well linked to one another in the interbank
market—the failure of a bank of one type could potentially lead to failures of banks
of the same type, then those of similar types, which could trigger the failure of the
entire network.
In 2009 Andrew Haldane pointed out that the diversity of banks had gradually
declined in the decades before the 2007–2010 financial crisis, owing to the pursuit
of similar business and risk management strategies.59 With less diversity, banks are
more susceptible to the same types of shocks and the banking system as a whole will
be less resilient.
In the same speech Haldane also stated that global and national bank-
ing ­networks had been increasing in density prior to the 2007–2010 crisis, with
large financial hubs becoming more common. With a concentration of activities
in hubs, or in systemically important institutions, the system is likely to be more
fragile, especially when there are shocks to the hubs or the systemically important
institutions.60

Financial Markets: Reasons for Market Failures

In traditional economic analysis, financial markets are portrayed as having many
attributes of the ideal, perfectly competitive market. Entries and exits are relatively
easy, such that no single player can have sustained appreciable effects on prices, and
market information can transmit quite fast and extensively.
The belief that financial markets are, to a great extent, efficient led regulators
to take a more hands-off approach toward financial market regulations. With effi-
cient financial markets, it was believed that market players would be able to make
sound financial transactions based on their preferences and their assessment of risks
as reflected by market prices.
Events relating to the global financial crisis of 2007–2010, however, sug-
gested that financial markets were not as efficient as had previously been believed.
Information asymmetry was indeed pervasive in the financial markets at all levels,
and prices in the financial market therefore did not accurately reflect the underlying
risks of financial market transactions. As Gertler pointed out in his 1988 work, inef-
ficiencies in financial markets could manifest themselves in the behavior of financial
markets and institutions, causing those inefficiencies to be significant factors contrib-
uting to aggregate economic activity.61
In the context of the 2007–2010 crisis, the presence of information asymmetry
implied that risks could be underpriced, and thus market players might be accumu-
lating excessive risks that, taken together, could threaten the stability of the system.
Indeed, as the financial crisis unfolded, the inherent presence of information asym-
metry in the financial markets became clearer. At the height of the crisis, the presence
of information asymmetry also led to various types of failures in financial markets,
such that intervention by the government was needed.
Studies on information asymmetry, which started in the 1960s, suggest at
least four key problems that could be applicable in the understanding of financial
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 203

• Owing to asymmetric
Bank A information, Bank A cannot
distinguish risky borrowers
from safe borrowers, and
thus charges a uniform
Information asymmetry 10.5% interest rate for all
loans.
Lends to risky
borrower
at 10.5%
• The 10.5% rate is the
average of breakeven
Safe Risky
interest rates
borrower borrower
for those two types of
customers.
Invests in a safer project Invests in a riskier project
• Expected returns = 10% • Expected returns = 20%
• Probability of success = 90% • Probability of success = 60% • However, at 10.5% only
• Breakeven interest rate = • Breakeven interest rate = risky borrowers will
(10%*90%) = 9% (20%*60%) = 12% borrow, putting the
bank at greater risk of loss.

FIGURE 10.5  A Stylized Model of Adverse Selection

stability issues, including (1) adverse selection, (2) the principal-agent problem,
(3) moral hazard, and (4) coordination failure. Furthermore, a fifth—externali-
ties—which is a classic factor in market failures, was also found to be a factor in
the financial crisis.

Adverse Selection  Adverse selection refers to situations in which inferior products,

services, or clients are more likely to be selected because buyers and sellers do not
have equal relevant information. In terms of banking, this could occur when a bank
cannot distinguish between safe and risky borrowers, and thus would charge them
the same (average) interest rate. This would deter safer borrowers from borrowing
from the bank, since that rate would be too high to make their safer projects prof-
itable. Only risky borrowers will borrow from the bank, since, if successful, their
projects could still be very profitable. Yet, since only risky borrowers would come
to borrow, and still be charged an average rate rather than the higher rate commen-
surate with their credit risk, the bank is more exposed to risks than it should be.
(See Figure 10.5.)

The Principal-Agent Problem  The principal-agent problem refers to a situation in which

a principal hires an agent but does not have complete information as to whether the
agent will act in the best interest of the principal or in the best interest of the agent.
(See Figure 10.6.)
In the wake of the 2007–2010 global financial crisis, the principal-agent problem
was revealed to be prevalent in many contexts and layers throughout the financial
industry. An example would be investment banks’ compensation packages, under
which the interests of the banks’ managers were not fully aligned with those of
shareholders. As is often the case, a large part of managers’ and traders’ compensa-
tion was bonuses paid according to the banks’ financial performance for the year.
With bonuses tied to yearly performance, managers and traders at investment banks
204 CENTRAL BANKING

Shareholders
(the principals) have the
Shareholders Principal primary objective of
Information asymmetry
a long-term
Board of sustained increase
directors in share values.
Information asymmetry

Investment Bank A
Agent Management and traders
Management
Information asymmetry (the agents) have
an incentive to go for
Traders short-term profits, which
sometimes could come at
the expense of the long-
term sustainability of the
business.

FIGURE 10.6  An Example of Principal-Agent Problem in an Investment Bank

are incentivized to focus on short-term profits instead of the long-term sustainability

of the business. The drive to achieve short-term profits often encouraged the banks’
managers and traders to engage in really aggressive business practices, such as pro-
prietary trading, even though these practices might be too risky for the banks and
their shareholders in the long run.
At a more micro level, Minsky’s argument that bankers are profit-maximizing
individuals who are under pressure to innovate and have incentives to leverage up
their banks for short-term profits also resonates rather well with the events that led
to the 2007–2010 crisis.62 Since then, various authorities in several jurisdictions have
attempted to introduce laws to regulate bankers’ compensation in order to deincen-
tivize bankers from undertaking undue risks, and have also introduced laws to limit
banks’ leverage ratio. In the last section of this chapter, when we review theories of
asymmetric information, we will discuss in more detail the issue of how bankers’
compensation packages might have led them to take undue risks.

Moral Hazard  Moral hazard refers to a situation in which players act more hap-
hazardly once they are insured. Moral hazard occurs because the insurer does not
have the ability to monitor or restrain the actions of the insured once the insurance
contract is implicitly or explicitly made. In banking and finance, popular examples
of the moral hazard problem include those related to deposit insurance and the gov-
ernment’s implicit bailout guarantees for financial institutions. With the presence of
deposit insurance or implicit bailout guarantees, depositors and investors have fewer
incentives to actively seek information or ensure the soundness of the banks or finan-
cial institutions that they deposit or invest their money with. Instead, the depositors
and investors will be more likely to deposit and invest their money with financial
institutions that offer the highest returns, since they know that their deposits and
investments will be covered by deposit insurance or by the government’s implicit
bailout guarantees.

Coordination Failure  The presence of information asymmetry can also lead to coor-
dination failure in the financial markets. In the presence of greater uncertainty, the
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 205

presence of information asymmetry in the financial markets might simply stop trans-
actions among market players. Such a situation occurred and became acute at the
height of the 2007–2010 financial crisis, as banks were unwilling to lend to each
other because no one was certain about the financial health of their counterparties.
In the presence of great uncertainty, information asymmetry means that interest rates
(which reflect the prices of transactions in the financial markets) could not act as a
signaling device for efficient allocation of funds in the financial markets. In that case
those with excess funds to lend can choose to either keep the funds to themselves or
charge prohibitively high interest rates to compensate for unknown risks.

Externalities  Externalities occur when the price of a product does not reflect the
social costs of producing the product. In other words, externalities occur when pri-
vate costs are socialized. In the context of banking and finance, the failure of a large
or systemically important financial institution (SIFI) imposes costs not only on its
depositors, shareholders, employees, and its direct counterparties, but also on other
financial market players and society at large.
The presence of externalities suggests that profits from the transactions of a
systemically important bank accrue only to the bank’s shareholders, employees,
and depositors, while losses from such transactions, if large enough to threaten the
bank’s survival, accrue to all market players and society at large.

CASE STUDY: Information Asymmetry and the Lead-Up to the 2007–2010 Crisis

As the 2007–2010 crisis unfolded, it became clear that prices at which financial transactions had been
done in the lead-up to the crisis were not based on full information. Information asymmetry was pres-
ent at various levels of financial transactions, from simple subprime mortgage lending to sophisticated
derivatives trading. In many ways, it could be argued that the pervasiveness of information asymmetry
in various pockets of the economy helped contribute to the emergence of the crisis.

Adverse Selection
An example of adverse selection in the context of the global financial crisis is subprime mortgage
­lending in the United States. The term subprime is often used for those borrowers who do not have
good credit histories, or have low debt repayment ability. Inquiries found that prior to the crisis, in
order to earn more brokerage fees from mortgage lenders, mortgage brokers had willfully disregarded
subprime borrowers’ ability to pay, in many cases requiring no proof of income or assets from borrow-
ers. Borrowers, in turn, were provided with mortgage loans whose terms were very disadvantageous
to them and were not easy to understand. (See Figure 10.7.)
In this subprime mortgage lending situation, bad mortgage loans were selected for borrowers
who had the least ability to pay. The ultimate outcome was that, as subprime borrowers started default-
ing on their mortgages, mortgage lenders took large losses and many went bankrupt. Apart from
illustrating a case of adverse selection, the above example also points to the principal-agent problem,
another problem related to information asymmetry.

The Principal-Agent Problem

In the subprime mortgage lending example above, we can see that mortgage brokers (agents) did not
act in the best interest of mortgage lenders (principals). Mortgage brokers were paid commissions
by mortgage lenders if they could get borrowers to sign up for mortgage loans. Here, the mortgage
brokers’ interest were misaligned with the mortgage lenders’ interest. Mortgage brokers’ main interest
was to sign up more and more borrowers so that they would get commissions from mortgage lenders.
206 CENTRAL BANKING

• Mortgage brokers, anxious to

Mortgage lender sign on borrowers so they can
get fees, took on subprime
Lends to subprime borrowers without proper credit
borrowers, pays checks.
Information asymmetry fees to broker
• Subprime borrowers, with low
Mortgage broker ability to repay, were lured by the
seemingly attractive but opaque
Information asymmetry Signs up subprime contracts, as well as by rising
borrowers for housing prices.
complicated loan
contracts
• Mortgage lenders added
Prime (safe) Subprime (risky) many more unhealthy
borrowers borrowers subprime loans to their books
than they should have.

FIGURE 10.7  A Stylized Adverse Selection Example: Subprime Lending

This could be done with little regard to the borrowers’ debt repayment ability, as long as the commis-
sions got paid. Mortgage lenders’ main interest, on the other hand, was that borrowers be able to repay
their mortgages.

Moral Hazard
The 2007–2010 crisis also highlighted the fact that investment banks’ compensation packages for
managers and traders were another case of the moral hazard problem. Since managers and traders’
bonuses were often directly tied to profits, it made sense for managers and traders to pursue strate-
gies that were likely to generate the most profits (e.g., buying securities backed by subprime mortgage
securities), even if the strategies were extremely risky. The events before the financial crisis revealed
that if the risky strategies that they pursued succeeded, managers and traders could make m ­ illions.
Since the managers and traders were essentially using other people’s money (the banks’ ­balance
sheets) in the pursuit of their strategies, the most they would lose would not be their own money,
only their jobs, if those strategies ultimately failed. Since managers and traders were largely insulated
from the financial risks they took, they were more likely to pursue riskier strategies in a blind chase for
profits, which could be costly for their banks but not, essentially, for them.

Implications of Market Failures for Financial Stability  As the preceding discussions have
shown, problems such as adverse selection, moral hazard, or the principal-agent
problem can lead to bad outcomes in financial transactions. In the context of finan-
cial stability, it could thus be said that if the prices of financial assets do not reflect all
known information, then such prices also might not accurately reflect inherent risks
of the underlying assets. Owners of those financial assets might be unknowingly
holding assets that are inherently too risky for them. (Think of banks owning bad
mortgage loans or homeowners owning houses they can’t afford, for example.) In
some cases, buyers of financial assets could be just agents for the ultimate owners of
those assets, and could have misaligned interest with those owners. (Think of invest-
ment banks’ managers and traders as agents who bought subprime mortgages that
were put on the banks’ balance sheet, with the banks’ shareholders as the ultimate
owners of the banks, for example.)
Financial Stability: Definition, Analytical Framework, and Theoretical Foundation 207

As players in the financial system accumulate their ownership of mispriced

assets, their financial positions can become extremely shaky without them realiz-
ing it. Taken in the aggregate, if the shaky financial positions of individual players
becomes a big enough problem, it could become a systemic risk and a threat to
the financial system. To deal with information asymmetry in the financial stability
context, hence, at least three broad issues must be addressed: (1) transparency in
financial information, (2) the financial literacy of the population, and (3) alignment
of incentives to correct for potential principal-agent problems.

SUMMARY
Financial stability is a relatively new term, and as such there is not yet a single, quan-
tifiable definition that is widely agreed upon, unlike, for example monetary stability,
which could be defined as low and stable inflation.
Definitions of financial stability often encompass many elements, including the
smooth and effective functioning of the financial system, the low probability of
default, the absence of stress and disruptions in the financial system, and the absence
of major financial imbalances in the economy.
To make the analysis more tractable, this book uses an analytical framework
divided into three key interrelated areas of financial stability: the macroeconomy,
financial institutions, and financial markets. Such a framework helps group frag-
mented theories with regard to financial stability, and also corresponds well with
modern central banks’ institutional setups.
Theoretically, threats to financial stability might occur in the macroeconomy
through the interaction between real economic activity and financial activities. Easy
money conditions could encourage more speculative activities, which can turn into
asset price bubbles and economic instability. The work of Gurley and Shaw in 1995,
Kindleberger in 1978, and Minsky in 1986 provides insight into this phenomenon.
According to the 1983 work of Diamond and Dybvig, a bank is inherently prone
to a run, since it takes in deposits that are very liquid but lends out the funds into
illiquid projects. The banking system network can promote the resiliency as well as
the fragility of banks, depending on the linkage structures, the diversity of banks,
and the density of banking activities (see, for example, the 2000 work of Allen and
Gale, and the 2009 work of Haldane).
In theory, if financial markets function efficiently, then prices in the markets
should reflect inherent risks. The inherent information asymmetry of the type pointed
out by Akerloff in 1970 and Stiglitz and Weiss in 1981, however, can lead to moral
hazard, adverse selection, externalities, coordination failures, and principal-agent
problems, which imply that financial market prices might not reflect inherent risks.

KEY TERMS
adverse selection externalities
asset price bubbles financial network
bank run financial stability
coordination failure hedge finance
credit risk information asymmetry
208 CENTRAL BANKING

macroeconomy principal-agent problem

moral hazard probability of default
nonmoney financial assets speculative finance
Ponzi finance systemic bank run

QUESTIONS
1. Why could there be diverse views as to the definition of financial stability?
2. Give examples of different views on the definition of financial stability. What
elements might be common among these views?
3. How might stability in the macroeconomy, financial institutions, and financial
markets be related?
4. Does a central bank with no bank supervisory function have a role in maintaining
financial stability? Why or why not?
5. How could weaknesses in households, firms, or the government’s balance sheets
affect stability of the macroeconomy?
6. Why might a central bank need to be mindful of the proliferation of new
nonmoney financial assets?
7. What could be theoretical reasons that nudged central banks to put less focus
on financial factors relative to monetary factors before the 2007–2010 global
financial crisis?
8. With reference to Minsky’s 1986 book, is the macroeconomy inherently stable
or unstable? Why or why not?
9. Why might overindebtedness of economic agents lead to financial instability?
10. Referring to the Diamond-Dybvig model, why might a bank run be a facet of an
equilibrium state of banking?
11. How might an increase in connectivity among banks increase resiliency of a
banking system?
12. How might an increase in connectivity among banks reduce resiliency of
a banking system?
13. In terms of interconnectedness among banks, what are direct exposures?
14. In terms of interconnectedness among banks, what are indirect exposures?
15. Why might troubled banks and firms cause stress and disruption in financial
markets?
16. Give an example of the principal-agent problem in the run-up to the global
financial crisis.
17. Give an example of moral hazard problem in the run-up to the global financial
crisis.
 CHAPTER 11
Financial Stability
Monitoring and Identifying Risks

Learning Objectives
1. Identify key indicators that central banks use in monitoring risks
in the macroeconomy that are threats to financial stability.
2. Identify key indicators that central banks use in monitoring risks
in the financial institutions system that are threats to financial
stability.
3. Identify key indicators that central banks use in monitoring risks
in financial markets that are threats to financial stability.

S uccessful maintenance of financial stability requires (1) monitoring and identify-

ing risks and (2) intervening to reduce risks when necessary. In this chapter we
discuss a variety of ways the central bank can monitor and identify risks to financial
stability.
In line with the analytical framework discussed in Chapter 10, this chapter first
reviews some of the basic tools for monitoring and identifying risks in the three
interrelated areas of financial stability, namely (1) the macroeconomy, (2) financial
institutions, and (3) financial markets. By grouping the monitoring tools into the
three interrelated areas, it is hoped that readers will be able to grasp the concepts
behind the tools and their interrelations more readily. In the real world, there are
often multitudes of risks and contagion channels that can lead to financial instability,
yet they are not easily disentangled or addressed by any one particular tool. At the
end of the chapter we also look at some of the approaches in risk monitoring and
risk identification that use data from the three areas of financial stability in a more
integrated way.*
Note that although after the global financial crisis of 2007–2010 a lot of research
effort was put into developing monitoring tools and a framework for financial

*It should be noted here that the discussion presented in this chapter aims to provide an over-
view of the tools that are relatively widely available and does not get deeply into technical
details. Those interested in researching technical details can refer to the Notes section.

209
210 CENTRAL BANKING

stability, these tools and the framework used for the identifying and monitoring of
risks to financial stability are still very much a work in progress.1 As in any human
endeavor, there is still ample room for refinement and improvement.
Furthermore, it should be noted that there is no one-size-fits-all, standard tool-
kit. Determining the appropriate tools to use in a particular situation depends on
the circumstances of a particular economy, including its structure, stage of financial
development, and regulatory regime.

11.1 MONITORING AND IDENTIFYING RISKS IN THE MACROECONOMY

As discussed in Chapter 10, events in the macroeconomy, possibly driven by the

interaction between financial activities and economic activity, can lead to financial
instability. As the economy enters into a protracted growth period, there is a ten-
dency for agents, whether households or firms, to take on more debt in order to
finance projects with rosy economic prospects. Heavy debt loads, however, mean
that there is a greater possibility that these economic agents will be unable to repay
their debts when an economic downturn arrives.
When households or firms face difficulties repaying debt, financial institutions
may have to absorb losses on their balance sheets. If the losses are large (or are
believed to be large) enough, then the solvency of the financial institution might come
into question. This raises the possibility of a bank run, or even a systemic bank run if
interbank exposures are large or when financial institutions have similar exposures.
Resulting liquidity squeezes could also lead to breakdowns in financial markets.
History has also shown that heavy debt loads in government (as opposed to
those of private sector agents, such as households and firms) can also lead to finan-
cial instability. When a government has difficulty repaying debt, it might be unable
to finance expenditures for things like employee payrolls and procurement contracts
made with private sector firms, which would have ripple effects throughout the
economy. This situation could be especially acute if the government has been rely-
ing mainly on borrowing foreign currency to finance its expenditures. Figure 11.1
shows factors in the macroecomony that may affect financial stability not only in the
macroeconomy itself, but also in financial institutions and financial markets through
interrelated areas.
To monitor and identify financial stability risks in the macroeconomy, the cen-
tral bank might want to look at the balance sheet of different groups of economic
agents (e.g., households and firms), as well as that of the macroeconomy itself.
Overindebtedness by any of the key agents of the real economy (households, firms,
and the government), as well as overindebtedness of the economy as a whole to
external creditors could lead to financial imbalances that weaken the financial sec-
tor and ultimately lead to financial instability. Although overindebtedness of agents
might be difficult to identify, the central bank might also consider adopting the gap
measurement approach advocated by Claudio Borio and Philip Lowe in two sepa-
rate papers published in 2002, whereby the actual level of credit to GDP is compared
to its historical trend as a rough indicator of agents’ degree of indebtedness.4
In addition to monitoring the indebtedness of economic agents, the central bank
might also want to monitor and identify risks from the asset side of the economy.
Fast-rising asset prices, such as those in stock and real estate markets, could indicate
Financial Stability: Monitoring and Identifying Risks 211

Financial imbalances
• Overindebtedness of
economic sectors
(households, firms,
the government, and the
external sector)
Areas of Macroeconomy • Asset price bubbles
concern for
financial Area of
stability concern for
financial
stability
Financial Financial
institutions markets

Area of concern for financial stability

FIGURE 11.1  Financial Stability Issues in the Macroeconomy

the possibility of widespread speculation in asset prices and possible asset price
bubbles. Speculation in asset prices often induce more and more players to take on
heavy debt loads in order to bid for assets. If asset prices rise to levels that are far
above those justified by their fundamentals, then it is also likely that buyers of those
assets have taken on debt loads at levels not justified by their fundamentals. Once the
economy starts to cool and asset prices start to drop, these buyers could be left with
unserviceable debt loads that lead them to default.
Using data from many economies that used a variety of policy regimes, Borio and
Lowe3 and Borio and Drehmann4 found that the coexistence of fast growth in credit
and asset prices often proceeded banking crises. This suggests that the fast growth of
credit will indicate a low capacity on the part of economic agents to absorb shock
(i.e., a sustained rise in credit suggests that economic agents have racked up too
much debt), while a fast rise in asset prices might indicate a high degree of asset price
misalignment. To monitor and identify financial stability risks in the macroeconomy,
the central bank thus needs to look at the possibility of overindebtedness on the part
of each economic agent, the possibility of overindebtedness in the overall economy,
and the movement of asset prices.

The Household Sector

At the most basic level, the central bank might want to look at the rate of growth of
overall household debt and the composition of that debt (mortgage, credit card, and
auto loans, for example). Data on household debt might come from various sources,
including loans granted to individuals and households by financial institutions and
comprehensive household surveys.
A fast rise in the level of household debt, even when accompanied by a simi-
lar rise in household income or household wealth, might warrant attention by the
central bank. Experience from the global financial crisis has shown that fast-rising
mortgage debt, even when accompanied by fast-rising household wealth (itself due
212 CENTRAL BANKING

to fast-rising stock and housing prices), can lead to financial instability when the
economy slows down or when housing prices start to drop.
Financial ratios, such as household debt to GDP and household interest
payments to income, as well as the growth in various types of credit extended to
households (e.g., credit card loans, auto loans, and mortgages), can be useful in
assessing household indebtedness. Such data might come from surveys at the micro
level, coupled with data from financial institutions and macrolevel data. Although
there is no hard and fast rule to determine exactly the point at which these ratios or
growth rates could reflect overindebtedness, a fast rise in these measures could be a
reason for concern. Historical experience coupled with cross-country analyses could
also help determine if there is a cause for concern.
In addition, the central bank might also consider adopting a gap measure
approach along the lines of that proposed by Borio and Lowe in 20025 and Borio
and Drehmann in 20096 to analyze whether a given rise in household debt should
raise concern. For example, the ratio of household debt to GDP might be compared
to its historical trend; a large gap between the current ratio of household debt to
GDP and the historical trend might warrant more concern. The central bank might
also want to see whether the rise in housing prices deflated by GDP is much beyond
its historical trend, in order to evaluate the degree to which the household sector
might be exposed to risk accumulation in housing prices.

The Corporate Sector

Similarly to the household sector, at the most basic level the central bank needs to
look at the growth rate of corporate sector debts to monitor and identify risks in
the corporate sector. Pertinent data would include loans to the corporate sector by
financial institutions as well as bond issuance by the corporate sector itself.
The dot-com bubble in the early years of the twenty-first century suggests that
fast-rising corporate debt, even in the midst of an economic boom and rosy economic
prospects, should be closely monitored. During an economic boom, firms might decide
to use borrowed funds to undertake large capital investments with rosy economic
prospects. Large capital investments, however, often take time to pay off, and thus
once the economy slows, firms might find it difficult to repay their large debt loads.
In addition to looking at the growth rate of corporate debts, the central bank
might find it useful to also examine the components of corporate debt, for example,
whether the loans are short-term or long-term and whether they are denominated
in local or foreign currencies. At a more nuanced level, the central bank might also
want to look at various key financial ratios—for example, debt-to-income, debt-to-
capital, and interest payments-to-income—to assess whether the corporate sector is
overindebted. To have a more complete picture, such assessments would need to be
done at both the micro and macro levels, and could be considered in a time-series
context as well as using a cross-country comparison. The same gap measurement
approach used for the household sector could also be applied to the corporate sector.

The Government Sector

At the most basic level, the central bank needs to assess the growth of public debt,
or debt for which the government is liable, to monitor and identify financial stability
Financial Stability: Monitoring and Identifying Risks 213

risks from the government sector. Fast-rising public debt might threaten fiscal sus-
tainability, that is, the ability of the government to repay debt without resorting to
a debt default. A debt default by the government would have far-reaching reper-
cussions on financial stability. Banks, pension funds, and mutual funds often hold
government securities as a staple in their portfolio holdings. A default by the govern-
ment would devalue portfolios of these entities considerably. Furthermore, interest
rates for private sector loans are often benchmarked against the yields of so-called
risk-free government debt. A debt default by the government could make interest
rates in the economy become very volatile and disrupt the financial intermediation
process in the economy.
In addition to public debt growth data, ratios of public debt to GDP and the
government debt repayments to total government expenditures are among the most
useful indicators for a fiscal sustainability assessment. Here the gap measurement
approach might be used to measure how the public debt-to-GDP ratio might have
deviated from its historical trend. To be comprehensive, however, the central bank
might also need to examine the composition of public debt, such as the currency of
debt denomination and debt maturity. Government debt denoted in a foreign cur-
rency requires that the government have enough of that foreign currency to repay
the debt when it becomes due. Local currency denominated debt, however, is easier
to roll over, or refinance, by new debt issuance.
In certain cases, the central bank might also need to look at the growth of
the government’s contingent liabilities, that is, those liabilities that might not cur-
rently be on the government’s balance sheet but ultimately must be financed by the
government when the need arises. Examples of contingent liabilities include every-
thing from future public healthcare liabilities to the debt of government-owned
enterprises.
In addition to balance sheet data, it might also be useful to look at the coun-
try’s sovereign debt ratings, as well as the difference (or spreads) between the yield
of securities issued by the government and the yields of those issued by another
country whose bonds are used as an international benchmark (such as the yields
of securities issued by the U.S. and the German governments, which are considered
international risk-free, or safe-haven, rates). The experience of the European sover-
eign debt crisis in the early 2010s showed that when fiscal sustainability is in doubt,
a drop in the country’s sovereign rating combined with a rise in the spread between
the government yield and the yield of a safe-haven benchmark can make refinancing
of existing government debt very difficult, making an actual government debt default
more likely. Another key variable that might warrant being closely monitored is the
movement in the yields of credit-default swaps (CDS) of the country’s sovereign
debt, which are essentially an insurance premium on the government securities of
the country.

The External Sector

A fast rise in debt owed to external creditors can also represent a grave threat to
financial stability. The experiences of the 1990s in Asia and Latin America have
shown that a fast rise in external debt (as also reflected in a fast rise in capital
inflows) could ultimately lead to concurrent currency and banking crises. Fast rising
capital inflows can easily find their way into stock market and real estate speculation,
214 CENTRAL BANKING

fueling asset price bubbles. When asset price bubbles start to burst, capital flights can
occur promptly, putting tremendous downward pressure on domestic currency. In
a fixed exchange rate regime, if the central bank does not have enough reserves to
satisfy those wishing to pull their capital out, then it might be forced to allow the
currency to be devalued. The currency devaluation could cripple the ability of agents
in the economy to repay their foreign currency debts, especially if the agents’ income
was mainly from domestic sources. Meanwhile, the domestic banking sector would
also likely be suffering from their exposures to asset price bubbles.
To monitor and identify financial stability risks in the external sector, the central
bank will need to look at both the growth and level of external debt incurred by
various agents of the economy, as well as the currency and maturity profiles of that
debt. Capital flows data will also need to be closely monitored. Useful indicators
for assessing the sustainability of foreign debt would include the ratio of short-term
debt to international reserves holdings, the degree of currency mismatch of the debt
and the source of income to finance that debt, the degree of maturity mismatch of
the debt (are short-term foreign currency debts being incurred to finance long-term
local projects?), as well as the net open currency positions of the debt (the degree of
foreign currency debt not being hedged for currency risk).7

Asset Price Bubbles

Apart from the overindebtedness of economic agents, financial stability concerns can
be indicated on the other side of the economy’s balance sheets by fast-rising asset
prices. Fast-rising asset prices, such as those for real estate or stocks, could indicate
that speculative activities are ongoing and becoming prevalent. A prevalence of specu-
lative activities could reflect inherent instability in the financial system, since specula-
tion often involves borrowing to invest in assets with the expectation of fast capital
gains. (The fast rise in prices does not necessarily reflect the fundamental value of
the assets.) Once the asset prices drop back to reflect their fundamental values, those
who borrowed to invest in the assets could face an overindebtedness problem, since
the value of the assets might be lower than the debt that they incurred when purchas-
ing the assets.
At the most basic level, the central bank needs to look at the growth rate of real
estate and stock market prices, as they are easily subject to speculation. In monitor-
ing and identifying financial stability risks from asset prices the increase in loans
related to these markets also needs to be closely monitored. Although it is very
difficult to judge ex ante whether prices in these markets have risen much beyond
fundamentals and are exhibiting signs of bubbles, comparisons with historical aver-
ages and across countries could provide some useful hints. As noted previously, Borio
and Lowe8 and Borio and Drehmann9 have suggested using the gap approach by
comparing the real (i.e., inflation adjusted) asset price to its historical trend (possibly
as represented by a statistically smoothed long-term trend line, such as the Hodrick-
Prescott filter whereby the short-term cyclical fluctuations are removed from a time
series data, leaving only the long-term trend line of the variable).
For the real estate market, one might also need to look at different segments of
the market separately, as speculation might be concentrated primarily in particular
types of real estate (e.g., housing versus commercial real estate, luxury condomini-
ums versus stand-alone houses, etc.), or in particular geographic areas. For the stock
Financial Stability: Monitoring and Identifying Risks 215

market, key indicators other than prices include price-earnings (P/E) ratios, for the
market as a whole as well as for different segments of the market.

The Link between the Macroeconomy and Financial Stability

Historically, experiences worldwide have shown that if any of the aforementioned
sectors in the real economy experience difficulties in debt repayment, or when asset
price bubbles started to burst, the financial sector will often also find itself in trouble.
Financial institutions that lent to those troubled sectors will have to absorb losses as
default rates rise. They might also need to cut back on lending and call in existing
loans. Meanwhile, activity in the financial markets could stop, as financial institu-
tions are often the key players in the financial markets. As financial institutions cut
back on lending and liquidity in the financial markets dries up, economic activity
could contract or slow down, which would weaken debt repayment ability in the
economy further.
Papers by Borio and Lowe10 and Borio and Drehmann11 have shown empirically
that strong increases in credit and asset prices have tended to precede banking crises.
Strong increases in credit and asset prices can signal accumulation of risks in the
system. Strong credit growth can indicate that economic agents are heavily indebted
and thus have low capacity to absorb shocks, while strong growth in asset prices can
reflect a greater degree of price misalignment. In such a situation, a shock to asset
prices could propel the system into a crisis.

11.2 MONITORING AND IDENTIFYING RISKS

TO FINANCIAL INSTITUTIONS

In monitoring and identifying financial stability risks that might arise from financial
institutions, one must look at both individual institutions and the financial institu-
tions system as a whole. In a world in which financial institutions are increasingly
connected with each other through both direct and indirect exposures, contagion
among financial institutions and systemic bank runs are very possible. Figure 11.2
shows factors relating to financial institutions that may affect financial stability not
only in the institutions themselves, but also in the macroeconomy and financial mar-
kets through interrelated areas.

Key Types of Risks to Individual Financial Institutions: Credit, Market,

Liquidity, and Operational
As discussed earlier, if agents in the macroeconomy are already overindebted and
finding it difficult to repay their loans, financial institutions might have to absorb
losses. If the losses are believed to be so large that they threaten to wipe out a large
part of the bank’s capital, then the bank’s financial position could be seriously jeop-
ardized, and there could be a run on the bank. The risk that the bank’s debtors or
counterparties might be unable to repay their debts in the manner specified in the
loan contracts, or fulfill their obligations to the bank, is part of what is known as
credit risk.
216 CENTRAL BANKING

Major risks to individual

institutions
• Credit
• Market
• Liquidity Macroeconomy
• Operational
Systemic risk
• Direct exposures
• Indirect exposures
Area of
concern for
Areas of Financial Financial financial
concern for institutions markets stability
financial
stability

Area of concern for financial stability

FIGURE 11.2  Financial Stability Issues among Financial Institutions

Risks to financial institutions, however, can come not only in terms of credit risk,
but also in many other forms, including market risk, liquidity risk, and operational
risk. Market risk arises when movements in market rates and prices (such as inter-
est rates, foreign exchange rates, and equity prices) adversely affect the institution’s
financial position. Liquidity risk arises from the possibility that an institution would
not be able to meet its obligations as they come due (possibly because it cannot liqui-
date assets or obtain adequate funding), as well as the possibility that an institution
would not be able to unload its holdings without significantly lowering the market
prices of the assets and incur large losses, owing to the dearth of market players dur-
ing market disruptions. Operational risk arises from the possibility that operational
problems (e.g., breaches in internal controls, fraud, or unforeseen catastrophes) will
lead to unexpected losses for an institution.12

Assessing Individual Institutions’ Risks

Traditionally regulatory authorities have assessed individual institutions’ safety
and soundness by examining the institutions’ CAMELS (as discussed in Chapter 3,
CAMELS stands for capital adequacy, asset quality, management, earnings, liquidity,
and sensitivity to market risk). As banking activities and financial institutions
became more complex (for example, through the addition of overseas subsidiaries
and branches as well as a more prevalent use of complex derivatives), however, regu-
latory authorities recognized that examinations of financial institutions must place
greater emphasis on the institutions’ risk management practices and internal con-
trols. At the same time it should be noted that the failure of a single or even a couple
of financial institutions may not necessarily cause serious threats to the stability of
the system as a whole, provided the failed institutions are not large or systemically
Financial Stability: Monitoring and Identifying Risks 217

important. Indeed, in the United States many small banks are allowed to fail each
year and are not rescued by the government.

Monitoring and Identifying Risks in the Financial Institutions System

The recent financial crisis has reemphasized the need for the monitoring and identi-
fication of risks inherent in the system of financial institutions, in addition to those
related to individual institutions.13 This is partly due to the fallacy of composition
problem: the seemingly robust health of individual financial institutions might not
reflect the true health and resiliency of the system as a whole, owing to complexities
of interrelationships, processes, and interactions among the individual institutions
themselves.
For example, while each individual financial institutions might seem to have a
high enough capital buffer to deal with shocks in normal times, when panic actually
arises it might be rational for these individual institutions to stop lending and bor-
rowing activities among themselves, which, in turn, would heighten credit and liquid-
ity risks for the system as a whole. The problem could easily be exacerbated when, in
response to the heightened risks, all institutions might at the same time attempt to do
a fire sale of their assets (to preempt or to arrest marked-to-market losses or to raise
capital), thereby lowering the prices of everyone’s assets.
The techniques for monitoring and identifying systemic risk in the financial system
are still in the early stages of development. Among the approaches that have gained
attention in the wake of the recent global financial crisis are those that target risk dis-
tribution within the financial network, and risk concentration in systemically impor-
tant financial institutions (SIFIs). (See for example, the 2009 work of Segoviano and
Goodhart,14 the 2011 work of Minoiu and Reyes,15 the 2010 work of Chan-Lau,16
and the 2011 and 2012 reports from the Basel Committee on Banking Supervision.17)

Risk Distribution within the Financial Network

The financial system can be seen as a type of network, where financial institutions
(banks and nonbanks) interact by borrowing and lending among themselves. The
network can help promote resiliency of individual institutions by enabling those
short of liquidity to tap funds from those with excess liquidity.18 As discussed in the
previous chapter, however, the network can also lead to risk contagion across institu-
tions, whether through direct balance sheet exposure or through indirect exposure,
such as through common types of assets in portfolio holdings.
As the 2007–2010 financial crisis has shown, as the network becomes more
complex, risk contagion can come through multiple channels, including breakdowns
in interbank lending and the fire sale of assets that lead to more losses on the banks’
portfolio holdings. Opacity of information regarding linkages within the network
tend also exacerbate the problem, since it makes it difficult for financial institutions
and regulatory authorities to locate exactly where the risks actually lie and who is
severely exposed, and thus makes it difficult to contain the problem.
To gain a more complete picture of how risks are distributed within the financial
system, network analysis techniques have increasingly been applied to the finan-
cial system. It is believed that network analysis, which has previously been done in
fields as diverse as medicine (disease contagion), ecology (ecological systems), and
218 CENTRAL BANKING

engineering (electrical power grids), can help in identifying and mapping the linkages
(direct and indirect) among various financial institutions within the network.19
By constantly monitoring (direct and indirect) linkages and financial institu-
tions within the financial network, it is expected that the authorities would be able
to better understand risk propagation and distribution within the financial system.
Currently, developments in this area are still in an early stage, as the researchers and
regulatory authorities are still grappling with issues related to the data that will pro-
vide a more complete picture of the system’s linkages and how risks might proliferate
among financial institutions in the system. (See, for example, the 2009 paper from
Segoviano and Goodhart.20)

Risk Concentration: Systemically Important Financial

Institutions (SIFIs)
Complementing the network analysis approach whereby risk distribution within the
financial system can be mapped out, the authorities also need to assess the systemic
importance of each individual financial institution (banks and nonbanks). Since the
failure of a systemically important financial institution (SIFI) could threaten the whole
system, it could be said that systemic risk is inherent to and concentrated in risks to
individual SIFIs. To monitor and identify system risk, the authorities thus need
to monitor and identify risks exposure in SIFIs.
Prior to the failure of Lehman Brothers in 2008, the notion of risk concentra-
tion in the banking system was deemed to be largely typified by the concept of too-
big-to-fail. A too-big-to-fail financial institution is one whose size is so large that
regulatory authorities would always come to its rescue, since its failure could cause
the system to collapse. Since then, the notion has grown to encompass the concepts
of too-connected-to-fail and systemically important financial institutions (SIFIs).21
When Lehman Brothers, a medium-sized global investment bank, was allowed to
fail in the midst of the global financial crisis, worldwide financial panic and stresses
threatened to cause a collapse in the financial system. With the benefit of hindsight,
we can see that although Lehman Brothers was not necessarily the largest bank, its
deep and extensive linkages to other financial institutions and markets around the
world meant that the failure of this one medium-sized bank could threaten the sur-
vival of the whole system.
Recognizing now that systemic risk can be concentrated within certain systemi-
cally important, core financial institutions (whether termed “too big” or not), in the
wake of the financial crisis researchers and authorities have been searching for ways
to identify and assess financial institutions with systemic importance. In 2011 and
2012 the Basel Committee for Banking Supervision (BCBS) came up with guidelines
to assess the systemic importance of individual institutions, both at the global level
(i.e., Global Systemically Important Banks, or G-SIBs) and the domestic level (i.e.,
Domestic Systemically Important Banks or D-SIBs).22
To help identify G-SIBs, BCBS’s 2011 report proposed five broad categories of
indicators, including size, interconnectedness, lack of readily available substitutes,
cross-jurisdictional activity, and complexity. Using these five categories of indicators,
the report identified 25 financial institutions as G-SIBs. For D-SIBs, BCBS’s 2012
report deemed that the actual identification was best be done by national authori-
ties, since the classification would depend a lot on the country-specific context. The
principles provided by BCBS for national authorities involved four categories of
Financial Stability: Monitoring and Identifying Risks 219

indicators, which mirrored those for G-SIBs except for cross-jurisdictional activity,
which was subsumed into the complexity category.23
In identifying D-SIBs, central banks would learn more about how risks were
concentrated in their domestic banking systems and therefore monitor and assess
risk more effectively. The identification of G-SIBs, meanwhile, would help regula-
tory authorities become better at identifying and monitoring their banking systems’
exposures to risks from global systemically important institutions.

CASE STUDY: Macro Stress Testing

Macro stress tests have been getting more and more attention since the middle of the first decade of
the twentieth century. Macro stress tests are tests done to assess how financial institutions as a system
would fare under adverse macroeconomic conditions. In conducting macro stress tests, regulatory
authorities first make assumptions about plausible extreme adverse macroeconomic scenarios and cor-
responding movements of pertinent macroeconomic variables, such as GDP growth, inflation, and inter-
est rates. Then assumptions about these macroeconomic variable movements are used in econometric
or other types of relevant models to map how the movements would likely affect the institutions’ finan-
cial positions; for example, through default rates, earnings, and the price of assets in the institutions’
portfolios. Very importantly, feedback loops among the institutions such as counterparty credit risk and
liquidity risk would also be taken into account before arriving at the final outcomes.24
Ideally, macro stress tests will be useful in helping regulatory authorities to determine the safety
and soundness of financial institutions as a whole. However, the development of macro stress testing
techniques was still in its infancy when the 2007–2010 crisis struck. There was still a lack of under-
standing of the interconnectedness among financial institutions, partly because of the growing com-
plexities of banking activities but also because of the rise of shadow banking. Although ever-evolving
activities in the financial sector could potentially dampen the success of macro stress tests in predict-
ing an oncoming crisis, regulatory authorities have recently found the use of macro stress tests as a
potent communication tool to alleviate panic after a crisis has actually occurred.
U.S. authorities used stress tests to determine the soundness of the largest U.S. banks right
after the 2007–2010 global financial crisis. While results from the tests suggested that some banks
had inadequate capital to deal with further shocks and would have required extra funding, they also
suggested that most of the banks were in sound condition and that the extra funding that would have
been required was at manageable levels. In this sense, apart from determining the ability of the banks
to deal with further stress in the wake of the crisis, the tests were used as a tool to communicate
with the public so that ungrounded fears would not turn into panics. Following the U.S. success,
authorities in the euro area also used macro stress test results to shore up public confidence in
European banks in the wake of Europe’s sovereign debt crisis.
In a post-crisis world, U.S. authorities have also calibrated macro stress tests for use as a pre-
emptive tool in sustaining financial stability. Banks that do not pass the macro stress tests given by the
Federal Reserve will not be allowed to raise dividend payments or to do a stock buyback.25 The aim is
to encourage both the shareholders and the management of the bank to be more mindful of the risks
they are taking.
Despite the growing profile of macro stress testing, Claudio Borio and Mathias Drehmann have
warned central bankers not to let macro stress testing lull them into a false sense of security. According
to their 2009 paper, potentially problematic issues of macro stress testing include the fact that (1)
traditional macroeconomic models often do not well enough incorporate financial variables, (2) the
source of shocks in macroeconomic models often come from macroeconomic variables, but shocks
to the financial system would not necessarily come from macroeconomic factors, (3) the relationships
between macroeconomic risk factors and credit risk are still often poorly modeled, and (4) important
items that might be crucial to financial institutions sometimes are not included in the financial institu-
tions’ balance sheets (e.g., off-balance-sheet commitments).26
220 CENTRAL BANKING

11.3 FINANCIAL MARKETS

Financial market indicators can provide useful information on the degree of risk
accumulation as well as the degree of stress and disruption in the financial sector.
Indicators of risks in the financial markets can often be extracted from transac-
tion data in the financial markets, whether they are movements in prices and yields
of financial products, or net positions of market players. Frequent transactions in
financial markets mean that, in many cases, these indicators could reflect conditions
in the financial system almost on a real-time basis. Figure 11.3 shows factors relat-
ing to financial markets that may affect financial stability not only in the markets
themselves, but also in the macroeconomy and financial institutions through inter-
related areas.

Prices and Yields

Despite the presence of information asymmetry in financial markets, prices and yields
of financial products (such as stocks, bonds, currencies, and money market loans)
and financial derivatives (such as credit default swaps) should reasonably reflect
publicly available information on those products. Unusual movements in prices and
yields of financial products would thus signal to the central bank threats to financial
stability that might arise from financial markets.

Risk Accumulation  As discussed earlier in the chapter, fast-rising prices of equity,

when taken together with credit growth, could reflect the risk accumulation that
comes with speculative activities and asset price bubbles.27 In general, fast increases
in prices of financial products—whether stocks, bonds, or securities backed by sub-
prime mortgages—can draw in more and more market player participation during
the price run-up.
In bidding for even higher returns, market players often fund their purchases
of financial products using leverage (i.e., borrowed money). As long as prices of the

Chains of default might

come from
• Market disruptions/
Macroeconomy
liquidity freezes
• Large and extreme price
swings
Areas of
Area of
concern for
concern for
financial Financial Financial financial
stability institutions markets stability

Area of concern for financial stability

FIGURE 11.3  Financial Stability Issues in Financial Markets

Financial Stability: Monitoring and Identifying Risks 221

products keep rising, players are tempted to pile on even more leverage to buy more
products, possibly by using the products themselves as collateral for more borrow-
ing. The greater degree of leverage could expose market players and their lenders
to tremendous losses once prices start to drop. In a speculative asset price bubble,
prices of financial products can rise far beyond levels justified by their economic
fundamentals, and thus the greater degree of leverage would lead to even more
severe losses.
In practice, although it is difficult to determine ex ante if prices of financial
products have risen beyond their economic fundamentals or not, it is crucial that
the central bank examines unusually fast run-ups in prices of financial products very
closely, even if the central bank itself does not trade in those products.

Stress and Disruption  While fast run-ups in prices of financial products could reflect
a rising degree of risk accumulation in system, rising volatility in financial product
prices could reflect a rising degree of stress and disruption in the financial markets.
As financial market prices should reflect publicly available information relating to
the markets, rising price volatility suggests that market players are not very certain
about the quality of information that they have and are very sensitive to new infor-
mation. With such uncertainty, market players might be willing to trade financial
products only at extreme prices (to hedge for missing information) or simply stop
trading. The stress and disruption in financial markets would affect not only market
players, but are likely to have ripple effects through the financial system and the
economy at large.
In practice, there are two key measures of price volatility: historical volatility,
which is calculated from historical price data, and option-implied volatility, which is
calculated from option prices of their underlying financial products when options on
those products are available. For both measures, rising volatility of financial market
prices would reflect a rising degree of uncertainty and the resulting stress and disrup-
tion in the financial markets.

Spreads
In financial market terms, a spread often refers to the difference in yields of two
types of financial products. An example would be a spread between corporate and
government bond yields of the same maturity, which means the difference in the
yields of these two bonds.

Risk Accumulation  As a rule of thumb, yields of riskier products (such as corporate

bonds) are supposed to be higher than those of less risky or risk-free products (such
as government bonds), since buyers of riskier products demand higher yields as a
premium to compensate for the extra risks that they take. The spread between the
yields of riskier and less risky financial products is also known as credit spread (with
reference to credit risk). When times are good, the spreads between the yields of risky
and risk-free products are likely to be narrow. This is because in good times, even
riskier projects have a lower chance of failure, and buyers of the riskier products
would demand a smaller risk premium.
When the spread between the yields of riskier and risk-free products have
become very narrow for a long period of time, however, risk accumulation in the
222 CENTRAL BANKING

economy might have also appreciably risen. With low credit spreads, funding of
riskier projects would be easier than otherwise. The number of riskier projects
undertaken in the economy might be more than optimal. This was what happened
in the global financial markets prior to the global financial crisis of 2007–2010,
when the credit spread remained compressed for a considerable period of time.
Borio and Drehmann28 termed a situation in which credit spreads are low, while
credit growth and asset prices are increasing quickly, as the paradox of financial
stability.
In practice, there is no established rule to determine if a spread is too narrow
or too wide. The central bank often compares the existing levels of credit spread
to their historical level and analyzes them together with other financial market
indicators.

Stress and Disruption  In contrast to the situation just described, when times are bad,
the spreads between yields of risky and risk-free financial products would likely
widen. The chance of failure of a riskier project would thus also rise. Buyers of
riskier products during such periods would demand a much higher risk premium if
they were to take on extra risks. This raises funding costs for projects, and further
raises the chance of actual project failures. In extreme conditions, such as during the
European sovereign debt crisis in the early 2010s, the spreads of riskier Greek gov-
ernment bond yields and less risky German government bond yields had widened so
much that the Greek government was unable to refinance its bonds and had to seek
international assistance.
During the 2007–2010 crisis, the widening of the Libor-OIS spread was also a
key important barometer of stress and disruption, as it could reflect credit risk in the
banking system, the market’s perception of risk endemic in the economy, as well as
liquidity risk in financial markets (see “Case Study: Libor-OIS Spread as an Indicator
of Stress and Disruption” in details).

CASE STUDY: Libor-OIS Spread as an Indicator of Stress and Disruption

During the 2007–2010 crisis, Libor-OIS spread became another important financial variable to monitor
as it reflected credit risk of the banking system, as well as liquidity risk in financial markets.

Libor Rate
Libor, or London interbank offered rate, is the interest rate that major banks in London agree to lend
among themselves, without collateral. Libor is calculated for 10 currencies, with fifteen maturities
ranging from overnight to one year. Libor is a popular benchmark used in calculating short-term fund-
ing costs among banks as well as other financial market players.29

Overnight-Indexed-Swap (OIS)
OIS, or overnight-indexed-swap, is a fixed/float interest rate swap, whereby a counterparty agrees to
receive a fixed rate of interest, called OIS rate, on a notional amount of money over a maturity (e.g.,
three months), in exchange for a compound interest payment to be determined by a reference floating
rate on the notional amount at the maturity. The reference floating rate is often tied to an overnight
interest rate such as the central bank’s policy rate (e.g., the effective federal funds rate in the United
States). As such, the OIS rate reflects the market’s expectations of the average of the reference over-
night interest rate over the maturity of the swap contract.30
Financial Stability: Monitoring and Identifying Risks 223

Monitoring Libor-OIS to Gauge Risk

Libor-OIS spread is the difference between the Libor rate and the OIS rate. Libor rate typically includes
credit risk since a Libor transaction is not secured by collateral and thus the lending bank is exposed to
a default by the borrowing bank. OIS, on the other hand, involves only a minimal credit risk since the
transaction does not involve any initial cash flow. The payments between the two counterparties in an
OIS transaction would occur only when the contract reaches maturity.
Since the Libor rate includes credit risk, it is generally higher than the OIS rate of the same
maturity. During times of stress, the Libor-OIS spread could be a useful indicator of credit risk within
the banking system. The widening of the Libor-OIS spread reflects the perception of the banks with
regards to the risk of default associated with lending to other banks. In early August 2007, the Libor-
OIS spread stood at around 13 basis points (0.13%), before it widened to about 350 basis points (3.50
percent) for a period after Lehman Brothers went bankrupt on September 17, 2008. The one-month
Libor-OIS spread subsequently narrowed down to around 28 basis points by April 6, 2009, although
the three-month and six-month Libor-OIS spreads remained much higher than they were before the
Lehman bankruptcy.31
Intuitively, while the Libor-OIS spread should reflect primarily credit risk in the banking system,
it could also reflect the market’s perception of risk endemic in the economy. Furthermore, it could also
reflect liquidity risk in financial markets. A higher Libor-OIS spread suggests a decreased willingness
to lend by major banks, which implies lower liquidity available.32 In practice, however, it could be quite
complicated to disentangle credit risk from liquidity risk from such a spread.33

Net Open Positions

A net open position in a financial product refers to a situation in which a player’s
total assets and liabilities in that particular product are unequal. If a player has an
excess of assets over liabilities in that particular product, then the player is said to
have a net long position in that product. If a player has an excess of liabilities over
assets, then the player is said to have a net short position.

Risk Accumulation  In cases where data are available, the central bank might find it
useful to monitor the aggregate net open positions for a key financial product, such
as foreign currencies (see, for example, the 2011 work from Lim et al.34). A dramatic
rise in net open positions (whether long or short) means that risk accumulation
in the system is rising, since players are exposing themselves to adverse moves in
foreign exchange rates.

Stress and Disruption  A net open position in a financial product, when taken together
with movements in the price or yield of that product, could also reflect a degree of
stress and disruption in a particular market segment. During the European sovereign
debt crisis in the early 2010s, for example, the net open position of U.S. dollars
as reflected by the International Monetary Market (IMM) data from the Chicago
Mercantile Exchange was a useful indicator of how market participants responded
to uncertainty and switched back and forth between the view favoring U.S. dollars
against the euro and vice versa. In this particular case, such an indicator could be
useful even for central banks outside Europe and the United States, because large
movements in the U.S. dollar-euro exchange rate would have implications for their
own currencies.
224 CENTRAL BANKING

C O N C E P T: AN INT EGRAT ED RISK MONI TOR I NG AND RI S K

ID E N T I F ICAT ION APPROACH: T HE CO NTI NG ENT C LA I MS ANALYS I S
While the separation of financial stability areas into the macroeconomy,
financial institutions, and financial markets might make analysis more trac-
table, in practice, the inherent relationships among the three areas suggest
that the central bank needs to take an integrated approach when monitoring
and identifying risks to financial stability. At the most basic level, the central
bank might construct a composite indicator or a heat map that takes account
of developments in the macroeconomy, financial institutions, and financial
markets.
Increasingly, however, many authorities are turning also to a more
advanced approach known as contingent claims analysis (CCA), which has
built-in forward-looking elements, and can also be applied to assess risk trans-
mission between different economic sectors in a more integrated manner.35

Contingent Claims Analysis (CCA)

CCA can be thought of an approach that employs data from financial markets
to estimate the probability of default for an economic entity. It is based on the
option pricing theory pioneered by Black-Scholes, and Merton, in 1973.36
The use of a CCA approach to monitor and identify risks to financial
stability has been proposed in the 2008 research of Gray, Merton, and Bodie37
and Gray and Malone,38 which provided a framework for assessing risk in the
different sectors and linking them in an integrated manner.
The gist of the CCA approach is that it looks at the balance sheet of an
entity (e.g., a household, a single firm, or an economic sector) and adjusts
for the probability that its assets might be subject to random shocks, which
could affect the entity’s ability to repay its debt obligations, that is, the entity’s
probability of default. A positive shock to the value of assets will reduce
the probability that the entity will be unable to repay its debt obligations.
Conversely, a negative shock to the value of assets could raise the probability
that the entity will be unable to repay its debt obligations and will default. If
the entity defaults, owners of the entity’s liabilities will be entitled to its assets.
Viewed this way, liabilities (which comprise debt and equity) of an entity
can be seen as contingent claims on the assets of the entity. Given that the mar-
ket price and volatility of market-traded securities—such as mortgage-backed
securities (households’ liabilities), pension fund and mutual funds (households’
assets), corporate bonds and stocks (corporate liabilities), and government
bonds (government liabilities)—can be observed directly, they could potentially
be used to estimate the implied value and volatility of the underlying assets,
and thus the probability of default in these sectors.
In practice, while there are currently data limitations in many cases, work
such as that done in 2008 by Gray, Merton, and Bodie and Gray and Malone
(cited above) suggests various ways to go forward. For the corporate sector
(an aggregation of all nonfinancial firms) and financial institutions (banks
Financial Stability: Monitoring and Identifying Risks 225

and nonbanks), domestic equity markets could provide pricing and vola-
tility information for the calculation of implied asset values, volatility, and
expected default frequencies. For nonlisted firms and financial institutions,
the relationship could be mapped using information from listed counterpar-
ties as a guide.
For the government, although the value of its assets cannot be observed
directly, it could be inferred both from prices in international markets (includ-
ing the foreign currency market) and information from domestic markets
regarding the value and volatility of certain liabilities on the government’s
balance sheet.
For the household sector, since there is no traded equity for use in esti-
mating assets, the 2008 research by Gray, Merton, and Bodie suggests that
macroeconomic data and information from the households themselves could
be used to construct measures of the portfolio of household assets directly.
Household balance assets would include financial assets and estimated labor
income. A subsidiary balance sheet of household real estate holdings might
also be estimated from real estate prices and volatility, and pertinent debt
obligations.
With balance sheets from the four sectors in place, the work from Gray,
Merton, and Bodie and Gray and Malone suggests that regulatory authorities
might then link the contingent claims balance sheets of the different sectors
(possibly adding the external sector to represent foreign claims) to assess in a
consistent manner how risk proliferates among the sectors. Furthermore, by
linking models of CCA analysis to macroeconomic models used for monetary
policy, potentially central banks would be able to assess the feedback loops
between economic activity, financial activities, and the probability of default
in the economy.
While it is still a work in progress, the use of CCA as a framework to
monitor and assess financial stability has several promising features. First,
it uses pricing and volatility from financial markets, which have built-in,
­forward-looking elements not afforded by the traditional balance sheet data.
Gray showed in 2012 how the use of CCA on a real-time basis would have
predicted the upcoming stresses leading to the 1997 Asian financial crisis, as
well as the global financial crisis of 2007–2010.39 Second, by linking the bal-
ance sheets of different economic sectors, CCA could be used to assess risk
transmissions from one sector to the others. Third, CCA risk indicators could
be linked to macroeconomic variables and to macroeconomic models, which
would enable further testing and simulations of stress scenarios.

SUMMARY
In the macroeconomy, the central bank needs to monitor and identify the risk that
economic agents might be unable to repay their debts. This might be done before-
hand by identifying risks of overindebtedness among households, firms, and the
government, as well as the overindebtedness of domestic economic agents to exter-
nal lenders.
226 CENTRAL BANKING

On the financial institutions front, risks to individual banks (whether in terms

of credit risk, market risk, liquidity risk, or operational risk) must be examined
by central banks that have a bank supervisory function. Risk distribution and risk
concentration within the financial institutions system needs to also be identified and
monitored.
In financial markets, prices and yields, spreads, and net open positions on finan-
cial instruments must be monitored in order to identify risk accumulation and stress
and disruption in the markets.
The contingent claims analysis (CCA) approach has good potential as an inte-
grated approach to monitoring and assessing risks in the different economic sectors
and needs to be developed further. CCA uses observable real-time market data to
assess the probability of default in the different sectors, whereby the probability
of default of one sector could be linked to that of another sector in an integrated
manner.

KEY TERMS
contingent claims analysis macro stress test
contingent liabilities maturity mismatch
credit default swaps (CDS) net long position
currency mismatch net open position
domestic systemically important banks net short position
(D-SIBs)
paradox of financial stability
fallacy of composition
probability of default
gap measure
public debt to GDP ratio
global systemically important banks
(G-SIBs) spread
historical volatility systemically important financial institu-
household debt tions (SIFIs)
implied volatility too-big-to-fail
Libor_OIS spread too-connected-to-fail

QUESTIONS
1. What are examples of indicators that central banks might want to monitor with
regard to households to ensure financial stability?
2. What are key indicators that central banks might want to monitor with regard
to the corporate sector to ensure financial stability?
3. What are key indicators that central banks might want to monitor with regard
to the government to ensure financial stability?
4. What are key indicators that central banks might want to monitor with regard
to the external sector to ensure financial stability?
5. What are key indicators that central banks might want to monitor with regard
to asset prices to ensure financial stability?
Financial Stability: Monitoring and Identifying Risks 227

6. According to a 2002 paper by Borio and Lowe and a 2009 paper by Borio and
Drehman, what might be good predictors of a banking crisis?
7. How might financial imbalances in the macroeconomy affect financial stability?
8. Please explain key types of risks that an individual financial institution normally
faces.
9. In examining financial institution risks, one widely adopted framework is
CAMELS; please explain what CAMELS is.
10. What might be a fallacy of composition problem in the context of a system of
financial institutions?
11. How might network analysis help identify risk distribution within the financial
system?
12. Give an example of the way in which risk concentration within the financial
system might be identified and monitored.
13. Please explain the principle behind a macro stress test.
14. How can a macro stress test be used as a preemptive tool in sustaining financial
stability?
15. How might prices and yields reflect risk accumulation in the financial system
ex ante?
16. How might it be difficult to use prices and yields to identify risk accumulation
ex ante?
17. How might prices and yields reflect stress and disruption in the financial system
ex post?
18. Why might sustained tight credit spreads indicate risk accumulation? Why is this
counterintuitive?
19. During periods of stress and disruption, why might the spreads between risk-free
and risky assets widen?
20. Why might a rise in the net open position of a currency reflect risk accumulation,
or stress and disruption, or both?
21. Please explain the idea behind Contingent Claim Analysis.
22. According to Contingent Claim Analysis, what can be valued as contingent
claims on the assets of an entity?
 CHAPTER 12
Financial Stability
Intervention Tools

Learning Objectives
1. Describe various tools that central banks can use to mitigate risks
in the macroeconomy in order to sustain financial stability ex ante
and ex post.
2. Describe various tools that central banks can use to mitigate
risks in financial institutions in order to sustain financial stability
ex ante and ex post.
3. Describe various tools that central banks can use to mitigate risks
in financial markets in order to sustain financial stability ex ante
and ex post.
4. Distinguish between Basel I, Basel II, and Basel III.

In Chapter 11 we reviewed some of the tools that can be used for monitoring and
identifying financial stability risks. In this chapter we look at some of the tools
that central banks might use to intervene, safeguard, and restore financial stability.
Following the analytical framework used in the previous chapters, we review the
tools in the context of three focus areas: (1) the macroeconomy, (2) financial insti-
tutions, and (3) financial markets. In each of the focus areas, we look at the tools
that are meant to be used ex ante (i.e., sustaining financial stability by reducing the
probability of a crisis happening, or reducing the severity of losses given a crisis), and
those that are meant to be used ex post (i.e., managing a crisis that is unfolding, or
providing a recovery resolution).

12.1 THE MACROECONOMY

The key tools that the central bank might use to intervene and maintain financial
stability in the macroeconomy would be (1) monetary policy, and (2) macropruden-
tial measures, especially those of a credit-related type.1 Although monetary policy
is normally used for the price stability objective, it can also be used to safeguard

229
230 CENTRAL BANKING

TABLE 12.1  Possible Tools to Address Financial Instability

Possible Tools

Area of Focus Ex ante Ex post

Macroeconomy ■■ Monetary policy tightening ■■ Conventional monetary policy
■■ Macroprudential measures easing
■■ Unconventional easing
■■ Macroprudential measures
Financial ■■ Supervisory actions ■■ Lender-of-last-resort facilities
institutions ■■ Capital adequacy requirements ■■ Special resolutions for troubled
■■ Coordination with regulators of financial institutions
nonbank financial institutions
Financial ■■ Regulations on market players ■■ Lender-of-last-resort facilities
markets under central bank supervision ■■ Direct market interventions
■■ Coordination with market (e.g., asset purchases)
regulators

financial stability ex ante as well as ex post, since monetary policy has the potential
to dampen amplification effects from the business cycle. Monetary policy, however,
is a relatively blunt tool that affects all sectors of the macroeconomy. To address
risk buildups or financial imbalances in specific areas of the macroeconomy ex ante,
macroprudential measures, which are more akin to precision instruments, might be
more appropriate. (See Table 12.1.)

The Debate on the Use of Monetary Policy for the Maintenance of

Financial Stability
Even after the global financial crisis of 2007–2010, there was a continuing debate
about how monetary policy should be used in the maintenance of financial stability.2
Some argued that monetary policy should be used to help lean on asset price bubbles
while they were still in the early forming stage so they would not grow excessively
large. The proponents of the use of monetary policy to lean on asset price bubbles
argued that it would help tame risk buildups in the economy, and possibly reduce the
severity of a crisis, should one occur.
Others, however, suggested that monetary policy should be used instead to
help clean up the aftereffects once the bubbles had burst. Those in this camp argued
that monetary policy should only be used to stabilize the economy after asset price
bubbles had actually burst. The arguments against the use of monetary policy in
addressing the buildup of bubbles included (1) the belief, especially prior to the
crisis, that in a market economy prices should reflect all relevant information, and
thus the central bank would not know any better than the public if rising asset
prices were beyond what was warranted by fundamentals and were actually bubbles,
(2) that since monetary policy is a rather blunt tool, its use would affect the cost
of money across the economy, not just in the sectors where bubbles were forming,
and (3) that placing financial stability as an additional objective of monetary policy
could place too much burden on monetary policy and compromise its credibility.3
Financial Stability: Intervention Tools 231

According to those opposed to central banks’ intervention during the period of

bubble buildups, the central bank should intervene only when there were clear signs
that financial stability was being impaired (i.e., when prices start falling and defaults
are rising). Essentially, this latter approach argues that the use of monetary policy,
a policy that affects all sectors of the economy, is appropriate only when financial
instability has been manifested and becomes a threat to all sectors.
Learning from the experiences of the global financial crisis of 2007–2010, how-
ever, there has been a rethinking of the role of monetary policy in addressing the
buildup of bubbles.4 By not intervening early, overindebtedness in the economy
could become a very large problem, and could ultimately overwhelm the ability of
the central bank to maintain financial stability.5 An alternative approach relies on
using macroprudential tools as a complement to monetary policy in maintaining
financial stability, rather than fully placing responsibility for maintaining financial
stability on monetary policy tools.6

Sustaining Financial Stability: Dealing with Threats Against the

Macroeconomy Ex Ante
To maintain financial stability, the central bank might want to deal with arising
threats early, before they lead to a full-blown crisis. After the 2007–2010 crisis, it
became increasingly recognized that the central bank could use monetary policy as
well as macroprudential measures as the main instruments to address those threats
ex ante. Monetary policy is a potent but blunt instrument that affects all sectors
of the economy. Macroprudential measures are more precise, and can be used to
address specific pockets of the economy. The central bank could also consider using
both types of instruments in a complementary manner.
Since financial instability and price stability are intertwined, there are grounds
for the central bank to take the possibility of excessive debt among economic agents
(whether households or firms) into account when making monetary policy decisions.
The Japanese experience of the late 1980s and early 1990s suggests that the inflation
rate can remain low even when the economy is experiencing extreme forms of asset
price bubbles and agents are taking on excessive debt.7
In Japan, once the bubbles burst, however, the excessive debt of economic agents
sunk the economy into a debt-deflation spiral that it could not get out of, even after
more than 20 years. To take financial stability into account in monetary policy deci-
sions, policy makers might thus need to look beyond the usual two-year inflation
outlook horizon. One possibility, practiced by the Bank of Canada, is to adjust the
policy horizon to factor in risks such as supply shocks or asset prices when deciding
on a monetary policy stance.8 A slight variation of this approach is one used by the
Reserve Bank of Australia, under which the horizon for monetary policy is described
as “over the cycle,” rather than as the typical two-year horizon.9 In both cases it
could be argued that looking out over a longer horizon is warranted, even for price
stability, since over the long run financial instability could threaten price stability, the
key objective of monetary policy.
In practice, if the central bank deems that agents are accumulating excessive
debt in the economy, or that asset prices are rising too fast beyond levels supported
by economic fundamentals (such that there might be too much speculative activity
taking place), the central bank might choose to tighten its monetary policy, possibly
232 CENTRAL BANKING

through hikes in the policy interest rate. An advantage of tightening monetary policy
early in this way is that it would prevent risks from building up to unsustainable
levels, which could seriously worsen the situation and make it more difficult to deal
with later on.
However, the use of monetary policy to discourage the taking on of excessive
debt by economic agents, or to preempt asset price bubbles early on, requires caution
on many fronts. Monetary policy normally affects all sectors of the economy, not
just those sectors or agents that are in danger of being overindebted. For example,
if the central bank chooses to hike the policy rate to temper a trend of fast-rising
household debt, the rise in costs of funds is likely to also affect the corporate sector,
even if the corporate sector was not the target of that hike. Another important con-
cern is that, how could the central bank ever be certain that the debt level in any one
sector is already too high, or that the rise in asset prices is excessive?

The Use of Macroprudential Measures  Acknowledging that monetary policy might

be too blunt a tool to deal with risk buildups in specific pockets of the economy,
authorities have increasingly turned to the use of so-called macroprudential mea-
sures, which are designed to address risk buildups in specific areas that, if remain
unchecked, could affect systemwide stability. Although there is no single definitive
set of macroprudential measures as yet, they can broadly be classified into those that
are credit-related, liquidity-related, and capital-related (see the 2011 paper from Lim
et al.10).
In addressing financial stability risks that might arise from the macroeconomy,
key macroprudential measures would be those of the credit-related type, since they
would address risk buildups that come with excessive borrowing by particular eco-
nomic sectors.* Among the more prominent credit-related types of macroprudential
measures are limits on the loan-to-value (LTV) ratio, limits on the debt-to-income
(DTI) ratio, ceilings on credit or credit growth, and caps on foreign currency lending
(again, see the 2011 paper from Lim et al. ).
It should be noted, however, that the use of such measures for financial stability
reasons are still in an early stage. There is no consensus on how the measures should
be used in practice. The following discussion provides a glimpse into the fundamen-
tal concepts behind the tools, but the actual application would depend on individual
contexts.

Limits on Loan-to-Value Ratios  Limits on LTV ratios are used to address risk buildups
in the housing market.11 LTV ratios limit households’ borrowing capacity through
the amount of the down payment required for a housing purchase. An LTV ratio
of 80 percent in a particular segment of the housing market, for example, means
that the buyer needs a down payment equivalent to 20 percent of the house’s value,
since banks would only be allowed to lend 80 percent of the value of the house in
that particular market segment. If the LTV ratio is lowered to 70 percent, buyers
will have to find more money for down payments, since they now need a 30 percent

*Liquidity-related and capital-related types of macroprudential measures are more relevant in

addressing risks that might come from the financial institutions system, and are thus discussed
later.
Financial Stability: Intervention Tools 233

down payment. By lowering the LTV ratio, regulatory authorities can help reduce
speculative activities in the housing market.
In practice, there are many variations on the use of limits of the LTV ratio. The
central bank might lower the LTV directly as described above, or it could use other
variations, such as imposing different risk weights for different LTV ratios, so that
the banks will have to set aside higher reserves if they decide to lend to a client at a
higher LTV ratio.

Debt-to-Income Ratio  Debt-to-income (DTI) ratios can also be used to address risk
buildups in the household sector. With limits on DTI ratios being imposed, lend-
ers can extend a new loan to a household only if the level of pertinent household
monthly debt repayments (mortgages, credit cards, auto loans, etc.) does not exceed
a certain percentage of the household’s income. By lowering limits on DTI ratios, the
central bank would be constraining the households’ capacity to borrow.12
In practice, limits on DTI ratios might be used in conjunction with LTV. They
both can be lowered when households are deemed to be incurring more debt so fast
that financial stability might be compromised.13

Ceilings on Credit Growth  Ceilings on credit growth can be put on total bank lending
as well as on lending to specific sectors.14 Ceilings on credit growth for total bank
lending could help reduce amplification effects from the business cycle in general.
Banks would have to ration credits among different borrowers as they see fit. By
putting ceilings on credit growth for specific sectors, on the other hand, regulatory
authorities can address risk buildups in a more targeted way.

Caps on Unhedged Foreign Currency Lending  Caps on unhedged foreign currency lending
are placed on banks, which may borrow overseas to lend to domestic borrowers in a
foreign currency.15 Caps on foreign currency lending can be used to limit exposure to
the unhedged foreign exchange rate risk that comes with external borrowing. When
lending in a foreign currency to a domestic borrower, the banks might thus require
the borrower to hedge the borrowing against foreign exchange rate risk, or they
might simply limit their foreign currency lending.
With caps on unhedged foreign currency lending, borrowers’ exposure to for-
eign exchange risk is limited, and thus their lenders are protected from credit risk.
The caps are especially important in the case of emerging-market economies with a
fixed exchange rate regime, since domestic interest rates that are higher than those
overseas might prompt banks to borrow from abroad at low interest rates in order
to lend to domestic borrowers at higher interest rates, without regard for the pos-
sibility that the central bank might be unable to keep the exchange rate at the fixed
level if banks do this on a large scale.

Sustaining Financial Stability: Dealing with Risks within the

Macroeconomy Ex Post
Once overindebtedness has started leading to chains of defaults, or when asset price
bubbles start to burst, the central bank can also decide to intervene ex post, and
deal with threats to financial stability that might arise from the macroeconomy.
234 CENTRAL BANKING

Such intervention could be done through (1) the easing of monetary policy, and
(2) the use of macroprudential measures.16

Monetary Policy Easing  The easing of monetary policy can be done conventionally
through a cut in interest rates, and, in more severe cases, can be accompanied by
unconventional measures, including the provision of credit to financial institutions,
the provision of liquidity to financial markets, and the purchasing of long-term secu-
rities from the private sector (i.e., quantitative easing).17

Conventional Monetary Policy Easing  Conventional monetary policy easing through a

cut in interest rates helps safeguard the macroeconomy and financial stability by
reducing risk among the agents within the economy, particularly credit risk. In a situ-
ation in which financial stability is severely at risk, an easing of the monetary policy
stance could help reduce credit risk in various sectors of the economy. Lowering of
interest rates can help ease the interest burdens of borrowers, especially at a time
when their income might also be falling, in line with the economic cycle. With a
lighter interest burden, economic agents might be better able to cope with falling
revenues and income, and may not resort to defaulting on their debts.

Unconventional Easing  In the case of an economic crisis, the central bank might choose
to use additional measures in addition to the easing of monetary policy stance. In
the wake of the 2007–2010 crisis, the U.S. central bank chose to do what had been
previously considered an unconventional measure. As discussed in more extensive
detail in Chapter 6, the unconventional monetary policy used to deal with the global
financial crisis of 2007–2010 had three elements: (1) lending to financial institutions,
(2) providing liquidity to key credit markets, and (3) purchasing of long-term securi-
ties.18 As noted by Ben Bernanke, then chairman of the Federal Reserve, one common
characteristic of the tools used for unconventional measures is that they rely on the
central bank’s authority to extend credit or to purchase securities.19
As discussed in Chapter 6, the first two elements (i.e., the lending to financial
institutions and the provision of liquidity to key credit markets) were of the lender-
of-last-resort type and were discontinued after the crisis had passed its peak. The last
element, that is, the purchase of long-term securities (government bonds as well as
asset-backed securities issued by the private sector), was aimed at providing liquid-
ity to the private sector, taking out so-called toxic assets from the private sector’s
balance sheets (in the case of privately issued asset-backed securities), and bringing
down long-term government bond yields. Given the fact that the last element is still
on going in 2014 at the time that this book goes to press, the first two elements might
fall into what Borio’s 2012 paper described as crisis management, while the third ele-
ment could be described as crisis resolution, as it was done to help the economy get
back on a path to sustained recovery.20

Macroprudential measures  To help safeguard the macroeconomy and financial sta-

bility ex post, the central bank can also loosen credit-related macroprudential
measures—such as caps on LTV, DTI, or credit growth—that had previously been
tightened during the period of economic upturn.21 The possibility of the countercy-
clical use of credit-related macroprudential measures has been given much attention
in the wake of the recent financial crisis, but it remains to be seen if such measures
Financial Stability: Intervention Tools 235

can actually reverse a downward trend in a crisis. During a crisis, it is reasonable

to expect that economic agents would be less willing to take out more loans, even
if LTV and DTI are lower. Still, the unwinding of such measures might at least give
some signals that are consistent with monetary policy easing.

12.2 FINANCIAL INSTITUTIONS

To help maintain stability of financial institutions, central banks with a bank super-
visory role can use various tools on banks or other financial institutions under
its supervision ex ante. The tools can be applied from a micro- or macroprudential
perspective, depending on the particular context. Central banks that do not have a
bank supervisory role still have the option of coordinating with regulatory authori-
ties that do, to impose such rules and regulations. Ex post, however, whether the
central bank has a bank supervisory role or not, it can intervene to safeguard finan-
cial stability through the provision of emergency liquidity or special resolutions for
troubled financial institutions where necessary.

Sustaining Financial Stability: Dealing with Threats to Financial

Institutions Ex Ante
To safeguard financial stability against risks that may come from financial institu-
tions ex ante, it might be helpful for a central bank with bank supervisory role to take
both a micro- and macroprudential perspective.22 For example, the use of micropru-
dential supervisory tools (such as those that come with onsite examinations) could
be used to ensure that individual banks comply with regulatory requirements, and
that their management is safe and sound, while macroprudential supervisory tools
(such as time-varying capital requirements and dynamic provisioning) could be used
to ensure the resiliency of the banking system against risks amplification by business
cycles, as well as by cross-sectional risk concentration within the system.

Microprudential Supervision  For central banks that have a bank supervisory role,
microprudential supervision would aim to ensure that individual banks do have
enough capital and liquidity to cover any emerging shocks, and that the banks are
managed in a safe and sound manner. Microprudential supervision is often associ-
ated with bank examinations and their associated actions, including enforcement of
regulations and laws to ensure bank compliance. As mentioned in Chapter 3, bank
examinations involve both onsite examination and offsite monitoring.
Through onsite examinations, the central bank would be aiming to ensure the
general safety and soundness of each of the individual banks under its supervision.
The use of the CAMELS rating in onsite examinations is one way that the central
bank can assess and address individual banks’ capital adequacy, asset quality, man-
agement, earnings, liquidity, and sensitivity to market risk. In the period that falls in
between onsite examinations, the central bank would perform offsite monitoring to
check if, where needed, corrective actions have been made. Analyses of current and
projected conditions of the banks would also be made during this period, so that
areas of focus on the next onsite examination could be determined.
236 CENTRAL BANKING

With onsite examinations and offsite monitoring, the central bank would know
the health of each of the individual banks in detail. Through its legal power and the
use of “moral suasion,” the central bank could ensure that banks comply with regula-
tions and the law, and that suggested corrective actions are made by the banks when
demanded. Since a serious breach of compliance could expose a bank to the risk of
failure, the central bank always has the option to remove directors or management
of the bank for negligence or misconduct, and install a temporary administration. In
an extreme case, in which a bank has already been deemed insolvent or at great risk
of insolvency, the central bank might recommend a forced sale or liquidation of the
bank to prevent a bank run.

Macroprudential Supervision  Unlike microprudential supervision, under which the

focus is on the resiliency of individual banks, macroprudential supervision puts
more emphasis on the resiliency of the banking system as a whole. Macroprudential
measures, especially those that are capital-related and liquidity-related, are used to
safeguard financial institutions against systemic risks. Capital-related macropru-
dential tools include time-varying capital requirements, dynamic provisioning, and
extra capital buffers for SIFIs.23 Liquidity-related macroprudential tools include lim-
its on net open positions (especially of foreign currencies) and limits on mismatches
(of currencies and maturities),24 as well as the liquidity coverage ratios (LCR) and
net stable funding ratios (NSFR) introduced in the wake of the 2007–2010 crisis by
the Basel Committee for Banking Supervision.25

Capital-Related Macroprudential Measures  Capital requirements are a key tool

that the central bank can use to help ensure resiliency of the banking system against
systemic risk, by requiring that banks hold enough capital to deal with multiple
types of risks. Capital requirements can be used to guard against systemic risk that
might arise from (1) risk amplification through the business cycle, and (2) risk con-
centration and distribution within the system.

C O N C E P T: T HE BASICS OF CAPITAL R EQ U I R EMENTS : TH E

R E L AT I O N SHIP BET WEEN ASSET S, LI A B I LI TI ES , A ND CA P I TAL
To comply with accounting rules, the total asset value of a bank must be equal
to the value of that bank’s liabilities. Bank liabilities can be categorized into
debt (mostly in the form of deposits) and capital (owned by the bank’s share-
holders). Assets on the bank’s balance sheet must be financed by either debt or
capital. In practice, the major part of a bank’s assets is often composed of loans
made to firms and households. The major part of a bank’s debt, on the other
hand, is often deposits put in the bank by depositors.
If a bank’s assets decline in value, possibly because borrowers cannot repay
their loans, the value of the bank’s total liabilities must also decline for the bal-
ance sheet to remain balanced. By law, to match the loss in total asset value, the
value of the bank’s capital must be completely written down before depositors
absorb any loss. As discussed in Chapter 11, however, if depositors fear that
Financial Stability: Intervention Tools 237

(1) Loan losses causes a fall (2) The bank’s capital is used
in asset value of the bank. to absorb losses from the
fall in asset value.

Assets Liabilities Assets Liabilities

Loans Deposits Loans Deposits

Capital
Capital

FIGURE 12.1  The Use of Bank Capital to Absorb Loan Losses

Source: Adapted from Jorge A. Chan-Lau, “Balance Sheet Network Analysis of Too-
Connected-to-Fail Risk in Global and Domestic Banking Systems” (IMF Working Paper
WP/10/107, April 2010).

their money might be affected then a run on the bank might occur even before
the capital is depleted. To buffer any shock to the value of its assets, and to
ensure the bank’s resiliency, a high level of capital is often maintained. Figure
12.1 illustrates how a bank might need to use its capital to absorb its lending
losses.

The Definition of Capital

In accounting terms, capital means the part of the business that actually belongs
to shareholders (as opposed to creditors). For banks, capital would normally
include common equity, preferred equity, retained earnings, and required
reserves. Capital can be classified into two different tiers. Tier 1 capital reflects
the banks’ strength (or lack thereof), as it refers to the banks’ paid in capital,
and also takes account of retained earnings or losses. Tier 2 capital often refers
to the part of capital that might temporary rise or might be transformed into
Tier 1 capital under certain circumstances, such as debentures. Tier 2 capital
also includes changes in valuation of fixed assets.

Capital Ratio
Determining whether an institution has enough capital or not is assessed by
the ratio of the bank’s capital to the value of the bank’s risk-weighted assets
(RWA).

Capital ratio = Capital/RWA

Since the value of different types of assets can behave differently when a
crisis hits, the effects on capital should be different. Loans that the bank has
made have different degree of riskiness, depending on (among other things) the
type of loan (housing loan, corporate loan, etc.) and the type of borrower (high

(Continued)
238 CENTRAL BANKING

(Continued)
or low income individual, large corporation, small enterprise, medium enter-
prise, etc.). Since different types of assets have different degrees of riskiness,
the amount that the bank needs to hold as a capital buffer against a particular
type of asset will also depend on the degree of asset riskiness. In aggregate, how
much capital the bank should hold against their assets should thus be deter-
mined by how many different types of assets are being held and the degree of
riskiness of each type.
In practice, however, maintaining high levels of capital can be costly for
banks. Funds that are maintained as capital normally do not earn high returns
when compared to funds that are lent out as loans. Higher capital requirements
imply not only higher opportunity costs for banks, but also impose higher
handicaps on them, since the banks still need to pay interest to depositors as
well as overhead costs for their own operations, whether the deposits are lent
out or not.

Capital Adequacy Requirements in the Macroprudential Context  In the macro-

prudential context, it is recognized that capital adequacy should be adjusted to take
account of risk accumulation and risk-taking behavior by both banks and borrow-
ers over the business cycle. As such, new regulations—such as Basel II and III—­
recommend that capital requirements vary over time. A proposal made by Goodhart
in a 2013 paper also suggested the use of capital requirements as an active tool to
prevent financial instability.26

time-varying capital requirements  The gist of time-varying capital

requirements is that capital requirements should be raised during good times and
lowered during bad times to safeguard the stability of the banking system from the
vagaries of the business cycle. During good times, economic and business projec-
tions often focus on the upside, which make risky projects often appear viable. An
increase in capital adequacy requirements would automatically reduce the likelihood
that banks would take on excessive exposures to risks. Apart from reducing risky
exposures, higher capital accumulated during good times will help banks better deal
with adverse shocks to their portfolios when bad times eventually arise.
As bad times arise, the lowering of capital adequacy requirements will help alle-
viate pressure on banks. Banks would not be required to keep their capital levels
high, and would thus be able to run down some of their capital to absorb shocks
that occur to their portfolios. With better ability to absorb shocks on their portfolios,
there will be less pressure for the banks to call back their loans, an action that not
only affects their immediate customers but also could appreciably worsen macroeco-
nomic prospects, which could lead to more pressure on their portfolios.
By raising capital requirements during good times and lowering capital require-
ments during bad times, it is expected that the banking system will be more robust
against the vagaries of business cycles. In practice, however, the actual application of
the concept of time-varying capital requirements is still very much in the early stages.
Financial Stability: Intervention Tools 239

Research is still being done on what measures should be used to assess what consti-
tutes good times, when capital requirements should be raised, and what constitutes
bad times, when capital requirements should be lowered.
In 2011, Borio, Drehmann, and Tsatsaronis suggested that the gap between the
credit-to-GDP ratio and its long-term backward-looking trend might be a good indi-
cator to signal the need for capital requirements to be raised, as it could capture the
buildup of systemic vulnerabilities. To signal the need for capital requirements to be
lowered, however, they found other indicators (such as credit spreads) to be better,
as they provide more timely signals of the banking sector distress that can precede
a credit crunch.27

capital requirements as an active tool to sustain financial stability 

According to Goodhart’s 2013 paper, there should also be “an increasing ladder of
penal sanctions” as a bank’s equity capital falls. As the bank’s capital adequacy falls
towards a “minimum intervention point,” official action should be taken to remove
management and shareholders, and to move to a resolution.28 Such an approach
would make capital adequacy requirements more potent as a macroprudential tool.
According to this view, rather than passively monitoring banks to ensure that they
comply with capital adequacy requirements, capital adequacy requirements could be
used by regulatory authorities as an active tool to maintain financial stability ex ante.

C O N C E P T: INT RODUCT ION T O BASEL I , I I , AND I I I

The international framework for capital adequacy requirements that central
banks often adopt is the one recommended by the Basel Committee on Banking
Supervision, an international committee of central banks and experts based in
Basel, Switzerland. As mentioned in Chapter 3, the first version of the recom-
mended framework was issued in 1988 and was known as the Basel Accord (or
later, Basel I). An updated version, known as Basel II, was introduced in 2004
but had not been fully or widely implemented by the time the 2007–2010 crisis
hit the global financial system. Incorporating lessons learned from the crisis,
the Basel Committee released Basel III as the latest version of the framework
in 2010.29

The Basel Accord (Basel I)

Under the original Basel Accord (or Basel I), issued in 1988, assets of financial
institutions were classified into five categories according to their perceived risk-
iness. Banks were required to hold capital as reserves against the assets at 0, 10,
20, 50, or 100 percent, depending on their perceived riskiness. The safest assets
(such as domestic government bonds, which are supposedly risk-free, since the
government is unlikely to default on debts denominated in domestic currency)
were assigned a risk-weight of 0 percent. Zero risk-weight means that banks
do not have to hold any capital as reserves against this type of asset on their

(Continued)
240 CENTRAL BANKING

(Continued)
balance sheets. At the other extreme, Basel I deemed corporate bonds to be
very risky and assigned them a risk-weight of 100 percent. This meant that for
corporate bonds held as assets on their balance sheets, the banks would have
had to hold capital as reserves equivalent to the full amount.
In total, Basel I specified that a bank had to hold capital of at least 8 per-
cent of risk-weighted assets. Basel I can thus be expressed as

Capital Adequacy Ratio = Capital/RWA ≥ 8 %

where Capital is the value of the bank’s capital and RWA is the value of the
bank’s risk-weighted assets. In setting the minimum capital adequacy ratio at
8 percent of risk-weighted assets, the Basel Committee did not clearly specify
economic reasons why it chose 8 percent as the minimum. It was believed,
however, that 8 percent would ensure that there was enough room for safety
and allow international banks from different jurisdictions to compete on a
level playing field.
In the 1990s the Basel Committee revised the Basel Accord to cover mar-
ket risk, which comes with changes in financial asset prices and could affect
financial institutions’ balance sheets along with credit risk. After its introduc-
tion in 1988, more than 100 countries adopted the guidelines of Basel I for the
supervision of their financial institutions, with the specifics adjusted according
to the countries’ specific needs and circumstances.30

Basel II
In 2004, the Basel Committee published new guidelines for capital requirements
known as Basel II. Basel II was an attempt to make improvements upon Basel I
through the use of the three pillars approach. Pillar 1 put emphasis on making
capital requirements more comprehensive and responsive with respect to risks
that financial institutions might be facing. Pillar 2, known as supervisory review,
stressed the importance of a banking supervisor making risk-weight adjustments
to truly reflect what the supervisor sees as the underlying risks faced by a bank.
Pillar 3, market discipline, emphasized the ability of market forces to discipline
the bank’s management to be vigilant about risks that the bank might take.
Under Pillar 1, capital requirements were made more comprehensive and
responsive to risk. Operational risk and market risk were covered, in addition
to credit risk and all three were required to be quantified. For small finan-
cial institutions with simple transactions, ratings from external rating agen-
cies such as Standard & Poor’s and Moody’s could be used to determine the
risk-weights to be assigned to different assets. For larger financial institutions
or those with complex transactions, Basel II allowed the use of in-house risk
models to determine the risk-weights of assets on their own balance sheets.
Basel II also emphasized that different types of assets might have risk charac-
teristics that offset each other (e.g., certain derivatives on the bank’s balance
sheets could mitigate risk for other assets in the bank’s portfolio).
Financial Stability: Intervention Tools 241

Under Pillar 2, the Basel Committee stressed the importance of regulatory

authorities examining banks with regard to the calculation of risk-weights and
ascertaining whether the weights came from external credit rating agencies or
were based on the banks’ internal risk models. The bank supervisory agency
would then require a bank to adjust its risk-weights to truly reflect underlying
risks if it saw fit.
Under Pillar 3, Basel II focused on having private investors validating
banks’ risk management practices to augment regulatory authorities’ assess-
ment of risk-weight calculation made by the banks. The transparency of finan-
cial institutions was emphasized so that market players themselves could better
assess whether the institutions were sound and had good prospects. Since
investors typically want to hold more shares of those financial institutions that
are sound with good prospects, they would be willing to bid up share prices
of those institutions. Accordingly, it was believed that share prices of financial
institutions would reflect the effectiveness of the management and help disci-
pline the institutions’ risk-management process in tandem with the supervisory
review carried out by regulatory authorities.31

Basel III
Although the Basel Committee published Basel II in 2004, its adoption took
time, as both regulatory authorities and banks needed to do a lot of prepa-
ration. By the time the global crisis became full-blown in 2008, however, it
became apparent that Basel II itself needed revision in many areas. The revi-
sions ultimately led to the issuance of Basel III in late 2010, which improved
upon Basel II with respect to the three pillars and laid out minimum global
liquidity standard as well as additional capital buffers for SIFIs.32

Improvements to the Three Pillars

In learning from the 2007–2010 crisis, the Basel Committee made considerable
adjustments in Basel III that improved upon the three pillars of Basel II.

Pillar I  Under Pillar I, Basel III aimed to improve the quality and quantity of
capital, as well as the coverage of risk and limits on the banks’ leverage.
With respect to capital quality, Basel III focused on having common equity
as capital. During the global financial crisis, despite the existence of capital
requirements, financial institutions did not have enough of a capital buffer to
absorb losses on their balance sheets. Partly this was due to the fact that Tier 2
capital, such as debentures and changes in the valuation of fixed assets, could
not actually be counted on to absorb the losses of the bank. Owners of deben-
tures of a bank are unlikely to convert the debentures into common equity
during a period of stress, since they would lose seniority in claims on the bank’s
assets. Fixed assets, such as the bank’s own real estate, can also fall in value
during the period of stress.

(Continued)
242 CENTRAL BANKING

(Continued)
By focusing on having common equity as a key ingredient in capital
requirements, Basel III raised the quality of capital, since common equity can
be written down directly against losses during a period of crisis. Under Basel
III, common equity must be 4.5 percent of risk-weighted assets. The relevant
authorities also have the discretion to demand the write-off or conversion of
other capital instruments (such as debentures) into common equity to absorb
bank losses.
With respect to capital quantity, Basel III also required that banks have
a capital conservation buffer in the form of common equity equivalent to 2.5
percent of risk-weighted assets. This requirement, together with the one just
described, brought the total common equity standard to 7 percent. The conser-
vation buffer was meant to help with a dilemma that became apparent during
the financial crisis: when losses actually occurred, financial institutions were
unable to write down their capital to absorb the losses, since a write-down
would have reduced their capital to below the minimum capital requirements.
Basel III also required a countercyclical (or time-varying) capital buffer
in the form of common equity, to be imposed in the range of 0–2.5 percent of
risk-weighted assets when the relevant authorities deemed that credit growth
would lead to excessive buildups of systemic risk.
With respect to risk coverage, in light of the 2007–2010 crisis, which was
partly precipitated by the growth in securitization and derivatives trading
among different types of counterparties, Basel III required stricter treatment
for securitized assets, for trading and derivatives activities and counterparty
credit risk, as well as for exposure to central counterparties who were respon-
sible for clearing financial market transactions.
As a backstop to risk-based capital requirements, Basel III also introduced
a nonrisk-based leverage ratio, under which a bank would not be allowed to
have assets (including off-balance sheet assets) in excess of capital beyond a
certain ratio. The leverage ratio was meant to limit the temptation and the
ability of bankers to make an excessive number of loans or take on excessive
off-balance sheet exposure, both of which could jeopardize the soundness of
the bank.

Pillar 2  Under Pillar 2, Basel III introduced supplemental requirements for

supervisory review by addressing issues relating to (1) bankwide governance
and risk management practices, (2) off-balance sheet exposures and securiti-
zation activities (3) the management of risk concentration within the bank,
(4) compensation and valuation practices, (5) accounting standards for finan-
cial instruments, and (6) supervisory colleges, which are multilateral working
groups of relevant supervisors that are formed specifically to do consolidated
supervision of an international banking group on an ongoing basis.

Pillar 3  Under Pillar 3, Basel III suggested revisions to disclosure require-

ments for all banks. The banks’ securitization exposures and sponsorship of
Financial Stability: Intervention Tools 243

off-balance sheet vehicles would have to be disclosed, along with specifics of

the components of the banks’ regulatory capital and calculations of regulatory
capital ratios.

Global Liquidity Standard for All Banks and Additional Loss Absorbency
Capacity for SIFIs
In addition to improvements in the three pillars, Basel III also introduced a
global liquidity standard and corresponding supervisory monitoring for all
banks, as well as higher loss absorbency capacity for SIFIs.

Global Liquidity Standard  The global liquidity standard introduced a liquidity

coverage ratio (LCR) that requires all banks to have liquid assets sufficient to
withstand a 30-day stress funding scenario as conducted by supervisors. A net
stable funding ratio (NSFR) was also introduced to incentivize banks to use
stable sources of funding (e.g., term deposits instead of money market borrow-
ing) and address liquidity mismatches. In addition, Basel III set out a regulatory
framework that includes a common set of monitoring metrics to assist supervi-
sors in identifying and analyzing trends in liquidity risk, both at the level of
individual banks and systemwide.

Additional Loss Absorbency Capacity for SIFIs  For SIFIs, Basel III required
additional loss absorbency capacity through progressive common equity Tier
1 capital requirements ranging from 1 percent to 2.5 percent, depending on
a bank’s systemic importance. Basel III also suggested a 1 percent additional
loss absorbency for banks that are already facing the highest SIB surcharge, to
discourage those banks from materially increasing their global systemic impor-
tance in the future.

dynamic loan loss provisioning  Another concept that has many similari-
ties to time-varying capital requirements is dynamic loan loss provisioning. Simply
put, dynamic provisioning suggests that banks raise their provisions for expected
losses for the loans they make during good times and lower their provisions for
expected losses during bad times.33 The key differences between dynamic provision-
ing and time-varying capital requirements are that (1) dynamic provisioning affects
the banks’ income statements directly, while time-varying capital requirements do
not, and (2) dynamic provisioning deals with expected losses from lending, while
time-varying capital requirements deal with unexpected losses that might come
through the business cycle.
During good times, the quantity of loans will increase but the quality of loans
may decrease as banks compete to extend credit. Accordingly, expected losses from
loans made during good times should rise, and banks should be expected to make
more provisions for lending during good times. As bad times come, with greater
provisions already made for the expected losses, the banks’ will not be affected as
244 CENTRAL BANKING

much as otherwise. Moreover, during bad times, as banks become more cautious,
and economic conditions are conducive only to the safest projects, loan quantities
are likely to decline, while the quality of loans is likely to rise. Expected losses from
lending during bad times are likely to be lower, and banks should be required to
make less provision.
The use of dynamic provisioning was pioneered by the Bank of Spain in 2000
and has since increasingly been adopted by many other central banks. A 2012 paper
from Wezel, Chan-lau, and Columba suggested that dynamic loan loss provision-
ing can be used as a complementary tool to time-varying capital requirements.34
Dynamic loan loss provisioning could act as a first line of defense, whereby banks
will have dynamic loan loss provision funds to run down during bad times, pro-
tecting their profits and capital unless it ultimately becomes necessary to tap into
their capital. To point out the complementarity between these two tools, it might
be worth repeating that dynamic loan loss provisioning will help safeguard banks
against expected losses, while time-varying capital requirements will help safeguard
the banks against unexpected losses.

Liquidity-Related Macroprudential Measures  Limits on banks’ net open positions

(e.g., on foreign currencies) ensure that banks are not overexposed to liquidity and
market risks. If many banks have large net open positions on a foreign currency at
the same time (e.g., in the case of a carry trade, where banks borrow in a foreign
currency that has low interest rates, in order to lend to domestic borrowers at higher
interest rates) and the exchange rate moves against the banks, for example, the banks
might suffer losses and need to raise funds quickly to meet those losses. If banks have
to raise funds at the same time, they might have to conduct a fire sale of their assets,
exacerbating the situation. By having limits placed on banks’ net open positions,
the banks will need to hedge their positions and the banking system might be less
exposed to liquidity and market risks.
Limits on currency and maturity mismatches also reduce the banking system’s
exposure to liquidity and market risks. A large currency mismatch suggests that
a bank has assets (e.g., loans) denominated largely in one currency, and liabilities
(e.g., its deposit base) largely in another currency. When the exchange rate moves
against the bank’s assets, but in favor of the bank’s liabilities, the bank will incur
losses, and might need to raise funds quickly. A maturity mismatch suggests a bank
is depending too much on short-term loans to finance long-term loans, which will
result in liquidity problems if the bank cannot roll over the short-term loans when
they become due.
Liquidity coverage ratios (LCR) and net stable funding ratios (NSFR) are also
among the global liquidity standard introduced by Basel III to strengthen banks’
liquidity positions. (See Concept: Introduction to Basel I, I, and III for specifics.)

Sustaining Financial Stability: Dealing with Threats to Financial

Institutions Ex Post
Micro- and macroprudential measures and capital adequacy requirements such as
those proposed in Basel I, II, and III are used to ensure that financial institutions are
generally in a safe and sound conditions ex ante. In practice, however, financial insti-
tutions often borrow short-term and lend long-term, meaning that it is very possible
Financial Stability: Intervention Tools 245

that they could experience unexpected liquidity shortages, whether from internal or
external factors, despite being very well capitalized.

The Discount Window  To prevent liquidity shortages from creating undue strain on
financial institutions and causing systemic failures, the central bank can provide
access to backup liquidity for eligible financial institutions through a facility that
is often known as the discount window. In the early days of central banking, the
discount window was the principal instrument of central banking operations where
the central bank provided funds to financial institutions that needed them. Later on,
with market operations becoming the dominant instrument of monetary policy, the
discount window was relegated to a complementary role, and was used primarily as a
safety valve to help alleviate unexpected liquidity pressures on financial institutions.35
As a provider of liquidity, the discount window can be used as another channel to
either inject liquidity into financial institutions that are under extreme liquidity pres-
sures, or to redistribute liquidity—through the borrowing financial i­nstitutions—to
other parts of the economy where it is needed.
To borrow from the discount window, eligible financial institutions normally
have to post eligible assets at a discount as collateral for the central bank. The inter-
est rate charged on discount window lending is often a little higher than the policy
interest rate, to discourage financial institutions from overreliance on the discount
window. By charging a higher interest rate on discount window lending, the central
bank is expecting financial institutions to manage their liquidity more prudently
and come to the discount window for backup liquidity only when necessary. In the
course of normal operations, financial institutions thus often try to access other
sources of liquidity first, since they are likely to be charged lower interest rates.
While the central bank might generally want to discourage banks from relying on
the discount window as their main source of liquidity, however, it has become increas-
ingly recognized that excessive stigma should not be placed on those that are truly in
need of temporary liquidity.36 Even well run banks might run into emergency liquidity
needs in times of general crisis, and the excessive stigma placed on discount window
borrowing might unduly deter them from tapping that much needed liquidity.
To resolve this dilemma, the central bank now often distinguishes between dif-
ferent tiers of liquidity provision, and accordingly charges different interest rates
at the discount window. The first tier is for provision of very short-term liquidity
backup to generally sound financial institutions, and the interest rate charged might
be only a little higher than the policy interest rate. Liquidity would be provided on a
no-questions-asked basis, and that liquidity could be used for any purpose. Financial
institutions that are not qualified to access the first tier of liquidity at the discount
window might still be allowed to access liquidity, but they would be charged a higher
interest rate, and the central bank might require confirmation that the loan is consis-
tent with regulatory requirements.

Special Resolutions for Troubled Financial Institutions and Living Wills  Despite various mea-
sures put in place, there is always a possibility that a bank might still fail. To ensure
financial stability, the central bank and related authorities might need special resolu-
tions to ensure that a troubled bank does not fail in a disorderly manner.
According to 2012 work from Claire McQuire, there are four key types of spe-
cial resolutions that regulatory authorities might resort to when they want to ensure
246 CENTRAL BANKING

an orderly resolution for a troubled bank: (1) liquidation, or closing of the bank; (2)
conservatorship, or temporary administration of the bank; (3) purchase and assump-
tion; and (4) nationalization.37

Liquidation: Closing of a Bank  Liquidation is often the preferred option in cases

in which regulatory authorities feel that the closure of the bank would not lead to
contagion effects. Under the liquidation option, regulatory authorities might simply
order the bank closed, withdraw the bank’s license, and follow procedures laid out in
either the country’s bankruptcy laws, commercial laws, or special resolution regimes
for banks. The bank’s assets would be sold over time to repay its liabilities to deposi-
tors and other creditors. If the country has a deposit insurance program, the insur-
ance agency would pay depositors up to an agreed amount and the payments would
be substituted for depositors’ claims during the recovery process. Bank shareholders
would only receive residual claims after all other bank creditors have been paid.

Conservatorship: Temporary Administration  If regulatory authorities feel that

closing the troubled bank immediately would create unnecessary disruption, regula-
tory authorities might appoint a temporary administration team who would take
over from the bank’s own senior executives. In a conservatorship, preexisting share-
holders may be removed from ownership of the bank or their rights might be tem-
porarily constrained. The administration team would reform the bank’s operations
to improve its financial health, with the goal of possibly selling or merging the bank
with another financial institution at a later date.

Purchase and Assumption: Facilitating an Acquisition by Another Party  To prevent

unnecessary disruptions, another alternative is for regulatory authorities to pursue
what is known as purchase and assumption (P&A). This approach essentially aims
to transfer the troubled bank’s operations to another healthy bank. Regulatory
authorities withdraw or cancel the license of the troubled bank, terminate sharehold-
ers’ rights, facilitate the assumption of the troubled bank’s good assets and deposits
by the other bank, and take over the troubled bank’s problem assets so they can be
managed and sold afterward. One form of P&A is for regulatory authorities to cre-
ate a bridge bank, which takes over all or part of the troubled bank with the goal of
selling it to a private party at some later date.

Nationalization: Assumption of Ownership by the Government  In the environment

in which the system is already under a lot of stress and a more market-based resolu-
tion might not be timely or effective, regulatory authorities might need to assume
ownership of the troubled bank. In such a case, all assets and liabilities of the troubled
bank are transferred to the government in exchange for cash injection and ownership.
The government might appoint new management or it might let current management
continue to improve the bank’s financial health, such that the government would
either be repaid over time or would sell the bank to a private party at a future date.

Living Wills  In the wake of the 2007–2010 crisis, it has been recognized that
modern financial institutions can be very large with very complex ownership struc-
tures and contractual obligations. Unless the banks’ structures are well-known to
regulatory authorities in advance, regulatory authorities’ efforts to provide a bank
Financial Stability: Intervention Tools 247

resolution at the time of the crisis might not be efficient or effective. Consequently,
financial reforms after the 2007–2010 crisis, such as the Dodd-Frank Act in the
United States, now require that the largest banks file living wills with regulatory
authorities that detail the banks’ existing ownership structures, assets, liabilities,
and contractual obligations plan for resolutions, in case the banks go bankrupt and
need to be wound down.38
Apart from helping regulatory authorities know in advance about the existing
structures and resolution plans of banks, the exercise of creating living wills forces
the banks’ management to know more about their own bank operations and plan
for emergencies. Among living wills of the 11 largest banks that filed living wills with
U.S. authorities in 2013, plans include recapitalizing of subsidiaries while putting
the parent company into bankruptcy, selling off assets and businesses, and closing
of business units.39 Given that the plans are done before the banks actually run into
trouble, living wills could also be considered an ex ante tool.

12.3 FINANCIAL MARKETS

Since the central bank is normally not the direct regulator of financial markets,* it
is often the case that the central bank will take a hands-off or a very selective and
very cautious approach in dealing with those markets. As it is not a direct regulator
of financial markets, the central bank might not have adequate regulatory tools to
mitigate risk buildup among financial market players, except possibly in cases in
which players are banks under its supervision (and that only applies if the central
bank is a bank supervisor).
Although the central bank is normally not a direct regulator of financial mar-
kets, there are at least three key reasons that the central bank might need to take an
active role in reducing risk in the financial markets.
First is the growing importance of financial markets. The 2007–2010 crisis high-
lighted the need to rethink the role of the central bank in maintaining financial
market stability. In the United States, financial intermediation was increasingly being
conducted in the financial markets, outside of the traditional depository institutions
that were under central bank supervision. At the same time commercial bank assets,
as a proportion of total financial intermediary assets, has declined, while the pro-
portion attributable to securities broker-dealers, hedge funds, and mutual funds has
grown in importance.
What came along with the growing importance of these nonbank institutions
was the securitization of financial institutions’ assets (such as mortgages, auto loans,
and credit card loans) into tradable securities. Trading of these securitized assets
became an important activity among financial institutions all by itself. If develop-
ments in the United States are any guide, it is likely that financial markets in other
countries will also grow in importance relative to traditional banking.

*Depending on the country, the role of financial market regulation is either assigned to a
single regulator (such as the Financial Services Authority) or to different regulators for differ-
ent markets (such as the Securities and Exchange Commission and the Commodity Futures
Trading Commission).
248 CENTRAL BANKING

Second, severe disruptions in the financial markets can result in shortages of

liquidity, which could cause chains of settlement failures to spread across the finan-
cial system and the economy. This is especially true for the many countries where
financial markets have grown in significance to become an important source of
funding for economic activity. The central bank, with its financial stability mandate,
cannot thus stay idle, especially if market disruptions threaten the stability of the
financial system and the economy.
As the ultimate creator of money, it is the central bank that has ultimate liquidity
provision power, and thus the ability needed to offset systemic liquidity shortages in
financial markets. The growing importance of financial markets and the intertwining
nature of financial markets, financial institutions, and ultimately, the macroeconomy,
make it inevitable that central banks will have to take a more proactive role in deal-
ing with risk buildup in financial markets.
Third, through its day-to-day monetary policy operations in the financial markets,
the central bank already has in place the network of contacts, tools, and facilities that
can readily be used to help sustain the smooth functioning of markets. For its day-to-
day monetary policy operations, the central bank normally is at the center of a network
of primary dealers, which may include institutions not under its direct supervision but
are key players in different segments of financial markets. In terms of gathering infor-
mation, in being connected to a network of primary dealers, the central bank is more
likely to be aware of disruptions outside the market segments in which the central bank
normally operates. In operational terms, the central bank can also use the primary deal-
ers as conduits to redistribute liquidity to where it is needed in the financial markets.

Sustaining Financial Stability: Dealing with Threats to Financial

Markets Ex Ante
A central bank is normally not the lead regulator of financial markets. Still, with its
monetary policy fundamentally affecting prices and cost of funds in financial mar-
kets, its extensive operations in the financial markets, and its regulatory power over
banks that are key financial market players (in cases in which the central bank is also
a bank supervisor), a central bank has the ability to deal with threats to financial
markets ex ante.

Using Monetary Policy to Address Risk Buildups in the Financial Markets  In theory, ex ante, a
central bank could choose to tighten monetary policy in order to prevent the buildup
of risk in financial markets. A tightened monetary policy stance raises the cost of funds
among players in financial markets, which discourages them from undertaking more
speculative activities. In practice, however, this is rarely done, unless it is also clear that
the buildup of risk in any particular segment of the market is already a serious risk to
financial stability and ultimately price stability. The central bank would be very hesitant
to tighten its monetary policy stance simply in response to fast-rising prices of stocks, for
example, since the tightening would affect all sectors of the economy, and it can never
be sure whether the fast-rising stock prices are justified by economic fundamentals.

Regulations on Market Players  Rather than simply tighten monetary policy stance,
the central bank might target regulations to financial market players under their
supervision (i.e., banks). Examples of such regulations include limits on net currency
Financial Stability: Intervention Tools 249

positions, limits on currency mismatches, and limits on maturity mismatches of

banks under the central bank’s supervision. (See the previous section on liquidity-
related macroprudential tools.)
For market players that are not directly under the central bank’s supervision, the
central bank might need to coordinate with the relevant regulators to ensure that
there is a level playing field among the different types of market players (i.e., mar-
ket activities are equivalently regulated among different types of market players).
Otherwise, risk-taking activities might simply migrate from players that are tightly
regulated to those that are lightly, or not adequately, regulated.

Sustaining Financial Stability: Dealing with Threats to Financial

Markets Ex Post
Given the central banks’ control of monetary policy, and their lender-of-last-resort
status, the central banks also are in a good position to deal with threats to financial
markets ex post.

Monetary Policy and Liquidity Risk  As overindebtedness or bubbles start to materially

affect financial stability, it becomes more likely that players in the financial markets
would be wary of lending to each other, as they become unsure of each other’s abil-
ity to fulfill their transaction obligations. If those with excess liquidity become very
worried and refuse to lend or demand excessively high interest rates for loans, even
those players who are solvent (the value of their assets exceeds their debt) but need
liquidity urgently (possibly to pay for their own transaction obligations, for exam-
ple), might also fall into trouble, which could create a trail of liquidity shortages that
runs through the whole system.
In the case where liquidity shortages spread widely, such that system’s stability
might be affected, the central bank might decide to use monetary policy to reduce the
system’s liquidity risk. This could be done through cuts in the policy interest rate, as
well as cuts in rates charged on emergency lending. The cuts in interest rates would
help lower the costs of funding in the financial markets, and ease liquidity shortages.

Liquidity Provision to Institutions Not Supervised by the Central Bank  Once financial mar-
kets are experiencing stress and disruption, the central bank might also decide to
intervene ex post by providing liquidity to financial market players (even those that
are not directly under its supervision), if not doing so would aggravate system insta-
bility. Traditionally, central banks often refrain from providing liquidity to financial
market players not under their supervision for fear of moral hazard. As financial
markets have grown in importance, however, it could be hazardous for the central
bank to ignore liquidity shortages of systemically important players just because
they are outside its direct supervision.
On this note, it is good to draw from the U.S. central bank’s experiences in alle-
viating pressure in the financial markets during the 2007–2010 crisis. Notably, the
Federal Reserve intervened in the financial markets ex post in three nontraditional
ways: (1) the provision of liquidity to institutions and firms not supervised by the
central bank, (2) the expansion of types of collateral taken in lieu of liquidity provi-
sions, and (3) the provision of nonrecourse loans of longer maturities in certain cases
normally outside traditional liquidity provision.40
250 CENTRAL BANKING

Notable among firms and institutions that the U.S. central bank provided liquid-
ity to during the crisis although they were not necessarily under its supervision were
(1) primary dealers, consisting banks that are under the Federal Reserve’s supervi-
sion as well as nonbanks that are not;41 (2) money market mutual funds, which are,
strictly speaking, outside the Federal Reserve’s supervision but which have gained in
importance as people have started to treat the money in money market accounts as a
substitute for bank deposits (details of money market mutual funds will be discussed
in Chapter 13);42 (3) commercial paper issuers, which includes many nonfinancial
corporations that issued paper in the financial markets to raise funds for their opera-
tional activities, including payroll payments; (4) investors in the asset-backed securi-
ties market, which included banks and various other types of financial institutions
that invested in asset-backed securities; and (5) foreign central banks, which might
have needed to meet a demand for U.S. dollars from domestic and foreign corpora-
tions in their own jurisdictions.43

SUMMARY
If risks to financial stability become apparent, the central bank can intervene to sus-
tain financial stability both ex ante and ex post. Ex ante means that the central bank
intervenes to preempt a crisis from occurring. Ex post means that the central bank
intervenes to restore stability after a crisis has occurred.
To deal with threats to financial stability in the macroeconomy, the central bank
might tighten monetary policy and use macroprudential tools to tame overindebted-
ness among economic sectors ex ante. The central bank might also loosen monetary
policy and macroprudential tools to less the effects of the crisis on economic agents
in the macroeconomy ex post.
To deal with threats to financial stability in the financial institutions system,
the central bank could rely on capital and liquidity-related measures. Time-varying
capital requirements, dynamic loan loss provisioning, Basel II and III, are measures
to help strengthen banks’ capital, while limits on net open positions, limits on mis-
matches of currencies and maturities, as well as liquidity coverage ratio, and net
stable funding ratio are examples of liquidity-related measures. Ex post, the central
bank might provide liquidity to financial institutions through the discount window,
as well as to resort to special resolutions for troubled banks. In addition, regulatory
authorities might also require largest banks to submit their living wills.
Although the central bank is often not the lead regulator in financial markets,
it could deal with threats to financial stability in financial markets ex ante through
the use of monetary policy and regulations on banks under its supervision. Ex post,
the central bank might restore stability in the financial markets through the use of
monetary policy as well as liquidity provision to institutions not supervised by the
central bank.

KEY TERMS
Basel I currency mismatch
Basel II dynamic loan loss provisioning
Basel III liquidity coverage ratio
commercial paper issuer macroprudential measure
Financial Stability: Intervention Tools 251

maturity mismatch net stable funding ratio

money market mutual fund primary dealer
net open position time-varying capital requirement

QUESTIONS
1. Given experiences from the 2007–2010 crisis, why might a central bank use
monetary policy to lean on asset price bubbles in addition to cleaning up after
the bubbles have burst?
2. How can monetary policy be used to lean on asset price bubbles?
3. Why might the central bank hesitate to use monetary policy to lean on asset
price bubbles?
4. How can monetary policy be used to clean up after asset price bubbles have
burst?
5. Give four examples of macroprudential tools.
6. What are the key differences between dynamic loan loss provisioning and time-
varying capital requirements?
7. How can macroprudential measures be used to help sustain financial stability ex
post (i.e., after a crisis has occurred)? Should we expect these measures to help
reverse the crisis or just alleviate the effect of the crisis?
8. Give examples of how capital-related macroprudential tools could be used to
safeguard financial institutions against systemic risks.
9. Give examples of how liquidity-related macroprudential tools could be used to
safeguard financial institutions against systemic risks.
10. When the value of loans are written down, which component on a commercial
bank’s balance sheet would first be used to absorb losses?
11. What is a capital ratio?
12. What does Basel I say regarding the capital ratio of commercial banks?
13. What are the three pillars of Basel II and Basel III?
14. What are the key improvements of Basel II over Basel I?
15. What are the key improvements of Basel III over Basel II?
16. Give examples of special resolutions for troubled financial institutions.
17. Why might the central bank be hesitant to use monetary policy to address risk
buildups in financial markets?
18. Why is a level playing field necessary in financial markets?
19. Why might the central bank be hesitant to provide liquidity to firms that are not
under its supervision?
20. In the wake of the global financial crisis of 2007–2010, what kind of extra
measures did the Federal Reserve embark on with respect to liquidity provision
in financial markets?
21. Give four examples of entities that were not under the Federal Reserve’s
supervision, but which were given access to liquidity by the Federal Reserve.
22. How could a macro stress test be used as a tool to help restore financial stability
ex post?
23. Why might we consider quantitative easing as a tool to help restore financial
stability?
 PART
Four
Sustaining Monetary
and Financial Stability
for the Next Era

P art IV looks at the future challenges of central banking and how central banks
might prepare themselves to meet those challenges.
Chapter 13 reviews three major forces that will likely shape the economic and
financial landscape that central banks will be operating in, in the near future: the
intensification of the globalization process, the continued evolution of financial
activities, and unfinished business from the global financial crisis.
Chapter 14 discusses how central banks might prepare themselves to meet future
challenges and deliver value to society using a public policy analysis framework
that involves improving the analytical capacity, operational capacity, and political
­capacity of central banks.

253
 CHAPTER 13
Future Challenges for Central Banking

Learning Objectives
1. Explain how the intensification of globalization might pose chal-
lenges to central banking in the future.
2. Explain how the recent evolution in financial activities might pose
challenges to central banking in the future.
3. Describe key features of financial reforms instituted after the
2007–2010 global financial crisis.

P art I of this book discusses how central banking has evolved over the centuries
to meet the challenges that have arisen with changes in political, economic, and
financial circumstances. Parts II and III of this book discusses how the practice of
modern central banking is shaped by theoretical developments and practical expe-
rience. Specifically, Part II focuses on the central banks’ use of monetary policy to
achieve their monetary stability mandate. Part III, meanwhile, focuses on the central
banks’ use of macroprudential tools in addition to monetary policy to help attain
their financial stability mandate, given the lessons learned from the 2007–2010
financial crisis.
In this chapter we look into the future and discuss three major forces that are
likely to continue to shape the economic and financial landscape that central banks
operate in. These three forces are (1) the intensification of globalization, (2) the
evolution in financial activities, and (3) unfinished business from the 2007–2010
financial crisis. (See Figures 13.1 and 13.2.)

13.1 THE INTENSIFICATION OF GLOBALIZATION

In economic terms, globalization involves the process of reduction and removal of

cross-border barriers to international trade, production, investment, and labor.1 Such
reduction and removal of barriers often arise through liberalization, privatization,
and deregulation of markets and economies, as well as advances in transportation,
information, and communications technology.
The intensification of the globalization process has gathered strong momentum
since the late 1970s, through changes in geopolitics, technological advances, and the

255
256 CENTRAL BANKING

Intensification of globalization

Economic and financial

environment

Central
bank

Evolution Unfinished
in financial business from the
activities global financial crisis

FIGURE 13.1  Three Future Challenges for Central Banks

Freer flows of international capital

Economic and financial

environment

Central
bank

Freer flows of Rise of

cross-border international
goods and intermediaries
services

FIGURE 13.2  The Intensification of Globalization

belief in market mechanisms. Despite various hiccups in the form of financial crises,
including the global financial crisis of 2007–2010, it is likely that the intensifica-
tion of globalization will continue. Through globalization, countries have become
so dependent on each other through international trade and investment that any
attempt to disentangle such interdependence would be too disruptive and costly.
The intensification of globalization will affect central banking through at
least three key dimensions: (1) freer flows of international capital, (2) freer cross-
border flows of goods and services and factor inputs, and (3) the rise of international
intermediaries. One important implication from the intensification of globalization
through these three dimensions is that external factors will have an increasing influ-
ence on domestic monetary and financial stability.
Future Challenges for Central Banking 257

Freer Flows of International Capital

As discussed in Chapters 4 and 9, freer flows of international capital could put
pressures on the exchange rate and domestic inflation, as well as trigger asset price
bubbles. If left unchecked, large inflows of capital into a small open economy could
easily lead to a sharp appreciation of the exchange rate. Once these inflows work
their way into the economy, they could also lead to a pickup in economic activity
as well as general price inflation. Often, the inflows could also trigger speculative
bubbles in domestic asset prices.
A sudden reversal of the capital inflows, in contrast, could lead to a sharp fall in
the exchange rate, a slowdown in economic activity and inflation, as well as sharp
falls in domestic asset prices. Accordingly, through freer flows of international capi-
tal, the intensification of globalization has the potential to destabilize both monetary
stability and financial stability.

CASE STUDY: The Growing Challenges from International Capital Flows

The challenges of freer flows of international capital for central banks have been felt at least since the
gold standard era, when outflows of gold could threaten the value of the currency. Speculative attacks
on European currencies in the 1960s and 1970s, financial crises in Latin America in the 1980s and
1990s, and the Asian financial crisis in the late 1990s were all also partly by-products of freer flows of
international capital.
Whereas the speculative attacks and financial crises of earlier eras had been largely confined
to particular countries or regions, as the globalization process has intensified, the effects of volatile
international capital flows now tend to be more global in nature. This was witnessed in the effects of
quantitative easing (used to fight the 2007–2010 crisis) in advanced economies, which led to large
capital outflows from advanced economies into emerging economies across the globe.2
Despite heavy intervention in the foreign exchange market by emerging-market central banks, the
large inflows of international capital led to a sharp appreciation in exchange rates, a pickup in domestic
economic activity and domestic inflation, as well as a pickup in asset prices in emerging-market econo-
mies across different regions from 2009 until early 2013.
Subsequently, in mid-2013, as the Federal Reserve announced the possibility of a tapering of the
quantitative easing program, the sharp outflows of international capital were felt across emerging-
market economies. The exchange rates of many emerging-market economies fell along with prices of
stocks, bonds, and in many cases, real estate.3
Going forward, in a world of freer capital flows, it will be a challenge for central banks of small,
open economies to temper the volatility of asset prices that the sharp reversal of international capital
flows brings about.

Freer Cross-Border Flows of Goods and Services and Factor Inputs

Freer cross-border flows of goods and services and factor inputs also imply that
external factors can have a great influence on domestic economic activity and domes-
tic inflation, at least in the short run. While globalization allows countries to reap
the benefits of comparative advantage, the greater reliance on imports and exports
of goods and services and global supply chains means that events occurring outside
their borders could affect the domestic economy more readily.4
On the import side, changes in international price levels have the potential to
affect domestic inflation through the import prices of factor inputs, for example.
258 CENTRAL BANKING

This is especially noticeable in the case of energy imports, which for many countries are
essential factor inputs to economic activity. For countries that rely heavily on energy
imports, fluctuations in oil prices can affect not only domestic energy prices, but also
the general price level, through cost-push inflation as well as the expectations effect.
Outsourcing of production to foreign countries with cheaper production costs, on the
other hand, could also help hold down inflationary pressures in the domestic economy.
On the export side, changes in global demand also have the potential to affect
both domestic economic activity and domestic inflation. A boom in global demand
for natural resources, for example, will likely lead to a boom in domestic economic
activity of a resource-producing country, as well as an uptick in inflationary pressure.
On the other hand, as countries are integrated more and more into a global sup-
ply chain, a glitch in that chain has the potential to affect economic activity in other
countries. For example, the major flood that disrupted car part and hard-disk drive
manufacturers in Thailand in 2011 did disrupt car and computer production, as well
as related activities, in other countries in these global supply chains.

CASE STUDY: The Growing Challenge of International Pressure on Domestic Economic

Activity and Domestic Inflation

In the past decade, through the intensification of globalization, many events seem to have had a great
impact on economic activity and inflation beyond their borders. In the early part of the first decade
of the twenty-first century, the burst of the dot-com bubble and terrorist attacks in the United States
helped slow down global demand and global economic activity for some time. Meanwhile, the acces-
sion of China into the WTO in 2001 and the entry of many low-cost emerging Asian economies into the
global trading system might have also contributed to a slowdown in global inflation through the floods
of their exports.5 In response to low inflation, many central banks, including the Federal Reserve, cut
their interest rates during this period.
In the middle of that same decade, as China and other emerging economies grew rapidly, they
started to demand more natural resources. Speculation that the demand for energy from China and
other emerging economies would keep going up helped push the price of crude oil from around USD
30 per barrel in 2000 to a peak of more than USD 140 in July 2008. The fear of a disinflation period that
had existed earlier in the decade started to dissipate.
To counter this pickup in inflation, by 2007 many central banks, including the Federal Reserve,
had started to raise their interest rates, only to find that as Lehman Brothers collapsed the following
year, they had to cut interest rates to near 0 percent to counter deflation.
While oil prices fluctuated wildly between USD 35 and USD 82 per barrel in 2009, by 2011 they
had again risen above USD 100 per barrel on concerns over the political uprising in Egypt. Although this
later spike in oil prices did not raise many inflation concerns in the advanced economies that were still
reeling from the financial crisis, it did raise concerns in many emerging economies, which were boom-
ing from capital inflows. In 2011, many emerging-market economy central banks in Asia started to
raise their interest rates to preempt inflationary pressures that were building from oil prices as well as
capital flows.
Going forward, it is easy to see that as countries integrate more and more into the global econ-
omy, their central banks will have to contend more and more with the ability of external factors to affect
domestic activities and domestic inflation.

The Rise of International Intermediaries

In the past three decades, as financial liberalization has taken place around the world,
financial intermediaries have started to expand their operations internationally. The
Future Challenges for Central Banking 259

increasing importance of international banks and the implications for global financial
stability has been recognized partly by the Basel Committee’s guidelines for the super-
vision of global systemically important banks (G-SIBs), as discussed in Chapter 11.
During the most critical phase of the financial crisis of 2007–2010, it became
recognized that the existence of international banks could have profound implica-
tions for financial stability, not only in the home countries where these banks based
their headquarters and the host countries where these banks operate their branches
and subsidiaries, but also in other countries through the interlinkages of financial
transactions and contagion effects.
Going forward, the rise of G-SIBs and other international intermediaries will
likely add more complexity to supervisory work for central banks. International
cooperation among central banks, whether bilaterally or through multilateral chan-
nels such as the Basel Committee or the Financial Stability Board, will also be very
important.

13.2 THE CONTINUED EVOLUTION IN FINANCIAL ACTIVITIES

Along with the increasing degree of globalization, the continued evolution of finan-
cial services will likely also shape the future of central banking, since they both will
change the landscape in which central banks operate. Two key features of the con-
tinued evolution in financial activities include (1) the rise of market-based financial
activities and (2) the rise of electronic payments.

The Rise of Market-Based Financial Activities

In the past three decades, liberalization and attainment of higher development stages
have resulted in the rising importance of market-based financial activities. Unlike in
a bank-based system—where banks play a leading role in mobilizing savings, allocat-
ing capital, overseeing the investment decisions of corporate managers, providing risk
management vehicles, and lending funds out to borrowers—in a market-based sys-
tem, securities markets share a leading role with banks in channeling savings to firms,
exerting corporate control, and facilitating risk management.6 (See Figure 13.3.)
The proliferation of market-based financial activities is partly reflected by (1) the
rise of nonbank financial entities in the mobilization of savings and the allocation of

Economic and financial

environment

Central
bank

Rise of market- Rise of

based financial electronic
activities payments

FIGURE 13.3  The Continued Evolution in Financial Activities

260 CENTRAL BANKING

funds in the economy, and (2) the embracing of market-based financial activities by
banks in their operations.

The Rise of Nonbank Financial Market Entities  Nonbank financial market entities are
those entities that are involved in investment, risk pooling, or contractual saving
of funds, yet are not operating under a banking license.7 Prominent among such
entities is a category called institutional investors, which includes mutual funds, pen-
sion funds, insurance companies, and hedge funds.* Broadly speaking, institutional
investors are collective investment vehicles that pool large sums of money and invest
those sums in securities and other investment assets including real estate.
Institutional investors specialize in investing on behalf of others. An individual
who buys a share in a mutual fund, for example, is effectively putting money in the
pool of money managed by the mutual fund, and is entitled to a proportion of the
assets held by the mutual fund as well as a proportion of the income or profits that
those assets generate. By pooling large sums of money, institutional investors can
spread their investments across many securities or assets, and thereby diversify away
some of the risks that are associated with investment in only a single security or asset.

Money Market Mutual Funds  The rise of institutional investors potentially poses
challenges to central banks in terms of financial stability. By pooling money from
retail investors and investing the pooled money on the retail investors’ behalf, insti-
tutional investors perform functions quite similar to banks, yet they are not super-
vised or regulated by central banks. The problem became apparent with the run
on money market mutual funds in the United States in the wake of the collapse of
Lehman Brothers (see Case Study: Money Market Mutual Funds for details).

CASE STUDY: Money Market Mutual Funds

Prior to the collapse of Lehman Brothers, money market mutual funds that invested money in short-
term debt securities (such as U.S. Treasury bills and commercial paper) were considered and accord-
ingly treated as near substitutes for bank deposit accounts by individuals in the United States. By
maintaining a stable net value of 1 U.S. dollar per share, and paying out steady dividends, money
market mutual funds allowed individuals to preserve their capital and earn yields that were slightly
higher than traditional bank deposits.
With large amounts of money being placed in money market mutual funds, the money market
mutual funds themselves became increasingly important as lenders of short-term liquidity to compa-
nies in the wholesale money market in the years leading up to the crisis. Companies and investment
banks (such as Lehman Brothers) borrowed short-term money in the wholesale money market by
issuing commercial paper that money market mutual funds would buy and hold.
When Lehman Brothers collapsed, however, the commercial paper issued by Lehman Brothers
became worthless and money market mutual funds that held Lehman Brothers’ commercial paper had
to absorb the loss and write down their assets. In the process of writing down the loss from Lehman
Brothers’ commercial paper, Reserve Primary Fund, which had been founded in the 1970s and was
the oldest money market fund, found that its shares fell below 1 dollar, to 97 cents per share.8 The fact

*Some smaller operators such as pawnshops are also considered nonbank financial market
entities, but they operate at a much smaller scale and their systemic impact is rather limited.
Future Challenges for Central Banking 261

that Reserve Primary Fund fell below 1 dollar per share caused panic among investors, since they had
deemed the investment in these funds to be almost as safe as bank deposits, and thought that they
would never lose their capital.
The run on Reserve Primary Fund and other money market mutual funds threatened not only
investors in the funds, but also companies and banks that relied on the funds as a key source of short-
term funding. In response to the run, the U.S. Department of the Treasury announced an optional pro-
gram (akin to a deposit insurance program) to guarantee that if a covered fund’s share price fell below
1 dollar, it would be restored back to 1 dollar.

Hedge Funds  Aside from the possibility of runs on mutual funds, the proliferation
of hedge funds also poses another challenge for central banks in terms of financial
stability. Hedge funds (unlike mutual funds, which aim to pool money from retail
investors and invest using relatively conservative styles) aim to pool money from
sophisticated or accredited investors and invest using relatively faster and riskier
styles, including short selling* and leveraging,† in order to achieve higher returns.
Since hedge funds need to be quick in exploiting good investment opportunities,
sometimes they can rush into similar kind of trades at the same time, which can tip
a market’s balance and financial stability. Examples include speculative attacks on
the British pound in 1992 and the Thai baht in 1997; in these instances, short selling
of the currency by a hoard of large hedge funds inflicted large losses on the central
banks of these countries and forced them out of their de facto fixed exchange rate
regimes.
Not all hedge fund operations are successful, however, and a failure of a highly
leveraged hedge fund could lead to systemic risk. The collapse in 1998 of Long Term
Capital Management (LTCM), a highly leveraged hedge fund, threatened to affect
many global banks and global financial markets, such that the Federal Reserve Bank
of New York had to step in and orchestrate a rescue despite the fact that it did not
regulate LTCM.

Insurance Companies  In the wake of the 2007–2010 crisis, the U.S. central bank also
had to rescue AIG, a large insurance company that it did not regulate. Traditionally,
insurance companies diversify their investments in relatively safe assets (e.g., stocks
and bonds) to match their liabilities (i.e., insurance payouts). By the middle of the
first decade of the twenty-first century, however, AIG had branched out into insuring
the credit risk of companies and financial securities via the selling of credit default
swaps to a large number of counterparties, including large banks.
In a credit default swap, an entity insures its holding of, say, Company X’s
bonds by regularly paying the insurer a premium. If Company X’s bonds get down-
graded, then the insurer has to post cash collateral to the entity. If Company X
then defaults on its bonds, the insurer pays the entity to cover the loss on the

*Short selling involves selling borrowed securities in the hope that the prices of the securities
will fall so that they can be bought back more cheaply. If the prices do fall, sellers make a
profit on the difference between the price they sold them at and the price they bought them
back at, before returning the securities to the rightful owner.
†
Leveraging involves borrowing funds beyond one’s own capital to invest. It can also be done
through the short selling of securities to raise funds to invest in other securities.
262 CENTRAL BANKING

entity’s bond holdings. Using this logic, AIG also expanded to provide insurance
on complex financial securities, including mortgage-backed securities and subprime
mortgages.9
As the subprime crisis raged on, banks, firms, and mortgage-backed securities
were downgraded. AIG started to take on heavy losses from its credit default swap
deals. When Lehman Brother filed for bankruptcy in September 2008, AIG itself was
downgraded, and was on the verge of collapsing as demands for large amounts of
cash collateral came in from their counterparties.10
Finally the Federal Reserve had to step in and rescue AIG, since if AIG were
also to go bankrupt, its counterparties (including many large banks) would have
faced large losses that could have brought the whole system down. The fact that the
Federal Reserve had to step in to orchestrate the rescue of a hedge fund like LTCM,
and had to actually bail out AIG, an insurance company, reflects how market-based
activities and nonbank financial institutions have become so important that they can
pose systemic risk.

The Embracing of Market-Based Activities by Banks  In the past three decades, not only have
market-based activities become plausible alternatives for bank-based activities, but
nonbank financial institutions have become very important as well. In many coun-
tries banks themselves have embraced market-based activities in their own opera-
tions. Among the important market-based activities that banks have embraced are
securitization and proprietary trading and in many cases banks have set up market-
based subsidiaries to handle these activities.

Securitization  Securitization involves the issuance of securities that entitle the

holder of the securities to a claim on future cash flows or income derived from
prescribed underlying assets. An entity (e.g., a bank) issues and sells the securities
to investors who then earn income from the underlying assets (e.g., mortgages). By
purchasing the securities, the investors have the rights to income derived from the
underlying assets, as well as a claim on the underlying assets in case of a default on
income payment.
For banks, securitization involves pooling contractual debts that often are tradi-
tional bank assets such as residential mortgages, commercial mortgages, auto loans,
and credit card debt obligations into packages, and selling those packages to outside
investors. With securitization, banks could drastically transform their traditional
banking business models into an originate-to-distribute model.
With the advent of securitization, rather than originating loans and holding
them on their books for the long haul as they traditionally had done, banks started
to originate the loans and distribute them out in packages. Banks took in money
from the sale of these securitized assets, money that could be lent out again to bor-
rowers. By repeating the process, a bank with an originate-to-distribute model could
earn high fees from both packaging and distributing the securitized assets.
Through securitization, traditional bank assets (such as loans) that are normally
illiquid, become liquid and more readily tradable. Often investors bought these secu-
ritized debts because they offered better returns than bank deposits, and (at least
prior to the 2007–2010 financial crisis) were deemed to be rather safe, since the
pooling of debts would have diversified away the risk of default by any one indi-
vidual bank borrower.
Future Challenges for Central Banking 263

Proprietary Trading  Proprietary trading refers to an arrangement under which

banks trade securities in financial markets using their own capital in the hope of
generating profits. Prior to the crisis banks had started to do a lot of proprietary
trading, including trading in financial securities (such as government and corporate
debt) as well as in derivative contracts (such as collateralized debt obligations, or
CDOs). The rise in proprietary trade occurred partly because there was a lot of
liquidity in the system and interest rates were low (which kept the cost of funds used
in such trading low), and banks had to seek ways other than giving out simple loans
to generate profits from the extra liquidity.
Given the need for profits, many banks decided to set up units devoted purely to
proprietary trading, that is, the so-called prop desks. Through proprietary trading,
banks themselves became heavily involved in financial market activities as active
traders who took on risks in order to generate profits. In the wake of the 2007–2010
financial crisis, however, it became clearer that proprietary trading could create
great risks for bank depositors. If the trading generates losses rather than profits,
the bank’s capital base is reduced, jeopardizing not only the bank’s shareholders but
also bank depositors.

C O N C E P T: PROPRIETARY T RADING, MA R K ET-MA K I NG, A ND THE

V O L C K E R RULE
The recognition that proprietary trading might bring unnecessary risks to banks
and losses to depositors led to the proposal of a ban on proprietary trading by
commercial banks. This proposal was advocated by Paul A. Volcker, the for-
mer chairman of the Federal Reserve who brought U.S. inflation down in the
early 1980s, and who later became the chair of President Obama’s Economic
Recovery Advisory Board in 2009. The proposal subsequently became known
as the Volcker rule.11
The Volcker rule aimed to make sure that banks would go back to their
traditional banking services and not get sidetracked by an excessive focus on
speculative activities in financial markets, as those activities might bring unnec-
essary risks to the banks and create conflicts of interest among the banks’
management, shareholders, and depositors.12 While the Volcker rule was being
proposed in the 2010 Dodd-Frank Act, however, there was some resistance
from the banks, as they believed that it was difficult to distinguish between a
bank’s proprietary trading activities and market-making activities.
Market-making activities in financial markets are warehousing of financial
securities for future resale to customers. A market-maker buys securities from
customers who want to get rid of the securities, and sells them to customers
who want to get hold of the securities. Since a bank normally has a large num-
ber of customers, some of whom might want to buy and some of whom might
want to sell securities, the bank might attempt to make market by committing
its own capital to buy securities from customers who want to sell and then
reselling those securities to customers who want to buy.

(Continued)
264 CENTRAL BANKING

(Continued)
At first glance, the line between market-making and proprietary trading
activities might look very thin. In a market-making activity, a bank might need
to commit its capital to buy securities from customers, similarly to proprietary
trading. In practice, however, given the opportunity costs involved in ware-
housing the securities, it could be argued that in a market-making activity, a
bank would want to keep as little inventory on hand as possible for the short-
est period of time possible. In a proprietary trading activity, however, a bank
would want keep a large position of securities for quite a longer period of time,
in order to generate the biggest possible profits.13
Despite quibbles on the definitions of market-making and proprietary
trading, many large banks officially started to dismantle their proprietary trad-
ing units in the early 2010s, partly in anticipation of the Volcker rule.14

The Proliferation of Market-Based Bank Subsidiaries  Aside from securitization and

proprietary trading, another trend that indicated that banks had embraced market-
based activities was the setting up of bank subsidiaries to engage in market-based
financial activities. This trend came about partly because banks saw wealth manage-
ment for their clients as an activity that could generate good fee-based income.
In many countries, banks are allowed to have mutual fund subsidiaries or to set
up affiliations with third party mutual funds with whom they can advise their own
clients to invest, as part of the financial products being offered to them. Although
these mutual fund subsidiaries are considered legally separate entities from the par-
ent bank, they also reflect the wider trend toward more market-based activities that
is occurring among banks.
With the proliferation of such subsidiaries, one may ask (1) how much respon-
sibility does the parent bank have to its mutual fund subsidiaries if the mutual
fund subsidiaries of a bank does face a crisis, and (2) what about bank clients who
invested in those funds based on the bank’s advice.
Although the fund affiliates and the banks are often legally separated, in cases
where the fund subsidiaries use names that imply ownership by the bank, it could
lead to contagion effects between the fund subsidiaries and the parent bank. The
question could become very poignant in cases where the assets of mutual subsidiar-
ies have grown to match or exceed the bank’s total assets.
On this note, in 2007 Bear Stearns, a U.S. investment bank, decided to rescue
and absorb the losses of its two hedge fund subsidiaries that invested primarily in
subprime mortgages, for fear that the failures of those funds would affect the bank’s
reputation, despite the bank’s initial small investments in these two funds.15 While
Bear Stearns initially survived this episode, the losses undermined confidence in the
bank and helped contribute to its fall in 2008. Through the assistance of the Federal
Reserve Bank of New York, Bear Stearns was bought by JPMorgan Chase, another
large U.S. bank. To prevent a similar problem from happening in the United States
in the future, Paul Volcker, with the backing of President Obama, sought to put an
Future Challenges for Central Banking 265

explicit ban on banks, or institutions that own a bank, from owning or investing in
a hedge fund or private equity fund.16

The Rise of Electronic Payments

The evolution of payment technology has had profound implication for central
banking since the start of central banking history, as shown by the rise of paper
money to replace coins in the early history of central banking, which later gave rise
to fractional reserve banking. In the past four decades the rise of information and
communications technology (ICT) has led to new electronic payments systems, as
evidenced by the proliferation of ATMs, credit cards, debit cards, mobile payments,
and e-money at the retail level, and real-time gross settlement systems (RTGS) at the
wholesale level.

The Rise of E-Payments Has Much Potential, but the Complete Picture Is Unclear  At the
moment, we are still in the initial stages of the ICT revolution, and it is still not
clear where the revolution will ultimately take us. What can be safely deduced from
recent ICT developments, however, is that electronic payments of various forms will
proliferate.

Competition with Paper Money: Debit Cards, Credit Cards, Online E-Payments,
Mobile Payments, E-Money  At the most basic level, the increase in electronic pay-
ments in retail transactions will compete with the use of paper money. The use of
debit cards, credit cards, online e-payments, mobile payments, and e-money will
potentially compete with the use of cash and checks. While this might potentially
reduce demands on central banks’ resources for money printing and handling, it also
implies that central banks will need to put more resources into understanding the
unintended consequences from the increase in these electronic forms of payment.

Unintended Consequences: Credit Card Promotion and Household Debt in South

Korea  Excessive promotion and use of credit cards have led to an unintended rise
in household debt in South Korea, which has implications for financial stability. In
2012, household debt in South Korea rose to 164 percent of income, partly helped
by the use of multiple credit cards in households; the government subsequently had
to set up a fund to relieve the poorest and most indebted households from their debt
burdens.17

Increasing Financial Access for the Poor: Mobile Payments  The rise of electronic
payments in the form of mobile payments has shown great benefits in increasing
financial access in remote places where there is little access to physical banks, but
where there is mobile phone coverage (e.g., in rural villages of developing countries).18
Some forms of mobile payment transactions can be made through mobile phone
services and charged through phone bills. This gives rise to the issue of appropriate
regulation to ensure consumer protection, that will not be stifling to innovation.

Another Unknown: E-Money  At a more fundamental level, certain forms of elec-

tronic payments (such as e-money) issued by private firms have the theoretical
266 CENTRAL BANKING

potential to supplant sovereign currencies, which unless properly regulated has

the potential to affect both monetary and financial stability.* In practice, however,
despite its introduction over a decade ago, the success of e-money is still very lim-
ited. Furthermore, regulations and guidelines have already been put in place in many
jurisdictions that require issuers of e-money be monitored by regulatory authori-
ties.19 (See Concept: Overview of Retail E-Payments for details on various types of
retail e-payments.)

C O N C E P T: OVERVIEW OF RETAIL E- PAYMENTS

With the progress in information and communications technology, new elec-
tronic payments methods have become more common and, to an extent, have
replaced coins, banknotes, and even checks. Here we look at some of the more
popular retail e-payments that have become quite common in our daily lives:
credit cards, debit cards, online payments, mobile payments, and e-money.

Credit Cards and Debit Cards

A credit card is issued by the issuer to the holder so that the holder can use
the card for payments to merchants who are in the credit card network. The
issuer of the card pays the merchants up front and the holder of the card repays
the issuer, probably with interest if the repayment is not made in full within a
specified period.
A debit card is also issued by the issuer to the holder so that the holder can
use the card for payments to merchants who are in the card network. Unlike
a credit card, however, a debit card allows merchants within the network to
deduct money from the holder’s account at the time he presents the card for
payment of goods and services.

Online Payments
One area in which the use of credit cards and debit cards has become domi-
nant is online payments. Online payments, where the holder uses his credit or
debit card to pay for online transactions, has grown steadily over the years. In
the immediate future, new innovations such as Square, a device attached to a
mobile phone that allows small businesses and individuals to take credit card
payments, will likely also encourage more use of credit cards in lieu of cash.

*Theoretically, the buyer of e-money could buy a certain amount of e-money from a private
issuer by depositing an equivalent amount of, say, paper money with the issuer. The buyer of
e-money could then use the e-money to buy goods and services from merchants that accept it.
If the number of these merchants is large enough, the issuer of e-money is effectively issuing
money that potentially could be used across the economy, just like paper money issued by the
central bank.
Future Challenges for Central Banking 267

Mobile Payments
Mobile payments refer to regulated payment services that allow payment for
goods and services to be made from or via a mobile phone, in lieu of cash,
credit cards, or debit cards. Mobile payments can take many forms. In certain
forms, the user needs to be preregistered with payment service operators such
as PayPal or a credit card company. In other forms, users of mobile payment
can be charged through their mobile phone accounts, bypassing banks and
credit card companies altogether. Mobile payments not only allow convenient
transactions in the advanced economies, but also are widely used in developing
countries where access to physical banks might be limited.

E-Money
E-money involves an electronic store of monetary value on a device that could
be used to trade for goods and services, possibly also bypassing the use of bank
accounts (and thus is different from a debit card).
An example of e-money is a multipurpose card, on which monetary value
is electronically stored, and which can be used to pay for small daily items as
well as public transportation services (these cards are used in countries such
as Belgium, the Netherlands, Hong Kong, and Singapore, although the rate of
success and the extent of use vary among countries).

13.3 UNFINISHED BUSINESS FROM THE GLOBAL FINANCIAL CRISIS

Although half a decade has passed since the bleakest periods of the 2007–2010
global financial crisis, the aftereffects are still being felt. Among the aftereffects of the
financial crisis that are still being played out and are likely to help shape the financial
landscape that central banks will operate in include (1) the heavy fiscal debt bur-
den in advanced economies, (2) the normalization of monetary policy in advanced
economies, and (3) the push for regulatory reforms.

The Heavy Fiscal Debt Burdens in Advanced Economies

The heavy fiscal debt burdens in the advanced economies will have implications for
the global economic landscape and global financial markets through the creditwor-
thiness of government securities issued by the advanced economies. Government
securities issued by major advanced economies such as the United States, Germany,
and Japan are deemed virtually riskless by investors and central banks across the
world. These securities are used as benchmarks in pricing other financial assets, as
well as in international reserves maintained by central banks of other countries.
The heavy fiscal debt burdens of many of the advanced economies, particularly
the United States, however, have raised growing concerns among investors glob-
ally, as reflected by the uncertainty in global financial markets surrounding the U.S.
government shutdown in October 2013. Although the shutdown was due to the
268 CENTRAL BANKING

Heavy fiscal debt burdens in advanced economies

Economic and financial

environment

Central
bank
Normalization
of monetary Push for
policy in crisis- regulatory
hit countries reforms

FIGURE 13.4  Unfinished Business from the Global Financial Crisis

Congress’s failure to enact legislation appropriating funds for fiscal year 2014, finan-
cial market players as well as President Obama saw the shutdown as being linked
to the debate on the raising of the U.S. government debt ceiling later that month.20

CASE STUDY: Heavy Fiscal Debt Burdens in Advanced Economies

Even before the financial crisis of 2007–2010, it had already been well recognized that for many
advanced economies, unfunded liabilities of the government, such as healthcare and pensions liabili-
ties, could likely pose heavy costs on these economies in the medium term. On top of these unfunded
liabilities, however, the financial crisis of 2007–2010 brought about large jumps in fiscal burden that
pushed the public debt-to-GDP ratio of the major advanced economies (G7 countries*) from 83.2
percent of GDP to 124.8 percent of GDP in 2012.21
To deal with the financial crisis, the governments of the advanced economies had to step in
not only to provide financial assistance to rescue the financial system, but also to provide large fis-
cal stimuli to prevent their economies from falling into deflationary traps. The interventions by these
governments were funded largely by issuance of government securities, which resulted in a fast rise in
public debt for these advanced economies.
In the United States, the ballooning government debt helped prompt a downgrade of U.S. govern-
ment securities, the safest financial asset in the world, from AAA to AA+ by Standard & Poor’s, one
of the three key rating agencies, in 2011.22 In the euro area, a combination of the banking crisis and a
sharp economic contraction resulted in many governments being unable to refinance their own public
debt, which threatened a breakup of the euro area in 2010–2012. In Japan, the legacy from its own
financial crisis in the early 1990s still lingered. With the economy battling deflation for more than 20
years, despite massive injections of fiscal stimulus, Japanese government debt reached 237.9 percent
of GDP in 2012.23

Unless the situation is corrected in a timely manner, the vast amounts of pub-
lic debt in advanced economies are likely to continue to pose challenges for cen-
tral banks globally. Any marked deterioration in fiscal prospects of the advanced

*The Group of Seven (G7) countries include Canada, France, Germany, Italy, Japan, the
United Kingdom, and the United States.
Future Challenges for Central Banking 269

economies would mean that seemingly risk-free assets will no longer be perceived
as risk-free. This would cause not only turmoil in the global financial markets, but
also hurt the ability of many emerging-market central banks to intervene and pro-
tect their domestic financial markets. This is because many emerging-market central
banks hold a large part of their international reserves in the form of government
securities issued by the advanced economies.

The Normalization of Monetary Policy in the Advanced Economies

For the advanced economy central banks, one of the short-term challenges that is
a legacy from the 2007–2010 global financial crisis is the timing of their exit from
their quantitative easing strategies (i.e., stopping the purchase of their own govern-
ment debt and starting the sale of government debt back into the financial system).
On the one hand, an early exit from the quantitative easing policy could trigger
panics in the financial markets. In 2013 the Federal Reserve’s mere announcement
of an intent to taper its purchases of government securities prompted panics in the
financial markets worldwide, before the Federal Reserve subsequently decided to
delay the taper owing to the weak economy.24 On the other hand, a late exit from the
quantitative easing could lead to asset price bubbles, and possibly inflation, since the
quantitative easing would keep interest rates artificially low, leading to speculation
in asset price booms.
For emerging-market central banks, the short-term challenges will be to deal
with the spillover effects from the existence of, and the exit from, the quantita-
tive easing policies of advanced economy central banks. On the one hand, a late
exit from quantitative easing in the advanced economies will pressure emerging-
market economies with capital inflows, which could lead to speculation in asset prices
in these economies. On the other hand, an early exit of quantitative easing in the
advanced economies may cause emerging-market central banks to have to deal with
the abrupt cutoff of flows of capital, which could be destabilizing to their economies.

The Push for Regulatory Reforms

The 2007–2010 financial crisis has revealed structural weaknesses in the increas-
ingly complex global financial systems. Such weaknesses partly reflected the fact that
existing regulations in place at the time had not kept up adequately with changes in
the global financial environment, and that regulatory reforms were needed. As of the
end of 2013, at the time that this book was being written, while many regulatory
reforms had been proposed at both national and international levels, only some had
been approved, while many were still being debated.
Whether all the reforms proposed will be approved or not will have a profound
impact on the future economic and financial landscapes that the central banks will
be operating in. The reforms, as well as the lack of reforms, are likely to affect
the behavior of banks, nonbank financial market players, as well as the regulators
themselves. In any case, it must be recognized that although any regulatory reform
is likely to address problems that have become apparent, the reform itself might also
lead to growing activities in less regulated areas, or unperceived new loopholes that
might arise with the reforms. Consequently, even regulatory reforms could pose new
challenges for central banks.
270 CENTRAL BANKING

Using a framework proposed by R. Glen Hubbard in 2009,25 here we will review

the regulatory reforms that came in the wake of the 2007–2010 crisis on three fronts:
(1) the reduction of systemic risk, (2) the increase in transparency, and (3) a change
in the financial regulatory structure, both at the national and global levels.

The Reduction of Systemic Risk  The effort to reduce systemic risk, at least at the inter-
national level, can partly be seen through the following initiatives.

1. The introduction of Basel III in 2010 by the Basel Committee on Banking

Supervision to make sure that banks have capital levels that are more responsive
to risk, and that the capital has a better ability to absorb loss. Basel III provides
guidance on bank supervision that is more sensitive to risk in all banks, and thus
should make the system as a whole more resilient. (See Concept: Introduction to
Basel I, II, and III in Chapter 12 for more details.)
2. The identification and publication of the list of global systemically important
financial institutions (G-SIFIs) by the Financial Stability Board* in 2011 (the
list was updated in 2012).26 The publication and the list of G-SIFIs made central
banks and national regulators more aware of the operations of these institutions,
as well as the international coordination required to supervise them.
3. The introduction of guidelines for the assessment of and additional loss
absorbency requirements for globally systemically important banks (G-SIBs) by
the Basel Committee on Banking Supervision in 2011, followed by a corollary
framework for domestically systemically important banks in 2012.27 These
guidelines and the framework provided will help provide guidance for central
banks and other regulators in supervising these systemically important banks.†

The Volcker rule against proprietary trading by banks that was discussed earlier
in the chapter was another effort that aimed to reduce systemic risk. Since the United
States is the leading financial center, where many international banks operate, the
adoption of the Volcker rule is likely to have an impact far beyond U.S. borders.

The Increase in Transparency  To increase transparency (as discussed in Chapter 12),

Basel III enhanced Pillar III (market discipline) through additional requirements on
the disclosure of a bank’s securitization exposures and sponsorship of off-balance
sheet vehicles, as well as on the details of the components of the bank’s regulatory
capital and calculations of its regulatory capital ratios.
In addition to Basel III requirements, another key example of a postcrisis reform is
the effort to put over-the-counter‡ (OTC) derivatives trades onto organized exchanges.28

*The Financial Stability Board was established in 2009 at the G20 London Summit, to act
as an international body that monitors and makes recommendations on financial regulations
and supervision. It is hosted by the Bank for International Settlements in Basel, Switzerland.
†
It must be noted, however, that the Financial Stability Board and the Basel Committee are not
direct regulatory bodies, and while their recommendations might be helpful, it still depends on
regulatory agencies at the national level to adopt their recommendations.
‡
Over-the-counter refers to an arrangement in which two parties (e.g., two banks, or a bank
and a nonbank counterparty) agree to execute a derivative contract (such as a credit default
swap) privately between themselves, rather than through an organized exchange.
Future Challenges for Central Banking 271

CASE STUDY: Putting Over-the-Counter Derivatives Trades onto Organized Exchanges

Prior to the crisis, many derivative deals were done privately between financial institutions or players
and dealers in the financial markets. No one kept track of the total number of deals in the market, or
how the different financial institutions might be exposed to risk through their counterparties. When a
counterparty failed, there would panic as to who was exposed and the degree of exposure.
Furthermore, while in normal times OTC derivative trades might function properly, with sufficient
liquidity to establish (or discover) the prices of derivatives, during a financial crisis that might not be
the case.29 Lack of transparency could reduce liquidity and make the valuation of one’s own portfolio
holdings very difficult, which could lead to panic selling with no buyers.
In an OTC market during normal times, there would be dealers willing to make markets by main-
taining inventories of derivatives and selling them to those who wanted them, or buying derivatives
from those who wanted to sell them. During a financial crisis, however, OTC dealers might be less
willing to take the risk of maintaining inventories of derivatives that could fluctuate wildly in value and
actually stop making markets for derivatives altogether. With no dealers willing to step in to buy and
sell derivatives, market players cannot easily sell securities. Furthermore, one would find it difficult to
determine what market prices are, or what market value should be assigned to derivative holdings.
The OTC arrangement is different from the arrangement in an organized exchange, where financial
market players make bids and offers through a central platform, not through separate dealers. In an
organized exchange, players can post bids and offers for assets to the platform, so that everyone else
can see the prices and trade with them if they find the prices of those bids and offers to be attractive
enough. During a financial crisis, if market players really want to unload their holdings, they can post a
low offer price for their holdings to the exchange. If another party feels that the price offered is attrac-
tive enough, that party can buy it.
Better transparency of prices in an organized exchange helps make the market more resilient
during times of crisis. Also, with the central clearing system that comes with an organized exchange,
it is easier to keep track of trading activities. Through the use of margin requirements, a standard for
organized exchanges, counterparty risk is reduced, as the parties to a derivative contract will either be
constantly paying in or receiving payments to keep the value of the contract whole, or the contract will
be canceled before any one party is overly exposed to loss from the failure of its counterparty.
While leaders of the G20 (the Group of Twenty finance ministers and central bank governors)
agreed in London in 2009 about the importance of putting derivatives onto organized exchanges, the
task will likely take some time.30 Given the interconnectedness of financial markets across the globe,
moving derivatives onto an organized exchange in one country will only yield a good result if the same
is done in other countries. Otherwise the playing field will not be level, especially since some financial
market players will want to avoid the transparency that comes with organized exchanges.
As a follow-up to the G20 London meeting, currently regulators from various countries are work-
ing together to set international guidelines for rules on putting derivatives onto organized exchanges.
Rules will eventually address which products to put onto exchanges, timing for adoption, and compli-
ance and regulatory measures.31

A Change in the Regulatory Structure  In addition to the efforts to reduce systemic risk
and increase transparency, the push for regulatory reforms has also focused on
needed changes in regulatory structures. The rise of shadow banking—that is,
intermediation and financial activities done by nonbank financial intermediaries or
market players—has meant that many market-based financial activities are being
done by different types of financial institutions, which themselves are supervised
by different regulatory agencies. Such complexities make it harder to pinpoint
responsibility and coordinate efforts to prevent a financial crisis or to rescue the
financial system.
272 CENTRAL BANKING

In the United States, a key example of changes in regulatory structure was the
creation of the Financial Stability Oversight Council (FSOC), which has regulatory
authority to identify risks that might be a threat to financial stability across the
entire financial system. FSOC was proposed as part of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, is chaired by the secretary of the Treasury,
and is composed of the heads of various U.S. financial regulatory agencies, such as
the Federal Reserve, the Securities and Exchange Commission, and the Commodity
Futures Trading Commission.
In the United Kingdom, it became apparent during the time of the global finan-
cial crisis that there had been difficulties in the coordination among the three key
agencies responsible for sustaining financial stability, that is, the Treasury, the Bank
of England, and the Financial Services Authority. The newly elected Conservative
Party thus decided to dissolve the Financial Services Authority, which previously had
been a super regulator overseeing various types of financial institutions, and create
two new regulators in its place: (1) the Financial Conduct Authority, with the focus
on consumer protection and ensuring healthy competition among financial institu-
tions, and (2) the Prudential Regulation Authority, with the task of regulating vari-
ous types of financial institutions, including banks, credit unions, insurers, and major
investment firms. The Prudential Regulation Authority is now part of the Bank of
England, while the Financial Conduct Authority is an independent agency.
In Europe, partly as a response to the European sovereign debt crisis, the
European Commission in 2012 proposed the Single Supervisory Mechanism, under
which the ECB would assume responsibility for the supervision of the largest banks
in the euro area and coordinate with euro area national central banks in the super-
vision of smaller banks.32 The proposal was a step toward a banking union within
the euro area, which the European Commission believed would help make it easier
should a decision be made to use European resources to recapitalize banks.33 The
ECB was to start assuming regulatory authority in 2014 and was to be accountable
to the European Parliament for supervisory decisions.34
It’s important to note that while a change in the financial regulatory structure
might help address problems that had already become apparent, by definition it may
lead to new, unanticipated problems. Financial players often move their activities
to where there is less regulation. Any change in regulatory structure creates new
avenues that are less regulated, and risk can build up in areas with less regulatory
oversight, or where new loopholes are created.

13.4 PIECING THEM TOGETHER

From the discussion above, we can see that the global financial and economic land-
scape that central banks will be facing will continue to evolve. The three major forces
that we discussed in this chapter can interact in numerous ways, and we can never
know the exact ways in which the global financial and economic landscape might
evolve.
Consequently, given that in the future central banks’ main mandates will still
be monetary and financial stability (notwithstanding the attention given to the full
employment mandate in the United States), there are three implications from our
analysis that central banks might focus on.
Future Challenges for Central Banking 273

First, the intensification of the globalization process (external forces)—

whether in terms of freer flows of international capital, freer flows of cross-border
goods and services, or the rise of international intermediaries—will have increas-
ing influence on domestic monetary and financial conditions. Risks to domestic
monetary and financial stability might originate from events outside the control of
central banks.
Second, financial activities are likely to keep evolving, and market-based activi-
ties of banks as well as nonbank financial institutions will play a greater role than
before. Given the revolution in information and telecommunications technology,
existing and new forms of electronic payments will gain more prominence.
Third, unfinished business from the global financial crisis—whether the heavy
debt burdens of major advanced economies, normalization of monetary policy in
crisis-hit countries, or the push for regulatory reforms—has the potential to alter the
financial and economic landscape that central banks operate in.
In Chapter 14, we will discuss how central banks might prepare themselves to
meet these future challenges.

SUMMARY
Looking forward, three major forces are likely to interact and shape the economic
and financial landscape that central banks will be operating in. The intensification
of the globalization process, the evolution in financial activities, and the unfinished
business from the 2007–2010 crisis are likely to raise the complexity of the land-
scape and pose challenges for central banks in their pursuit of monetary and finan-
cial stability.

KEY TERMS
credit card international intermediary
credit default swap leveraging
cross-border flows of goods and services market-making
debit card mobile payment
the Dodd-Frank Act money market mutual fund
domestic systemically important bank online payment
(D-SIB) organized exchanges
e-money over-the-counter derivatives
Financial Conduct Authority proprietary trading
Financial Stability Oversight Council Prudential Regulation Authority
global systemically important bank securitization
(G-SIB)
shadow banking
globalization
short selling
hedge fund
single supervisory mechanism
home countries
the Volcker rule
host countries
international capital
274 CENTRAL BANKING

QUESTIONS
1. How might globalization affect the future of central banking through freer flows
of international capital?
2. How might globalization affect the future of central banking through freer
cross-border flows of goods and services and factor inputs?
3. How might globalization affect the future of central banking through the rise of
international intermediaries?
4. How might the rise of money market mutual funds affect financial stability?
5. How might the rise of hedge funds affect financial stability?
6. Why should a central bank worry if banks have nonbank financial intermediaries,
such as mutual funds, as their subsidiaries?
7. In the promotion of the use of credit cards as a means of payment, what
implications on financial stability might we want to look out for?
8. What is e-money in terms of multipurpose card?
9. Why might the heavy fiscal debt burdens in advanced economies be detrimental
to stability of the financial markets in general, and emerging-market central
banks in particular?
10. How have quantitative easing measures in advanced economies affected
emerging-market central banks in the wake of the 2007–2010 global financial
crisis?
11. What are examples of regulatory reforms that would help reduce systemic risk
in the global financial system in the wake of the 2007–2010 global financial
crisis?
12. What are the similarities and differences between proprietary trading and
market-making activities?
13. What are the goals of the Volcker rule?
14. What are examples of regulatory reforms that would help increase transparency
in the global financial system in the wake of the 2007–2010 global financial
crisis? How are these reforms supposed to work?
15. What are examples of changes in the financial regulatory structure in the United
States in the wake of the 2007–2010 global financial crisis?
16. What are examples of changes in the financial regulatory structure in the United
Kingdom in the wake of the 2007–2010 global financial crisis?
17. What are examples of changes in the financial regulatory structure in the euro
area in response to the European sovereign debt crisis?
 CHAPTER 14
Future Central Banking
Strategy and Its Execution

Learning Objectives
. Describe the concept of central banking strategy.
1
2. Identify what might have proven to be bad central banking
strategies.
3. Identify how central banking strategies might have changed in the
wake of the 2007–2010 global financial crisis.
4. Explain how a central bank might better meet future challenges
by improving its analytical capacity.
5. Explain how a central bank might better meet future challenges
by improving its organizational capacity.
6. Explain how a central bank might better meet future challenges
by improving its political capacity.

I n Chapter 13, we discussed three major forces that might shape the future economic
and financial landscape that central banks operate in. Since these forces could inter-
act in ways that are unpredictable, if central banks are to succeed in the ever-­changing
landscape, they will have to be flexible, nimble, and adapt their operations to a fluid
environment. In Chapter 14 we propose using a framework based on public policy
literature, which central banks could adopt to enhance their capacity to effectively
navigate changes in the environment and successfully deliver value to society.

14.1 CENTRAL BANKING STRATEGY

To successfully deal with the future challenges described in Chapter 13, central
banks will need to carefully consider their strategies in pursuing their mandates. As a
public sector entity, however, a central bank will consider strategy differently than a pri-
vate sector entity. Unlike a private sector entity (say, a commercial bank), a central bank
does not have a competitor or profit motive to consider, as would have been assumed
for the kind of business strategy analysis pioneered by Michael Porter in 1980.1

275
276 CENTRAL BANKING

In this section we will look the concept of strategy at both a basic and an
advanced level, and examine various strategies that have been proposed or adopted
by central banks.

Strategy and the Central Bank

According to Richard Rumelt, author of the 2011 book Good Strategy, Bad Strategy:
The Difference and Why It Matters, at the most basic level we can think of strategy
as “the application of strength against weakness,” or “strength applied to the most
promising opportunity.”2 As we have learned from hard experience—including vari-
ous episodes of hyperinflation, the Great Depression, the Great Inflation, speculative
attacks in both emerging-market and advanced economies, and the recent global
financial crisis—for modern central banks the most promising opportunity seems to
be the delivery of monetary stability and financial stability, as opposed to short-term
economic growth.
At a more advanced level, Rumelt suggests that the two most important natural
sources of strength include (1) “having a coherent strategy” (i.e., one that coordi-
nates policies and actions) and (2) “the creation of new strength through subtle
shifts in viewpoint.” In Rumelt’s view, “a good strategy doesn’t just draw on existing
strength, but through the coherence of its design,” and “an insightful reframing of the
competitive situation can create whole new patterns of advantage and weakness.”3
At this more advanced level, a central bank would thus need to (1) make sure
that its monetary policy framework, its conduct of monetary policy, its financial
stability framework, and its conduct of policies to sustain financial stability (e.g.,
macroprudential policy as well as monetary policy) are well coordinated, and (2)
regularly reflect on and rethink ways to use its strengths.

Proven Bad Strategies

Given that the environment that central banks operate in will continue to change,
and that the context might differ from one central bank to another, there might not
be one absolute best strategy for all central banks. Lessons from history suggest, how-
ever, that there are certain strategies that central banks should not pursue. Examples
of bad central banking strategies include (1) directly financing government spending
or pursuing excessively easy monetary policy to stimulate short-term growth, which
could lead to rising inflation, and ultimately the hyperinflation problem; (2) allow-
ing a financial crisis to deepen without adequate early intervention efforts, which
ultimately could lead to the deflation problem as in the case of the Great Depression
in the 1930s; (3) pursuing excessively accommodative monetary policy in the face
of supply shocks, which can lead to rising inflation expectations and wage-price
spirals, as during the Great Inflation period in the 1970s; (4) pursuing the impossible
trinity (i.e., trying to maintain free flows of international capital, a fixed exchange
rate regime, and independent monetary policy concurrently), which could ultimately
lead to speculative attacks on the currency as in the case of the Asian financial crisis
in the 1990s; and (5) narrowly focusing on securing low inflation in the short run,
while ignoring the possibility that a low interest rate policy during the time of low
inflation might also encourage the buildup of asset price bubbles, which might result
in financial instability, as in the case of the global financial crisis of 2007–2010.
Future Central Banking Strategy and Its Execution 277

THE SEARCH FOR NEW CENTRAL BANKING STRATEGY

The recent global financial crisis of 2007–2010, like many crises before it, has
prompted a reexamination of central banking strategy by central bankers, policy
makers, and academic economists. Work by Borio in 2011, Posner in 2009, and
Taylor in 2009, among others, suggest that central banks need to be aware that mon-
etary stability and financial stability are intertwined in the long run.4 If anything, low
interest rates prior to the 2007–2010 crisis might have contributed to its emergence.5
As the depth of the 2007–2010 crisis has shown, financial instability can lead to the
threat of debt deflation, which in turn will come back to haunt monetary stability.

Monetary Policy Strategy

On the monetary policy front, lessons from the recent global financial crisis and
Japan in the 1980s suggest that in the conduct of its monetary policy, central banks
might follow the lead of the Bank of Canada and the Reserve Bank of Australia and
explicitly look beyond their normal two-year horizon, since low inflation and low
interest rates might lead to asset price speculation, which could ultimately lead to
financial instability. Also, a central bank might consider using macroprudential tools
to address specific pockets of financial imbalances ex ante in case it finds the use of
monetary policy to be too blunt for addressing such imbalances.
In terms of using monetary policy to ensure financial stability ex post (i.e., as
a tool for crisis resolution), there is more widespread agreement that massive pur-
chases of long-term securities might be needed, especially once interest rates have
reached the zero lower bound. By 2014 the central banks of four advanced econ-
omies, including the Federal Reserve, the ECB, the Bank of Japan, and the Bank
of England, had adopted various forms of such purchases, which were previously
deemed as constituting unconventional monetary policy. For emerging-market econ-
omies, the use of capital controls now seems to be more acceptable, since massive
flows of capital from the advanced economies can create excess volatilities that affect
the stability of financial markets.

Supervisory Strategy
On the supervision front, the use of macroprudential measures in addition to tradi-
tional microprudential supervision is now being emphasized, as reflected partly by
the introduction of Basel III. Since the 2007–2010 global financial crisis, there has
been great interest in creating and refining macroprudential tools that would deal
with risk buildups over time (e.g., time-varying capital requirements and dynamic
loan loss provisioning), as well as across institutions (e.g., macro stress testing, the
global liquidity standard, and additional loss absorbency capacity for systemically
important institutions). The use of macroprudential measures should also help allevi-
ate the burden placed on monetary policy with regard to sustaining financial stability.
Closer coordination among supervisors seems to be another popular strategy
adopted after the 2007–2010 crisis, as it has become clear that the line between dif-
ferent types of financial institutions (e.g., banks, asset management firms, and insur-
ance companies) has become rather blurred. The creation of the Financial Stability
Oversight Council in the United States, the absorption of the Prudential Regulation
278 CENTRAL BANKING

Authority into the Bank of England in the United Kingdom, and the introduction
of the Single Supervisory Mechanism (SSM) in the euro area seems to point in that
direction (although in the case of SSM, the main key driver was the blurring national
boundary lines among euro area members).
In addition to the above strategies, the recent crisis has also led to a fresh
re­examination of the role of central banking in the future. One of the more radical
ideas came from Goodhart’s 2010 paper that examined historical roles of central
banks. In it he asked whether it might be better to spin off the interest rate setting
function from central banks and put it into a separate, independent entity, while
(since the essence of central banking is liquidity provision) central banks retain the
liquidity management function and adopt the financial stability role.6 (See Case
Study: A Radical Rethinking of the Future Role of Central Banking.)

CASE STUDY: A Radical Rethinking of the Future Role of Central Banking

A 2010 paper by economist Charles Goodhart argued that the essence of central banking is its power to
create liquidity by manipulating its own balance sheet, and thus the key role of central banking should
be liquidity management for the financial system (e.g., through open market operations), not the actual
setting of interest rates, which could be done by some other entity.7 In the paper, Goodhart quotes a
former governor of the Bank of England who is reputed to have once said that a central bank is a bank,
not a “study group.”8
Following this line of argument, Goodhart suggested that the interest setting role (i.e., the conduct
of monetary policy) could be spun off from central banks, possibly to a politically independent study
group. Central banks, meanwhile, would concentrate on liquidity management and other tasks that
might be related to a central bank’s balance sheet (e.g., the lender-of-last-resort role and the implemen-
tation of quantitative easing when interest rates hit the zero lower bound). In normal times, a central
bank would do open market operations (OMOs) to ensure that short-term interest rates would remain
close to the interest rates set by the so-called study group.9
Although Goodhart argued in favor of spinning off the interest rate setting function (since liquidity
management and crisis resolution and prevention might need to be closely coordinated with the gov-
ernment while the interest rate setting function requires political independence), he also acknowledged
that in practice, setting interest rates and OMOs are two closely connected facets of monetary policy. If
the interest rate setting body is outside the central bank, then which entity would decide on the size of
quantitative easing measures? Or, if interest rates have risen beyond the zero lower bound, which entity
would set the width of the interest rate corridor, or the terms on the discount window, for example?10

14.2 EFFECTIVE EXECUTION OF CENTRAL BANKING STRATEGY

Whatever strategy a central bank ultimately chooses to adopt, the success of a cen-
tral bank in achieving its mandates also relies heavily on effective execution of its
adopted strategy. In this section, we will use a public policy analysis framework to
examine ways that a central bank might enhance its capacity to effectively execute
its chosen strategy.
Here is should be noted that while a central bank is a bank, in the modern con-
text it is essentially a public entity. The modern central bank’s role in society is to
deliver monetary stability and financial stability, which are essentially public goods
that cannot be efficiently provided by the private sector, since markets are not able to
correctly price public goods. As such, a public policy framework is used here for the
analysis of how to enhance a central bank’s capacity to execute its strategies.
Future Central Banking Strategy and Its Execution 279

A Public Policy Analysis Framework for Enhancing a Central Bank’s

Capacity to Execute Its Chosen Strategy
In successfully formulating a strategy to meet future challenges, a central bank first
needs to assess its likely future environment. As discussed in the previous chapter,
the intensification of globalization, the continued evolution in financial activities,
and unfinished business from the global financial crisis could all bring fundamental
changes that affect the global financial and economic landscape that a central bank
operates in, although the actual context might differ from one central bank to another.
To successfully operate in the new environment, which is likely to be very com-
plex and full of uncertainty, and deliver value to its society,* a central bank will
need to (1) understand and adequately prepare for changes in the environment it is
operating in, (2) be flexible and inventive in the use of its policy instruments, and (3)
be able to gain public support when implementing necessary policies that might also
create winners and losers. (See Figure 14.1.)
To meet such future challenges, one might find it useful to adopt the framework
proposed by Wu, Ramesh, Howlett, and Fritzen in their 2010 book, which argues
that for a public entity to effectively conduct its policy, the institution will need (1)
analytical capacity, (2) organizational capacity, and (3) political capacity.11
Such a framework is advocated here because it recognizes that to succeed in an
uncertain environment, a central bank needs not only analytical capacity (something
that is well recognized within central banks’ circles), but also the capacity to effec-
tively execute and coordinate policies in order to deliver value to its society.
A central bank does not operate in a vacuum, and it does indeed have stakehold-
ers to tend to or to work with. Consequently, along with analytical capacity, organi-
zational capacity and political capacity are also essential ingredients if a central bank
is to be able to effectively deliver value to society (e.g., by sustaining monetary and

Analytical capacity

The capacity to analyze the

context and policy options to
deliver value; that is, to fulfill the
mandates

Central bank
mandates

Organizational capacity Political capacity

The capacity to coordinate The capacity to form strategic alliances, and to
effectively both inside and build coalitions and general support among
outside the organization in stakeholders, given that stakeholders have
order to execute policies different priorities and needs

FIGURE 14.1  A Public Policy Analysis Framework for Central Banks

Source: Adapted from X. Wu, M. Ramesh, M. Howlett, and S. A. Fritzen, The Public Policy
Primer: Managing the Policy Process (New York: Routledge, 2010).

*In the modern context, the value that a central bank delivers to society is reflected in its
mandates, whether those mandates are monetary stability, financial stability, or, in the case of
the United States, full employment.
280 CENTRAL BANKING

financial stability, or by achieving their other mandates, such as full employment in

the case of the United States).

Analytical Capacity
Analytical capacity in our context refers to a central bank’s capacity to effectively
analyze how changes in the economic and financial environment might affect their
mandates, and what policy options might be available to address those changes. This
capacity depends on cognitive ability, expertise, and the experience of central bank
staff, as well as the availability of data to be used in the analysis.

Greater Emphasis on Cross-Discipline Institutional Knowledge  In the past 40 years, with

the emphasis on maintaining monetary stability, a lot of focus has been given to
analytical capacity in the field of macroeconomics. However, given emerging chal-
lenges such as the intensification of globalization, and the rise of financial markets
and international intermediaries, it is easy to see that analytical capacity as related
to financial stability will become very important. To achieve monetary and financial
stability in the next era, central bankers will not only need deep technical knowl-
edge in macroeconomics, but also in finance, law, accounting, and financial risk
management.
To effectively increase analytical capacity, deep technical knowledge will need
to be augmented by a practical understanding of the actual inner workings of three
key overlapping areas: the macroeconomy, financial markets, and financial institu-
tions, as well as how risk factors in each of the three areas might interact. To top it
off, information needed for pertinent economic and financial analyses will also need
to be systemically gathered, organized, stored, and used. Central banks will need to
invest in IT capability.

Academic and Professional Training, Hands-On Experience, Job Rotation, Data Collection and
Dissemination  For central bankers, such an enhancement in analytical capacity
might be gained from academic training and professional training and augmented by
hands-on experience and job rotations. Such training and rotation might take place
within the central bank or with outside agencies, domestic as well as international.
In addition, to effectively raise analytical capacity, the availability and capability
of a central bank’s IT system for data collection and dissemination, and the ability of
central bankers to utilize such a system, will also be vital.
This need for analytical capacity in the key areas of macroeconomics, finance,
and risk management is reflected in the recent selections of the heads of the Bank of
England, the Federal Reserve, the ECB, and the Bank of Japan in the period imme-
diately after the 2007–2010 crisis. Each of the heads of these major central banks
have advanced degrees in economics, as well as extensive experience in dealing with
international financial markets and financial institutions.*

*Mario Draghi (an Italian) became the head of the ECB in 2011; Mark Carney (a Canadian)
became the governor of the Bank of England in 2013; Haruhiko Kuroda became the governor
of the Bank of Japan in 2013; and Janet Yellen became chair of the Federal Reserve in 2014.
Future Central Banking Strategy and Its Execution 281

Organizational Capacity
Organizational capacity refers to the capacity to coordinate effectively, both inter-
nally within the organization and externally with outside stakeholders. Given that
risks to stability can manifest themselves differently in each of the three key areas—
the macroeconomy, financial markets, and financial institutions—and that such
manifestations can also interact across these three areas, a central bank will need to
organize itself to be nimble and flexible enough to deal with emerging risks. Effective
coordination will be required, not only internally but also externally (for example,
with other regulatory agencies at home and abroad). A central bank’s ability to
coordinate effectively both inside and outside the organization will be beneficial
to its decision making and policy implementation.

Internal Coordination  Internal coordination includes data sharing and joint problem
solving across the organization. For example, data from banks showing a fast rise
in credit card and mortgage debt might be shared by the bank supervision unit with
the unit that is responsible for monetary policy and monetary stability, which itself
is monitoring the rise in household debt. Another example could be data sharing
between the unit that does foreign exchange market interventions, the unit that mon-
itors banks’ foreign currency exposures, and the unit that is monitoring the effects of
the exchange rate on the macroeconomy.
In cases in which internal data sharing and joint problem solving needs to be
improved, a central bank might set up an internal committee to coordinate and
facilitate these activities across units, or even to make relevant decisions. The key,
however, is to make sure that the committee is flexible and nimble enough to identify
risks as they emerge. If the context or the situation permits, such a committee might
also be given the responsibility to deal with the risks identified.

External Coordination: Domestic as Well as International  As risks to stability can also

come from areas outside a central bank’s full jurisdiction (e.g., money market funds
and insurance companies), a central bank’s ability to effectively coordinate with
outside agencies will be essential in terms of both identification and management
of risks. A central bank might proactively try to reach out to agencies on its own,
or it could participate through an interagency forum if there is one. In the United
States, the Financial Stability Oversight Council, composed of the heads of various
regulatory agencies and the Federal Reserve and chaired by the Treasury secretary,
was set up in 2010 in response to the lessons learned from the collapse of Lehman
Brothers in 2008.
In addition to external coordination with other domestic regulatory agencies,
given that external factors are having an increasing influence on domestic stabil-
ity, a central bank will also need to coordinate effectively with its foreign coun-
terparts and foreign agencies, including multilateral financial institutions such as
the IMF and the BIS (Bank for International Settlements). During the height of the
2008–2010 financial crisis, the ability of many central banks to open reciprocal
currency swap lines with the Federal Reserve helped ensure that there would not
be a shortage of U.S. dollars in international markets, avoiding the potential for
global panics.
282 CENTRAL BANKING

Political Capacity
Political capacity in this context means the ability of a central bank to form strategic
alliances and build coalitions and support among its key stakeholders and the pub-
lic, so that it can effectively and efficiently achieve its mandates and create value for
society.* This capacity is important since many of the policies conducted by a central
bank can create winners and losers within the society, drawing political resistance
from the losers. Yet such policies might be necessary for the greater good of the pub-
lic in the long run.

Ability to Create Consensus and Legitimacy for Policies  Given the intensification of glo-
balization, the rise of financial markets, and the rise of international financial inter-
mediaries, the environment that a central bank operates in is likely to grow more
complex. In such a situation, a central bank will need to deal with the fact that
different stakeholders might have conflicting interests and conflicting perceptions of
situations. To effectively implement its policy in a complex environment, a central
bank will need to generate trust among its stakeholders so that they are confident
that the bank has the best interests of the public in mind.
To do this, a central bank will first need to identify the key stakeholders and
their interests. The bank will then need to communicate clearly to the stakeholders
what the ultimate goals of its policies are and what the short-term and long-term
effects of such policies might be.
For example, to ensure both long-term monetary stability and long-term finan-
cial stability, a central bank might find itself needing to raise interest rates to cool
down overheated economic and financial activities. The decision to raise interest
rates, however, might draw criticism and political resistance from the government,
which inherently wants more growth in the economy, as well as from businesses,
which want to keep the cost of capital low.
If a central bank does not have enough political capacity, then it might need
to spend excessive energy defending its position. Worse, without adequate political
capacity a central bank might be pressured to back away from its decision, a decision
that had been made based on improving the welfare of the public as a whole.

CASE STUDY: Political Capacity in the Context of Exchange Rate Policy in a Small,
Open Economy

A rush of capital inflows can affect different stakeholders in a small, open economy differently, which
means that different stakeholders might react to the situation in conflicting ways. In such a situation,
the central bank of that small, open economy might need to rely on its political capacity to ensure that
its policy decision is effective.
In this example, the rush of capital inflows could quickly push up the exchange rate of that small,
open economy. The fast appreciation of the exchange rate, however, could affect importers, consum-
ers, exporters, and local producers that compete with imports rather differently, or even in opposite
ways. On the one hand, importers and consumers might gain additional purchasing power from a

*The term politics can be a charged word in central bank circles. Here we employ the term
political capacity used in the 2010 book from Wu, Ramesh, Howlett, and Fritzen.
Future Central Banking Strategy and Its Execution 283

stronger exchange rate. On the other hand, exporters and local producers that compete with imports
might lose from such a situation, since their products will have a cost disadvantage.
While importers and consumers might keep relatively quiet about the gains that they have
­gotten—partly because the gains are dispersed widely across many individuals and firms—exporters
and local producers that compete with imports might be more vocal about the situation—partly
because they feel that they are bearing the brunt of the burden of the fast appreciating exchange rate.
The government, meanwhile, might see the situation as an opportunity to pressure the central
bank to lower interest rates (at least through the media), using the argument that having domestic
interest rates that are higher than those in the advanced economies is actually attracting capital inflows.
Many businesses might agree with the government’s push for lower interest rates, since they might
want the cost of funds to be lower.
Against this backdrop, the central bank’s own internal analysis might suggest that interest rates
actually need to be raised to maintain monetary and financial stability in the face of such capital inflows.
Its internal analysis might suggest that capital inflows are the result of an external factor (quantitative
easing in this case), since all countries in the region have similar levels of interest rates and all are on
the receiving end of the capital inflows.
In such a complex situation, in order to carry out its policy as effectively and as efficiently as pos-
sible, a central bank will need to deal effectively with pressures coming from the different stakeholders.
A central bank will need to communicate its assessment of the situation to the different stakeholders
in the clearest manner possible to generate trust among them. Furthermore, the central bank might
need to engage with the media and the academic community to form a strategic alliance that can com-
municate the situation to the public and build public support. (This example reflects a situation faced
by the Bank of Thailand between 2010 and mid-2013.12)

Forming Strategic Alliances with Key Stakeholders and Communicating with the Public  To
ensure consensus and that its policy is seen as legitimate, a central bank might need
to form strategic alliances with influential actors, including the media, academics,
think tanks, and other stakeholders who can help communicate its position to the
public. One key example of the use of political capacity is the decision of the chair-
man of the Federal Reserve, Ben Bernanke, to give an unprecedented exclusive inter-
view to 60 Minutes, a popular television investigative news program, in 2009 at the
height of the crisis.13
In the interview, Chairman Bernanke led the interviewer to the inside of the
Federal Reserve building in Washington, DC, and then into the room where the
Federal Open Market Committee (FOMC) meets to deliberate on monetary policy
decisions. He also brought him to his childhood home in South Carolina. Bernanke
was able to answer the questions about the Federal Reserve’s policies that had
been on the minds of many Americans, explaining his answers in simple terms.14
By opening up and humanizing the Federal Reserve, and clearly articulating the
Federal Reserve’s positions, Ben Bernanke was able to generate public trust that
many believed greatly helped the Federal Reserve in subsequently dealing with the
financial crisis.

14.3 EPILOGUE: FROM THE PAST TO THE PRESENT AND BEYOND

The central bank has evolved greatly during its nearly 400 years of history. From its
humble origins as an institution set up to simply help sort metal coins, the central
284 CENTRAL BANKING

bank is now at the center of modern economic and financial life. While the actual
operations and structures of different central banks differ, it is widely accepted at
this time in history that central banks’ key mandates include the maintenance of
monetary stability and financial stability (and perhaps full employment, at least in
the United States).
The current state of central banking has been shaped by both theoretical devel-
opments and hard experience learned through episodes of instability and crisis. With
respect to monetary stability, it is now widely agreed that a central bank can best
use monetary policy to support long-run economic growth by ensuring that inflation
remains low and stable. With the central bank delivering low and stable inflation,
agents in the economy will be able to make their investment and consumption deci-
sions more effectively. A push by a central bank to stimulate growth in the short
run through easy monetary policy is likely to be futile and could lead to detrimental
effects, since it can feed inflation.
With respect to financial stability, the crisis in Japan in the 1990s and the 2007–
2010 global financial crisis have shown that monetary stability cannot exist without
financial stability. Financial imbalances can and do build up during periods of low
and stable inflation. Once such imbalances tip into a full-blown financial crisis, the
economy can face a deflationary spiral. Given such a threat, a central bank’s focus on
delivering low and stable inflation will not be enough. A central bank will need to be
mindful of how a monetary policy of low interest rates during a time of low inflation
might also bring about financial imbalances.
The lessons from the 2007–2010 global financial crisis, however, also high-
lighted the fact that monetary policy is not a cure-all. For one thing, monetary policy
is too blunt an instrument to deal with financial imbalances, as it affects everyone
in the economy. Lessons from the 2007–2010 financial crisis suggest a greater role
for macroprudential tools, which could be used to address financial imbalances in
specific sectors of the economy. Many of these macroprudential tools are currently
in an early developmental stage and are constantly being refined; examples are dis-
cussed in Chapter 12.
Going forward, the intensification of globalization, the rise of financial ­markets,
and unfinished business from the recent crisis could add complexity to the economic
and financial landscape that central banks have to operate in. To successfully main-
tain monetary and financial stability and deliver value to society, central bankers will
need to understand the inner workings of and be able to operate across three key
overlapping domains: the macroeconomy, financial markets, and financial institu-
tions. The public policy analysis framework discussed earlier in this chapter can be
used by central banks to improve their ability to execute their policies; the frame-
work’s emphasis on enhancing analytical capacity, organizational capacity, and
political capacity will allow central banks to be better able to meet future challenges
and effectively deliver value to society.

SUMMARY
According to Rumelt, strategy can be thought of as “strength against weakness.”
Two natural sources of strength include (1) having a coherent strategy, that is, one
that coordinates policies and actions, and (2) the creation of new strength through
subtle shifts in viewpoint.
Future Central Banking Strategy and Its Execution 285

For central banks, experience has shown that the pursuit of short-term eco-
nomic growth (whether through the direct financing of the government’s budget or
excessively easy monetary policy), the interventions that come too late in preventing
a financial crisis from deepening, the pursuit of overly accommodative monetary
policy in the face of a supply shock, the pursuit of the impossible trinity, and a nar-
row focus on inflation without regard to the possibility of asset price bubbles are bad
central banking strategies.
In the wake of the 2007–2010 crisis there has been a rethinking of central bank-
ing strategy, whether in terms of monetary policy or supervisory functions. It is now
recognized that monetary stability and financial stability are inherently intertwined,
and that monetary policy and macroprudential tools might be used together.
In order to meet future challenges and deliver value to society, a central bank, as
a public entity, needs to consider enhancing its ability to execute policies. This can be
done by the enhancement of analytical capacity, organizational capacity, and politi-
cal capacity as defined in the public policy framework proposed by Wu, Ramesh,
Howlett, and Fritzen in 2010.
To enhance analytical capacity, a central bank might want to ensure that (1) its
staff is well versed in technical and practical knowledge of the macroeconomy, finan-
cial institutions, and financial markets; and (2) it has access to appropriate data and
tools to be used to analyze the macroeconomy, financial institutions, and financial
markets.
To enhance organizational capacity a central bank will want to ensure effective
coordination, both internally (within the central bank) and externally (with other
regulatory agencies and stakeholders).
To enhance political capacity, a central bank will need to be able to articulate
clearly to stakeholders the tradeoffs and synergies that might occur in the pursuit
of its mandates, so that it can gain support for the effective conduct of its policies.

KEY TERMS
analytical capacity strategic alliances
organizational capacity strategy
political capacity study group
public entity

QUESTIONS
1. According to Rumelt, what is the basic concept of strategy?
2. What have proven to be bad strategies for central banks?
3. How might central banking strategy change in the wake of the 2007–2010
crisis?
4. What impact will its role as a public sector entity have on a modern central
bank?
5. What aspects of a central bank’s analytical capacity might be crucial in the face
of future challenges such as the intensification of the globalization process, the
rapid evolution of financial services, and unfinished business from the 2007–
2010 crisis?
286 CENTRAL BANKING

6. How might a central bank improve its analytical capacity?

7. What aspects of a central bank’s organizational capacity might be crucial in the
face of future challenges such as the intensification of the globalization process,
the rapid evolution of financial services, and unfinished business from the 2007–
2010 crisis?
8. How might a central bank improve its organizational capacity?
9. What aspects of a central bank’s political capacity might be crucial in the face
of future challenges such as the intensification of the globalization process, the
rapid evolution of financial services, and unfinished business from the 2007–
2010 crisis?
10. How might a central bank improve its political capacity?
 Notes

CHAPTER 1  A Brief Look at Central Banking History

1. Majorie Deane and Robert Pringle, The Central Banks (New York: Viking Penguin, 1995).
2. Ibid.
3. Deane and Pringle, Central Banks; Stephen Quinn and William Roberds, “The Big
Problem of Large Bills: The Bank of Amsterdam and the Origins of Central Banking,”
Federal Reserve Bank of Atlanta, 2005.
4. Deane and Pringle, Central Banks.
5. Ibid.
6. Ibid.
7. Ibid.
8. Michael D. Bordo, “A Brief History of Central Banks,” Economic Commentary, Federal
Reserve Bank of Cleveland, December 2007.
9. Deane and Pringle, Central Banks.
10. Ibid.
11. Ibid.
12. Ibid.
13. Ibid.
14. Ibid.
15. Ibid.
16. Charles Goodhart and Dirk Schoenmaker, “Should the Functions of Monetary Policy and
Banking Supervision Be Separated?,” Oxford Economic Papers, New Series vol. 47, no. 4
(October 1995): 539–560.
17. Ibid.
18. Goodhart, “The Organisational Structure of Banking Supervision,” Financial Stability
Institute Occasional Papers no. 1, October 25, 2000.
19. Ibid.
20. Goodhart and Schoenmaker, “Should the Functions of Monetary Policy.”
21. Goodhart, “Organizational Structure of Banking Supervision.”
22. Maurice Obstfeld and Paul Krugman, International Economics: Theory and Policy, 8th
ed. (Upper Saddle River, NJ: Pearson Addison-Wesley, 2009).
23. Bordo, “A Brief History of Central Banks.”
24. Obstfeld and Krugman, International Economics.
25. Charles Goodhart, Money Information and Uncertainty, 2nd ed. (London: Macmillan
Press, 1989).
26. Ibid.
27. Goodhart, Money Information and Uncertainty; Frederic S. Mishkin, “International
Experiences with Different Monetary Policy Regimes” (NBER Working Paper 6965,
National Bureau of Economic Research, 1999).
28. Lars E. O. Svensson, “Inflation Targeting,” in The New Palgrave Dictionary of Economics,
2nd ed., ed. Larry Blum and Steven Durlauf.
29. Mishkin, “International Experiences with Different Monetary Policy Regimes.”
30. Obstfeld and Krugman, International Economics.

287
288 NOTES

31. European Central Bank, “Banking Supervision,” 2013, www.ecb.europa.eu/ssm/html/

index.en.html, accessed February 13, 2014.

CHAPTER 2  A Brief Overview of the International Monetary System

1. Maurice Obstfeld and Paul Krugman, International Economics: Theory and Policy, 8th
ed. (Upper Saddle River, NJ: Pearson Addison-Wesley, 2009).
2. Ibid.
3. Majorie Deane and Robert Pringle, The Central Banks (New York: Viking Penguin, 1995);
Obstfeld and Krugman, International Economics.
4. Obstfeld and Krugman, International Economics.
5. Ibid.
6. Obstfeld and Krugman, International Economics; Deane and Pringle, Central Banks.
7. Ibid.
8. Obstfeld and Krugman, International Economics.
9. Ibid.
10. Obstfeld and Krugman, International Economics; James M. Boughton, “The IMF and
the Forces of History: Ten Events and Ten Ideas that Have Shaped the Institution” (IMF
Working Paper 04/75, May 2004).
11. Ibid.
12. Obstfeld and Krugman, International Economics.
13. Ibid.
14. Ibid.
15. Ibid.
16. Ibid.
17. Ibid.
18. Obstfeld and Krugman, International Economics; William L. Silber, Volcker: The Triumph
of Persistence (New York: Bloomsbury Press, 2012).
19. Obstfeld and Krugman, International Economics.
20. Ibid.
21. Edward Nelson, “The Great Inflation of the Seventies: What Really Happened?” (The
Federal Reserve Bank of St. Louis, Working Paper Series 2004-001, January 2004).
22. C. A. E. Goodhart, Money Information and Uncertainty, 2nd ed. (London: Macmillan
Press, 1989).
23. Obstfeld and Krugman, International Economics.
24. Ibid.
25. Ibid.
26. Sebastian Mallaby, More Money than God (New York: Penguin Press, 2010).
27. B. S. Bernanke, T. Laubach, F. S. Mishkin, and A. S. Posen, Inflation Targeting: Lessons
from the International Experience (Princeton, NJ: Princeton University Press, 1999);
Guillermo A. Calvo and Carmen M. Reinhart, “Fear of Floating,” Quarterly Journal of
Economics 107, no. 2 (May 2002): 379–408.
28. Mallaby, More Money than God.
29. Hanspeter K. Scheller, The European Central Bank: History, Role, and Functions

(Frankfurt, Germany: European Central Bank, 2004).
30. Ibid.
31. Ibid.
32. Obstfeld and Krugman, International Economics.
33. Richard A. Posner, “Underlying Causes of the Financial Crisis of 2008–2009,” in New
Directions in Financial Services Regulation, ed. Roger B. Porter, Robert R. Glauber, and
Thomas J. Healey (Cambridge, MA: MIT Press, 2009).
34. Ibid.
Notes 289

35. Ibid.
36. Ibid.
37. James R. Barth, Gerard Caprio Jr., and Ross Levine, Guardians of Finance: Making
Regulators Work for Us (Cambridge, MA: MIT Press, 2012).
38. Randall S. Kroszner, “Making Markets More Robust,” in Reforming US Financial

Markets: Reflections and Beyond Dodd-Frank, ed. Benjamin Friedman (Cambridge, MA:
MIT Press, 2011).
39. Barth, Caprio, and Levine, Guardians of Finance.
40. Ibid.
41. Gregory Viscusi, “EU Nations Commit 1.3 Trillion Euros to Bank Bailouts (Update3),”
Bloomberg, October 13, 2008, www.bloomberg.com/apps/news?pid=newsarchive&sid=
aAAqUi9CW.h4.
42. Maria Woods and Siobhan O’Connell, “Ireland’s Financial Crisis: A Comparative

Context,” Quarterly Bulletin, October 2012, Central Bank of Ireland.
43. Reuters, “Spain’s Public Debt to Approach 100 Percent of GDP End-2014,” ­Sep­tember 30,
2013, http://uk.reuters.com/article/2013/09/30/uk-spain-debt-economy-idUKBRE98T0
G320130930.

CHAPTER 3  Modern Central Banking Roles and Functions

1. F. S. Mishkin, The Economics of Money, Banking, and Financial Markets, 6th ed. (Reading,
MA: Addison Wesley, 2001).
2. Majorie Deane and Robert Pringle, The Central Banks, (New York: Viking Penguin,
1995).
3. Anthony M. Santomero, “A United States Perspective on the Changing Pattern of
Payments,” Central Banks in the 21st Century, Banco de España Conference, Madrid,
2006; Curzio Giannini, The Age of Central Banks (Cheltenham, UK: Edward Elgar,
2011).
4. Maxwell J. Fry, Isaack Kilato, Sandra Roger, Krzysztof Senderowicz, David Sheppard,
Francisco Solis, and John Trundle, “Payment Systems in Global Perspective,” Routledge
International Studies in Money and Banking, London, 1999; Gertrude Tumpel-Gugerell,
“Driver for Change in Payment and Securities Settlement System,” Central Banks in the
21st Century, Banco de España, Madrid, 2006.
5. Ibid.
6. Ibid.
7. Fry, Kilato, Roger, Senderowicz, Sheppard, Solis, and Trundle, “Payment Systems in
Global Perspective.”
8. Deane and Pringle, The Central Banks.
9. Xavier Freixas, Curzio Giannini, Glenn Hogarth, and Farouk Soussa, “Lender of Last
Resort: A Review of the Literature,” Financial Stability Review, November 1999.
10. Ibid.
11. Ibid.
12. Tobias Adrian, Christopher R. Burke, and James J. McAndrews, “The Federal Reserve’s
Primary Dealer Credit Facility,” Current Issues in Economics and Finance 14, no. 4
(2009).
13. Tobias Adrian, Karin Kimbrough, and Dina Marchioni, “The Federal Reserve’s

Commercial Paper Funding Facility,” Federal Reserve Bank of New York Economic Policy
Review, May 2011.
14. Deane and Pringle, The Central Banks.
15. Glenn Tasky, “Introduction to Banking Supervision,” United States Agency for

International Development, June 25, 2008.
16. Ibid.
290 NOTES

17. Tasky, “Introduction to Banking Supervision”; J. Beverly Hirtle and Jose A. Lopez,

“Supervisory Information and the Frequency of Bank Examinations,” FRBNY Economic
Policy Review, April 1999.
18. Tasky, “Introduction to Banking Supervision”; Board of Governors of the Federal Reserve
System, The Federal Reserve System: Purposes and Functions (Washington, DC: Board of
Governors of the Federal Reserve System, 2005).
19. Tasky, “Introduction to Banking Supervision.”
20. Hirtle and Lopez, “Supervisory Information and the Frequency of Bank Examinations.”
21. Simon Gray, “Central Bank Balances and Reserve Requirements” (IMF Working Paper
WP11/36, February 2011).
22. Ibid.
23. Ibid.
24. Tasky, “Introduction to Banking Supervision.”
25. Ibid.
26. Claire L. McGuire, Simple Tools to Assist in the Resolution of Troubled Banks (Washington,
DC: World Bank, 2012).

CHAPTER 4  A Brief Review of Modern Central Banking Mandates

1. Bank of England, “Core Purposes,” accessed November 28, 2013, www.bankofengland
.co.uk/about/Pages/corepurposes/default.aspx.
2. Daniel L. Thornton, “The Dual Mandate: Has the Fed Changed Its Objectives?,” Federal
Reserve Bank of St. Louis Review 94, no. 2 (2012).
3. The European Central Bank, “Tasks,” accessed November 28, 2013, www.ecb.europa.eu/
ecb/tasks/html/index.en.html; Bank of Japan, “Outline of the Bank,” accessed November
28, 2013, www.boj.or.jp/en/about/outline/index.htm/.
4. Thomas Baxter Jr., “Financial Stability: The Role of the Federal Reserve System,” Remarks
at the Future of Banking Regulation and Supervision in the EU Conference, Frankfurt,
Germany, November 15, 2013, www.newyorkfed.org/newsevents/speeches/2013/bax
131120.html; Frederic S. Mishkin, Frederic S. (2007), “Monetary and the Dual Mandate,”
speech given at Bridgewater College, Bridgewater, Virginia, April 10, 2007, www
.federalreserve.gov/newsevents/speech/mishkin20070410a.htm.
5. Baxter, “Financial Stability.”
6. Aaron Steelman, “The Federal Reserve’s ‘Dual Mandate’: The Evolution of an Idea,”
Economic Brief, The Federal Reserve Bank of Richmond, December 2011; Thornton,
“The Dual Mandate.”
7. Ibid.
8. Claudio Borio and Philip Lowe, “Asset Prices, Financial and Monetary Stability: Exploring
the Nexus” (BIS Working Paper no. 114, July 2002).
9. Richard A. Posner, “Underlying Causes of the Financial Crisis of 2008–2009,” in New
Directions in Financial Services Regulation, ed. Roger B. Porter, Robert R. Glauber, and
Thomas J. Healey (Cambridge, MA: MIT Press, 2009).
10. Thornton, “The Dual Mandate.”
11. Ibid.
12. Ibid.
13. Ibid.
14. Bank of England, “Core Purposes.”
15. Claudio Borio, and Mathias Drehmann, “Towards an Operational Framework for

Financial Stability: ‘Fuzzy’ Measurement and Its Consequences” (BIS Working Paper no.
284, June 2009); Garry Schinasi, “Defining Financial Stability” (IMF Working Paper,
WP/04/187, International Monetary Fund, Washington, DC, October 2004).
16. Ibid.
Notes 291

7. Borio and Lowe, “Asset Prices”; Schinasi, “Defining Financial Stability.”

1
18. Borio and Lowe, “Asset Prices”; Claudio Borio, “Rediscovering the Macroeconomic Roots
of Financial Stability Policy: Journey, Challenges and a Way Forward” (BIS Working Paper
no. 354, September 2011); Claudio Borio and William White, “Whither Monetary and
Financial Stability? The Implications of Evolving Policy Regimes” (BIS Working Paper no.
147, February 2004).
19. Borio, “Rediscovering the Macroeconomic Roots”; Frederic S. Mishkin, “How Should
Central Banks Respond to Asset-Price Bubbles? The ‘Lean’ versus ‘Clean’ Debate After the
GFC,” Bulletin, Reserve Bank of Australia, June Quarter, 2011.
20. Ibid.
21. Borio, “Rediscovering the Macroeconomic Roots”; Mishkin, “How Should Central Banks
Respond?”
22. Borio and White, “Whither Monetary and Financial Stability?”
23. Shigenori Shiratsuka, “The Asset Price Bubble in Japan in the 1980s: Lessons for Financial
and Macroeconomic Stability” (paper prepared for the IMF-BIS Conference on Real Estate
Indicators and Financial Stability, International Monetary Fund, Washington, DC, October
27–28, 2003), www.bis.org/publ/bppdf/bispap21e.pdf; Borio and Lowe, “Asset Prices.”
24. Ibid.
25. Shiratsuka, “The Asset Price Bubble”; Borio and Lowe, “Asset Prices.”
26. Posner, “Underlying Causes of the Financial Crisis of 2008–2009”; John B. Taylor,

“Origins and Policy Implications of the Crisis,” in New Directions in Financial Services
Regulation, ed. Roger B. Porter, Robert R. Glauber, and Thomas J. Healey (Cambridge,
MA: MIT Press, 2009).
27. Stefan Ingves (2011), “Central Bank Governance and Financial Stability: A Study Group
Report,” Bank for International Settlements, Basel, Switzerland, May 2011.
28. Steelman, “The Federal Reserve’s ‘Dual Mandate.’”
29. Ibid.
30. Steelman, “The Federal Reserve’s ‘Dual Mandate’”; Thornton, “The Dual Mandate.”
31. Ibid.
32. Ibid.
33. Ibid.
34. Board of Governors of the Federal Reserve System, “How Does Forward Guidance about
the Federal Reserve’s Target for the Federal Funds Rate Support the Economic Recovery?,
Current FAQs,” 2013, www.federalreserve.gov/faqs/money_19277.htm.
35. Ibid.
36. John B. Taylor, “Discretion versus Policy Rules in Practice,” Carnegie-Rochester

Conference Series on Public Policy, 39 (1993), 195–214.
37. Richard Clarida, Mark Gertler, and Jordi Galí, “Monetary Policy Rules in Practice: Some
International Evidence,” European Economic Review 42, no. 6 (1998): 1033–1067.
38. Committee on International Economic Policy and Reform, “Rethinking Central Banking,”
Brookings Institution, Washington, DC, September 2011.
39. Thornton, “The Dual Mandate.”
40. Stefan Ingves, “Central Bank Governance and Financial Stability: A Study Group

Report,” Bank for International Settlements, Basel, Switzerland, May 2011; Committee
on International Economic Policy and Reform, “Rethinking Central Banking.”
41. Ingves, “Central Bank Governance;” Committee on International Economic Policy and
Reform, “Rethinking Central Banking.”
42. Ibid.
43. Borio and Drehmann, “Towards an Operational Framework for Financial Stability”;
Committee on International Economic Policy and Reform, “Rethinking Central Banking.”
44. Committee on International Economic Policy and Reform, “Rethinking Central Banking”;
Posner, “Underlying Causes of the Financial Crisis of 2008–2009.”
292 NOTES

45. Borio and Drehmann, “Towards an Operational Framework for Financial Stability”;
Ingves, “Central Bank Governance and Financial Stability.”
46. Thornton, “The Dual Mandate”; Board of Governors of the Federal Reserve System,
“How Does Forward Guidance?”
47. Posner, “Underlying Causes of the Financial Crisis of 2008–2009.”
48. Borio and Lowe, “Asset Prices.”
49. Ibid.
50. Borio, “Rediscovering the Macroeconomic Roots.”
51. Ibid.
52. Thornton, “The Dual Mandate.”
53. Thornton, “The Dual Mandate”; Clarida, Gertler, and Galí, “Monetary Policy Rules in
Practice.”
54. Thornton, “The Dual Mandate.”

CHAPTER 5  Theoretical Foundations of the Practice of Modern

Monetary Policy
1. Charles Goodhart, Money Information and Uncertainty, 2nd ed. (London: Macmillan
Press, 1989).
2. Daniel L. Thornton, “Why Does Velocity Matter?,” Federal Reserve Bank of St. Louis
Review, December 1983.
3. Goodhart, Money Information and Uncertainty; N. Gregory Mankiw, Principles of
Economics, 6th ed. (Mason, OH: South-Western Cengage Learning, 2012).
4. Goodhart, Money Information and Uncertainty.
5. Majorie Deane and Robert Pringle, The Central Banks (New York: Viking Penguin, 1995).
6. Paul A. Samuelson and William N. Nordhaus, Economics, 16th ed. (New York: McGraw-
Hill, 1998).
7. Goodhart, Money Information and Uncertainty; Marco A. Espinoza-Vega and Steven
Russel, “History and Theory of the NAIRU: A Critical Review,” Federal Reserve Bank of
Atlanta Economic Review, Second Quarter (1997).
8. Ibid.
9. Edmund S. Phelps, “Phillips Curves, Expectations of Inflation and Optimal Unemployment
Over Time,” Economica 34, no. 3 (1967): 254–281.
10. Milton Friedman, “The Role of Monetary Policy: Presidential Address to the American
Economic Association,” American Economic Review, 1968.
11. Goodhart, Money Information and Uncertainty.
12. Friedman, “The Role of Monetary Policy.”
13. Joseph Stiglitz, “Reflections on the Natural Rate Hypothesis,” Journal of Economic

Perspectives 11, no. 1 (1997): 3–10.
14. Lawrence Ball and N. Gregory Mankiw, “The NAIRU in Theory and Practice,” Journal of
Economic Perspectives 16, no. 4 (2002): 115–136.
15. Robert J. Gordon, “The Phillips Curve Is Alive and Well: Inflation and the NAIRU During
the Slow Recovery” (NBER Working Paper no. 19390, August 2013).
16. Edward S. Knotek II, “How Useful Is Okun’s Law?,” Federal Reserve Bank of Kansas
City Economic Review, Fourth Quarter (2007); Arthur M. Okun, “Potential GDP, Its
Measures and Significance,” Cowles Foundation Paper No. 190, 1962. Reprinted from
the 1962 Proceedings of the Business and Economic Statistics Sections of the American
Statistical Association.
17. Knotek, “How Useful Is Okun’s Law?”; Okun, “Potential GDP.”
18. Ibid.
19. Michael T. Kiley, “Output Gaps,” Finance and Economics Discussion Series (2010-

27), Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board,
Washington, DC., 2007.
Notes 293

20. Kiley, “Output Gaps”; S. Beveridge and C. R. Nelson, “A New Approach to the

Decomposition of Economic Time Series into Permanent and Transitory Components
with Particular Attention to Measurement of the Business Cycle,” Journal of Monetary
Economics 7 (1981): 151–174.
21. Okun, “Potential GDP.”
22. Robert Lucas, “Economic Policy Evaluation: A Critique,” in The Phillips Curve and Labor
Markets, Carnegie-Rochester Conference Series on Public Policy, 1, ed. K. Brunner and A.
Meltzer (New York: American Elsevier, 1976), 19–46.
23. Thomas Sargent and Neil Wallace, “Rational Expectations and the Theory of Economic
Policy,” Journal of Monetary Economics, no. 2 (April 1976): 169–183.
24. Charles A. Goodhart, Monetary Theory and Practice: The UK Experience (London:
Macmillan, 1984).
25. Bennett T. McCullum, “Rational Expectations and Macroeconomic Stabilization Policy:
An Overview,” Journal of Money, Credit, and Banking 2, no. 4 (1980).
26. Ibid.
27. Finn E. Kydland and Edward C. Prescott, “Rules Rather than Discretion: The Inconsistency
of Optimal Plans,” Journal of Political Economy 85: 473–490.

CHAPTER 6  Monetary Policy Regimes

1. Frederick S. Mishkin, “International Experiences with Different Monetary Policy
Regimes” (NBER Working Paper 6965, National Bureau of Economic Research, February
1999); Vladimir Kyuev, Phil de Imus, and Krishna Srinivasan, “Unconventional Choices
for Unconventional Times: Credit and Quantitative Easing in Advanced Economies,” IMF
Staff Position Note, SPN/09/27, International Monetary Fund, November 4, 2009.
2. B. S. Bernanke, T. Laubach, F. S. Mishkin, and A. S. Posen, Inflation Targeting: Lessons
from the International Experience (Princeton, NJ: Princeton University Press, 1999).
3. Bernanke, Laubach, Mishkin, and Posen, Inflation Targeting; Frederic S. Mishkin,
“Monetary Policy,” NBER Reporter, Winter 2001/2002, www.nber.org/reporter
/winter02/mishkin.html.
4. Mishkin, “International Experiences.”
5. Ibid.
6. Ibid.
7. William H. Branson and Louka T. Katseli, “Currency Baskets and Real Exchange Rates”
(NBER Working Paper No. 666, National Bureau of Economic Research, April 1981).
8. Branson and Katseli, “Currency Baskets and Real Exchange Rates.”
9. Christopher J. Neely, “Realignments of Target Zone Exchange Rate Systems: What Do We
Know?,” Federal Reserve Bank of St. Louis Review, September/October 1994; Mishkin,
“International Experiences.”
10. Hong Kong Monetary Authority, “An Introduction to the Hong Kong Monetary

Authority,” 2013, www.hkma.gov.hk/media/eng/publication-and-research/reference-
materials/intro_to_hkma.pdf.
11. Mishkin, “International Experiences.”
12. Frederic S. Mishkin, “From Monetary Targeting to Inflation Targeting: Lessons from the
Industrialized Countries” (Bank of Mexico Conference, “Stabilization and Monetary
Policy: The International Experience,” Mexico City, November 14–15, 2000).
13. Ibid.
14. Ibid.
15. William L. Silber, Volcker: The Triumph of Persistence (New York: Bloomsbury Press, 2012).
16. Mishkin, “From Monetary Targeting.”
17. Ibid.
18. Ibid.
19. Ibid.
294 NOTES

20. Ibid.
21. Mishkin, “From Monetary Targeting”; Silber, Volcker.
22. Mishkin, “From Monetary Targeting.”
23. Ibid.
24. Mishkin, “From Monetary Targeting”; Alan Greenspan, “Monetary Policy under

Uncertainty.” (Remarks at a symposium sponsored by the Federal Reserve Bank of Kansas
City, Jackson Hole, Wyoming, August 29, 2003).
25. Mishkin, “From Monetary Targeting.”
26. Ibid.
27. Ibid.
28. Ibid.
29. Ibid.
30. Charles Goodhart, Money Information and Uncertainty, 2nd ed. (London: Macmillan
Press, 1989); Mishkin, “From Monetary Targeting.”
31. Daniel L. Thornton, “Why Does Velocity Matter?,” Federal Reserve Bank of St. Louis
Review, December 1983, http://research.stlouisfed.org/publications/review/83/12/Velocity
_Dec1983.pdf.
32. Ibid.
33. Daniel L. Thornton, “Why Does Velocity Matter?”; Goodhart, Money Information and
Uncertainty; Mishkin, “From Monetary Targeting.”
34. Goodhart, Money Information and Uncertainty.
35. Charles A. Goodhart, Monetary Theory and Practice: The UK Experience (London:
Macmillan, 1984).
36. Goodhart, Money Information and Uncertainty.
37. Ibid.
38. Bernanke, Laubach, Mishkin, and Posen, Inflation Targeting; Mishkin, “International
Experiences;” Greenspan, “Monetary Policy under Uncertainty.”
39. Mishkin, “International Experiences”; Greenspan, “Monetary Policy under Uncertainty.”
40. Alan Greenspan, “The Challenge of Central Banking in a Democratic Society.” (Remarks
at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for
Public Policy Research, Washington, DC, December 5, 1996), www.federalreserve.gov/
boarddocs/speeches/1996/19961205.htm.
41. John B. Taylor, “Discretion versus Policy Rules in Practice,” Carnegie-Rochester

Conference Series on Public Policy 39 (1993): 195–214.
42. Mishkin, “International Experiences”; Greenspan, “Monetary Policy under Uncertainty.”
43. John B. Taylor, “Origins and Policy Implications of the Crisis,” in New Directions in
Financial Services Regulation, ed. Roger B. Porter, Robert R. Glauber, and Thomas J.
Healey (Cambridge, MA: MIT Press, 2009).
44. Bernanke, Laubach, Mishkin, and Posen, Inflation Targeting; Lars E. O. Svensson,

“Inflation Targeting after the Financial Crisis” (Challenges to Central Banking in the
Context of Financial Crisis, International Research Conference, Mumbai, February 12,
2010), www.bis.org/review/r100216d.pdf?frames=0.
45. Charles Freedmand and Douglas Laxton, “Inflation Targeting Pillars: Transparency and
Accountability” (IMF Working Paper WP/09/262, 2009).
46. Bernanke, Laubach, Mishkin, and Posen, Inflation Targeting; Freedmand and Laxton,
“Inflation Targeting Pillars.”
47. Bernanke, Laubach, Mishkinand, and Posen, Inflation Targeting.
48. Mervyn King, “Changes in UK Monetary Policy: Rules and Discretion in Practice,”

Journal of Monetary Economics 39 (1997): 81–97; Svensson, “Inflation Targeting.”
49. Mishkin, “International Experiences”; Ben S. Bernanke and Mark Gertler, “Inside the
Black Box: The Credit Channel of Monetary Policy Transmission,” Journal of Economic
Perspectives 9, no. 4 (1995): 27–48; Lawrence J. Christiano, Martin Eichenbaum, and
Notes 295

Charles L. Evans, “Nominal Rigidities and the Dynamic Effects of a Shock to Monetary
Policy,” Journal of Political Economy 113, no. 1 (2005): 1–45.
50. Mishkin, “International Experiences”; Christopher Ragan, “Monetary Policy: How It

Works, and What It Takes,” in Why Monetary Policy Matters: A Canadian Perspective, 2005,
www.bankofcanada.ca/monetary-policy-introduction/why-monetary-policy-matters/4-
monetary-policy/; Bernanke and Gertler “Inside the Black Box”; Christiano, Eichenbaum,
and Evans, “Nominal Rigidities.”
51. Svensson, “Inflation Targeting.”
52. Bernanke, Laubach, Mishkin, and Posen, Inflation Targeting.
53. Jonathan Spicer,“In Historic Shift, Fed Sets Inflation Target,”Reuters, January 25, 2012, www
.reuters.com/article/2012/01/25/us-usa-fed-inflation-target-idUSTRE80O25C20120125.
54. Federal Reserve Open Market Committee, Press Release, January 25, 2012, www

.federalreserve.gov/newsevents/press/monetary/20120125c.htm; Spicer, “In Historic Shift.”
55. Svensson, “Inflation Targeting.”
56. Ibid.
57. Bank of Canada, “Monetary Policy,” Backgrounders, 2012, www.bankofcanada.ca/

wp-content/uploads/2010/11/monetary_policy.pdf.
58. Svensson, “Optimal Inflation Targets, ‘Conservative’ Central Banks, and Linear Inflation
Contracts” (NBER Working Paper no. 5251, September 1995).
59. Claudio Borio and Philip Lowe, “Asset Prices, Financial and Monetary Stability: Exploring
the Nexus” (BIS Working Paper no. 114, July 2002).
60. Masaaki Shirakawa, “One Year under ‘Quantitative Easing,’” Institute for Monetary and
Economic Studies, Bank of Japan, Discussion Paper No. 2002-E-3, 2002; Richard A.
Posner, “Underlying Causes of the Financial Crisis 2008–2009,” in New Directions in
Financial Services Regulation, ed. Roger B. Porter, Robert R. Glauber, and Thomas J.
Healey (Cambridge, MA: MIT Press, 2009).
61. Shirakawa, “One Year under ‘Quantitative Easing’”; Borio and Lowe, “Asset Prices.”
62. Claudio Borio, “Rediscovering the Macroeconomic Roots of Financial Stability Policy:
Journey, Challenges and a Way Forward” (BIS Working Paper no. 354, September
2011).
63. Ibid.
64. Reserve Bank of Australia, “Inflation Target,” in Monetary Policy, 2013, www.rba.gov.au/
monetary-policy/inflation-target.html
65. Stefan Ingves, “Central Bank Governance and Financial Stability: A Study Group Report,”
Bank for International Settlements, May 2011.
66. Kyuev, de Imus, and Srinivasan, “Unconventional Choices”; Shirakawa, “One Year under
‘Quantitative Easing.’”
67. Ben S. Bernanke, “The Crisis and the Policy Response” (speech given at the Stamp Lecture,
London School of Economics, January 13, 2009), www.federalreserve.gov/newsevents/
speech/bernanke20090113a.htm; Kyuev, de Imus, and Srinivasan, “Unconventional
Choices.”
68. Bernanke, “The Crisis and the Policy Response.”
69. Bernanke, “The Crisis and the Policy Response”; Kyuev, de Imus, and Srinivasan,

“Unconventional Choices.”
70. Bernanke, “The Crisis and the Policy Response.”
71. Bernanke, “The Crisis and the Policy Response”; Kyuev, de Imus, and Srinivasan,

“Unconventional Choices.”
72. Ibid.
73. Federal Open Market Committee, Press Release, Board of Governors of the Federal
Reserve System, September 13, 2012, www.federalreserve.gov/newsevents/press/
monetary/20120913a.htm.
74. Kyuev, de Imus, and Srinivasan, “Unconventional Choices.”
296 NOTES

75. Louise Armidstead, “Debt Crisis: Draghi Presents ‘Unlimited’ Bond Buying Plan to

ECB Council,” The Telegraph, September 5, 2012, www.telegraph.co.uk/finance/
financialcrisis/9523871/Debt-crisis-Draghi-presents-unlimited-bond-buying-plan-to-
ECB-council.html.
76. Ibid.

CHAPTER 7  Monetary Policy Implementation

1. Corrine Ho, “Implementing Monetary Policy in the 2000s: Operating Procedures in Asia
and Beyond” (BIS Working Paper no. 253, June 2008).
2. The Monetary Policy Committee, “The Transmission Mechanism of Monetary Policy,”
Bank of England, 1999, www.bankofengland.co.uk/publications/Documents/other/
monetary/montrans.pdf.
3. Robert N. McCauley, “Developing Financial Markets and Operating Monetary Policy
in Asia” (Financial Market Development and Their Implications for Monetary Policy:
BNM-BIS Conference, August 13, 2007).
4. Bernanke, “The Crisis and the Policy Response.”
5. Zvi Bodie, Alex Kane, and Alan Marcus, Essentials of Investments, 9th ed. (New York:
McGraw-Hill/Irwin, 2013).
6. Frank J. Fabozzi, Steve V. Mann, and Moorad Choudhry, The Global Money Markets
(New York: John Wiley & Sons, 2002).
7. Board of Governors of the Federal Reserve System, The Federal Reserve System: Purposes
and Functions (Washington, DC: Board of Governors of the Federal Reserve System,
2005), www.federalreserve.gov/pf/pdf/pf_complete.pdf; Ho, “Implementing Monetary
Policy.”
8. Ho, “Implementing Monetary Policy.”
9. Ho, “Implementing Monetary Policy”; Board of Governors of the Federal Reserve System,
The Federal Reserve System.
10. Posner, “Underlying Causes.”
11. Ibid.
12. Board of Governors of the Federal Reserve System, The Federal Reserve System.
13. Ibid.
14. Ho, “Implementing Monetary Policy”; Board of Governors of the Federal Reserve System,
The Federal Reserve System.
15. Ho, “Implementing Monetary Policy.”
16. Piti Disyatat, “Monetary Policy Implementation: Misconceptions and Their Consequences”
(BIS Working Paper no. 269, December 2008).
17. Ibid.
18. Ho, “Implementing Monetary Policy”; Board of Governors of the Federal Reserve System,
The Federal Reserve System; David E. W. Laidler and William B. P. Robson, Two Percent
Target: Canadian Monetary Policy Since 1991 (Toronto: C.D. Howe Institute, 2004).
19. Ho, “Implementing Monetary Policy”; Board of Governors of the Federal Reserve System,
The Federal Reserve System.
20. Board of Governors of the Federal Reserve System, The Federal Reserve System; Ho,
“Implementing Monetary Policy.”
21. Ho, “Implementing Monetary Policy.”
22. Ibid.
23. George A. Kahn, “Monetary Policy under a Corridor Operating Framework,” Economic
Review 95, no. 4 (2010): 5; Ho, “Implementing Monetary Policy.”
24. Ho, “Implementing Monetary Policy”; Board of Governors of the Federal Reserve System,
The Federal Reserve System.
25. Board of Governors of the Federal Reserve System, The Federal Reserve System.
Notes 297

6. Bodie, Kane, and Marcus, Essentials of Investments.

2
27. Ibid.

CHAPTER 8  The Monetary Policy Transmission Mechanism

1. The Monetary Policy Committee, “The Transmission Mechanism of Monetary
Policy,” Bank of England, 1999, www.bankofengland.co.uk/publications/Documents/
other/monetary/montrans.pdf; Bank of Canada, “How Monetary Policy Works: The
Transmission of Monetary Policy,” Backgrounders, 2012, www.bankofcanada.ca/
wp-content/uploads/2010/11/how_monetary_policy_works.pdf; Ben S. Bernanke and
Mark Gertler, “Inside the Black Box: The Credit Channel of Monetary Policy Trans­
mission,” Journal of Economic Perspectives 9, no. 4 (1995): 27–48.
2. The Monetary Policy Committee, “The Transmission Mechanism”; Bank of Canada,
“How Monetary Policy Works”; Bernanke and Gertler, “Inside the Black Box.”
3. Treasury Direct, “Treasury Inflation-Protected Securities (TIPS),” Bureau of Fiscal Service,
U.S. Department of the Treasury, 2013, https://www.treasurydirect.gov/indiv/products/
prod_tips_glance.htm.
4. Joseph G. Haubrich, George Pennacchi, and Peter Ritchken, “Estimating Real and Nominal
Term Structures Using Treasury Yields, Inflation, Inflation Forecasts, and Inflation Swap
Rates” (Federal Reserve Bank of Cleveland Working Paper no. 0810, 2008), www
.clevelandfed.org/research/workpaper/2008/wp0810.pdf.
5. The Monetary Policy Committee, “The Transmission Mechanism”; Christopher
Ragan, “Monetary Policy: How It Works, and What It Takes,” in Why Monetary Policy
Matters: A Canadian Perspective, 2005, Bank of Canada, www.bankofcanada.ca/
monetary-policy-introduction/why-monetary-policy-matters/4-monetary-policy/.
6. The Monetary Policy Committee, “The Transmission Mechanism.”
7. The Monetary Policy Committee, “The Transmission Mechanism”; Ragan, “Monetary
Policy.”
8. The Monetary Policy Committee, “The Transmission Mechanism.”
9. Ibid.
10. Ibid.
11. The Monetary Policy Committee, “The Transmission Mechanism”; Bank of Canada,
“How Monetary Policy Works”; Bernanke and Gertler, “Inside the Black Box.”
12. The Monetary Policy Committee, “The Transmission Mechanism.”
13. Ibid.
14. The Monetary Policy Committee, “The Transmission Mechanism”; Bank of Canada,
“How Monetary Policy Works.”
15. The Monetary Policy Committee, “The Transmission Mechanism”; Ragan, “Monetary
Policy”; Bernanke and Gertler, “Inside the Black Box.”
16. The Monetary Policy Committee, “The Transmission Mechanism.”
17. Ibid.
18. Ibid.
19. The Monetary Policy Committee, “The Transmission Mechanism”; Bernanke and Gertler,
“Inside the Black Box.”
20. The Monetary Policy Committee, “The Transmission Mechanism.”
21. Ibid.
22. Ibid.
23. Ibid.
24. Ibid.
25. Laidler and Robson, Two Percent Target; Bernanke and Gertler, “Inside the Black Box.”
26. Ibid.
27. Ibid.
298 NOTES

8. Laidler and Robson, Two Percent Target; Bernanke and Gertler, “Inside the Black Box.”
2
29. Ibid.
30. The Monetary Policy Committee, “The Transmission Mechanism.”
31. The Monetary Policy Committee, “The Transmission Mechanism”; Bank of Canada,
“How Monetary Policy Works.”
32. The Monetary Policy Committee, “The Transmission Mechanism”; Ragan, “Monetary
Policy.”

CHAPTER 9  The Exchange Rate and Central Banking

1. Jeffery Amato, Andrew Filardo, Grabriele Galati, Goetz von Peter, and Feng Zhu,
“Research on Exchange Rates and Monetary Policy: An Overview” (BIS Working Paper
no. 178, June 2005).
2. Ibid.
3. Ibid.
4. Ibid.
5. Ibid.
6. Barry Eichengreen and Raul Razo-Garcia, “The International Monetary System in the
Last and Next 20 Years,” Economic Policy 21, no. 47 (2006): 393–442; Maurice Obstfeld
and Paul Krugman, International Economics: Theory and Policy, 8th ed. (Upper Saddle
River, NJ: Pearson Addison-Wesley, 2009).
7. Ibid.
8. International Monetary Fund, “De Facto Classification of Exchange Rate Arrangements and
Monetary Policy Frameworks,” Appendix Table II.9, Annual Report, April 30, 2013, www.
imf.org/external/pubs/ft/ar/2013/eng/pdf/a2.pdf; Tony Latter, The Choice of Exchange
Rate Regime, Handbooks in Central Banking No. 2 (London: Centre for Central Banking
Studies, Bank of England, May 1996); Stanley Fischer, “Exchange Rate Regimes: Is the
Bipolar View Correct?” (Distinguished Lecture on Economics in Government, jointly spon-
sored by the American Economic Association and the Society of Government Economists,
at the meetings of the American Economic Association, New Orleans, January 6, 2001).
9. Latter, Choice of Exchange Rate Regime; Fischer, “Exchange Rate Regimes.”
10. Latter, Choice of Exchange Rate Regime.
11. Ibid.
12. International Monetary Fund, “De Facto Classification.”
13. Hong Kong Monetary Authority, An Introduction to the Hong Kong Monetary Authority,
accessed December 14, 2013, www.hkma.gov.hk/media/eng/publication-and-research/
reference-materials/intro_to_hkma.pdf.
14. Latter, Choice of Exchange Rate Regime.
15. International Monetary Fund, “De Facto Classification.”
16. Latter, Choice of Exchange Rate Regime.
17. Ibid.
18. International Monetary Fund, “De Facto Classification.”
19. Latter, Choice of Exchange Rate Regime.
20. Ignatius Low, Fiona Chan, Gabriel Chen, et al., Sustaining Stability, Serving Singapore—
40th Anniversary 1971–2011 (Singapore: Monetary Authority of Singapore, 2011).
21. Amato, Filardo, Galati, von Peter, and Zhu, “Research on Exchange Rates.”
22. K. Pilbeam, International Finance (London: Macmillan, 1992).
23. Jeffrey Frankel, “Monetary and Portfolio Balance Models of Exchange Rate

Determination,” in Economic Interdependence and Flexible Exchange Rates, ed. Jagdeep
Bhandari and Bluford Putnam (Cambridge: MIT Press, 1983), reprinted with 1987
Addendum in Jeffrey Frankel, On Exchange Rates (Cambridge, MA: MIT Press, 1993),
www.hks.harvard.edu/fs/jfrankel/Monetary&PB%20Models%20ExRateDetermtn.pdf;
Pilbeam, International Finance.
Notes 299

4. Frankel, “Monetary and Portfolio Balance Models”; Pilbeam, International Finance.

2
25. Ibid.
26. Frankel, “Monetary and Portfolio Balance Models.”
27. Pilbeam, International Finance; Frankel, “Monetary and Portfolio Balance Models.”
28. T. Anderse, T. Bollerslev, F. Diebold, and C. Vega, “Micro Effects of Macro Announcements:
Real-Time Price Discovery in Foreign Exchange,” American Economic Review 93, no. 1
(2003): 38–62; J. Zettlemeyer, “The Impact of Monetary Policy on the Exchange Rate:
Evidence from Three Small Open Economies,” Journal of Monetary Economics, 51, no. 3
(2004): 635–652; Jonathan Kearns and Phil Manners, “The Impact of Monetary Policy
on the Exchange Rate: A Study Using Intraday Data,” 2, no. 4 (2006).
29. Latter, Choice of Exchange Rate Regime.
30. Ibid.
31. Ibid.
32. Ibid.
33. Ibid.
34. Ibid.
35. Ibid.
36. Ibid.
37. Ibid.
38. Garry Schinasi, “Defining Financial Stability” (IMF Working Paper, WP/04/187,

International Monetary Fund, Washington, DC, October 2004).

CHAPTER 10  Financial Stability: Definition, Analytical Framework,

and Theoretical Foundation
1. Claudio Borio and William White, “Whither Monetary and Financial Stability? The
Implications of Evolving Policy Regimes” (BIS Working Paper no. 147, February 2004).
2. Claudio Borio and Mathias Drehmann, “Towards an Operational Framework for
Financial Stability: ‘Fuzzy’ Measurement and Its Consequences” (BIS Working Paper no.
284, June 2009); Claudio Borio, “Rediscovering the Macroeconomic Roots of Financial
Stability: Journey, Challenges and a Way Forward” (BIS Working Paper no. 354,
September 2011).
3. Borio and Drehmann, “Towards an Operational Framework”; Borio, “Rediscovering
the Macroeconomic Roots”; O. Aspachs, C. Goodhart, M. Segoviano, D. Tsomocos, and
L. Zicchino, “Searching for a Metric for Financial Stability,” in Financial Stability in
Practice, ed. C. Goodhart and D. Tsomocos (Cheltenham, UK: Edward Elgar, 2006).
4. Ben S. Bernanke and Mark Gertler, “Financial Fragility and Economic Performance,”
Quarterly Journal of Economics 105 (February, 1990): 87–114.
5. Aspachs, Goodhart, Segoviano, Tsomocos, and L. Zicchino, “Searching for a Metric.”
6. Charles Goodhart, “What Can Academics Contribute to the Study of Financial Stability?,”
The Economic and Social Review 36, no. 3 (2005): 189–203.
7. Borio and Drehmann, “Towards an Operational Framework.”
8. Gary J. Schinasi, “Defining Financial Stability” (IMF Working Paper WP/04/187, October 2004).
9. Mark Gertler, “Financial Structure and Aggregate Economic Activity: An Overview,”
Journal of Money, Credit, and Banking 20, no. 3 (1988).
10. Claudio Borio and Philip Lowe, “Asset Prices, Financial and Monetary Stability: Exploring
the Nexus” (BIS Working Paper no. 114, July 2002); Thammarak Moenjak, Warangkana
Imudom, and Siripim Vimolchalao, “Monetary and Financial Stability: Finding the Right
Balance under Inflation Targeting” (Bank of Thailand Symposium, September 2004).
11. Irving Fisher, “The Debt-Deflation Theory of Great Depressions,” Econometrica 1(October
1933): 337–357.
12. John G. Gurley and E. S. Shaw, “Financial Aspects of Economic Development,” The
American Economic Review XLV, no. 4 (1955).
300 NOTES

13. Hyman P. Minsky, Stabilizing an Unstable Economy (New Haven, CT: Yale University
Press, 1986).
14. Charles P. Kindleberger, Manias, Panics and Crashes: A History of Financial Crises (New
York: John Wiley & Sons, 1978).
15. Bernanke and Gertler, “Financial Fragility.”
16. Borio and White, “Whither Monetary and Financial Stability?”
17. Claudio Borio and Philip Lowe, “Assessing the Risk of Banking Crises, “BIS Quarterly
Review, December 2002.
18. Ibid.
19. Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and

Liquidity,” Journal of Political Economy 91, no. 3 (1983): 401–419.
20. J. C. Rochet and J. Tirole, “Interbank Lending and Systemic Risk,” Journal of Money,
Credit and Banking 28, no. 4 (1996): 733–762.
21. F. Allen and D. Gale, “Financial Contagion,” Journal of Political Economy 108, no. 1
(2000): 1–33.
22. X. Freixas, B. Parigi, and J. C. Rochet, “Systemic Risk, Interbank Relations and Liquidity
Provision by the Central Bank,” Journal of Money, Credit and Banking 32, no. 3 (2000):
611–638.
23. Andrew Haldane, “Rethinking the Financial Network” (speech delivered at the Financial
Student Association, Amsterdam, April 2009).
24. George G. Akerloff, “The Market for ‘Lemons’: Quality Uncertainty and the Market
Mechanism,” The Quarterly Journal of Economics 84, no. 3 (1970).
25. Joseph E. Stiglitz and Andrew Weiss, “Credit Rationing in Markets with Imperfection,”
The American Economic Review 71, no. 3 (981).
26. Irving Fisher, “The Debt-Deflation Theory of Great Depressions,” Econometrica 1

(October 1933): 337–357.
27. Gertler, “Financial Structure and Aggregate Economic Activity.”
28. Gurley and Shaw, “Financial Aspects of Economic Development.”
29. Kindleberger, Manias, Panics and Crashes.
30. Hyman P. Minsky, Stabilizing an Unstable Economy (New Haven, CT: Yale University
Press, 1986).
31. Bernanke and Gertler, “Financial Fragility and Economic Performance.”
32. Borio and Lowe, “Asset Prices, Financial and Monetary Stability.”
33. Borio and White, “Whither Monetary and Financial Stability?”
34. Borio and Drehmann, “Towards an Operational Framework.”
35. Borio, “Rediscovering the Macroeconomic Roots.”
36. Claudio Borio, “The Financial Cycle and Macroeconomics: What Have We Learnt?” (BIS
Working Paper no. 395, December 2012).
37. Carmen Reinhart and Kenneth Rogoff, “Growth in a Time of Debt” (NBER Working
Paper no. 15639, January 2010).
38. Hyman P. Minsky, Stabilizing an Unstable Economy.
39. Gurley and Shaw, “Financial Aspects of Economic Development.”
40. Kindleberger, Manias, Panics and Crashes.
41. Ibid.
42. Hyman P. Minsky, Stabilizing an Unstable Economy.
43. Ben S. Bernanke, “Nonmonetary Effects of Financial Crisis on the Propagation of the
Great Depression,” The American Economic Review 73, no. 3 (1983): 257–276.
44. Gertler, “Financial Structure and Aggregate Economic Activity”; Borio, “The Financial
Cycle and Macroeconomics.”
45. Gertler, “Financial Structure and Aggregate Economic Activity.”
46. Franco Modigliani and Merton Miller, “The Cost of Capital, Corporation Finance, and
the Theory of Investment,” The American Economic Review 48 (June, 1958): 261–297.
47. Milton Friedman and Anna J. Schwartz, A Monetary History of the United States: 1867–
1960 (Princeton, NJ: Princeton University Press, 1963).
Notes 301

8. Borio, “Rediscovering the Macroeconomic Roots.”

4
49. Diamond and Dybvig, “Bank Runs, Deposit Insurance, and Liquidity.”
50. Allen and Gale, “Financial Contagion.”
51. Freixas, Parigi, and Rochet, “Systemic Risk, Interbank Relations and Liquidity Provision
by the Central Bank.”
52. Diamond and Dybvig, “Bank Runs, Deposit Insurance, and Liquidity.”
53. Ibid.
54. J. C. Rochet and J. Tirole, “Interbank Lending and Systemic Risk,” Journal of Money,
Credit and Banking 28, no. 4 (1996): 733–762.
55. Allen and Gale, “Financial Contagion.”
56. Freixas, Parigi, and Rochet, “Systemic Risk, Interbank Relations and Liquidity Provision
by the Central Bank.”
57. Haldane, “Rethinking the Financial Network.”
58. Allen and Gale, “Financial Contagion.”
59. Haldane, “Rethinking the Financial Network.”
60. Ibid.
61. Gertler, “Financial Structure and Aggregate Economic Activity.”
62. Hyman P. Minsky, Stabilizing an Unstable Economy.

CHAPTER 11  Financial Stability: Monitoring and Identifying Risks

1. Claudio Borio and Mathias Drehmann, “Towards an Operational Framework for
Financial Stability: ‘Fuzzy’ Measurement and Its Consequences” (BIS Working Paper
no. 284, June 2009); C. Lim, F. Columba, A. Costa, P. Kongsamut, A. Otani, M. Saiyid,
T. Wezel, and X. Wu, “Macroprudential Policy: What Instruments and How to Use Them?
Lessons from Country Experiences” (IMF Working Paper WP/11/238, 2011); Christian
Weisstroffer, “Macroprudential Supervision: In Search of an Appropriate Response to
Systemic Risk,” Current Issues: Global Financial Markets, Deutsche Bank, May 24, 2012.
2. Claudio Borio and Philip Lowe, “Asset Prices, Financial and Monetary Stability: Exploring
the Nexus” (BIS Working Paper no. 114, July 2002); Claudio Borio and Philip Lowe,
“Assessing the Risk of Banking Crises,” BIS Quarterly Review, December 2002.
3. Borio and Lowe, “Assessing the Risk of Banking Crises.”
4. Borio and Drehmann, “Towards an Operational Framework for Financial Stability.”
5. Borio and Lowe, “Asset Prices, Financial and Monetary Stability”; Borio and Lowe,
“Assessing the Risk of Banking Crises.”
6. Borio and Drehmann, “Towards an Operational Framework for Financial Stability.”
7. Lim et al., “Macroprudential Policy.”
8. Borio and Lowe, “Asset Prices, Financial and Monetary Stability”; Borio and Lowe,
“Assessing the Risk of Banking Crises.”
9. Borio and Drehmann, “Towards an Operational Framework for Financial Stability.”
10. Borio and Lowe, “Assessing the Risk of Banking Crises.”
11. Borio and Drehmann, “Towards an Operational Framework for Financial Stability.”
12. Mark Carey and Rene M. Stultz, “The Risks of Financial Institutions” (NBER Working
Paper no. 11442, National Bureau of Economic Research, June 2005).
13. Lim et al., “Macroprudential Policy”; Weisstroffer, “Macroprudential Supervision.”
14. Miguel A. Segoviano and Charles Goodhart, “Banking Stability Measures” (IMF Working
Paper WP/09/4, 2009).
15. Camelia Minoiu and Javier A. Reyes, “A Network Analysis of Global Banking: 1978–
2009” (IMF Working Paper WP/11/74, April 2011).
16. Jorge A. Chan-Lau, “Balance Sheet Network Analysis of Too-Connected-to-Fail Risk in
Global and Domestic Banking Systems” (IMF Working Paper WP/10/107, April 2010).
17. Basel Committee on Banking Supervision, “Global Systemically Important Banks:

Assessment Methodology and the Additional Loss Absorbency Requirement,” Bank for
International Settlements, November 2011; Basel Committee on Banking Supervision,
302 NOTES

“A Framework for Dealing with Domestic Systemically Important Banks,” Bank for
International Settlements, October 2012.
18. Franklin Allen and Ana Babus, “Networks in Finance,” in The Network Challenge,

Strategy, Profit, and Risk in an Interlinked World, ed. Paul R. Kleindorfer and Yorram
Wind with Robert E. Gunther (Upper Saddle River, NJ: Pearson Education, 2009).
19. Franklin Allen and Ana Babus, “Networks in Finance”; Haldane, “Rethinking the

Financial Network.”
20. Segoviano and Goodhart, “Banking Stability Measures.”
21. Chan-Lau, “Balance Sheet Network Analysis”; Basel Committee on Banking Supervision,
“A Framework.”
22. Basel Committee on Banking Supervision, “Global Systemically Important Banks”; Basel
Committee on Banking Supervision, “A Framework.”
23. Ibid.
24. Borio and Drehmann, “Towards an Operational Framework.”
25. Douwe Miedeman, “U.S. Fed Sets Tough Tests in Annual Bank Health War Games,”
Reuters, November 1, 2013, www.reuters.com/article/2013/11/01/us-banks-fed-tests-
idUSBRE9A00W120131101.
26. Borio and Drehmann, “Towards an Operational Framework.”
27. Borio and Lowe, “Asset Prices.”
28. Borio and Drehmann, “Towards an Operational Framework.”
29. British Bankers’ Association, “BBA Libor,” http://www.bbalibor.com/.
30. Rajdeep Sengupta and Yu Man Tam, “The Libor-OIS Spread as a Summary Indicator”
(Economic Synopses, Federal Reserve Bank of St. Louis, 2008). http://research.stlouisfed
.org/publications/es/08/ES0825.pdf, Retrieved March 10, 2014.
31. Daniel L. Thornton, “What the Libor-OIS Spread Says” (Economic Synopses, Federal
Reserve Bank of St. Louis, May 2009). http://research.stlouisfed.org/publications/es/09/
ES0924.pdf, Retrieved March 10, 2014.
32. Steven Drobny, The Invisible Hands: Hedge Funds Off the Record—Rethinking Real
Money, (Hoboken, NJ: John Wiley & Sons, 2010).
33. Rajdeep Sengupta and Yu Man Tam, “The Libor-OIS Spread as a Summary Indicator”
(Economic Synopses, Federal Reserve Bank of St. Louis), http://research.stlouisfed.org/
publications/es/08/ES0825.pdf, Retrieved March 10, 2014.
34. Lim et al., “Macroprudential Policy.”
35. Dale Gray, Robert C. Merton, and Zvi Bodie, “A New Framework for Analyzing and
Managing Macrofinancial Risks and Financial Stability” (NBER Working Paper No.
13607, National Bureau of Economic Research, November 2007).
36. Fischer Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities”
Journal of Political Economy 81, no. 3: 637–654, 1973; Robert C. Merton, “Theory of
Rational Option Pricing,” Bell Journal of Economics and Management Science, The Rand
Corporation 4, no. 1: 141–183, 1973).
37. Dale F. Gray, Robert C. Merton, and Zvi Bodie, “New Framework for Measuring and
Managing Macrofinancial Risk and Financial Stability” (Working Paper, August 2008).
38. Dale Gray and Samuel W. Malone, Macrofinancial Risk Analysis (Hoboken, NJ: John
Wiley & Sons, 2008).
39. Dale F. Gray, “Using Contingent Claims Analysis (CCA) to Measure and Analyze Systemic
Risk, Sovereign and Macro Risk” (presentation to Macro Financial Modeling Conference,
International Monetary Fund, September 13, 2012).

CHAPTER 12  Financial Stability: Intervention Tools

1. Claudio Borio and Mathias Drehmann, “Towards an Operational Framework for
Financial Stability: ‘Fuzzy’ Measurement and Its Consequences” (BIS Working Paper
no. 284, June 2009); C. Lim, F. Columba, A. Costa, P. Kongsamut, A. Otani, M. Saiyid,
Notes 303

T. Wezel, and X. Wu, “Macroprudential Policy: What Instruments and How to Use Them?
Lessons from Country Experiences” (IMF Working Paper WP/11/238, 2011).
2. Claudio Borio, “Rediscovering the Macroeconomic Roots of Financial Stability Policy:
Journey, Challenges and a Way Forward” (BIS Working Paper no. 354, September 2011).
3. J. Patrick Raines, J. Ashley McLeod, and Charles G. Leathers, “Theories of Stock Prices and
the Greenspan-Bernanke Doctrine on Stock Market Bubbles,” Journal of Post Keynesian
Economics 29, no. 3 (2007): 393–408; Borio, “Rediscovering the Macroeconomic
Roots”; Lim et al., “Macroprudential Policy”; Christian Weisstroffer, “Macroprudential
Supervision: In Search of an Appropriate Response to Systemic Risk,” Current Issues:
Global Financial Markets, Deutsche Bank, May 24, 2012; International Monetary Fund,
“Macroprudential Policy: An Organizing Framework,” March 14, 2011, www.imf.org/
external/np/pp/eng/2011/031411.pdf; Financial Stability Board, “Macroprudential Policy
Tools and Frameworks—Progress Progress Report to G20,” October 27, 2011, www
.financialstabilityboard.org/publications/r_111027b.htm.
4. Borio, “Rediscovering the Macroeconomic Roots.”
5. Richard A. Posner, “Underlying Causes of the Financial Crisis 2008–2009,” in New
Directions in Financial Services Regulation, ed. Roger B. Porter, Robert R. Glauber, and
Thomas J. Healey (Cambridge, MA: MIT Press, 2009); John B. Taylor, “Origins
and Policy Implications of the Crisis,” in New Directions in Financial Services Regulation,
ed. Roger B. Porter, Robert R. Glauber, and Thomas J. Healey (Cambridge, MA: MIT
Press, 2009).
6. Borio, “Rediscovering the Macroeconomic Roots.”
7. Claudio Borio and Philip Lowe, “Asset Prices, Financial and Monetary Stability: Exploring
the Nexus” (BIS Working Paper no. 114, July 2002).
8. Bank of Canada, “Monetary Policy,” Backgrounders, 2012, www.bankofcanada.ca/
wp-content/uploads/2010/11/monetary_policy.pdf.
9. Reserve Bank of Australia, “Inflation Target,” in Monetary Policy, 2013, www.rba.gov
.au/monetary-policy/inflation-target.html.
10. Lim et al., “Macroprudential Policy.”
11. Ibid.
12. Ibid.
13. Ibid.
14. Ibid.
15. Ibid.
16. Ben S. Bernanke, “The Crisis and the Policy Response” (speech given at the Stamp Lecture,
London School of Economics, January 13, 2009), www.federalreserve.gov/newsevents/
speech/bernanke20090113a.htm; Vladimir Kyuev, Phil de Imus, and Krishna Srinivasan,
“Unconventional Choices for Unconventional Times: Credit and Quantitative Easing in
Advanced Economics” (IMF Staff Position Note SPN/09/27, November 4, 2009).
17. Bernanke, “The Crisis and the Policy Response”; Kyuev, de Imus, and Srinivasan,

“Unconventional Choices.”
18. Ibid.
19. Bernanke, “The Crisis and the Policy Response.”
20. Claudio Borio, “The Financial Cycle and Macroeconomics: What Have We Learnt?” (BIS
Working Paper no. 395, December 2012).
21. Lim et al., “Macroprudential Policy.”
22. Borio, “Rediscovering the Macroeconomic Roots.”
23. Lim et al., “Macroprudential Policy.”
24. Ibid.
25. Basel Committee on Banking Supervision Reforms, Basel III Summary Table, accessed
May 11, 2013, www.bis.org/bcbs/basel3/b3summarytable.pdf.
26. Charles Goodhart, “Ratio Controls Need Reconsideration,” Journal of Financial Stability
9, no. 3 (2013): 445–450.
304 NOTES

27. Mathias Drehman, Claudio Borio, and Kostas Tsatsaronis, “Anchoring Capital Buffers:
The Role of Credit Aggregates” (BIS Working Paper no. 355, November 2011.)
28. Ibid.
29. Basel Committee on Banking Supervision, Report to G20 Finance Ministers and Central
Bank Governors on Basel III implementation, October 2012.
30. Basel Committee on Banking Supervision, “International Convergence on Capital

Measurement and Capital Standards,” Bank for International Settlements, July 1988,
www.bis.org/publ/bcbs04a.pdf.
31. Basel Committee on Banking Supervision, “International Convergence on Capital

Measurement and Capital Standards: A Revised Framework,” Bank for International
Settlements, November 2005, https://www.bis.org/publ/bcbs118.pdf.
32. Basel Committee on Banking Supervision Reforms, Basel III Summary Table.
33. Lim et al., “Macroprudential Policy.”
34. Torsten Wezel, Jorge A. Chan-Lau, and Francesco Columba, “Dynamic Loan Loss

Provisioning: Simulations on Effectiveness and Guide to Implementation” (Working
Paper 12/110, 2012).
35. Committee on the Global Financial System, “Central Bank Operations in Response to the
Financial Turmoil” CGFS Paper no. 31, Bank for International Settlements, July 2008);
Corrine Ho, “Implementing Monetary Policy in the 2000s: Operating Procedures in Asia
and Beyond” (BIS Working Paper no. 253, June 2008).
36. Committee on the Global Financial System, “Central Bank Operations.”
37. Claire L. McGuire, Simple Tools to Assist in the Resolution of Troubled Banks

(Washington, DC: World Bank, 2012).
38. Jesse Hamilton, “Banks File Living Wills Outlining Plans to Dismantle,” Bloomberg

.com, October 4, 2013, www.bloomberg.com/news/2013-10-03/banks-file-living-wills-
outlining-plans-to-dismantle.html.
39. Ibid.
40. Tobias Adrian, Christopher R. Burke, and James J. McAndrews, “The Federal Reserve’s
Primary Dealer Credit Facility,” Current Issues in Economics and Finance 15, no. 4 (2009),
www.newyorkfed.org/research/current_issues; Tobias Adrian, Karin Kimbrough, and
Dina Marchioni, “The Federal Reserve’s Commercial Paper Funding Facility,” FRBNY
Economic Policy Review, May 2011.
41. Adrian, Burke, and McAndrews, “The Federal Reserve’s Primary Dealer Credit Facility.”
42. Adrian, Kimbrough, and Marchioni, “The Federal Reserve’s Commercial Paper Funding
Facility.”
43. Ibid.

CHAPTER 13  Future Challenges for Central Banking

1. International Monetary Fund, “Globalization: Threat or Opportunity?,” 2000, www.imf
.org/external/np/exr/ib/2000/041200to.htm#II.
2. Peter J. Morgan, “Impact of US Quantitative Easing Policy on Emerging Asia” (ADBI
Working Paper Series no. 321, Asian Development Bank Institute, November 2011); The
Economist, “Electronic Payments in Africa: Cash Be Cowed,” September 14, 2013.
3. The Economist, “Electronic Payments in Africa: Cash Be Cowed,” September 14, 2013.
4. International Monetary Fund, “How Has Globalization Affected Inflation?,” World
Economic Outlook, Chapter III, April 2006, www.imf.org/external/pubs/ft/weo/2006/01/
pdf/c3.pdf.
5. Haruhiko Kuroda and Masahiro Kawai, “Time for a Switch to Global Reflation,” FT.com,
December 1, 2002.
6. Asli Demirguc-Kunt and Ross Levine, “Bank-Based and Market-Based Financial Systems:
Cross-Country Comparisons” (Policy Research Working Paper 2143, The World Bank,
July 1999).
Notes 305

7. Jeffrey Carmichael and Michael Pomerleano, Development and Regulation of Non-Bank

Financial Institutions (Washington, DC: The World Bank, 2002), 12.
8. Christopher Condon, “Reserve Primary Money Fund Falls Below $1 a Share,” Bloomberg,
September 16, 2008, www.bloomberg.com/apps/news?pid=newsarchive&sid=a5O2y1go
1GRU.
9. Satyajit Das, Extreme Money: Masters of the Universe and the Cult of Risk (Hoboken,
NJ: John Wiley & Sons, 2011).
10. Ibid.
11. William L. Silber, Volcker: The Triumph of Persistence (New York: Bloomsbury Press,
2012).
12. Paul Volcker, “The Financial Crisis in Perspective” (keynote address at Harvard’s Kennedy
School of Government), in New Directions in Financial Service Regulation, ed. Roger B.
Porter, Robert R. Glauber, and Thomas J. Healey (Cambridge, MA: MIT Press, 2009).
13. Silber, Volcker.
14. Ibid.
15. Julie Creswell, and Vikas Bajaj, “$3.2 Billion Move by Bear Stearns to Rescue Fund,” New
York Times, June 23, 2007, www.nytimes.com/2007/06/23/business/23bond.html.
16. The White House (2010), “President Obama Calls for New Restrictions on Size and Scope
of Financial Institutions to Rein in Excesses and Protect Taxpayers,” January 31, 2010,
www.whitehouse.gov/the-press-office/president-obama-calls-new-restrictions-size-and-
scope-financial-institutions-rein-e.
17. Lucy Williamson, “South Korea’s Growing Credit Problem,” BBC, September 16, 2013,
www.bbc.co.uk/news/world-asia-24059038.
18. The Economist, “Electronic Payments in Africa.”
19. European Central Bank, “Report on Electronic Money,” August 31, 1998, www.ecb
.europa.eu/press/pr/date/1998/html/pr980831.en.html.
20. British Broadcasting Service, “US Shutdown: Barack Obama Warns of Default Danger,”
October 2, 2013, www.bbc.co.uk/news/world-us-canada-24375591.
21. International Monetary Fund, World Economic Outlook Database, April 2013, https://
www.imf.org/external/pubs/ft/weo/2013/01/weodata/index.aspx.
22. Standard & Poors, “United States of America Long-Term Rating Lowered to ‘AA+’ Due
to Political Risks, Rising Debt Burden; Outlook Negative,” Press Release, August 5, 2011,
www.standardandpoors.com/ratings/articles/en/us/?assetID=1245316529563.
23. International Monetary Fund, World Economic Outlook Database.
24. “The Fed and Emerging Markets: The End of the Affair: The Prospect of Less Quantitative
Easing in America Has Rocked Currency and Bond Markets in the Emerging World,” The
Economist, June 15, 2013; Martin Crutsinger, “Fed Delays Bond Tapering, Wants to See
More Data,” Associated Press, September 18, 2013, http://finance.yahoo.com/news/fed-
delays-bond-tapering-wants-180106376.html.
25. R. Glen Hubbard, “The Morning After: A Road Map for Financial Regulatory Reform,”
in New Directions in Financial Service Regulation, ed. Roger B. Porter, Robert R. Glauber,
and Thomas J. Healey (Cambridge, MA: MIT Press, 2009).
26. Financial Stability Board, “Policy Measures to Address Systemically Important

Financial Institutions,” November 2011, www.financialstabilityboard.org/publications/
r_111104bb.pdf; Financial Stability Board, “Update of Group of Global Systemically
Important Banks,” November 2012, www.financialstabilityboard.org/publications/
r_121031ac.pdf.
27. Basel Committee on Banking Supervision, “Global Systemically Important Banks:

Assessment Methodology and the Additional Loss Absorbency Requirement: Rules Text,”
Bank for International Settlements, November 2011.
28. Hubbard, “The Morning After”; Volcker, “The Financial Crisis in Perspective”; Randall
Dodd, “Markets: Exchange or Over-the-Counter,” Finance & Development, International
Monetary Fund, March 2012, www.imf.org/external/pubs/ft/fandd/basics/markets
306 NOTES

.htm; U.S. Securities and Exchange Commission, Joint Press Statement of Leaders on
Operating Principles and Areas of Exploration in the Regulation of the Cross-Border
OTC Derivatives Market, December 2012.
29. Dodd, “Markets: Exchange or Over-the-Counter.”
30. U.S. Securities and Exchange Commission, Joint Press Statement of Leaders.
31. Ibid.
32. European Commission, “Commission Proposes New ECB Powers for Banking Supervision
as a Part of Banking Union” (press release, September 12, 2012), http://europa.eu/rapid/
press-release_IP-12-953_en.htm; European Central Bank, “Banking Supervision: What Is
It?,” accessed February 20, 2014, www.ecb.europa.eu/ssm/html/index.en.html.
33. European Commission, “Commission Proposes New ECB Powers.”
34. European Commission, “Commission Proposes New ECB Powers”; European Central
Bank, “Banking Supervision.”

CHAPTER 14  Future Central Banking Strategy and Its Execution

1. Michael E. Porter, Competitive Strategy (New York: Free Press, 1980).
2. Richard P. Rumelt, Good Strategy, Bad Strategy: The Difference and Why It Matters (New
York: Crown Business, 2011).
3. Ibid.
4. Claudio Borio, “Rediscovering the Macroeconomic Roots of Financial Stability Policy:
Journey, Challenges and a Way Forward” (BIS Working Paper no. 354, September 2011);
Claudio Borio, “Central Banking Post-Crisis: What Compass for Uncharted Waters?,” in
The Future of Central Banking, ed. Robert Pringle and Claire Jones (London: Central
Banking Publications, 2011); Richard A. Posner, “Underlying Causes of the Financial
Crisis 2008–2009,” in New Directions in Financial Services Regulation, ed. Roger B.
Porter, Robert R. Glauber, and Thomas J. Healey (Cambridge, MA: MIT Press, 2009);
John B. Taylor, “Origins and Policy Implications of the Crisis,” in New Directions in
Financial Services Regulation, ed. Roger B. Porter, Robert R. Glauber, and Thomas J.
Healey (Cambridge, MA: MIT Press, 2009).
5. Posner, “Underlying Causes”; Taylor, “Origins and Policy Implications.”
6. Charles Goodhart, “The Changing Role of Central Banks” (BIS Working Paper no. 326,
Bank of International Settlements, 2010).
7. Ibid.
8. Ibid.
9. Ibid.
10. Ibid.
11. X. Wu, M. Ramesh, M. Howlett, and S. A. Fritzen, The Public Policy Primer: Managing
the Policy Process (New York: Routledge, 2010).
12. Suttinee Yuvejwattana and Yumi Teso, “Kittiratt Cites Rift With Bank of Thailand Chief
as Baht Rises,” Bloomberg, April 19, 2013, www.bloomberg.com/news/2013–04–19/
kittiratt-cites-rift-with-bank-of-thailand-chief-as-baht-rises.html; Yumi Teso, “Thai Baht
Climbs to 16-Year High on Capital Inflows Into Bonds,” Bloomberg, April 22, 2013,
www.bloomberg.com/news/2013–04–22/thai-baht-climbs-to-16-year-high-on-capital-
inflows-into-bonds.html; Daniel Ten Kate and Suttinee Yuvejwattana, “Kittiratt Urges
Thai Rate Cut Exceeding Quarter Percentage Point,” Bloomberg, May 10, 2013, www
.bloomberg.com/news/2013–05–10/kittiratt-urges-thai-rate-cut-exceeding-quarter-
percentage-point.html; Suttinee Yuvejwattana, “Thailand Holds Rate as BOT Resists
Government Call for Cut,” BloombergBusinessweek, May 2, 2013, www.businessweek
.com/news/2012–05–02/thailand-holds-key-rate-as-bot-resists-government-call-for-cut.
13. CBS News, “Fed Chairman Bernanke On The Economy,” 60 Minutes, December 4, 2010,
www.cbsnews.com/video/watch/?id=7120553n.
14. Ibid.
 Index

Absolute purchasing power parity, 169 Bank of France, 5

Activist monetary policy, 9–10 Bank of Japan
Adaptive expectations, 86 delegation of bank supervisory
Advanced economies function by, 13
fiscal debt burden in, 267–269 inflation targeting and, 11
inflation targeting in, 11 monetary policy and, 67
normalization of monetary policy supervisory role and, 8
in, 269 Bank of Spain, 5
speculative attacks on currencies in, Bank of Stockholm, 4–5
25–29 Bank of the United States, 7
Adverse selection, 203, 205–206 Bank run, 193–194, 198–200
AIG, 261, 262 Banks. See also Central banks;
Akerloff, George, 194 Commercial banks
Allen, F., 199, 201 diversity of, 202
Analytical capacity, 280 historical background of, 4–6
Asian financial crisis (1990s), 176–177 licensing of new, 49–50
Asset-price bubbles, 107–108, 194, market-based activities by,
210–211, 214–215 262–263
Asset price effect of monetary policy, special resolutions for troubled,
149, 160–161 245–247
Bank subsidiaries, 264–265
Balance of payments crisis, 21–22 Bank supervisory role
Balance sheet channel, 154–155 central banks and, 7–8, 13, 49–53
Banker to banks, central banks as, issues related to, 53–54
5–6, 46 new strategies for, 277–278
Banker to government, 5 in United Kingdom, 8
Bank for International Settlements Basel Accord (Basel I), 239–240, 270
(BIS), 281 Basel Accord (Basel II), 240–241, 270
Banking system, as network, 200–201 Basel Accord (Basel III), 41–243, 270
Bank of Amsterdam, 4–5 Basel Committee for Banking
Bank of England Supervision (BCBS), 218–219, 239
delegation of bank supervisory Base money, 40
function by, 13 Basket of currencies, 95, 96
Great Depression and, 19 Bear Stearns, 30, 32, 264
historical background of, 5, 6 Beggar-thy-neighbor policy, 19
influence of, 18 Bernanke, Ben, 106, 190, 199,
monetary stability and, 64 234, 283
money supply growth targeting and, Big Mac index, 170
100–101 Bond prices, interest rates and, 148
supervisory role and, 8, 54, 279 Borio, Claudio, 190

307
308 INDEX

Breakeven inflation, 145 Central banks

Breakeven yield, 146 as banker to banks, 5–6
Bretton Woods system as bank supervisors, 49–534
balance of payment crisis and, commonalities in modern, 12–13
21–22 diversity in modern, 13–14
demise of, 23 electronic payments and, 265–267
explanation of, 9–10, 20 financial stability and, 12, 13, 38,
International Monetary Fund and, 190, 192–193
20–21 financial system and, 6–7
pressures on, 21 full employment and, 14
Triffin dilemma and, 22–23 future challenges for, 256, 272–273
U.S. macroeconomic policy package global financial crisis of 2007-2010
and, 22 and, 8, 14, 67–68, 71–73, 267–272,
277
CAMELS, 51, 216, 235 globalization and, 255–259
Capital, 237 gold standard and, 9
Capital adequacy ratio, 240 historical background of, 3–6
Capital flows influence in money market, 122–123
effects of, 96–97 as lender of last resort, 7, 48–49
exchange rate targeting and, 98 market-based financial activities and,
globalization and international, 257 259–265
regulation of, 181–182 monetary policy and, 8–11, 13, 38,
Capital ratio, 237–238 44–46, 70, 175–176
Capital requirements monetary stability and, 12, 13, 38
assets, liabilities and, 236–238 money creation and, 38–44
Basel Committee on Banking operational independence of, 89
Supervision and, 239–243 payment system oversight and, 46–47
explanation of, 51–52 as protector of financial system, 6–7
financial stability and, 239 regulatory and supervisory functions
macroprudential measures and, of, 7–8, 13
236, 238 relationship between government
time-varying, 236, 238 and, 5–6
Ceilings, on credit growth, 233 roles and functions of, 38, 39, 54
Central banking mandates standing facilities of, 127
balance among, 69–73 yield curve and, 132–133
evolving nature of, 59–61 China, globalization and, 258
financial stability and, 65–68, 73 Coins, 4
full employment, 14, 62–63, Coin sorting, 13
68–69, 73 Commercial banks
intertwining nature of, 61–62 compliance of, 52–53
monetary stability and, examination and monitoring of,
63–65, 73 50–51
outlook for, 74 regulatory requirements for, 51–52
Central banking strategies resolution for troubled, 53
effective execution of, 278–283 risks associated with, 7–8
evolution of, 284–286 Commercial Paper Funding Facility
function of, 275–276 (Federal Reserve), 49
search for new, 277–278 Commercial paper issuers, 250
Index 309

Common currency, 164 Dynamic loan loss provisioning, 236,

Conservatorship, 246 243–244
Contingent claims analysis, Dynamic stochastic general equilibrium
224–225 (DSGE), 87, 88, 157
Contingent liabilities, 213
Coordination failure, 204–205 East Asian currency crisis in 1997-1998,
Corporate debt, 212 26–27
Crawling peg, 95, 166 Economic activity, money creation
Credit cards, 265, 266 process and, 39, 43–44
Credit channel, 153, 154 Electronic payments
Credit default swaps (CDS), 213, retail, 266–267
261–262, 270 rise of, 265–266
Credit easing, 110–111 Emerging-market economies
Credit market, 119 inflation targeting in, 11
Credit risk, 190, 214 international capital inflow into, 34
Cross-border flows of goods and speculative attacks on currencies
services, 257–258 of, 24
Currency E-money, 265–267
demand for domestic, 96 Equation of exchange, 79
explanation of, 40 Equilibrium, in money market,
free-float, 164 121–122
Currency board, 164–165 Equilibrium exchange rate, 177–179
Currency mismatch, 214, 249 Euro, 11, 29–30
European Central Bank (ECB)
Debit cards, 266 bank supervisory function and, 13
Debt function of, 11, 29, 30, 164, 272
in corporate sector, 212 monetary policy and, 13
in external sector, 213–214 sovereign debt crisis and, 111–112
global financial crisis and, European Commission, 272
267–269 European Economic Community
in government sector, 213–214 (EEC), 29
in household sector, 211–212 European Monetary System (EMS),
Debt-to-income (DTI) ratios, 233 speculative attacks on currencies in
Deflation, 31, 44 countries within, 25–26
Deleveraging, 112 European sovereign debt crisis, 33,
Deposit facility, 122, 127–129 111–112
Diamond, Douglas, 194, 198–200 European Union (EU), 11, 29
Diamond-Dybvig model, 199–200 Ex ante, 67, 229, 250
Direct lending, to government, 12 Exchange rate
Discount window, 245 Asian financial crisis and, 176–177
Dodd-Frank Wall Street Reform and Bretton Woods system and, 20, 22
Consumer Protection Act, effects of, 162–163
247, 263 equilibrium, 177–179
Domestic systemically important banks explanation of, 161
(D-SIBs), 218, 219, 270 fixed, 166, 176
Dot-com bubble, 30–31 floating, 23
Drehmann, Mathias, 190 interest rate, inflation and, 175
Dybvig, Philip, 193, 194, 199–201 macro concepts and, 174–179
310 INDEX

Exchange rate (continued) government security purchases

official foreign reserves and, and, 269
182–183 inflation targeting and, 11, 106
at operational level, 179–182 money supply growth targeting and,
purchasing power parity and, 100–101, 103
178–179 Primary Dealer Credit Facility, 49
Singapore and, 167–168 repros and reverse-repos and, 126
Exchange rate effect of monetary policy risk management approach and,
transmission, 149 102–103
Exchange rate market microstructure Federal Reserve Act (1977), 68
theory, 173 Federal Reserve Open Market Reserve
Exchange rate policy, political capacity (FOMC), 62
and, 282–283 Federal Reserve System, historical
Exchange rate regimes background of, 7
explanation of, 163 Feedback loops, 156, 219
spectrum of, 163–167 Financial assets, nonmoney, 198
Exchange rate risk, Asian financial crisis Financial Conduct Authority, 272
and, 176–177 Financial institutions
Exchange rate targeting balance sheet channel and,
capital flows and, 98 154–155
explanation of, 94–95 credit channel and, 154
monetary policy independence and, financial stability and, 191–192,
97–98 198–201, 235–247
stylized model of, 95–97 monetary policy and, 153–154
Exchange rate theory monitoring and identifying risks to,
exchange rate policy and, 173–174 215–219
overview of, 162, 168 special resolutions for troubled,
purchasing power parity and, 245–247
168–170, 174 Financial markets
uncovered interest parity and, central bank operations in,
170–173 118–129
Expectations effect of monetary policy explanation of, 118–120, 192
transmission, 152–153 failure in, 201–202
Ex post, 67, 229, 250 financial stability and, 201–206,
External coordination, 281 199–202, 247–250
Externalities, 205 global financial crisis of 2007-2010
and, 202
Factor inputs, 257–258 list of key, 119
Fallacy of composition problem, 217 money market and, 119–123
Federal funds rate, 122 net open positions and, 223
Federal Reserve operations of, 45–46
AIG and, 262 prices and yields and, 220–221
Commercial Paper Funding risk accumulation and, 220
Facility, 49 spreads and, 221–222
federal funds rate and, 122 Financial network
full employment and, 13–14, 68–69 explanation of, 194–195, 201
global financial crisis of 2007-2010 risk distribution within,
and, 31, 32, 269, 281 217–218
Index 311

Financial stability Fixed exchange rate, 166, 176

analytical framework for, 191–192 Flexible inflation targeting, 106–108
central banks and, 12, 13, 38, 60, 61, Floating exchange rates, 23
71, 192–193 Foreign direct investment, 176
definitions of, 189–190 Foreign exchange intervention,
exchange rate and, 162 180–181
ex post and ex ante, 67 Foreign exchange investment, 176,
financial institutions and, 191–192, 180–181
199–202, 235–247 Foreign exchange market, 119
financial markets and, 202–207, Foreign loans, 176
220–225, 247–250 Free-float regime, 163, 165–166
function of, 65–66 Friedman, Milton, 198
implications of market failures Full employment mandate
for, 206–207 background of, 68–69
importance of, 67–68 communication of, 72–73
liquidity shortages and, 66 explanation of, 68–69
macroeconomy and, 191–198, 215, Federal Reserve and, 13–14, 60–61
229–235 importance of, 69
macroprudential tools and, 72 issues related to, 62–63
macro stress tests and, 219 monetary stability and, 60
monetary policy and, 72, 229–231 Fundamental equilibrium exchange rate,
overindebtedness of economic agents 177, 178
and, 66 Funding costs effect of monetary policy
paradox of, 222 transmission, 149, 160
requirements for, 209 FX swaps, 126–127
risks in macroeconomy and,
210–215 G20, 271
risks to financial institutions and, Gale, D., 201
215–219 Gap measure, 210, 212, 213
theoretical foundations of, Germany
193–206 bank supervision in, 7–8
Financial Stability Oversight Council, hyperinflation in, 79–80
272, 277–278, 281 money supply growth targeting
Financial supervisory authority (FSA), and, 101
53, 54 purchasing power parity and,
Financial system 169, 170
bank supervisory role and, 8 Gertler, Mark, 190, 198, 202
central banks as protector of, 6–7 Global financial crisis of 2007-2010
Firm behavior central banks and, 8, 14, 67–68,
asset price effect and, 150–151 71–73, 277
exchange rate effect and, 151 coordination failure and, 204–205
expectations effect and, 152–153 effects of, 24, 34, 267–272, 284
funding costs effect and, 150 employment mandate and, 69
monetary policy and, 149–150 explanation of, 30
second-round effect and, 153 Federal Reserve and, 31, 32,
Fiscal policy, advent of activist, 9 269, 281
Fisher, Irving, 79, 145, 194 financial markets and, 202, 247
Fisher equation, 145 inflation targeting and, 11
312 INDEX

Global financial crisis (continued) Host countries, 259

information asymmetry and, Household behavior
205–206 exchange rate effect and, 149
principal-agent problem and, expectations effect and, 152–153
202–204 income effect and, 147–148
regulatory reforms and, 269–270 intertemporal substitution effect and,
self-reexamination after, 14 146–147
subprime crisis and, 30–33 monetary policy and, 146, 149
Globalization second-round effect and, 153
domestic inflation and, 258 wealth effect and, 148–149
goods and services cross-border flows Household debt, 211–212
and, 257–258 Housing bubble, 31–32, 110–111
intensification of, 255–256 Hubbard, R. Glen, 270
international capital flows and, 257 Hyperinflation. See also Inflation
international intermediaries and, explanation of, 44
258–259 in Germany, 79–80
Global systemically important banks
(G-SIBs), 218, 219, 270 Implied volatility, 221
Gold exchange standard, 9, 18–19 Impossible trinity, 177
Gold standard Income effect of monetary policy
background of, 8 transmission, 147–148
explanation of, 18 Inflation. See also Hyperinflation
Great Depression and, 19 breakeven, 145
monetary policy and, 9, 10, 19 exchange rate, interest rate and, 175
Goodhart, Charles, 102, 190, explanation of, 44
239, 278 globalization and domestic, 258
Goodhart’s law, 86, 87, 102 money supply and, 10–11
Government bond yield curve in 1970s, 23–25
as benchmark for setting other Phillips curve and, 80, 81
interest rates, 131–132 Inflation expectations, 145
explanation of, 130 Inflation-protected security, 145
Government securities market, 119 Inflation targeting
Government securities yield curve, application of, 106
130, 131 central banks and, 11, 13
Government yield curve, 109 explanation of, 103–104
Great Depression of 1930s flexible, 106–108
financial system collapse and, 198 stylized model of, 104–106
gold standard and, 9, 19 Information asymmetry, 205–206
Great Inflation of 1970s, 24–25 Institutional investors, 260
Greece, debt crisis in, 33 Insurance companies, 261–262
Greenspan, Alan, 102, 103 Interest rate
exchange rate, inflation and, 175
Haldane, Andrew, 201 long-term, 130
Hedge finance, 196 policy, 45–46, 122, 123, 130–139
Hedge funds, 261 subprime crisis and, 30–31
Historical volatility, 221 Interest rate corridor, 122, 128–129
Home countries, 259 Internal coordination, 281
Hong Kong Monetary Authority, 13 International capital, 257
Index 313

International Economic Conference Long Term Capital Management

(1922), 18–19 (LTCM), 261
International intermediaries, Lucas critique, 86–87
258–259
International Monetary Fund (IMF), Macroeconometric model, 157
20–21, 281 Macroeconomic policy package of
International Monetary Market (IMM) 1965-1968, 22
data, 223 Macroeconomy
International monetary system financial and economic cycles and,
after Bretton Woods, 23–33 194–198
Bretton Woods system and, 20–23 financial stability and, 191–193, 215,
before end of World War II, 18–19 229–235
forces in future, 34 monitoring and identifying risk in,
Intertemporal substitution effect, 210–215
146–147 Macroprudential measures
Inverted yield curve, 139 capital related, 236
explanation of, 231
Japan liquidity-related, 244
financial crisis in, 67, 284 use of, 232, 234–235
inflation in, 231 Macroprudential supervision, 236
JPMorgan Chase, 32, 264 Macroprudential tools, 71, 72
Macro stress tests, 219
Keynes, John Maynard, 9 Managed float, 167
Mandates. See Central banking
Lehman Brothers, 33, 258, 260, 281 mandates
Lender of last resort, 7, 48–49 Market-based financial activities
Lending facility, 127–129 banks and, 262–263
Lending standards, global financial bank subsidiaries and, 264–265
crisis of 2007-2010 and, 31 explanation of, 259–260
Leveraging, 261 Market-based subsidiaries, 262
Libor-OIS spread, 222–223 Market-making, 263–264
Liquidation, 53, 246 Market risk, 216
Liquidity coverage ratio (LCR), Market segmentation theory, 135–137
236, 244 Maturity mismatch, 214, 249
Liquidity preference theory, 135 Maximum employment, 681
Liquidity problem, 7, 49 McQuire, Claire, 245–246
Liquidity-related macroprudential Medium of exchange, precious metals
measures, 244 as, 3–4
Liquidity risk, 216 Mexican currency crisis in 1994, 26
Liquidity shortages, financial stability Microprudential supervision,
and, 66 235–236
Living wills, 246–247 Microprudential tools, 72
Loan-to-value (LTV) ratios, 232–233 Miller, Merton, 197
Long-run Phillips curve Minsky, Hyman P., 194–196, 198, 204
explanation of, 80, 81 Mobile payments, 265, 266
nonaccelerating inflation rate of Modigliani, Franco, 197
unemployment and vertical, Monetary Authority of Singapore
82, 83 (MAS), 13, 167–168
314 INDEX

Monetary policy Monetary policy transmission

in advanced economies, 269 mechanism
advent of activist, 9–10 expectations effect and, 152–153
Bretton Woods and, 9–10 financial institutions and, 153–155
central banks and, 8–11, 13, 38, firm behavior and, 149–151
44–46 Fisher equation and, 144–145
easing of, 234 household behavior and, 146–149
exchange rate and, 180 inflation expectations and, 145
financial stability and, 72, overview of, 143–144
229–231 second-round effects and, 153
gold standard and passive, 9 time lags and uncertainty in,
inflation targeting and, 11 155–157
natural rate of unemployment and, Monetary stability
78, 81–85, 91 central banks and, 12, 13, 38, 61, 71
new strategies for, 277 exchange rate and, 162
Phillips curve and, 78, 80–81, 90 function of, 63
quantity theory of money and, importance of, 64–65
77–80, 90 monetary policy and, 60, 72
rational expectations and, 78, 86–88, price stability vs., 63–64
91 Money
risk buildups in financial markets central banks and regulation of, 45,
and, 248 46
Taylor rule and, 70 cost of holding, 101
theoretical foundations of, 77–78, electronic form of, 39
90–91 issuance of, 38–39
time inconsistency problem and, 78, nonmoney financial assets vs.,
88–89, 91 197–198
unconventional, 108–113 quantity theory of, 77–78, 90
yield curve and, 137–140 Money creation process
Monetary policy implementation description of, 40–43
central bank operations in financial influence of, 39, 43–44
market and, 118–129 Money market
overview of, 117–118 central bank’s influences in,
transmission of money market 122–123
interest rates to other interest rates demand for funds in, 120–121
and, 130–137 explanation of, 118–119
yield curve and, 130–140 interest rate corridor and, 128–129
Monetary policy rules open market operations and,
exchange rate targeting and, 123–127
94–98 reserve requirements and, 129
inflation targeting and, 103–108 standing facilities and, 127
money supply growth targeting and, supply of funds in, 121
98–102 theoretical equilibrium in,
overview of, 93–94 121–122
risk management approach and, Money market interest rates, 155
102–103 Money market mutual funds, 250,
unconventional monetary policy and, 260–261
108–113 Money multiplier, 43
Index 315

Money supply, 12, 43 explanation of, 182

Money supply growth targeting management of, 183–184
experiences in, 99–100 Offsite monitoring, 50, 51, 235–236
explanation of, 98–99 Oil prices, in 1970s, 24
in Germany, 101 Okun’s law, 85
inflation and, 10–11 Online payments, 266
stylized model of, 99 Onsite examination, 50–51, 235
in United States and United Kingdom, Open market operations
100–101 explanation of, 48, 122, 123
Moral hazard, 48, 204, 206 types of, 123–127
Mortgages Operational independence, of central
securitized, 32 banks, 10
subprime crisis and, 30–31 Operational risk, 216
Organizational capacity, 281
Nationalization, 246 Organized exchanges, 270
Natural rate of unemployment Output gap, 85
explanation of, 78, 81–82, 90, 91 Outright transactions, 123, 124
Okun’s law and, 85 Overnight-indexed-swap (OIS),
shifts in, 83–84 222, 223
vertical long-run Phillips curve Over-the-counter derivatives, 271
and, 82
Net borrowers, households as, 148 Paradox of financial stability, 222
Net lenders, households as, 148 Passive monetary policy, gold standard
Net long position, 223 and, 9
Net open position, 223, 226 Pass-through effect, 162
Net short position, 223 Payment systems oversight, 45–47
Net stable funding ratio (NSFR), Payment systems provision, 47
236, 244 Pegging
New Zealand, inflation targeting Bretton Woods system and, 20,
and, 11 22, 163
Nixon, Richard M., 23 explanation of, 9–10, 18
Nominal interest rate, monetary Pegs
transmission mechanism and, 145 crawling, 95, 166
Nonaccelerating inflation rate of rigid, 163–165
unemployment (NAIRU) Peoples’ Bank of China (PBOC), 13
explanation of, 69, 81–82 Phillips, A. W., 80
shifts in, 83–84 Phillips curve
vertical long-run Phillips curve economic fine-tuning and, 81
and, 82 explanation of, 78, 80, 90
Nonmoney financial assets, 194, long-run, 80–83
197–198 Policy ineffectiveness proposition,
Northern Rock, 32 86, 87
Policy interest rate
Obama, Barack, 264, 268 central banks and, 122
Official foreign reserves (OFRs) explanation of, 45, 123
center bank balance sheet and, long end of yield curve and, 137–139
182–183 regulation of monetary conditions
exchange rate policy and, 182 and, 45–46
316 INDEX

Political capacity, 282–283 Lucas critique and, 86–87

Ponzi finance, 196–197 policy ineffectiveness proposition
Porter, Michael, 275 and, 87
Portfolio balance model of the exchange Real interest rate, monetary
rate, 171, 172 transmission mechanism and, 145
Portfolio investment, 176 Recession
Portugal, debt crisis in, 33 explanation of, 44
Precious metals, as medium of in 1980s, 24
exchange, 3–4 Relative purchasing power parity, 169,
Preferred habitat theory, 135–137 175
Price stability Repo transactions, 124–126
explanation of, 189–190 Repurchase agreement, 124. See also
as monetary policy goal, 24 Repo transactions
monetary stability vs., 63–64 Reserve balance, 122
Primary Dealer Credit Facility (Federal Reserve Bank of Australia
Reserve), 49 financial stability and, 231
Primary dealers, 250 inflation targeting and, 107–108
Principal-agent problem, 202–205 supervisory role and, 8, 13
Probability of default, 190, 224 Reserve Bank of New Zealand (RBNZ),
Prop desks, 263 11, 106
Proprietary trading, 262–264 Reserve ratio, 43
Prudential Regulation Authority, 272, Reserve requirements
277–278 central banks and, 45, 51–52, 122
Public debt to GDP ratio, 213 explanation of, 43
Public entity, 278, 279, 285 money market and, 129
Public policy analysis, 279–280 Reserves, 43
Purchase and assumption Retail e-payments, 266
(P&A), 246 Reverse-repro transactions, 124–126
Purchasing power parity (PPP) Reverse repurchase agreement, 126
exchange rate and, 178–179 Rigid peg
explanation of, 168–170, 174 explanation of, 163, 164
Pure expectations theory, rationale for, 165
133–135 Risk
associated with commercial banks,
Quantitative easing 7–8
credit easing plus, 110–111 exchange rate, 176–177
effects of, 34 to financial institutions, 215–219
explanation of, 11, 108 in macroeconomy, 210–215,
stylized model of, 108–110 233–235
timing exit from, 112 reduction of systemic, 270
Quantity theory of money systemic, 218–219
explanation of, 77–79, 90 Risk accumulation, 220–222
hyperinflation and, 79–80 Risk concentration
Quantum Fund, 28, 29 explanation of, 217
systemically important financial
Rational expectations hypothesis institutions and, 218–219
explanation of, 78, 86, 91 Risk distribution, within financial
irrationality and, 87–88 network, 217–218
Index 317

Risk management approach Strategic alliances, 279, 282, 283

explanation of, 102 Strategy, 275, 276
Federal Reserve and, 103 Study group, 278
stylized model of, 102–103 Subprime borrowers, 31, 205
Risk premium, 172, 177 Subprime crisis in 2007-2010
Risk-weighted assets (RWAs), 237 effects of, 30, 262
Rumelt, Richard, 276 full employment mandate and,
62–63
Schinasi, Gary, 190 lending standards deterioration
Schwarz, Anna, 198 and, 31
Second Bank of the United States, 7 low interest rates and, 30–31
Second-round effects of monetary opacity surrounding new financial
policy transmission, 153 innovations and, 32
Securitization, 32, 262, 270 outcome of, 32–33
Segoviano, Miguel, 190 Supervisory role. See Bank supervisory
Shadow banking, 271 role
Short selling, 261 Supply shock
Singapore, exchange rate management inflation and, 106–107
in, 167–168 monetary policy and, 24–25
Single supervisory mechanism, 272 Sveriges Riksbank (Sweden), 4–5
Solvency problem Systemically important financial
commercial banks and, 7 institutions (SIFIs), 218–219
explanation of, 48–49 Systemic bank run, 194, 200–201, 215
Soros, George, 28 Systemic risk, 270
South Korea, 265
Sovereign debt ratings, 213 Target band, 95
Speculative attacks on currencies Taylor, John B., 70
in advanced European economies, Taylor rule
25–29 explanation of, 70
anatomy of, 28 risk management approach and,
defense against, 28–29 102–103
on emerging-market economies, Time inconsistency problem
26–27 central bank’s operational
underlying causes of, 27–28 independence and, 89
Speculative finance, 196 explanation of, 78, 88–91
Spreads, 213, 221–222 monetary policy rules and, 89
Square device, 266 Time lags of monetary policy
Stabilizing an Unstable Economy transmission, 155–157
(Minsky), 195 Time-varying capital requirement, 236,
Stagflation, 24–25, 100 238
Standing facilities, 122, 127 Tobin tax, 181
Sterilized foreign exchange Too-big-to-fail, 218
intervention, 181 Too-connected-to-fail, 218–219
Stiglitz, Joseph, 194 Traditional fixed exchange rate
Stock prices, interest rates and, 148 regime, 166
Store of value Transitory unemployment, 68
explanation of, 12 Treaty of Rome, 29
precious metals and, 3–4 Triffin, Robert, 23
318 INDEX

Triffin dilemma, 22–23 unconventional monetary policy in,

Tsomocos, Demetrios, 190 110–111
Units of account, 4
Uncertainty of monetary policy Unremunerated reserve requirement
transmission, 155–157 (URR), 181
Unconventional monetary policy. See U.S. dollar
also Monetary policy gold holdings and, 22–23
challenges to, 112–113 pegged to gold, 9–10, 20, 22–23
easing and, 234 post-Bretton Woods, 23, 95
explanation of, 108
quantitative easing and, 108–110 Velocity of circulation, 79
in United States, 110–111 Volcker, Paul, 25, 100, 263, 264
yield curve and, 139–140 Volcker rule, 263–264, 270
Uncovered interest parity (UIP)
central banks and, 175 Wage-price spiral, 24
deviations from, 172–173 Wealth effect of monetary policy
example of, 170 transmission, 148
explanation of, 170 Weiss, Andrew, 194
portfolio balance models and, World War I, gold standard and, 9, 18
171, 172
usefulness of, 171 Yield curve
Unemployment, natural rate of, 78, central bank influence on, 132–133
81–85, 91 explanation of, 130–131
Unhedged foreign currency lending, 233 government, 109
United Kingdom government bond, 130–132
bank supervisory function in, 8 as leading economic indicator, 139
global financial crisis and, 272 liquidity preference theory and, 135
money supply growth targeting in, market segmentation and preferred
100–101 habitat theories and, 135–137
United States monetary policy and, 137–140
financial intermediation in financial pure expectations theory and,
markets in, 247 133–135
fiscal debt burden in, 267–268 shapes of, 131, 133–137
government security downgrades unconventional monetary policy and,
and, 268 139–140
money supply growth targeting in,
100–101 Zicchino, Lea, 190
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