Central Banks

This chapter develops further the role of a central bank and its interplay with commercial banks. Together, the two ensure the provision of liquidity to the economy, such that the real sectors are shielded from flows of funds originating from household and investors. We also disaggregate the banking system into two banks to represent deposit flows between banks and their impact on the central bank’s balance sheet, and to distinguish between what we call “relative” and “absolute” central bank intermediation. We then integrate deposit money creation by commercial banks into our system of financial accounts, and revisit some old debates, such as the limits of bank money creation and the role of related parameters that the central bank can set (not only the reserve requirement ratio, but also the collateral framework). Finally, we explain the concepts of “plain money” and “full reserve banking” within the financial accounts, and also discuss in this framework the recent proposals regarding central bank digital currency (CBDC).

Economic Accounts and Financial Systems

This chapter introduces the system of accounts of the main sectors of the economy (households; non-financial corporations, the government; banks, and the central bank), describing how these sectors are interrelated through financial claims and liabilities. A financial system, consisting of commercial banks and the central bank, manages flows of funds originating from households, without these flows causing a need for the real sectors to liquidate illiquid real assets. The basic types of assets and liabilities are: real goods, gold, banknotes, deposits, bonds, loans, and equity. We explain how the shortcomings of both IOU and commodity-money based financial systems can be solved via establishing a central bank. A central bank is defined here by its balance sheet and central bank money is the central bank’s basic liability. Both monetary policy implementation and lender of last resort issues relate to liquidity flows within balance sheets. Understanding the logic of basic financial flows is therefore the basis for understanding central banking.

The Central Bank as Lender of Last Resort

In this chapter we review the function of the central bank as lender of last resort (LOLR), starting from the understanding of financial crises developed in the previous chapter. We recall long-established LOLR principles: proactive lending, inertia of the central bank risk control framework, and risk endogeneity. Because of its systemic role, a central bank should not tighten its collateral framework in a crisis, as restrictive policies are likely to not only increase the overall damage done by a crisis to society, but to even increase central bank losses. We explain in more detail the main reasons why a central bank should act as LOLR: prevent negative externalities from fire sales; its unique status as institution with unlimited liquidity; its status as a risk-free counterparty making others accept to deliver collateral to it even at high haircuts; and its mandate to preserve price stability. We distinguish three different forms of LOLR: elements built into the regular operational framework; readiness to relax parameters in a crisis; and provision of emergency liquidity assistance to individual firms. We then discuss what could be the optimal propensity of a central bank to engage in LOLR activities and outline possible trade-offs. Last but not least, we develop a bank-run model which highlights the role of asset liquidity and central bank eligible collateral. We calculate through a model variant with binary asset liquidity and uniform central bank collateral haircut, but then also introduce a model variant with continuous asset liquidity and haircuts.

Unconventional Monetary Policy

This chapter introduces the reader to unconventional monetary policy, i.e. monetary policy using instruments going beyond the steering of short-term interest rates as described in the previous chapter. We start by providing the rationale of unconventional monetary policy, i.e. essentially pursuing an effective monetary policy when conventional policies are not able to provide the necessary monetary accommodation because of the zero lower bound. We then discuss negative interest rate policies, and explain why rates slightly below zero have proven to be feasible despite the existence of banknotes. We also discuss possible unintended side-effects of negative interest rates. We continue with a discussion of non-conventional credit operations: lengthening of their duration, the use of fixed-rate full allotment, the widening of the access of counterparties to the central bank’s credit operation, targeted operations, credit in foreign currency, and widening the collateral set. Finally, we turn to the purposes and effects of securities purchase programmes. We end the chapter by revisiting the classification of central bank instruments in three categories: conventional, unconventional, and lender of last resort.

International Monetary Frameworks

In this chapter we turn to representing flows of funds in alternative international monetary frameworks, and what global liquidity these different frameworks provide. We first recall some arguments in favour of and against fixed exchange rate systems. We then introduce two international monetary arrangements of the past which imply fixed exchange rates, namely the gold standard and the Bretton Woods system, and recall why both eventually failed. We then turn to three international monetary frameworks in the context of the current paper standard, i.e. fixed exchange rate systems, flexible exchange rate systems, and the European monetary union. We explain the role of an international lender of last resort and related solutions, and how these allow for more leeway in running fixed exchange rate systems. We also show how banks and central bank balance sheets are affected by international flows of funds and the balance of payments. Finally, we briefly review recent developments of foreign currency reserves, being the key central bank balance sheet position in this context.

Conventional Monetary Policy

This chapter introduces conventional monetary policy, i.e. monetary policy during periods of economic and financial stability and when short-term interest rates are not constrained by the zero lower bound. We introduce the concept of an operational target of monetary policy and explain why central banks normally give this role to the short-term interbank rate. We briefly touch macroeconomics by outlining how central banks should set interest rates across time to achieve their ultimate target, e.g. price stability, and we acknowledge the complications in doing so. We then zoom further into monetary policy operations and central bank balance sheets by developing the concepts of autonomous factor, monetary policy instruments, and liquidity-absorbing and liquidity providing balance sheet items. Subsequently we explain how these quantities relate to short-term interest rates, and how the central bank can rely on this relation to steer its operational target, and thereby the starting point of monetary policy transmission. Finally, we explain the importance of the collateral framework and related risk control measures (e.g. haircuts) for the liquidity of banks and for the conduct of central bank credit operations.

Financial Instability

In this chapter, the central bank is put aside and we review simple models of financial instability, which will be the basis for the subsequent chapter to explain the role of the central bank as lender of last resort. We first recall that financial instability is mostly triggered by a negative shock on asset prices, and thereby on the solvency of debtors, which in turn worsens access to credit and can set in motion a liquidity crisis with vicious circles. We develop the concepts of solvency “conditional” and “unconditional” on liquidity: a decline in asset prices can lead an unconditionally solvent debtor to become only conditionally solvent, such that sufficient liquidity becomes decisive for preventing its default. We then apply these concepts to the stability of bank funding and introduce the problem of bank runs. We subsequently show why asset liquidity in a dealer market deteriorates during a financial crisis (increased volatility and uncertainty increase the required bid-ask spread); how asymmetric information can lead to a freeze of credit markets in a simple adverse selection model; how declining and more volatile asset prices drive increases of haircut, and how these can force fire sales and defaults of borrowers. We finally discuss the interaction between these various crisis channels.