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Central Banking (Lecture Notes, TU Berlin, Summer 2019)

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Central Banking (Lecture Notes, TU Berlin, Summer 2019) An introduction to central banking (Lecture notes, TU Berlin, summer 2019) U. Bindseil* 1. Economic accounts and financial system 2. Central bank 3. Conventional monetary policy 4. Unconventional monetary policy 5. Financial stability 6. Lender of last resort 7. International monetary system List of References *European Central Bank, Directorate General Operations and Technical University Berlin. Views are not necessarily the ones of the ECB Chapter 1: Economic accounts and financial system 1.1 Introduction 1.2 Real economic sectors and economic transactions 1.3 Banks and central banks 1.4 An example: the German stylised financial accounts of 2013 1.1 Introduction This chapter introduces a system of financial accounts to allow for a representation of real and financial flows. Transactions are represented within a closed economy consisting of the following sectors: (i) households; (ii) banks; (iii) non-financial corporations and the government; (iv) the central bank. These sectors have financial claims and liabilities towards each other, and some of the sectors, namely households, non-financial corporates, and the government, are the main holders of the real assets of the economy. The basic types of assets and liabilities are: real goods, gold and other precious metals (which can also be classified under real goods), banknotes, deposits, bonds, loans, and equity. Not all of these assets and liabilities will be present in every of our illustrations as we will always choose the simplest representation to make our point. Why starting with a chapter recalling such basic issues? Money is a financial asset and liability. The central bank is to a large extent defined 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 or “flows of funds” issues within balance sheets. Recalling the logic of financial flows at the most basic level is therefore the best basis for understanding the nature of central banking. 1.2 Real economic sectors and basic types of transactions The first economic sector “on earth” is the household, who initially owns potentially n real goods and who has no debt. According to United Nations (2008), “a household is a group of persons who share the same living accommodation, who pool some, or all, of their income and wealth and who consume certain types of goods and services collectively, mainly housing and food”. We can characterise this household in terms of its holdings in the n real assets of the economy, of which gold is the n-th asset, i.e. its asset quantity vector X’ = {x1, x2, …xn}. For that we need to have specified what the n goods are, and in what units we express them. For example, the household owns: X = {x1 chicken, x2 cows, … xn gold coins}. If we are interested in value aggregation and wealth, we in addition need to characterise each asset position by its value, expressed in a unit of account, which we call numeraire. The numeraire is one of the n goods, and the price of each good expressed in the numeraire is the number of units one needs to offer in the market of the numeraire good to obtain one unit of it. In principle every pair of goods has one relative price, say p(Chicken, Cow) is the number of Chicken needed to buy one cow. Obviously p(cow, chicken) = 1/p(chicken, cow). Also p(chicken, cow) = p(gold coin, cow) / p(gold coin, chicken). With n goods, we have n-1 independent relative prices. Assume now that we chose the n-th good, a well specified gold coin (like the Florentine ducat with a fine gold content of 3.44 grams), as numeraire. Let’s simplify notation writing the relative price P(Gold coin, chicken) simply as p1 and P(Gold coin, cow) as p2, etc. Call P’={p1, p2, … 1} the vector of prices expressed in the n- th good. The total value of the households’ assets is then P’X and we can write the balance sheet of the household as follows. That the total value of household assets is equal to equity means that the household has no external financing, i.e. it has no liabilities but its own wealth. 2 Household accounts Real Assets P’X Household Equity P’X One heroic implicit assumption in the above approach (but common in economics) is the one of universal and immediately executable prices. Reality differs from this ideal: • Illiquidity. Many real and financial markets are illiquid meaning that the assets are rarely traded, and that if one wants to purchase a certain asset in a relatively short period of time (within a minute, within a day, etc.), then one normally will have to pay (significantly) more than if one has a lot of time to purchase it. Similarly, or often even worse, if one wants to sell the good in a short period of time, one will have to accept a significant price reduction, relative to the price one may be able to achieve if one has a lot of time. Immediacy of execution has a price, measurable e.g. in the form of bid ask spreads offered by dealers (therefore one says that the dealer offers “immediacy services”). As everyone can easily verify, in many used good markets (antiques, cars and other consumer durables), dealer bid ask quotes are around 30% to 50%. In the most efficient parts of financial markets, e.g. US Government “on the run” bonds, bid ask spreads are below 1 basis point (0.01%). Most other markets are somewhere in between. • Asset specificity. A machine may have been tailor-made to exactly fit into the production process of a unique factory. Therefore, the value of the machine for the factory is much higher than for any other use, even with an unlimited time to sell. Also human capital may be specific, as an employee may be an expert in a certain unique production process, or a manager in terms of knowing and being able to manage the psychological idiosyncracies of the members of a specific team. The crucial role of asset specificity for economic organisation was worked out in particular by Williamson (1984). Both distinct matters will play a key role in chapters 5 and 6. Introducing a (non-financial) corporate sector and the state We now introduce two other sectors which we treat most of the time as one: corporates and the state. All those are distinct from households, in the definition of United Nations (2008), these are “legal or social entities …whose existence is recognized by law or society independently of the persons, or other entities, that may own or control it. Such units are responsible and accountable for the economic decisions or actions they take, although their autonomy may be constrained to some extent by other institutional units; for example, corporations are ultimately controlled by their shareholders”. The simplified financial accounts of an economy with a corporate and government sector can be represented as follows, after introducing financial claims into the economy (financial claims and liabilities in bold, real items in normal font). Indeed, the corporate sector will hold real assets, and as counterpart financial liabilities, representing the means through which the corporates have been funded. There is one major difference between the corporate and the state sector: in the case of the corporate sector, also equity is a financial liability, i.e. the equity is owned by e.g. households. In the case of the state, equity is genuine equity not owned by anyone (such as household equity is not owned by anyone). The definition of the corporate sector that we consider here is closest to what United Nations (2008) calls an “enterprise”, namely “an institutional unit as a producer of goods and services”. 3 Household Real Assets HE-G-CE-CD-SD Household Equity HE Gold G Company Equity CE Company Debt CD State Debt SD Corporates Real assets CE+CD Corporate Equity (“financial equity”) CE Debt CD State Real assets SE + SD State Equity (“real equity”) SE Debt SD Why is there a separate corporate sector, separated from households? Economic production and therefore welfare can be spectacularly expanded by establishing “capitalist” firms, which have as liability both debt and equity (held by investors) in some maybe optimal proportion, and that as counterpart own a part of the real assets of the economy. Why there are “capitalist” firms is discussed for instance in Coase (1937) or Williamson (1984). Alternatives to pool ownership for larger scale industrial endeavours would be for instance the labour owned firm or state-owned production like in a socialist economy. Both alternatives work to some extent, but the capitalist firm has overshadowed all alternatives in its efficiency – at least for a large part of productive activity. The amount of real assets in the economy does not change due to the creation of the corporate sector. A part of the real assets moves into the ownership of the corporate sector, and the household is compensated by receiving financial claims such that neither the net wealth nor the balance sheet length of the household changes. Of course, over time the creation of the real sector will make a difference: (i) it leads to a higher productivity and therefore to a steeper growth trend of the real assets held by the corporate sector (and hence the total amount of real assets of society); (ii) individual households will have different individual exposures to real assets, to equity and to debt, and therefore also their wealth will evolve over time differently, depending on how they positioned themselves.
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