The Operational Role of the Bank of England

Guo Chenzi Nov.8

The Structure of Bank System

Central Bank

Exchange market

Money market

Gilt market

Part I the objectives of Bank’s market operation

Part of government’s overall economic strategies

Fulfill the monetary of price stability

Part II The Foreign Exchange Market

Question 1: What is the role of central bank under gold standard?

Question 2: What is the role of central bank under a floating exchange rate standard?

Q1

Assumption:1. Domestic currency is maintained at a

fixed rate against an external standard.

2. No government in the market could control such standard.

Q1:The market clearing condition

Priority is given to maintain the ratio between par value of money and gold

Increasing the money supply according to the gold reserve.

Central bank loses independent monetary policy.

Q1:the role of central bank

The central bank, under the gold standard in the exchange market, could do nothing but just maintain such commitment that the price of domestic currency is fixed to a particular level.

Q2:

Features in the market:

The price of domestic currency is basically determined by supply and demand in the market.

Government can intervene the market

Q2:the role of central bank

Central bank has independent monetary policy

Central bank could control exchange rate to some extent by selling or buying domestic currency.

Q2:two puzzles

1. Whether could the central bank foresee the appropriate equilibrium?

2. What determine the ability of central bank to intervene exchange market, especially while they want to achieve the interest rate stability?

Part III The Money Market

The Bank’s operational aim

is “to keep very short-term interest rates within an unpublished band”, which would be determined by the authority with a view to achieve their monetary objectives.

Two major questions:

1. What influence the operators in the Bank have upon money market interest rate?

2. How far these operators should concentrate their influence upon the quantity of cash in the system, rather than directly upon interest rate?

What we will discuss below about the money market.

Mechanics of the present arrangements designed in 1981

Problems of the 1981’s arrangements

Relationship between cash flow and interest rate

Mechanics of the present arrangements designed in 1981(1)

Cash flowDuring the day, two things happen

Government the amount of people using

commercial banks

Bank forecasting its likely cash position

maintain operation balances at the bank

Mechanics of the present arrangements designed in 1981(2)

Cash flowat the end of the day

Every bank settle their

net difference with each

other

Difference is settled by debit

or income at Bank

Mechanics of the present arrangements designed in 1981(3)

Bank influence

short-term

interest rate in

two ways

Buy 3 months bills price of bill interest rate

Policy implication, such as Green Span’s secret

smile

Mechanics of the present arrangements designed in 1981(4)

Cash flow from government to others

Discount market

Debt market

Call back depositsPlaced with others

Selling bills

Commercial banks

Problems of the 1981’s arrangements (1)

1. The balances yield no interest at Bank. So, we should have to ask why banks should maintain its balance? (the incentive problem)

2. Sales of government debt cause regular and substantial shortage of cash

Problems of the 1981’s arrangements (2)

3. The influence of the authority is both visible and substantial.

A sudden supply of money in the

market

Reluctant to increase the interest rate

Open market operation to maintain the interest rate

(visible effect)

Change the expectation of financial institutions (substantial effect)

Relationship between cash flow and interest rate (1)

The trade-off banks have to face with:Holding enough

assets convertibleMinimize the

opportunity cost

The equilibrium is determined by the attitudes of central bank

Relationship between cash flow and interest rate (2)— pegged interest rate

Proponents① In practice, pegged

interest rate is inclined to achieve monetary target.

② Market force in the present UK bank system could put pressure on such bias

Y

X

Q1 Q2

i

Q

Relationship between cash flow and interest rate (3)— Monetary Base Control

Proponents 1. Money would vary pro-cyclicallyDemand of credit P i

i is determined by market

2. In practice, there is political difficulty of raising interest rate

Relationship between cash flow and interest rate (4)— Monetary Base Control

Opponents 1. Inelasticity of cash demand to

interest rate

2. Interest rate could be more volatile

A further discussion

Which one, between pegged interest rate and monetary base

control, in your opinion, is better?

Part IV Gilt Market

The history of the gilt market

The role of central bank in the market

The problem about such operation

The history of the gilt market

World War I & II massive accumulation of debt to fund

government deficits

After wars fund fiscal deficits monetary purposes

The role of central bank in the market

when banks is over-funding the private sector,

Central bank

Raise medium term interest rate

Selling more public sector

debts

Restrain bank lending

Offset the immediate impact

on monetary aggregate

The problem about such operation

Decrease the cash in the bank system, while decreasing the deposits in banks

The cooperation between Bank and Treasury in other nations

Part V something more about ECB

European System Central Bank

European CentralBank

Central Banks of the participating

EU nations

Central Banks of the non-participating EU

nations

IndependentPolicy

Not member in the ECB’s government

council

Government council Executive board

The reason of such structure of ESCB

The establishment of a single central bank for the whole euro area would not have been acceptable on political grounds.

The Eurosystem approach builds on the experience of the NCBs, preserves their institutional set-up, infrastructure and operational capabilities and expertise;

Given the large geographic area of the euro area, it was deemed appropriate to give credit institutions an access point to central banking in each participating Member State.

Thank you!

Zhou WeiChen YuXu Ting

Guo Chenzi