Monetary Policy is the process by which the government, central bank, or monetary authority of a country controls
- the supply of money,
- the availability of money,
- the interest rate, in order to attain a set of objectives oriented towards the growth and stability of the economy.
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This paper refers the above theme to two countries: China and USA. As such, there are three broad objectives. The first is to discuss monetary policy generally as carried out in the USA. The second is to discuss monetary policy generally as it is carried out in China. The third is to compare and analyze the way monetary policy is implemented in the two countries.
USA Monetary Policy
- How is the Federal Reserve structured?
The Federal Reserve System (called the Fed, for short) is the nation's central bank.
It was established by the Federal Reserve Act and consists of the Board of Governors in Washington, D. C., and twelve Federal Reserve District Banks. The Congress structured the Fed to be independent within the government. Therefore although the Fed is accountable to the Congress and its goals are set by law, its conduct of monetary policy is insulated from day-to-day political pressures. This reflects the conviction that the people who control the country's money supply should be independent of the people who frame the government's spending decisions.
What makes the Fed independent? Three structural features give the Fed independence in its conduct of monetary policy: the appointment procedure for Governors, the appointment procedure for Reserve Bank Presidents, and funding.
Appointment procedure for Governors
The seven Governors on the Federal Reserve Board are appointed by the President of the United States and confirmed by the Senate. Independence derives from a couple of factors: first, the appointments are staggered to reduce the chance that a single U. S.
President could "load" the Board with appointees; second, their terms of office are 14 years - much longer than elected officials' terms. Appointment procedure for Reserve Bank Presidents: Each Reserve Bank President is appointed to a five-year term by that Bank's Board of Directors, subject to final approval by the Board of Governors. This procedure adds to independence because the Directors of each Reserve Bank are not chosen by politicians but are selected to provide a cross-section of interests within the region, including those of depository institutions, nonfinancial businesses, labor, and the public.
Funding: The Fed is structured to be self-sufficient in the sense that it meets its operating expenses primarily from the interest earnings on its portfolio of securities. Therefore, it is independent of Congressional decisions about appropriations. How is the Fed "independent within the government"? Even though the Fed is independent of Congressional appropriations and administrative control, it is ultimately accountable to Congress and comes under government audit and review. Fed officials report regularly to then Congress on monetary policy, regulatory policy, and a variety of other issues, and they meet with senior Administration officials to discuss the Federal Reserve's and the federal government's economic programs. The Fed also reports to Congress on its finances.
Who makes monetary policy?
The Fed's FOMC (Federal Open Market Committee) has primary responsibility for conducting monetary policy. The FOMC meets in Washington eight times a year and has twelve members: the seven members of the Board of Governors, the President of the Federal Reserve Bank of New York, and four of the other Reserve Bank Presidents, who serve in rotation.
The remaining Reserve Bank Presidents contribute to the Committee's discussions and deliberations. In addition, the Directors of each Reserve Bank contribute to monetary policy by making recommendations about the appropriate discount rate, which are subject to final approval by the Governors. Objective of Monetary policy Monetary policy has two basic goals: to promote "maximum" sustainable output and employment and to promote "stable" prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act.
In the long run, the amount of goods and services the economy produces (output) and the number of jobs it generates (employment) both depend on factors other than monetary policy. These factors include technology and people's preferences for saving, risk, and work effort. So, maximum sustainable output and employment mean the levels consistent with these factors in the long run. But the economy goes through business cycles in which output and employment are above or below their long-run levels. Even though monetary policy can't affect either output or employment in the long run, it can affect them in the short run.
For example, when demand weakens and there's a recession, the Fed can stimulate the economy temporarily and help push it back toward its long-run level of output by lowering interest rates. That's why stabilizing the economy, or smoothing out the peaks and valleys in output and employment around their long-run growth paths—is a key short-run objective for the Fed and many other central banks.
- Gold and Foreign Exchange
- Held by public
- Vault cash
- Federal Reserve Credit
- Bank Deposits
- Loans & Discounts
- Government Securities
- Other credits
The Federal Reserve has three instruments for controlling the money supply. They are:
- Open Market Operations
- The discount rate; and
- The required reserve ratio.
When using Open market operations, the Fed buys or sells government securities to affect the level of the money supply. For example, if the Fed wishes to increase the money supply by $2 million, it will purchase government securities worth $ 2 million. The Fed’s assets increase by $ 2 million under the securities heading. In order to pay for the government security, the Fed writes a check on itself.
In return for the bond, the seller receives a check instructing the Fed to pay the seller $ 2 million. The seller then takes the check to his bank, which credits the depositor with $ 2 million, and then deposits the check at the Fed. The bank has an account with the Fed, which is now credited with $ 2 million. Thus the Fed’s liabilities increase by $ 2 million under the heading of bank deposits, as the commercial bank has just increased its reserves by $ 2 million which are held by the first instance as a deposit at the Fed. Another monetary policy instrument used to affect the level of the money supply is the Discount rate, which is the interest rate charged by the Fed to banks that borrow from it to temporary needs for reserves.
Increasing the discount rate discourages banks from borrowing from the Fed, while lowering the rate encourages banks to borrow from the Fed and thus increase the money supply. The required reserve ratio refers to the percentage of total deposits that the Fed requires individual financial intermediaries to keep at the Fed as reserves. The significance of the required reserve ratio is that it affects the money multiplier, and thus the level of the money supply. For example, if the Fed wants to increase the money supply, it can do so by reducing the required reserve ratio. Because there are now less reserves and more money is available for the banks to be able to meet their customer’s demand for cash. This increases the money multiplier, which also has a positive effect on the level of the money supply.
Required reserves do not pay any interest, so increases in the required reserve ration has undesirable side effects on bank profits. Open market operations are nearly always the favored tool of choice by the Fed. The Fed Open Market Operations in 2008 summarizes all monetary policies and tools used by the Fed for that year. The two tables below shows the changes in the federal funds target rate, and the primary credit rate, and the interest paid on the required reserves and excess reserve balance.. These were operational measures taken by the Fed to influence the Federal funds rate. It is evident that the Fed rapidly and continually decreased the federal funds rate and the primary credit rate throughout 2008.
Furthermore, on October 8th 2008 the Fed started to pay interest on despository institutions’ required and excess reserves balances as authorized to under the Financial Services Regulatory Relief Act.
Policy Body in charge of Monetary Policy
Monetary policy in China is conducted by the People’s Bank of China. Article 12 of the Law of the Peoples Republic of China on the Peoples Bank of China provides " the People`s Bank of China is to establish a monetary policy committee, whose responsibilities, composition and working procedures shall be prescribed by the State Council and shall be filed to the Standing Committee of the National Peoples Congress. The Monetary Policy Committee shall play an important role in macroeconomic management and in the making and adjustment of monetary policy. "
Rules on Monetary Policy Committee of the People? s Bank of China stipulates that the Monetary Policy Committee is a consultative body for the making of monetary policy by the PBC, whose responsibility is to advise on the formulation and adjustment of monetary policy and policy targets for a certain period, application of monetary policy instrument, major monetary policy measures and the coordination between monetary policy and other macroeconomic policies. The Committee plays its advisory role on the basis of comprehensive research on macroeconomic situations and the macro targets set by the government.
The Monetary Policy Committee is composed of the PBC Governor and two Deputy Governors, a Deputy Secretary-General of the State Council, a Vice Minister of the State Development and Reform Commission, a Vice Finance Minister, the Administrator of the State Administration of Foreign Exchange, the Chairman of China Banking Regulatory Commission, the Chairman of China Securities Regulatory Commission, the Chairman of China Insurance Regulatory Commission, the Commissioner of National Bureau of Statistics, the President of the China Association of Banks and an expert from the academia. The Monetary Policy Committee performs its functions through its regular quarterly meeting. An ad hoc meeting may be held if it is proposed by the Chairman or endorsed by more than one-third of the members of the Monetary Policy Committee.
Objective of Monetary policy
The main objective of the Chinese monetary policy is to maintain the stability of the value of the currency (the Renminbi), and thereby to promote economic growth.
- Credits to FI
- Deposits of FI
- Central Bank Reserves
- Excess Reserves
- Foreign Exchange Reserves
- Central Bank Bills
- Deposits of Treasury
- Currency in Circulation
The People’s Bank of China in conducting Monetary policy has several instruments at its disposal which include:
- The reserve requirement ratio
- The Central Bank base interest rate
- Central Bank Lending
- Open Market Operations
Other policy instruments as specified by the State Council In essence, the monetary instruments listed above correspond to the descriptions given under the Fed’s monetary policy heading. However, the main tool of choice for the PBC is the reserve requirement ratio. For example, in the PBC 2008 Annual Report on Monetary Policy it was reported that in order to sterilize excess liquidity in the first half of 2008, the reserve requirement ratio was decreased cumulatively by 3 percentage points on 5 occasions. Furthermore, a lower required reserve ratio was applied to rural credit cooperatives (RCCs) and financial institutions in the quake-hit areas.
Furthermore, in the second half of 2008 with the heightened international turmoil and in order to ensure ample liquidity in the banking system, the PBC further reduced the required reserve ration of financial institutions on another four occasions resulting in a cumulative decrease of 2 percentage points for large financial institutions, and a cumulative decrease of 4 percentage points for smaller financial institutions. According to PBC calculations, by the end of 2008 a total of 800 billion yuan of liquidity was released into the economy. The choice of the reserve requirement ratio as the mail policy instrument is not coincidental to China which runs a high current account surplus. There is a large and growing demand for the RMB, and to maintain the RMB at the desired level the PBC issues RMB to meet this demand thereby increasing the money circulating in China.
To keep inflation and economic growth under control, the PBC sterilizes its foreign exchange market interventions by buying back some of the RMB it issued to buy US dollar. In particular, it does so by selling low yield government securities to state-owned banks. So far, the banks have been able to absorb those low yield bonds in part because the interest rates paid on them bank deposits are also maintained at artificially low rates. Nonetheless, the increases in foreign reserves are not fully neutralized. Over the last five years broad money supply in China has been growing at above 15% per annum while real economic growth has averaged about 10. 5%. Furthermore unlike more developed market economies, China is reluctant to raise domestic interest rates to slow its domestic growth.
Doing so might mean attracting more capital inflows, which would in turn, require further money issuance to stabilize the exchange rate. That is precisely why the PBC instead changes the reserve requirement ratio on an ongoing basis to control the expansion of money and credit.
Comparison of China and USA’s monetary policies
There are three main differences between China and the United States where monetary policy is concerned: independence of the monetary policy implementing body, choice of instruments to use in implementing monetary policy, and direct or indirect means of setting interest rates to effect monetary policy. Furthermore, these three differences are inter-related and country specific.
The first major difference between the Federal Reserve System (the Fed) and the People’s Bank of China (PBC) concerns their independence from national politics. The intention of Congress when designing the Federal Reserve Act was to keep politics out of monetary politics. The Fed is totally independent of other branches and agencies of the government. Furthermore, it is self financed and therefore is not subject to the congressional budgetary process.
On the other hand, the PBC is not independent from national politics in China. The PBC reports directly to the State Council which serves as China’s cabinet as well as its highest executive body. Moreover, monetary policy in China is aimed at limiting the appreciation of the renminbi (RMB), while eeping economic growth at a sustainable pace and inflation under control plus preserving a fragile banking system. The Fed in contrast implements a monetary policy that has a dual objective of maximum employment and price stability. The second difference regards the choice of the monetary policy instruments used by the Fed as opposed to the PBC. The choice of instruments used in implementing monetary is essentially the same, except that the PBC has the an additional instrument; namely “additional instruments as specified by the State Council. ” It is therefore no surprise that this ‘extra instrument’ arises from the lack of independence on the part of the PBC.
The third difference between the Fed and the PBC lies in the way they set the interest rates. The Fed sets its federal funds rate indirectly by setting a specified target rate and then using the the tools of monetary policy (open market operations, discount window lending, and reserve requirements) to achieve that target rate. As a result, the changes in the federal fund rates trigger a chain of events that affect other short term interest rates, long term interest rates, the amount of money and credit in the economy, plus other macro-economic variables such as employment, growth and the prices of goods and services. In contrast, the PBC has a direct influence on its interest rate because of the extra instrument described above.
Because there is provision for other policy instruments as specified by State Council, this allows the PBC to set interest rates directly, and thus have a direct impact on the its balance sheet.
There are major differences in monetary policy and central banking in China and the USA. China has a complex political economy that represents a hybrid of private ownership and state control. Therefore, the PBC’s monetary policies, choice of instruments and methods of implementation are quite different from that of the Fed. Monetary policy in China aims at curbing the appreciation of the RMB while keeping economic growth at a sustainable pace, inflation under control, and preserving a fragile banking system. This is contrasted with the Fed’s monetary policy with the dual objective of maximum employment and price stability.
Different monetary policy objectives, coupled with the degree of political independence on the part of the Fed and the PBC greatly influence the choice of instruments used and the method of implementing monetary policy in the two respective countries.
- Federal Reserve Bank of New York Domestic Open Market Operations During 2008 Federal Reserve Bank of New York: “Annual Report Domestic Open Market Operations during 2008”
- Federal Reserve Statistical Release 19 November 2009 Ian Sheldon, “US-China Trade Policy: Who gains from a rise in the Yuan? ” at http://aede. osu. edu/programs/Anderson/trade Luc de Wulf and David Goldsbrough, “The Evolving Role of Monetary Policy in China”, IMF Staff Papers WP/04/125
- Michael Moskow and Cathy Lemieux “China up close: Understanding the Chinese economy and financial system”, at www. chigacofed. org
- People’s Bank of China Monetary Policy Annual Report 2008 Peter Stella, “The Federal Reserve System Balance Sheet: What Happened and Why it matters” IMF Staff Papers WP/09/120
- Financial Services Regulatory Relief Act 2006 (USA)
- Federal Reserve Act 1913 (USA)
- Law of the People’s Republic of China on the People’s Bank of China 1995 (China) http://www. frbsf. org/publications/federalreserve/monetary/structure.html
- http://www. pbc. gov. cn/english/huobizhengce/MPC. asp
- http://en. wikipedia. org/wiki/Monetary_policy
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