The Role of the Bank of England - Case Study Example

The Role of the Bank of England and Compare It to That of the Federal Reserve In the Banking System Table of Contents Introduction 1 Role of the Bank of England 2 Role of the Federal Reserve 4 Comparison between the Bank of England and the Federal Reserve 6 Conclusion 9 References 11 Bibliography 12 Introduction This project aims to bring forth the role of the Bank of England and the role of the Federal Reserve. Each of them is responsible for influencing the macroeconomic environment of the nations by monitoring the macroeconomic policies. This project aims to bring forth how the two of them set the interest rates in order to maintain a low rate of inflation. It also tries to explain each ones contribution towards maintaining stability in the financial system. They are also responsible for issuing notes and special security features in the nation. The US and the United Kingdom was greatly affected at a time when there were widespread issue of illegal notes. This brought about instability in the economy. The Bank of England and the Federal Reserve has implemented special techniques for prohibiting such practices and winning back confidence of the people. The project explains how they have been doing this to gain and maintain public confidence in the currency. The Bank of England and the Federal Reserve has been working towards establishing a stable financial system which would make for a successful and healthy economy. The citizens need to have the confidence on the government regarding the financial stability of the economy. That is why both these financial institutions have to intervene in such problem areas which would prohibit disruption in the financial system. The project also brings forth how the two monitor the holdings of banks. It explains the bank’s credibility in providing the accurate information regarding the costs of credit that would be available to the consumers. The banks follow certain measures to prohibit all kinds of discriminations in the process of lending. The two financial institutions play critical roles in maintaining stability in the economy through the monetary policies. It explains how the monetary policies are regulated to promote stability of prices, maximise sustainable employment and economic growth. Role of the Bank of England The bank of England uses several policies to monitor the interest rates to keep the inflation level low. This is done by the method of inflation targeting. Inflation targeting involves minimising the deviations of the inflation from the inflation target. If the inflation is much away from the inflation target, it is gradually brought back towards the target. In an equivalent way, central banks aim to meet the inflation target in the future. The two common methods used in this context are “interest rate smoothing” and “output-gap stability” (Svensson, 1998, p.16). The Bank of England makes a “standard partial adjustment interpretation” of the interest rate policy followed by the bank. This policy is based on the present macroeconomic performance of the country. When the lag coefficients are greater than zero and less than one, then the present rate is fixed to the weighted average of the present desired rate of interest and the rate in the previous quarter. This policy of partial adjustment is advanced by a number of authors. Such adjustment behaviour has been referred to as the interest rate smoothing because the consequent rate of interest rate is less volatile than that determined by the policy (Rudebusch, 2001, p.7). Certain changes were introduced by the Bank of England which had enormous demand in the economy. By the introduction of VAT, the amount of sales tax was partially passed on to the consumers. It is assumed that doing this would result in either delaying or forwarding the consumption of the consumers. The magnitude of this impact would depend on the sensitivity of the consumption to the interest rates. The interest rate is so adjusted that it does not have great impact on the level of consumption in the economy (Lewis, 2002, p.17). The rise in oil prices increased the short term interest rates in England. This required tightening of the monetary policies by the country to control the inflation in the nation (Neumann & Hagen, 2002, p.17). The method of double difference is used to measure the change during the period of increasing oil prices. This is done by taking note of the indicator at the point of start and end of the hike in oil prices. The effect of oil price is eventually passed on to the consumer prices. The policy was to keep the interest rates low to absorb the shock. The volatility of the short term rates of interest rates have also been reduced significantly (Neumann & Hagen, 2002, p.9). In the United Kingdom, a tripartite framework functions for maintaining stability in the financial system. The banking and financial regulations are monitored by the “Financial Services Authority (FSA)” (Davis, 2009, p.10). The Bank of England maintains stability on the system through its monetary policy. It uses its “lender of last resort operations” (Davis, 2009, p.10) and the macro prudential surveillance. The treasury takes care of the public finances and the overall structure of the financial system. There were certain threats in the financial system in England. The reproduction of bank note using palaeography was the most important one. This method uses photochemical and lithographic techniques of duplication of notes. Recently the bank has started using threat indicators. The threat indicators are based on aspects like the number of counterfeits in deceptions, bank note circulation and the amount of financial damage caused. These features have gone a long way in gaining the confidence of the public (Heij, 2010, p.16). Role of the Federal Reserve This paper also brings forth the financial and monetary policies undertaken by the Federal Reserve in US to maintain macroeconomic stability in the economy. Since 1980, the Federal Reserve has been following a policy of managing the short term nominal rates of interests as a measure of controlling inflation. By keeping the rates of interest at a constant level, during the time of exogenous shocks to the demand for money in the economy, the policy forms insulation to the economy from such shocks. The interest rate policy followed by the Federal Reserve also helps the economy to adjust to the technological shocks. Positive shocks coming from the supply side causes temporary pressures of deflation. The Federal Reserve counters the shock by persistently reducing the short term rates of interests. When the prices remain sticky, the ease with which this policy is conducted accelerates and thus the output is increased even further. This allows the output to react and respond in the way it would in the absence if rigidities in prices. By focussing on the nominal variables and the rates of inflation the Federal Reserve works towards improving the cyclical performance of the economy. This improves the overall welfare of the economy. In fact, the Federal Reserve’s emphasis on inflation accounts for a critical factor behind its success (Ireland, 1999, p.21). Before the 1980s, the Federal Reserve used to respond to the changes in the inflation rates only on weekly basis. This led to the increase in the nominal and real rate’s instability substantially. Under the “constant money growth rate rule” (Ireland, 1999, p.21) there is no response by the supply of money. The rigidity in the nominal prices of goods causes a sharp fall in the output level in the economy. According to the Federal Reserve’s rule, the interest rates accommodate the money demand increase. The conventional banking system in the US is to provide long term loans and issue short term deposits to fund them. Recently the Federal Reserve has implemented rules which have cut down the roles of the traditional banks to function as financial intermediaries. Thus the deposits which would provide funds to the intermediaries have also come down in terms of their importance (Edwards & Mishkin, 1995, p.1). The declining functions of the banking system faced a number of challenges. The banking system underwent complete restructuring to maintain its financial stability in the long run. Instead the traditional banks were allowed to expand their operations into the non traditional and more profitable activities. During the transition period, regulators were used to guard the banks against risk taking and financial instability (Edwards & Mishkin, 1995, p.1). Economic forces have led to the increase in competition in the financial market. Competition has reduced the cost advantage enjoyed by banks in fund acquisition. Their positions in the loan markets have also come down. This has led to the diversification of these banks into new operations that fetch greater returns. The banks have been experiencing reduced income advantages. Growth of the bond market has undercut the bank’s advantage from providing credits. To maintain their profits, they have been maintaining their activities of lending in the riskier areas (Edwards & Mishkin, 1995, p.7). Comparison between the Bank of England and the Federal Reserve The primary function of the Federal Reserve since 1980 has been to manage the short term nominal rate of interest to keep inflation under control. Its policy is to insulate the aggregate output of the economy from the effects of external demand side disturbances by reducing the interest rates. On the other hand the Bank of England’s main priority is to control inflation through the method of inflation targeting. This is done by the method of interest rate smoothing in which a less volatile rate of interest rate is used for moving the inflation from its present level towards the target level. In the industrial countries like UK, emphasis is given on reserved transactions because they can be easily implemented and are more flexible. They do not lead to much impact on the prices of securities. In this system the purchase and sale of the securities are reserved at some specific price for the future under a contract. In England, the central bank takes the initiative to set the amounts, duration and time of the contract. It decides whether the contracts require to be renewed or unwind on maturity. This policy is used for countering the supply towards the reserves in the bank from various other sources. On certain occasions the private markets are also used. Such “reserved security transactions” (Dalla, 1995, p.61) are used for implementing the monetary policy in the country (Dalla, 1995, p.61). In the United States of America, the private market for the reserved transactions in the government securities is highly active. The Federal Reserve uses the reserved-securities transactions for the purpose of withdrawing and depositing from the banks in large amounts and for short time periods. Without the presence of the Federal Reserve’s operations the federal funds’ rate could fluctuate considerably. Reverse transactions mainly help to stabilise the interest rates. This helps to finance the dealer’s position which would otherwise be liquidated (Dalla, 1995, p.62). Bank of England recently has been carrying out purchase or resale transitions in government securities with the banks. These transactions were primarily used for meeting the liquidity needs existing in the economy. The techniques remained limited to the availability of collaterals. Resale and purchase transactions were done more frequently according to the terms of the central banks on expectations of falling rates of interest and unwillingness of the market on offering long term bills for sale (Dalla, 1995, p.62). Procedures for the implementation of monetary policies in the two countries are quite similar with some minor differences. Both emphasise on the short term rates of interest. The changes in the monetary policies are conducted by changes in the rates charged by the central bank on the refinancing facilities. The Bank of England supplies the reserve shortages and absorbs the reserve surpluses at the existing rate of interest on a regular basis. When it changes the policy, it keeps the rate at such a level below which it does not buy bills. If the bills offered is below sufficient the discount houses are compelled to borrow from the bank of England. This is done at a rate which is different from the rate existing in the market. In the United States this practice is marginally different. The monetary authorities adjust the discount rates but not very frequently. Instead the policy directions are indicated according to the movements in the rates determined in the market. In the United States, the federal funds’ rate is influenced through the market operations (Dalla, 1995, p.63). In both countries the monetary policies are based on the supply of the bank reserves which influences the short term rates of interest. Both authorities employ either inter-bank operations or open market operations for managing their reserves. For this purpose, repurchase and matched sale purchase are used. The Federal Reserve relies more on the short term bonds while in UK the reserved-security transactions are not considered to have much importance. The bank of England uses the repurchase agreements only to meet the peak reserve demands. The functions of the discount windows used for managing short term reserves have declined for both countries. In America, the rediscount rate is the short term market rate. In UK, no such discount windows exists in spite of the fact that it lends to the discount house at a rate different from the prevailing market rates (Dalla, 1995, p.64). In both nations, the Central bank does not give loans to the treasury. But they extend credit to the government by the acquisition of government papers with the aim of managing the interest rates in the market. There are auction procedures in the two markets. The holdings of the central banks through the policies of debt management remain small but stable. The policy of debt management was used in UK in 1980. This was used as an instrument of moderating the imbalances in the balance sheets in the banking system. Debt management was done by selling of the government papers to a large extent (Dalla, 1995, p.65). Conclusion It is seen that the most prominent responsibilities of the Bank of England and the Federal Reserve is to monitor the interest rates in the economy. In England the policy of smoothening interest rates finds special prominence as a measure of controlling inflation. It is seen monitoring the short term interest rates is the most commonly used method which has been found effective in controlling inflation. In America, the interest rates are maintained at a constant level to absorb any kind of abrupt and external shocks confronting the economy. It is seen that the introduction of VAT and rising oil prices have accounted for the rise in inflation levels in the economy. The interest rates have been used as a tool for countering the oil price hike and consequently controlling inflation. In both countries the monetary policies have been used in a similar manner. Both use the methods of monitoring the interest rates in the short term. An important point worth noting is how the banks monitor the holdings of the traditional banks. The Federal Reserve has undertaken complete restructuring of the banking system in order to increase financial stability of the economy. This has cut down the functions of the traditional banks or the financial intermediaries to a considerable extent. Thus it is seen how the Bank of England and the Federal Reserve enjoy immense power, responsibility and independence in exercising control over the economy. References Dalla, I. 1995. The emerging Asian bond market. World Bank Publications. Davis, E. P. July 17, 2009. Financial Stability in the United Kingdom: Banking on Prudence. Brunel University, United Kingdom. [Pdf]. Available at: http://ephilipdavis.com/uk%20financial%20stability%20oecd.pdf. [Accessed on November 25, 2010]. Edward, F. R. & Mishkin, F. S. July 1995. The Decline of Traditional Banking: Implications for Financial Stability and Regulatory Policy. [Pdf]. Available at: http://www2.econ.iastate.edu/classes/econ353/ganco/documents/DeclineofTraditionalBanking.pdf. [Accessed on November 25, 2010]. Heij, H. A. M. February 9, 2010. Innovative approaches to the selection of banknote security features. Available at: http://www.dnb.nl/en/binaries/Innovative%20approaches%20to%20the%20selection%20of%20banknote%20security%20features_tcm47-229381.pdf. [Accessed on November 25, 2010]. Ireland, P. N. 1999. Interest Rates, Inflation, and Federal Reserve Policy Since 1980. Boston College. Available at: http://escholarship.bc.edu/cgi/viewcontent.cgi?article=1212&context=econ_papers. [Accessed on November 25, 2010]. Lewis, S.W. 8th March 2002. Fiscal Policy, Inflation and Stabilisation in EMU. University of Exeter. [Pdf]. Available at: http://www.economics.ox.ac.uk/members/simon.wren-lewis/docs/EC_conference_2002.pdf. [Accessed on November 25, 2010]. Neumann, M. J. M. & Hagen, J., V. December 2001. Does Inflation Targeting Matter? [Pdf]. Available at: http://www.zei.de/download/zei_wp/B02-01.pdf. [Accessed on November 25, 2010]. Svensson, L.E.O. August 1998. Inflation Targeting as a Monetary Policy Rule. Institute for International Economic Studies, Stockholm University; CEPR and NBER. [Pdf]. Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.37.3000&rep=rep1&type=pdf. [Accessed on November 25, 2010]. Rudebusch, G. D. August 2001. Term structure evidence on interest rate smoothing and monetary policy inertia. Federal Reserve Bank of San Francisco. [Pdf]. Available at: http://www.frbsf.org/publications/economics/papers/2001/wp01-02bk.pdf. [Accessed on November 25, 2010]. Bibliography Sayers, R. S. 1976. The Bank of England, 1891-1944, Volume 1. CUP Archive. Read More