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Korean Monetary Policy and the Financial System

Korean Monetary Policy and the Financial System. Spring 2011. 10 Non-participants. The United Kingdom Denmark, Sweden Hungary, Poland Romania, Bulgaria Czech Republic, Latvia, Lithuania. 17 Member States. Germany, France, Austria, Ireland, Greece, Spain, Portugal

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Korean Monetary Policy and the Financial System

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  1. Korean Monetary Policy and the Financial System Spring 2011

  2. 10Non-participants The United Kingdom Denmark, Sweden Hungary, Poland Romania, Bulgaria Czech Republic, Latvia, Lithuania 17 Member States Germany, France, Austria, Ireland, Greece, Spain, Portugal Italy, The Netherlands, Belgium, Luxembourg, Slovakia Finland, Cyprus, Malta, Slovenia, Estonia Map of European Central Bank (ECB) area

  3. Map of Europe

  4. A Brief History of EU • 1946-1950: Recovering from the effects of World War II, discussions about the possibility of cooperation begin among several countries • 1951: The Treaty of Paris was signed by ‘The Six’(France, Belgium, the Netherlands, Luxembourg, Germany, and Italy). Establishes the European Coal and Steel Community (ECSC) • 1957: The Treaty of Rome was signed, establishing the European Economic Community (EEC) and the European Atomic Energy Community(Eurotom). • 1958: The Monetary Committee was formed as an advisory body to the Economic and Financial Affairs Council(ECOFIN). 4

  5. 1964: The Committee of Central Bank Governors was formed. • 1965: ‘The Six’ signs the Merger Treaty in Brussels, merging the executives of the three Communities (the ECSC, ECC and the Euratom), giving them a Single Commission and Single Council. Entered into force July 1967, forming the European Community(EC). • 1970: The Final report of the Werner plan is completed. (Feasibility of a European Monetary System) • 1973: Denmark, Ireland, and UK join the European Community 5

  6. 1979: The European Monetary System (EMS) enters into force. The EMS is based on a European Currency Unit(ECU), whose value is based on several national currencies, weighted according to the relative strength of each. The EMS consisted of three components: • Exchange Rate Mechanism (ERM) • European Currency Unit (ECU) • European Monetary Cooperation Fund (EMCF) • 1981:Greece joins the European Community. • 1986: Spain and Portugal join the European Community. In February, The Single European Act(SEA) is signed to come into force in July 1987. The SEA is a wide revision of the 1957 Treaties of Rome, and includes issues such as the single market. 6

  7. Towards the European Monetary Union(EMU) • Overall EMS worked well in insulating intra-European trade from turbulence in global currency markets and from the wild swings in the value of the dollar that marked the Reagan years of 1981-1988. • As EMS evolved into a de facto fixed rate regime, the next logical step became a move to full EMU. • As currency fluctuations affected the prices of goods and services and constituted a barrier to trade due to transaction costs, it became clear that single market program was inconsistent with different currencies within the EC. “One Market, One Money” was then pursued 7

  8. 1989: The Delors Report is published. (Recommends three stages for deployment of a full monetary union for the EC). (On November 9, the Berlin Wall opens. East Germans can now travel to West Germany via Berlin.) • 1990: The Schengen Agreement is signed in June. This abolishes border checks between participating member states of the European Communities. (On October 3, Germany is reunited.) • 1991:The Maastricht Treaty on European Union was approved by the heads of the EC states in 1991, signed in Maastricht in 1992, and comes into force in 1993. The basic components are: - A common foreign security policy - Closer cooperation on justice and home affairs - Creation of an economic and monetary union 8

  9. Summary of Delors Report • Based on principles of gradualism and convergence, defines three stages in the process towards monetary union. • First Stage (from 1 July 1990 to 31 December 1993): The EMS countries abolished all remaining capital controls. The degree of monetary cooperation among the EMS central banks were strengthened. Realignments were possible. Member states undertake programs that make possible fixed exchange rates. • Second Stage (from 1 January 1994 to 31 December 1998): A new institution, the European Monetary Institute (EMI) was created. 9

  10. EMI was a precursor to the European Central Bank (ECB) and was created to • - Coordinate monetary policies and ensure price stability. • - Prepare the establishment of the European System of • Central Banks (ESCB) overseen by the European • Central Bank (ECB). • - Prepare the introduction of a single currency in stage 3. • Third (Final) Stage (from 1 January 1999 to 31 June 2002): The exchange rates were irrevocably fixed. Establishment of the European Central Bank in charge of the European monetary policy. The ECB issued the euro. The transition to this final stage was made conditional on a “number of convergence criteria.” 10

  11. 1993: The European Union(EU) was established creating a single market for the member countries. • 1995: Austria, Finland, and Sweden join the European Union. • 1997: The Amsterdam Treaty is signed (to come into force May 1, 1999). This treaty gives the EU new powers and responsibilities. • 1998: The European Central Bank (ECB) was established as the central authority that oversees monetary policy in the common currency area. • 1999:The European Monetary Union(EMU) is launched replacing the currencies of 11 EU countries. (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain). 11

  12. 2001: The Treaty of Nice is signed (to come into force 1 February 2003) to prepare the EU’s decision making system for enlargement. Greece became the country number 12 to adopt the euro. • 2002: Euro notes and coins come into circulation in 12 Euro Area countries. On March 1, 2002, the euro is the sole legal tender in these countries. • 2004: 10 new states join the European Union: Cyprus, the Czech Republic, Estonia, Hungary, Latvia,, Lithuania, Malta, Poland, Slovakia, and Slovenia. • 2007: Romania and Bulgaria join the European Union, bringing the total number of member states to 27. • 2008: Cyprus and Malta adopted the euro as their common currency. 12

  13. 2009: Slovakia adopted euro. • 2011: Estonia adopted euro. (So, 17 out of 27 EU member states currently use euro as their common currency.) 13

  14. What is Monetary Union? • Weak form • Fixed bilateral exchange rates (with a narrow band) • Each member undertakes monetary policies to defend the rates • Strong form • Individual currencies are replaced by a single currency • Individual monetary authorities are replaced by a single authority 14

  15. Costs and Benefits of Euro • Benefits: • Reduction in transaction costs. • Elimination of the exchange rate risk. • Greater competition leading to greater efficiency. • Greater integration among the European financial markets and greater investment efficiency. • Inflation discipline guaranteed by the independence of the European Central Bank. • Fiscal discipline as a requirement to enter and stay in the system. • Increase the urgency of structural reforms in Europe. 15

  16. Costs: • The system of fixed exchange rates eliminate the possibility of using exchange rate adjustments as a policy tool in the presence of asymmetric shocks. • Individual countries cannot use monetary policy to face country-specific shocks. • Limited ability to use fiscal policy as a stabilization tool in absence of monetary independence. • Absence of a system of fiscal redistribution to insure against regional/national shocks. • Europe may not be an optimal currency area due to: • Likelihood of asymmetric or country-specific shocks. • Limited labor mobility. • Structural labor market rigidities. 16

  17. The Treaty of Maastricht (1991) • The main economic element was a firm commitment to launch a single currency by January 1999 • Its key provisions regarding EMU were • A list of five criteria for admission to the monetary union (the ‘convergence criteria’) • A precise specification of central banking institutions • Additional conditions mentioned (e.g. the excessive deficit procedure) 17

  18. Motivation for the Maastricht Criteria: • Impose fiscal prudence and prevent free riding (e.g. on low interest rates) • Eliminate threat of national governments seeking bail-outs from the ECB. • Increase stability of the EMU and the common currency. 18

  19. The Convergence Criteria These criteria had to be fulfilled in 1998 (the last year before admission). • Price stability: the average inflation rate must not exceed that of the three best-performing states (with lowest inflation) by more than 1.5%. • Interest rate convergence: the average long-term interest rate must not exceed that of the best three states (with lowest inflation) by more than 2%. • Exchange rate stability: During the two years preceding the entrance into the union, no exchange rate realignments. (means two years membership in the ERM without devaluation) • Budget deficit: deficit less than 3% of GDP • Public debt: debt less than 60% of GDP 19

  20. Note that long-term nominal interest rates reflect market expectation of long-run inflation(Fisher effect) • Membership of ERM/EMS is needed to convince the markets of commitment to low inflation. • Budget deficit and public debt criteria aim at eradicating long-run incentives to create inflation • Though inflation might be bad for society as a whole, some groups gain from it (including the government  major cause of inflations) Problem: what is a sustainable level of gov’t debt? Budget deficit is based on German ‘golden rule’ (gov’t investment should equal its deficit) Public debt limit is more arbitrary (simply average debt level in 1991) 20

  21. How did countries perform in 1998? • Inflation and long-term interest rates brought in line in 1997 • Budget deficit as well albeit with some accounting tricks. • Majority of countries failed the 60%-criterion but benefited from earlier exception made for Belgium • Greece didn’t even try to bring down inflation in time but simply postponed its entry to 2001 • The UK, Denmark and Sweden voluntarily remained outside the Euro. 21

  22. Government Debt Criteria Source: European Commission (figures for 1998) 22

  23. European System of Central Banks Key Players • European Central Bank(ECB) : The central authority in Frankfurt, Germany, that oversees monetary policy in the common currency area. (Established July 1, 1998) • National Central Banks(NCBs): The central banks of the countries that belong to the European Union. Each country’s central bank stayed in business, but now operates much like the Regional Reserve Banks in the US do. • Eurosystem: The ECB plus the NCBs of participating countries; together, they carry out the tasks of central banking in the euro area. 23

  24. • European System of Central Banks(ESCB): The ECB plus the NCBs of all the countries in EU, including those that do not participate in the monetary union. • ECB Executive Board: The six-member body in Frankfurt that oversees the operation of the ECB and the Eurosystem. • Governing Council: The (currently) 23-member committee that makes monetary policy in the common currency area. • General Council: an advisory board that comprises the President and Vice-President of the ECB, plus the governors of the national central banks (NCBs) of the 27 EU Member States. • Euro: The currency used in the countries of the European Monetary Union. • Euro Area: The countries that use the euro as their currency 24

  25. European System of Central Banks EUROSYSTEM Formulatesmonetary policy GOVERNING COUNCIL(Decision-making Body) Executive BoardPresident 1Vice President 1Members 4 6 Governors of NCBs17 Total 23 EUROPEAN CENTRAL BANK (ECB)Frankfort, Germany National Central Banks implement monetary policy in the Euro Area … NCB17 NCB1 NCB2 advise National Central Banks that have not adopted the euro GENERAL COUNCIL(Advisory Body) President 1Vice President 1Governors of NCBs of all countries 27 Total 29 … NCB26 NCB27 NCB17 25

  26. Institutional Setup 26

  27. ECB Executive Board • Consists of the President, Vice-President and 4 other members . All members are appointed by common accord of the governments of the euro area countries. • The main responsibilities are: • to implement monetary policy in the euro area in accordance with the guidelines and decisions specified laid down by the Governing Council. • to manage the day-to-day business of the ECB • To exercise certain powers, including regulatory powers, delegated to it by the Governing Council. 29

  28. The first president was Willem Duisenberg, previously the governor of the Dutch Central Bank. • The second president is Jean-Claude Trichet, previously president of the French Central Bank. • Both presidents are known for their strong stance on price stability in their countries. Jean-Claude Trichet (In office since November 2003) Willem Duisenberg (In office July 1998 – October 2003) 30

  29. The Governing Council • Consists of the six members of the Executive Board, plus the governors of the national central banks of the 17 euro area countries. • The main decision-making body of the ECB, dealing with management of the target interest rate and monetary policy. • The Maastricht Treaty requires the Governing Council to convene at least 10 times per year, but it usually meets twice a month in the Eurotower in Frankfurt, Germany. 31

  30. It has three (3) major functions: • Provide price stability, • Provide liquidity to the entire Euro Area banking and financial system, and • Establish and maintain an efficient payments mechanism throughout the EU. • The Governing Council controls bank reserves, sets certain key interest rates, and ultimately attempts to control the money supply in the Euro area. 32

  31. The Eurosystem • Monetary policy in the Euro Area is entrusted to the Eurosystem that consists of: • The European Central Bank (ECB) • 17 National Central Banks (NCBs) of the 17 euro area countries • The organization is remarkably similar to the U.S. Federal Reserve System. • There will be an NCB for each country that joins. • Along with the 10 NCBs of non-euro countries, this • constitutes the European System of Central Banks • (ESCB). 33

  32. Distinguish between Euro-members and non-members • The ECB plus all EU NCBs  the European System of • Central Banks (ESCB) • The ECB plus Euro-member NCBs  the Eurosystem • Note that the distinction between the Eurosystem and the ECSB will continue until all EU member countries join the EMU and adopt the euro. 34

  33. The ECB’s Objective and Strategy • Price stability is currently defined as inflation below but close to 2 percent in terms of a euro-area measure called the Harmonized Index of Consumer Prices(HICP) over the medium term. 35

  34. Harmonized Index of Consumer Prices(HICP) • The measure of prices used by the Governing Council • to assess price stability in the euro area. • Calculated and published by Eurostat, the Statistical • Office of the European Communities. • Captures the price changes relating to consumption • expenditure on goods and services by all households. • Compiled on the basis of over 1.7 million individual • price observations of goods and services every month, • in 200,000 outlets in some 1,500 towns and cities • throughout the euro area. 43

  35. Euro Area Inflation Rate (Annualized Rate of Change in Monthly HICP) (January 1991 – February 2011) 44

  36. Main Components Of M3 45

  37. M3 Growth Rate 46

  38. 3 Major Monetary Policy Instruments Open Market Operations: • Main Refinancing Operations: regular liquidity- • providing transactions with a frequency and maturity of • one week. • Longer-term Refinancing Operations: liquidity- • providing transactions with a monthly frequency and a • maturity of three months. • Fine-tuning Operations: executed on an ad hoc basis • to manage the liquidity situation in the market and to • steer interest rates. In particular, they aim to smooth • the effects on interest rates of unexpected liquidity • imbalances. 47

  39. Structural Operations: can be carried out by the • Eurosystem through reserve transactions and • issuance of debt certificates Standing Facilities The Eurosystem also offers two standing facilities, which set boundaries for overnight interest rates by providing and absorbing liquidity • The Marginal Lending Facility: allows credit institutions • to obtain overnight liquidity from the national central • banks against eligible assets. • The Deposit Facility: can be used by credit institutions • to make overnight deposits with the national central • banks in the Eurosystem. 48

  40. Minimum Reserve Requirements • Credit institutions are required to hold minimum • reserves in accounts with the national central banks. • Each credit institution must keep a certain percentage • of some of its own customer deposits (as well as some • of other bank liabilities) in a deposit account with the • relevant national central bank on average over a • reserve maintenance period of around one month. • The Eurosystem pays a short-term interest rate on • these accounts. The purpose of minimum reserve • system is to stabilize money market interest rates and • create (or enlarge) a structural liquidity deficit in the • banking system. 49

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