Inflation and price development
Ing. Tomáš Paleta, Ph.D., ESF MU


Centraly planned economy
* Problem: economic balance was achieved by central plan
–Amount of production
–Prices
* Characteristics of CPE
–Low economic performance
–Ineffective explotation of resources
–High energy consumption
–Equalization of earnings (not motivating but reduction on poverty)
–
–
–

Factors of price developement
* Banking sector
–Relation of government and CB
–Monetary policy
* Price liberalization
* Tax developement
–

Banking sector in Czechoslovakia
§massive nationalization + liquidation of two-tier banking sector after the communist coup 1948,
§liquidation of the central bank (Czechoslovak National Bank) – creation of the monobank (SBČS –
Czechoslovak State Bank),
§SBČS was owned by the state, executing orders in the monetary area from the political centre,
§SBČS had branches in all larger communities, performing bank service,
§SBČS controlled vassal commercial banks according to the central plan.

The situation in socialist Czechoslovakia can be characterized from the standpoint of financial
economy as a typical monobank system. Two-tier banking system, established in 1926 by setting up
the central bank – the Czechoslovak National Bank, functioned including the disruption during the
World War II up to the year 1948. The communist coup launched a wave of massive nationalization,
which did not spare the banking sector, and the liquidation of political freedom was followed by
the liquidation of economic freedom. In 1950 the Czechoslovak National Bank went into liquidation
and along with it also two-tier banking sector. In the following 40 years Czechoslovakia
implemented a rigid model of one-tier banking system – the monobank (see Diagram 4). The main
component of the system was the all-embracing central bank – Státní banka Československá (SBČS –
Czechoslovak State Bank), owned by the state, executing orders in the monetary area from the
political centre. It had branches in all towns and larger communities, and practically controlled
vassal commercial banks.  SBCS branches performed banking functions in relation to firms[1], which
consisted especially in distribution of credits according to the central plan and in providing
money services in paying out wages.
[1] It should be noted that all firms were ether owned by the state or they assumed a form of
cooperatives related to the central plan.

Major tasks and issues, which had to be solved:
§to create and implement a standard money market,
§to conceive a functioning standard banking system, based on non-state commercial banks and an
autonomous central bank,
§to define the degree of the central bank’s independence,
§to outline the main strategy of monetary policy and its objective (within the condition of the
unstable economic environment: price liberalization, liberalizing foreign trade, flows of foreign
capital).

At the outset of economic transformation the government and parliament faced major tasks and
issues, which had to be solved. As far as the monetary policy was concerned, it was necessary to
create and implement a standard money market, which had not existed for decades. The task required
to conceive a functioning standard banking system, based on non-state commercial banks and an
autonomous central bank. Position of the newly established central bank with respect to the
government had to be specified, i.e. it was necessary to define the degree of the bank’s
independence. Then the central bank had to outline the main strategy and monetary policy objective
and stick to it in the unstable economic environment characterized by price liberalization and by
liberalizing foreign trade and flows of foreign capital.

Function and position of a central bank         in the economy
•Central bank fulfils irreplaceable functions in modern market economy particularly in two major
areas:
§monetary policy
§banking system regulation and supervision.
§
Importance and contents of each function depends on the degree and strength with which the
government affects economic processes.

As the previous chapter indicated, a central bank fulfils irreplaceable functions in modern market
economy particularly in two major areas:
·        monetary policy,
·        banking system regulation and supervision.
Importance and contents of individual functions depend on the degree of state interventionism, i.e.
the degree and strength with which the government affects economic processes.

Functions of central bank
•Contents and importance of central-bank´s functions differ according to the type of economic
policy + level of economic liberalism:
® during the transformation the functions were gradually changing.

Contents and importance of individual central bank functions differ according to the type of
economic policy, level of economic liberalism – it means that during the transformation process the
central bank’s position was not rigid while its position and functions were gradually changing. As
stated in the previous chapter, the first step of transformation in monetary area was the
establishment of the central bank; further measures altered and developed its position and
functions. The central bank performs six principal functions:

Relationship between the central bank and the government
•® central bank’s autonomy = the degree of decision-making independence from political pressures.
§government seeks the easiest way to finance state-budget deficit
§the easiest way is to use inexhaustible credit capacity of the central bank
§money supply grows with each credit provided to the government - the inflation increases as well
If the central bank is closely dependent on the government, the danger of inflation is quite high.
§

The relationship between the central bank and the government is seen from the viewpoint of central
bank’s autonomy, i.e. the degree of decision-making independence from political pressures. As
mentioned above, a high degree of central bank’s independence proved vital for achieving stable
non-inflationary environment in the economy. It is not sufficient to declare independence; it is
necessary to set up such a system of rules and provisions, which would effectively prevent the
central bank from accommodating any undesirable fiscal development. Since central bank’s
independence has a character of a symbolic guarantee, while its practice deeply intervenes in the
economy, it is quite important to determine unambiguous criteria for evaluating the degree of this
independence. It is also vital for its retroactive accountability for monetary policy, since this
accountability is indivisible. The degree of independence then appears as a criterion of
accountability: a highly independent central bank is fully responsible for the quality of currency,
while a bank having a low degree of independence delegates the responsibility for currency
stability to the institution, which it reports to, i.e. which it is dependent on. Central bank‘s
independence can be viewed either from the economic point of view or from the political one.

Long-term comparisons imply that there is a correlation between the central bank’s independence and
the inflation.
Graf_1

Development of functions and position of the Czech central bank
•Mutual coordination of monetary and fiscal policies depend on two basic things :
§the level of central bank’s independence
§concept of macroeconomic tasks
§
During the transition, both these things were developing Þ the functions and position of the
central bank were changing.

4.1 Economic equilibrium and monetary and fiscal policy
It is not allowable for economic policy to be left uncoordinated. It means it is not possible for
monetary and fiscal policies to head for different targets or to head for a common target in a
principally different and incompatible manner. Monetary policy should be determined with a view to
the intentions in fiscal policy and vice versa the fiscal policy should allow for the fact that a
given measure will provoke a corresponding response of monetary policy. At the same time, however,
the primary aim of modern economy must be price stability. Uncoordinated implementation of each
policy will probably make the situation worse. It will lead to overloading one policy and to
replacing one imbalance by another. In better case the imbalance will be successfully eliminated,
but at higher social costs than in case of a coordinated course of action. In connection with the
process of economic transformation, Isard emphasizes this fact, when he states “In the absence of a
well-defined and credible timetable for phasing out restrictions, the process of economic
transformation and growth may be seriously weakened or undermined^[1]”. Problems of mutual
coordination of monetary and fiscal policies will depend on two basic facts: (i) on a legislatively
stipulated relationship between the government and the central bank (i.e. the degree of central
bank’s independence) and (ii) on setting macroeconomic targets, i.e. understanding the concept of
macroeconomic balance or quantification of imbalance, which is still acceptable. Economic policy
will obtain the best results, if monetary and fiscal policy measures (i.e. government’s and central
bank’s activities) will be mutually coordinated – not at random, but according to predetermined
rules. It is also related to setting and quantification of macroeconomic targets publicly and to
efficient public control. It should be noted that macroeconomic equilibrium would be viewed
differently in a developed market economy, in a developing country, and in a country passing
through economic transformation. The definition of macroeconomic equilibrium, quantification of
acceptable imbalance and determination of the scope of economic and political provisions needed for
its removal became an apple of contention between the Czech government and the central bank. The
situation can be described with a certain amount of simplification by using different stages of
transformation process in respect with the position of the Czech central bank and the government
(see also Table 14).
[1] [Isard, P. 1991] s. 19

Socialist monobank till 1989
§SBČS was completely subordinated to decisions of the government and to interests of the communist
political authority
§monetary policy was a subject of a central plan
§SBČS was absolutely dependent

There was no point in talking about the central bank until 1989, because the entire banking system
was run by the principle of the monobank. The main pillar of this system – Státní banka
československá (SBČS) – fulfilled the functions of the central bank and those of a commercial bank.
However, either of these functions was directly linked to the central plan, by means of which the
power centre controlled the whole economic life in socialist Czechoslovakia. The activity, which
could be called monetary policy, was limited to issuing currency and distributing credits and funds
to state firms. It was completely subordinated to decisions of the government and interests of the
communist political nomenclature.
The central bank was Státní banka Československá – SBČS, whose relationship to the government can
be described as an absolute dependence, for SBČS was a part of centralized economic and political
power.

First stage 1990 – 1992
§meeting basic macroeconomic objectives had an absolute priority for the government
§SBČS´s main function was to be the state’s bank and the bankers’ bank
§SBČS was dependent both politically and economically
§relationship between the SBČS and the government was relatively obliging, due to a complex
economic situation and personal, friendly relations
§

The first stage encompasses the beginning of transformation until the end of 1992. At this stage
the central bank (SBČS) was dependent both politically and economically, particularly in the area
of setting objectives; generally speaking, this situation can be described as dependence of
monetary policy on fiscal policy. It had two reasons: (i) the newly emerging banking system did not
operate in a functioning money market and (ii) the principal target was not to maintain price
stability, but to alleviate inflationary consequences of price liberalization which was then under
way.  With regard to situation at the outset of transformation, the given state can be considered
appropriate for the primary transition period, when meeting basic macroeconomic objectives had an
absolute priority for the government because of political reasons and therefore it was not in any
conflict with central bank‘s policy.
Státní banka Československá – SBČS was still in the position of the central bank but was already
reformed. The area of commercial banking was shifted to the independent Komerční banka (KB) and
Všeobecná úverová banka (VÚB). The SBČS continued functioning only as the central bank.  At that
time its main function was to be the state’s bank and the bankers’ bank. The banking sector of
those years operated in a relatively noncompetitive cooperative environment, when the savings bank
(ČSSP) provided other commercial banks (KB, ČSOB, IB, ŽB) necessary funds accumulated in the form
of household savings. These banks, in turn, provided commercial loans to both state-owned and
private firms. If needed, the SBČS itself provided cheap credits to commercial banks, which were at
the interest rate equal to the discount rate. A special type of credits, called redistribution
credits, was provided by the SBČS at the interest rate that was even lower than the discount rate.
Those credits were to cover bad debts left by state enterprises, which gradually went bankrupt. The
SBČS was a formally autonomous central bank, however it depended heavily on the government. The
relationship between the SBČS and the government was relatively obliging, due to a complex economic
situation and personal, friendly relationships.

Second stage 1993 – up to the present
§running banking system, money market, price liberalization, and privatisation Þ reform of the
central bank
§SBČS had to be split due splitting of the republic
§new ČNB was established as a modern central bank, totally independent from the government
(Bundesbank)
§principal target of monetary policy – to maintain a low inflation

Establishment of a newly conceived Czech central bank – the Czech National Bank (CNB) – can mark
off the second stage. A stabilized banking sector and functioning money market together with
advanced price liberalization and privatisation made it possible to complete the reform of the
entire banking system – i.e. the reform of the central bank. Break-up of Czechoslovakia contributed
to its establishment from the political point of view, because the existing central bank had to be
split. The process of dividing liabilities and assets of SBČS was utilized for a complete reform of
the institution and ended in establishing a new central bank.

Central bank’s instruments and objectives
5.1 Monetary policy objectives
•Principal macroeconomic objectives:
§economic growth
§employment
§low inflation
§equilibrium in the balance of trade
      Monetary policy targets monetary objective –       i. e. low inflation.

Generally speaking, objectives of monetary policy are identical with principal macroeconomic
objectives - economic growth, employment, price level stability (i.e. low inflation rate),
equilibrium in the balance of payments and stable exchange rate[1]. Practical monetary policy
formulates its basic strategy on the basis of specific targets that are derived from the principal
objectives. Monetary policy targets are viewed in a different way according to the central bank’s
position in international economy and the relationship of monetary policy to fiscal policy fiscal
in individual countries. E.g. the American Federal Reserve System sets its objectives as: high
employment, economic growth, price stability, interest rate stability, financial and exchange
market stability[2]. The European Central Bank has specified as its principal objective price level
stability along with maintaining support to the EU economic policy. In its present neo-conservative
concept, the monetary policy does not usually set directly as one of its objectives economic growth
or employment but it focuses on the monetary objectives, through which economic growth and hence
employment is targeted. Using monetary policy and its instruments and objectives for targeting high
employment was typical for Keynesian economic policy in the 60s and 70s of the 20^th century.
However, exclusion of other than monetary objectives does not relieve monetary policy from the
responsibility for the entire economic development.
[1] Exchange rate stability as a target of monetary policy should be viewed differently on
introducing of different exchange rate systems - see chapter  XXX.
[2] cf. Mishkin, F.S. [1991] s. 344

principle:
§direct inflation targeting – based on forecasts and prognoses
§monetary targeting - central bank targets quantity of money in circulation
§interest rate targeting - central bank targets interest rate levels on the money market
§exchange-rate anchor – targeting of the fixed exchange rate
Each strategy requires some particular conditions – not all could be used during the transition.

 A central bank can pursue its primary objective – price level stability – directly. In that case
it is known as direct inflation targeting. Another typical method of monetary policy control is
money targeting, in which the central bank targets interest rate levels on the money market or a
certain quantity of money in circulation. The central bank estimates, based on experience, economic
models and prognoses, that if a certain interest rate or money supply are maintained, then the
primary objective (hitting a certain level of inflation) will be fulfilled. In both cases it is
important for money market institutions and market mechanism to function properly in the country,
otherwise the central bank’s monetary strategy could fail. Another possibility how to ensure the
price level stability, is to peg the price of domestic currency to the currency of some other
country, whose price level is stable. A central bank implements the peg by announcing the fixed
exchange rate (see chapter XXX). Domestic price level is thus anchored to a stable foreign price
level (from here the name of the provision “price level nominal anchor“) and the central bank
pursues the monetary policy targeted at maintaining the announced fixed rate. This method is
especially appropriate for the situations, when the domestic economy experiences a difficult period
of uncontrollable inflations or when market mechanisms of the money market do not function.
Economic transformation is an example of such a period and a number of transitive countries applied
this method of monetary policy targeting.
To reach monetary objectives, the central bank can use a portfolio of instruments. In principle,
central bank’s instruments are its institutionalised powers within monetary policy. In a standard
two-tier banking system, selected instruments are the ways, by means of which the central bank
enters the money market and affects the money supply and demand. The central bank is, on account of
its position within the banking system, endowed with extraordinary possibilities of such
interventions. Central bank’s instruments can be divided into direct and indirect according to
their general effect.

Direct instruments
§based on directive, administrative decisions, which commercial banks have to follow by law
§not rely on the money market - not require its proper functioning
§can become exponents of economic dictatorship
§their application is minimized in modern market economies
•Direct instruments can be a way of controlling monetary policy in a situation, when the money
market does not work – during the economic transition.

Direct instruments of the central bank are based on using directive, administrative decisions,
which commercial banks have to obey by law. Such instruments are very efficient, involve minimum
costs for the central bank, do not rely on the money market and therefore do not require its proper
functioning. Simultaneously, using direct instruments means that the basic principles of free
enterprise and competition are curbed considerably. As these instruments do not act through the
money market, their application can be contra-productive, because they can throw the economy off
balance. If the central bank is linked to the political power centre, then direct instruments can
become exponents of economic dictatorship. That is why their application is minimized in modern
market economies.
On the other hand, direct instruments can be perceived as an appropriate way of controlling
monetary policy in a situation, when the money market does not work. A typical situation of this
kind is the period of economic transformation. The previous chapters dealt with establishment of a
two-tier banking system and emergence and revival of the money market. At the outset of economic
transformation the central bank was incorporated into the monetary system, in which commercial
banks were anchored as new institutions. The money market based on freedom of choice and
competition slowly began to function and was purposefully cultivated especially on the lowest
level, i.e. between commercial banks and their clients (firms and households), and step by step
among commercial banks. However, the mechanisms of such money market were still limited and
imperfect, the market was prone to panics, rational behaviour of agents and their experience were
not sufficiently developed, their expectations failed, etc. In this situation the relationship
between the central bank and commercial banks was not built on market principles and the only
effective way of controlling the money market by the central bank, as an alternative to the
previous directive monetary plan, was to implement direct instruments. Implementation of direct
instruments in such a period is appropriate and appears to be the only effective method how to
control the imperfect money market. Direct instruments can be complemented with indirect
instruments until institutional framework for a functioning money market has been developed. Then
direct interventions can be phased out. Direct instruments can be divided into several groups.

Prudential rules
§principal instrument of banking supervision
§short-term, low-interest deposits should not be used to provide long-term, high-interest loans
§can be focused on money market regulation: selectively set for different banks, or purposefully
changed after some time
§result - banks can provide higher or lower volume of credit to their clients, which raise or lower
quantity of money in the economy

One of the primary functions of the central bank is to supervise the banking sector. A principal
instrument of the supervision is setting prudential rules for banks. The rules are based on
international records of the Basle Committee on Banking Supervision[1]. The agreements require for
commercial banks a binding ratio between their liabilities (accepted deposits) and assets (provided
credits) in a certain time structure. In principle, short-term, low-interest deposits should not be
used to provide long-term, high-interest loans. Even if this practice is highly profitable, its
degree of risk is high. Prudential rules determine the maximum allowable ratio between long-term
assets and short-term liabilities.  The purpose of the measure is to reach a balance between
profitability and degree of risk so that the stability of the entire banking sector may not be
jeopardized. The instrument is implemented in this manner in all modern market economies.
Prudential rules can be also used as a direct instrument of monetary policy focused on money market
regulation in such a way that the rules are selectively set for different commercial banks, or are
purposefully changed after some time. As a result, commercial banks can provide higher or lower
volume of credit to their clients, which raise or lower quantity of money in the economy. Thus the
central bank can thus reach a change in behaviour on the money market, without entering the market.
[1] for more detail see [Revenda, 2001]

Loan quotas
§the hardest directive provision
§maximum volume of funds, which a  commercial bank can provide to one client
§sum of funds over a certain period to all its clients
§result - limited free entrepreneurial behavior of banks and strongly affected the money market and
the whole economy

One of the hardest directive provisions of the central bank is to implement loan quotas. Their
principle is that the central bank determines the maximum volume of funds, which a  commercial bank
can provide to one client or  a sum of funds over a certain period to all its clients. The quotas
can be the same for all banks or they can be selective. In any case they severely limit free
entrepreneurial activities of banks and at the same time strongly affect the situation on the money
market and the whole economy in general. Implementation of this instrument differs from the
distribution of credits based on the central plan in the monobank by the fact that the central bank
allows commercial banks to decide, whom to grant the credit  – it dictates only its volume. A
comparatively softer provision is so-called relative quota, which means that the central bank
determines the maximum allowable volume of credit, which the bank itself is going to grant to a
single commercial bank in its function of bankers’ bank.

Limits on interest
§direct setting of private credits´ interest rate by the central bank
§limited entrepreneurial freedom of both commercial banks, and their clients
§result - strong and quick impact on interest rates in the economy

Monetary policy management is principally based on reaching a certain required, equilibrium price
of money on the money market, i.e. a certain interest rate. The central bank reaches this interest
rate indirectly by means of interventions on the money market and by changes of supply and demand
for money from commercial banks. The interest rate can be targeted directly without any own
activities by ordering commercial banks to grant loans and/or accept deposits at particular
interest rates or it sets a margin (band) of the rates or sets their floor or ceiling. Thus the
central bank can grossly interfere with entrepreneurial freedom of both commercial banks, and their
clients. However, it meets its objective very quickly.

Gentlemen agreements
§between the central bank and commercial banks from an urgent request to recommendation
§commonly used in modern market economies - fulfilling is not legally binding
§together with the other direct instruments form a powerful tool
§

The last category of direct instruments is gentlemen’s agreements between the central bank and
commercial banks. The agreements include anything ranging from an urgent request to
recommendations, through which the central bank stimulates commercial banks to certain activities
or behaviour. The behaviour of the central bank must be strictly distinguished from the behaviour
of the leading bank in the monobank system – in that case commercial banks were really centrally
controlled under the former legal system. Gentlemen’s agreements are commonly used in modern market
economies, but fulfilling the wishes of the central bank is not legally binding. Hardly any
commercial bank, however, dares to openly resist expressed wish of the central bank. On the other
hand, the central bank should not misuse the informal powers. In the transformation process
gentlemen’s agreements were frequently used as an instrument motivating for building up a desirable
banking sector structure.

Indirect instruments
§based on central bank’s actions on the money market
§very well functioning money market is required
§using need not be successful and exactly predictable
§absolutely consistent with market economy: full sovereignty, free enterprise and free competition
of commercial banks are ensured
Within a developed market economy just indirect instruments can and must be used.

Central bank’s indirect instruments are the opposite of direct instruments in the sense that their
action is directly determined by the existence of a functioning money market. Therefore indirect
instruments include behaviour of the central bank with which it enters the money market in its
function of bankers’ bank and currency issuer. The central bank tries to change the behaviour of
commercial banks on the money market with help of indirect instruments and change the price of
money, i.e. interest rate in such a manner that it itself behaves as a subject of the market. Using
indirect instruments need not be successful, and it is not exactly predictable if the selected
objective will be met. Moreover, the central bank often has to bear the costs incurred in using
indirect instruments. But their application is absolutely consistent with market principles; it
ensures full sovereignty of commercial banks, free enterprise and free competition. To reach its
objectives, the central bank usually uses several instruments at the same time. Implementation of
individual instruments also brings some side effects into economy and by a suitable combination of
several instruments the central bank can more effectively attain its given objective. Indirect
instruments can be divided into several groups.

Discount rate
§the principal rate of interest of the central bank
§the price of money charged by the central bank to commercial banks on loans
§related to the central bank´s functions a bankers’ bank, and a lender of last resort
§great signalling importance

Discount rate is the principal rate of interest of the central bank and in general it is the price
of money charged by the central bank to other commercial banks on loans. It is related to the
function of the central bank, which acts as a bankers’ bank and a lender of last resort. A rise in
the discount rate curbs the demand of commercial banks for loans from the central bank and vice
versa.  Reactions of commercial banks to discount rate movements hinge on[1] the dependence of
commercial banks on loans from the central bank, on the possibilities to get credit from other
commercial banks or foreign agents, and on the possibilities of commercial banks to transfer the
rise in discount rate to their clients by increasing the interest rates on provided loans. Changes
in the discount rate have a great signalling importance. Banks and economic agents in general are
thus informed about the future character of monetary policy (i.e. whether the central bank tightens
or softens monetary policy) and they adjust their expectations accordingly. A great influence on a
change in expectations has even a mere announcement that the central bank is going to change the
discount rate. In modern market economies the discount rate is not the price of current funds
provided by the central bank, but the price of a emergency credit, which should ward off liquidity
problems of a commercial bank. Commercial banks are obliged to seek additional funds on the
inter-bank market at market interest rates. The discount rate is usually the lowest interest rate
in economy and all other interest rates move above it and are influenced by it indirectly. The
effect of movements of the discount rate is shown in Diagram 15.
[1]  [Revenda, 2001]

central bank´s
discount rate
RISE
commercial bank´s credit capacity
DECLINE
commercial bank´s supply of credits
DECLINE
money supply in economy
DECLINE
inflation
DECLINE
economic growth
DECLINE
employment
DECLINE
balance of payments
INFLOW

Lombard rate
§the rate of „Lombard credit“
§central bank provides credit to commercial banks against collateralised security (i.e. state
bonds)
§common source of commercial banks´ funds
§related to the central bank´s functions a bankers’ bank

Lombard credit is provided against collateralised security. In modern market economies it is a
common source of funds provided by the central bank to commercial banks. As a collateral are
accepted only state securities, i.e. those with zero risk. Lombard credit is provided at a set
interest rate, which is specified and announced by the central bank as its Lombard rate. It is
usually higher then the market short-term interest rate on the inter-bank market. If the Lombard
credit were cheaper than the market one, commercial banks would tend to use funds from Lombard
loans for speculation on the financial market and the central bank would be pushed into “Lombard
trap”. Lombard credit mainly acts as an issue instrument, complements sources of funds of
commercial banks. Effects of change in the Lombard rate on the economy are shown diagrammatically
in Diagram 16.

central bank´s
Lombard rate
DECLINE
commercial bank´s credit capacity
RISE
commercial bank´s supply of credits
RISE
money supply in economy
RISE
inflation
RISE
economic growth
RISE
employment
RISE
balance of payments
OUTFLOW

Repo rate
§central bank purchases state bonds to commercial banks with the obligation of repurchas at a
specific time with the interest - repo rate
§central bank provides commercial banks with sufficient liquidity
§very efficient and operational for regulating market interest rates
•
Øeffect of change in the repo rate is similar to that of change in the discount or Lombard rates

A specific instrument that is based on a perfectly functioning money market is called
repo-operations  (repurchase agreements). Their objects are the securities accepted by the central
bank (i.e. government bonds), which the central bank purchases with the obligation of the selling
commercial bank that they will be repurchased at a specific time with the interest that is given by
the announced repo rate. Repo tenders are agreed for standard periods of time and the central bank
declares e.g. one-week, two-week etc. repo rate. In this way the central bank provides commercial
banks with sufficient liquidity. To decrease the money supply, the central bank uses reverse repo,
which means that the seller is the central bank and agrees to buy the securities back at a
specified time along with the interest given again by the announced repo rate. Repo became a widely
used instrument because of its operativeness and universality both for influencing commercial
banks´ liquidity and for regulating market interest rates. The effect of change in the repo rate is
similar to that of change in the discount or Lombard rates (see Diagram 15 and 16).

Open market operations
§purchasing and selling of state bonds by the central bank on the money market
§raise or lower the money supply directly
§central bank has to keep the securities in its portfolio
§standard financial market + a sufficient volume of adequate securities are requested

Open market operations are a term denoting purchasing and selling of state securities by the
central bank on the money market. The principle of their function lies in influencing credit
capacity of banks. By purchasing state securities, the central bank increases the credit capacity
and liquidity of commercial banks (supplies the economy with additional funds). By selling state
securities, the central bank lowers the credit capacity and liquidity of commercial banks
(withdraws surplus money from the economy). Hence it is the instrument that directly raises or
lowers the money supply. Efficiency of open market operations depends on concrete conditions in an
economy. The central bank need not have in its portfolio the securities, which the banking sector
would be willing to purchase in sufficient volumes. In that case the central bank is obliged to
issue its own securities (treasury bills) and by doing so commit itself to provide debt servicing –
paying out any accrued interests. A condition for smooth functioning of open market operations is
the existence of standard financial markets and of course a sufficient volume of adequate
securities. Open market operations are linked with the above problem of financing government
deficit by loan from the central bank, if the central bank purchases state securities directly from
the government instead from commercial banks. As mentioned earlier, law in most market economies
prohibits the direct purchases. The effect of open market operations is schematically indicated in
Diagram 17.

central bank´s
open market op.
PURCHASE
commercial bank´s credit capacity
RISE
commercial bank´s supply of credits
RISE
money supply in economy
RISE
inflation
RISE
economic growth
RISE
employment
RISE
balance of payments
INFLOW

Minimum reserves requirement
§percentage from clients’ deposits - commercial banks have to keep it at cental bank´s account
§management of liquidity in commercial banks with the aim to provide security and functioning of
the banking system
§long-term stability and a low level in  developed market economies
§frequent changes during transition + gradual lowering to the level common in market economies

The main purpose of minimum reserves requirement is to regulate liquidity in commercial banks with
the aim to provide security and functioning of the banking system. Minimum reserves requirement is
determined as a percentage from clients’ deposits with commercial banks. Thus they represent
compulsorily created receivables of commercial banks with the central bank that are usually
interest-free.  In the commercial bank’s balance it is one of the items of assets, in the central
bank’s balance it belongs among one of the important items of liabilities. The main advantage of
minimum reserves requirement is that it acts uniformly and very efficiently on all banks. Their
biggest disadvantage lies in the low operativeness: the rate changes of minimum reserves cannot
finely tune monetary policy. Therefore, they are adopted especially in unstable periods, when the
raised rates ensure stability and liquidity of the banking system. Changes in rates of minimum
reserves are thus usually linked with regulation of behaviour of the banking system as a whole
rather than with controlling the monetary policy. A long-term stability and a low level of minimum
reserves requirement are typical of standard market economies. On the contrary, changes in the
minimum reserve requirements are relatively frequent during transformation process and there is a
trend towards their gradual lowering to the level common in market economies. Effects of minimum
reserves requirement on the economy are schematically shown in Diagram 18.

central bank´s
rate of MRR
RISE
commercial bank´s credit capacity
DECLINE
commercial bank´s supply of credits
DECLINE
money supply in economy
DECLINE
inflation
DECLINE
economic growth
DECLINE
employment
DECLINE
balance of payments
- NON -

Use of monetary policy instruments
 Stage of the SBČS 1989 - 1992
§limits on interest
§loan quotas
§„re-financing credits“ - non-standard loans to help to big state-owned banks
§minimum reserves requirement
§
no money market + no competition in the banking system = the SBČS used mostly direct instruments:

The use of individual monetary policy instruments matched the possibilities, which the central bank
had with regard to its position in the banking system and the economic situation. In summary it can
be stated that the SBČS used mostly direct instruments, while the CNB since 1993 indirect ones. The
non-existence of the money market and competition in the banking system forced the SBČS to
implement limits on interests and credit ceilings. In the first years of economic transformation
the SBČS implemented refinancing credits enabled commercial banks a relatively easy access to
credit. Refinancing credit for 1 - 3 months was provided in the form of an auction at the market
interest rate. Banks that did not succeed in the auction could get refinancing credit for 1 - 7
days at the a priori declared fixed interest rate derived from the discount rate. The amount of
this credit, however, could not exceed the double of the commercial bank’s capital. Refinancing
credit were non-standard instruments of monetary policy, whose use was enforced by the situation on
the money market at the beginning of transformation. Gradually the SBČS and later the CNB adopted
the use of standard indirect instruments and refinancing credits were abolished. The CNB was
established as a standard central bank and that is why it used standard, indirect instruments. It
was made possible by already functioning market environment of the banking system and functioning
money market. The CNB resorts to non-standard measures only in its function of banking supervision
and regulation, if it intervenes in a concrete case. Repo tender, discount and Lombard rates, open
market operations and minimum reserves requirement gradually became principal monetary policy
instruments:

Stage of the ČNB from 1993
§repo rate - two-week repo tender is announced daily
§discount rate - overnight deposit at the ČNB
§Lombard rate - marginal lending facility from the ČNB
§open market operations - fine-tuning interventions on money market or foreign exchange market
§minimum reserves requirement – a "cushion" ensuring the smooth functioning of the banking system
standard central bank + standard money market = the ČNB used standard, indirect instruments:

·        The main monetary instrument is the two-week repo tender. The two-week repo tender is
announced daily and commercial banks may come with bids. Because of the systemic liquidity excess,
the repo tenders are for liquidity withdrawal. The two-week limit repo rate, set up by the CNB, is
the most important policy rate of the central bank. The supplementary monetary instrument is the
three-month repo tender. This is usually announced weekly, and the tenders are for liquidity
withdrawal as well.
·        The deposit facility is a non-collateralised overnight deposit with the CNB that any Czech
bank may place, provided it applies for it not later than 15 minutes before the end of the
accounting day at the CNB's clearing centre. The rate used for these deposits is the discount rate.
The marginal lending facility is and collateralised overnight repo that any Czech bank may use to
borrow from the CNB, provided it applies for it not later than 25 minutes before the end of the
accounting day. The rate used for this facility equals the Lombard rate. Because of the nature of
the automatic facilities, the discount rate and the Lombard rate create and corridor (setting the
floor and ceiling) for the two-week repo rate and hence for the very short-term money market rates.
·        The CNB may, at its discretion, initiate several fine-tuning interventions on money market
or foreign exchange market buying or selling securities – state bonds. The CNB may from time to
time issue its own short-term securities (treasury bills), which may be used as eligible collateral
in its own operations or in commercial bank operations.
·        Apart from these instruments, the CNB also makes use of and minimum reserves requirement.
The role of the minimum reserves requirement as a monetary policy instrument is low at present.
However, the funds deposited by banks on non-interest bearing accounts with the CNB to meet the
requirement serve as and "cushion" ensuring the smooth functioning of the banking system.
An overview of using various types of monetary instruments in different transformation stages is
summarized in table 22.

Price developement
* Stormy price development at the begining of inflation
* Increasing inflation differential
–1991-2000: inflation in CR nine times higher than in Germany
* 1991-1993: Price liberalization, currency separation, new tax system
* 1994-2001: demand growth, deregulation
–1994-1997: inertial inflation
–Since 1998: desinflation process
–

Monetary policy strategy in Czechoslovakia / Czech Republic

Conception of monetary policy objective
•Clear targeting of low inflation was not possible at the beginning of the transition:
1.money market did not exist
2.extensive price liberalisation was on process
3.
Objective was changing during the transition according to the needs and possibilities of the
economy.

The conception of monetary policy objective was changing during the transformation process
according to the needs and possibilities given by the shape the national economy was in. As early
as in 1989 monetary policy targeting was abandoned, as it was based on the uniform mechanism of the
central plan, which was only politically motivated. However, the central bank could not switch to
unambiguous targeting of price level stability, due to the state of Czechoslovak economy, its
institutional structure and with respect to the state of the banking system. Two reasons existed
for it: (i) the money market did not function and so the central bank (SBČS) could not base its
monetary policy strategy focused on price stability and above all (ii) price stability could not a
priori be maintained, since the process of far-reaching price liberalization was launched at that
time. Price liberalization was based on comparing the pressure of supply and demand on the markets
and was accompanies by a vast price increase. Although prices of a number of services and goods
were still regulated and were freed only gradually, the inflation rate attained the order of tens
of percent. The price growth in that situation was a necessary associated phenomenon of the
emerging market economy and could not be anyhow eliminated. The aim of monetary policy was not to
target a certain inflation rate but simply prevent the one-off price shock from getting out of
control to degenerate into the inflationary spiral. In the early years of transformation the
central bank’s task was to maximally soften inflationary pressures resulting from price
liberalization and gradually stabilize the inflation rate. The proper objective of the SBČS was a
fixed exchange rate of Czechoslovak crown anchored in the composite of west-European currencies and
the US dollar (for more detail see chapter XXX). The strategy proved successful, the inflation
stabilized rather quickly and fell to the level of 10% p.a.

Fixed exchange rate   –  1989 - 1996
§the monetary policy´s target was not a certain rate of inflation
§prevent of price shock at the beginning of the liberalization
§exchange rate of the Czechoslovak koruna was fixed - anchored in the composite of west-European
currencies and the US dollar
•
•Þ strategy proved successful, the inflation stabilized rather quickly and fell to the level of 10%
p.a.

The conception of monetary policy objective was changing during the transformation process
according to the needs and possibilities given by the shape the national economy was in. As early
as in 1989 monetary policy targeting was abandoned, as it was based on the uniform mechanism of the
central plan, which was only politically motivated. However, the central bank could not switch to
unambiguous targeting of price level stability, due to the state of Czechoslovak economy, its
institutional structure and with respect to the state of the banking system. Two reasons existed
for it: (i) the money market did not function and so the central bank (SBČS) could not base its
monetary policy strategy focused on price stability and above all (ii) price stability could not a
priori be maintained, since the process of far-reaching price liberalization was launched at that
time. Price liberalization was based on comparing the pressure of supply and demand on the markets
and was accompanies by a vast price increase. Although prices of a number of services and goods
were still regulated and were freed only gradually, the inflation rate attained the order of tens
of percent. The price growth in that situation was a necessary associated phenomenon of the
emerging market economy and could not be anyhow eliminated. The aim of monetary policy was not to
target a certain inflation rate but simply prevent the one-off price shock from getting out of
control to degenerate into the inflationary spiral. In the early years of transformation the
central bank’s task was to maximally soften inflationary pressures resulting from price
liberalization and gradually stabilize the inflation rate. The proper objective of the SBČS was a
fixed exchange rate of Czechoslovak crown anchored in the composite of west-European currencies and
the US dollar (for more detail see chapter XXX). The strategy proved successful, the inflation
stabilized rather quickly and fell to the level of 10% p.a.

Controlling the quantity of money – 1993 - 1996
§the Act of ČNB changed the objective:  “to maintain stability of currency“
§external stability related to exchange rate stability
§internal stability related to price level stability
§
•Þ it failed to decrease the inflation rate to the EU average level
•Þ quantity of money wasn’t maintained on the planned level due foreign capital inflows

A certain breakthrough in the direction of monetary policy was the establishment of the Czech
National Bank in 1993. The objective of CNB’s monetary policy was laid down by the Constitution of
the Czech Republic and the Act on the CNB and it was worded as “to maintain currency stability“.
Monetary stability had an internal and an external dimension: (i) the internal stability related to
price level stability, while (ii) the external stability related to exchange rate stability of the
Czech koruna. The CNB’s principal objective in this period was (i) to minimize the inflation rate
and (ii) to maintain the fixed exchange rate declared at the beginning of transformation. It
executed disinflation policy by controlling the quantity of money in circulation, maintained
exchange rate stability by trading on the foreign exchange market. The purpose of this monetary
policy strategy was to utilize good experience with the fixed exchange rate as a price level
stabilizer. Besides, by means of controlling the quantity of money in circulation, to decrease the
inflation rate, which in the mid-90s oscillated permanently round 9 – 10% p.a. Although the CNB
tried to meet the set objectives conscientiously and risked an open conflict with the government,
it failed to decrease the inflation rate to the target level that equalled average EU inflation.
The main reason was that CNB did not succeed in maintaining the quantity of money in circulation on
the planned level: the money supply increased every year at a higher rate due foreign capital
inflows. That is why the inflation rate continued to be relatively high.

Direct inflation targeting - from 1998
§under the pressure of foreign capital outflow the fixed rate was left in May 1997
§the concept of nominal anchor had to be abandoned
§targeting of quantity of money was not very successful so far
•
•Þ The ČNB specified short-term and medium-term stages, during which it tried to squeeze the
inflation within the set limits.
•

A significant turning point in the conception of monetary policy objective came in 1997 after
monetary turbulences, when the CNB, under the pressure of foreign capital outflow, was obliged to
abandon the fixed rate of the koruna and went floating (for more detail see chapter XXX). Thus it
abandoned the concept of nominal anchor, on which monetary policy had been based since the
beginning of transformation. Because targeting of quantity of money was not very successful so far,
termination of the fixed rate meant a marked worsening of the central bank’s ability to control
inflation. The CNB therefore decided to completely change its monetary policy strategy and switched
to direct inflation targeting. It signified that the CNB made an obligation to target a particular
explicit inflation rate during a particular concrete time horizon. In practice it implied that the
CNB specified short-term and medium-term stages, during which it tried, by means of its indirect
instruments, to squeeze the inflation within the set limits. Table 19 indicates direct inflation
targets set by this method.

the first targets:
Target month
Target level
Set in
December 1998
5.5% – 6.5%
December 1997
December 1999
4% – 5%
November 1998
December 2000
3.5% – 5.5%
December 1997
December 2001
2% – 4%
April 2000
December 2005
1% – 3%
April 1999

Net inflation
•Problem:
•in 1998, more than 18% of goods and services had administratively regulated or controlled prices
§
§inflation target was related to net inflation = movement of prices of the goods and services,
whose prices were set freely by the free market
§the ČNB was not responsible for the inflation caused by a government’s decision to raise some
regulated prices
§the ČNB was responsible only for the inflation caused by market forces
§

When direct inflation targeting was implemented in 1997, price liberalization had not been finished
yet and a number of goods and services had administratively regulated or controlled prices (more
than 18% items of the consumer basket). That is why the direct inflation target was not related to
headline inflation but only to net inflation. Net inflation represented movement of prices of the
goods and services, whose prices were set freely by the free market. Net inflation was calculated
by excluding from the consumer basket all the items, whose price was not set by the market – they
are shown in Table 20. The purpose of this measure was that the CNB was not made responsible for
the inflation caused by a government’s decision to raise some regulated prices, but it was
responsible only for the inflation caused by market forces. It was only this inflation that could
be influenced by its instruments.

calculation of the net inflation
A. Items with maximum prices
Constant
weight in %
a) set by the Ministry of Finance of the Czech Republic

net rent for rental flats
1,6531
electricity
2,5249
gas
0,9589
medicine and health care output
0,6734
passenger railway transport
0,2081
telecommunication services – telephone
0,7605
b) set by local authorities

municipal public transport
0,7716
parking services
0,0171
taxi services
0,0295

B. Items with prices regulated on and cost-plus basis

water and sewerage
0,9867
heating for households
3,0174
bus transport
0,6899
postal services
0,1163
telegraph
0,0121
propane-butane gas
0,1464
household waste disposal
0,2744
housing-related services for rental flats
0,2495
housing-related services for co-operative flats
0,1131
supplementary educational services (student fares)
0,1785

C. Fees

health insurance
3,4783

mandatory insurance of motor vehicles
0,4099

motor vehicle owner registration
0,0196
radio and TV fees
0,8155
signature authentication
0,0629
divorce application fee
0,0154
dog ownership fee
0,0247
postal order C
0,0354
building permit issuance
0,0808
Total
18,3239

Headline inflation
§the rate of inflation dropped significantly
§progress in price liberalization
§the headline inflation has a higher informative value
•Starting from 2002, the ČNB switched to direct targeting of headline inflation:

The new strategy of targeting of monetary policy proved successful in the sense that the rate of
inflation really dropped significantly. Its negative feature, however, was a considerable inflation
rate fluctuation, which is attributed to a still relatively short market history of Czech economy.
To overcome these problems, the CNB, starting from 2002, switched to direct headline inflation
targeting. It was made possible by further progress in price liberalization. Targeting of headline
inflation has a higher informative value and the CNB increased transparency of this system by
setting the inflation target in the form of a continuous band, instead of using irregular intervals
for declaring the net inflation (see Table and Diagram 21).

Prices in CPE
* Deformation of price levels
* Domestic prices set directively from centre
* Because of low interaciton with then rest of the world – different price development
–Crude oil
* Conservative monetary policy
–Low inflation X high inflation in PL and HU

Inflation rates in socialistic Czechoslovakia
Inflace-socialismus


Price liberalization
* Key element of transition
–Necessary condition for the introduction of the market mechanism
–During CPE prices did not reflect the cost of production nor value to the consumers
* Liberalization = change of relative price = improvement in resources allocation
* Also redistribution = winners and losers

Price liberalization
* Several partial measures during 1990
–Removing the subsidies for food
–Petrol prices
* Big one-off liberalization – 1.1.1991
–Result: cca 80% of prices were free
–Some prices administratively set or controled
–Subsidies gradually reduced

Results of liberalization
* No more queues in shop
* Increased availability of goods
* Increased efficiency
* Reduction of social wasteful activities
* Drop in real wages
–Improvement of competitiveness of firms
–Harmfull mainly for low-income households
–Some privileged classes droped in social status and income
* Increasing earning differential

CPI monthly development
CPI


Real wage development 89-94
realne mzdy


Inflation 1992-1993
* Forced savigs from CPE – increased comsumption – demand growth – price increase
* 1993 – split of Czechoslovakie
–onother inflation jump
* New tax system
* Introduction of VAT (previously turnover tax)
* Growth of wages supported by growth of productivity = boost of demand
* Monetary restriction – aim acceptable inflation and stable ER
*

Year-to-year chance of domestic demand and GDP (%)
HDP a D


GDP development
*
GPD po 1993

Inflation after 1993
* Low dymanic of changes
–Inflation still higher then in developed countries (1% per month)
–Inflation differential
* Further lowering unsuccessful
–Expectations (collective bargaining)
–Downward price rigidity
–Short-term inflow of foreign capital
* More money in economy – against restrictive MP
*
–
–

Inflation differential
InflacniDifer


Cumulative incerase of consumer prices
InflacniDifer2


Monetary crisis - 1997
* Growth of demand higher than growth of GDP
–Deficit of CA
* Financed by inflow of „hot-money“
* 1997: lost confidence in fixed ER
*  Decrease of inflation in first months
–Econonimc slowdown
–But increase of import prices
–Incerase of energy prices

Nominal exchange rate
nominkurz


Balance of payments
PB


Current account of BP/GDP (%)
BU PB a HDP


Drop of inflation
* Change of monetary strategy
–Inflation targeting
* Economic slowdown
* Slowing down deregulation
* Drop of import prices
* Strong decrease of inflation
–

Consumer prices 1994-2000
Inflace-úp1994


* This is the end…