Post on 05-Apr-2018
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Principles of Banking and Finance
Part 5
Introduction
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Introduction to Banking
Chapter 5
1. What are the mainfunctions of centralbanks?
2. What are the monetaryfunctions of a centralbank?
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I. Learning Objectives:
To understand the crucial role of central banks infinancial sector.
To describe the main functions of the central bank.
To understand the monetary policy functions ofcentral banks
To understand the arguments put forward by the
free banking theorists.
To discuss the arguments for and against anindependent central bank.
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II.Lecture/DiscussionDefinition of Some important TermsA. Main Functions of Central Bank:
It controls the issue of notes and coins (legal
tender).
It has the power to control the amount of credit-
money created by banks. It has control over non-bank financial
intermediaries that provide credit.
It uses relevant tools and instruments of monetary
policy in order to control: credit expansion,
liquidity, and the money supply of an economy.
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5. Oversees the financial sector in order to
prevent crises and act as a lender-of- a- last-
resort in order to protect depositors, prevent
wide spread panic withdrawal.
6. A central bank acts as the governments banker.
7. It acts as the official agent to the government in
dealing with all its gold and foreign exchange
matters.
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a. How does monetary policy work?
1. Monetary Policy- it is concerned with the
actions taken by central banks to influence the
availability and cost of money and credit by
controlling some measure of the money supply
and or level and structure of interest rates.
2. Fiscal Policy- relates to changes in the level
and structure of government spending and
taxation designed to influence the economy.
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3.Exchange Rate Policy
-involves the targeting of a particularvalue of a countrys currency exchangerate thereby influencing the flows within
the balance of payments.
4.4.Prices and Income Policy- is intendedto influence the inflation rate by means ofeither statutory or voluntary restrictionsupon increases in wages, dividends, and
or prices.
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5.National Debt Management Policy
-is concerned with the manipulation of the
outstanding stock of government debt
instruments held by the domestic private
sector with the objective of influencing thelevel and structure of interest rates and or
the availability of reserve assets to the
banking system.
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The Concepts and Functions of Money
1.Medium of Exchange
2.Unit of Account
3.Store of Value4.Standard of Deferred payment
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Monetary Policy Objectives
1. High Employment- to increase the
level of employed people.
2. Price stability- price of basic
commodities does not fluctuate.
3.Stable economic growth- to alleviate
the standard of living of the population.
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4. Interest Rate Stability- interest rate on
banks does not fluctuate to encourage
investors.5. Financial Market Stability- it is
influenced by the stability of interest rates
for it can lead to increase or decrease ofthe value of bonds and other investment
6. Stability in Foreign Markets the
foreign exchange rate does not change.
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Monetary Policy Functions of Central Bank:
1. Debt Securities and Open marketoperations These are represented by
government treasury bills/securities.
The central bank operates in the market andpurchases and sells govt debt to the non-
bank private sector. The government can
influence the portfolio of assets held by private
sectors.
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The open Market operations
Instruments or
Tools of
Monetary Policy
1. Open market
Operation
If the Central Bank sells government
securities, the money supply decreases.
If the Central Bank buys government
securities, the money supply increases.
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2.Loans to banks and the discount flow
Discount window- is often referred to asstanding facilities . It is the instrument that
allows eligible banking institutions to borrow
money from the central bank, to meet shortterm liquidity needs. By changing the discount
rate (the interest rate) that monetary authority
are prepared to lend to banking system, the
central bank can control the supply of moneyin the system.
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The Discount Window
Instruments or Tools of Monetary Policy
2. Discount
Window
The higher the discount rate, the lower
The amount of funds that banks will
decide to borrow.
The lower the discount rate, the higher
The amount of funds that banks will
decide to borrow.
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3.Reserve Requirements
Reserve requirement- is officially imposed toeffectively monitor the banks capacity tocontinue its operation and to protect thedepositors.
- By changing the fraction of deposits that banksare obliged to keep as reserves, the centralbank can control the money supply. Thisfraction is expressed in percentage calledREQUIRED RESERVE RATIO
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3.Reserve Requirement
Instruments or Tools of Monetary Policy
3. ReserveRequirement
The higher the required reserve ratio,
The lower the amount of funds available
to the bank.
The lower the rate, the lower required
reserve ratio, the higher the amount
of funds available to the bank
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Other Instruments of Portfolio Constraint
1.Special Deposits- these deposits are equalto a specified proportion of certain elements of
of banks deposits liabilities, are then frozen
at the bank and may not be used as part ofthe reserve asset base for lending purposes.
-The main objective of special deposits is to
remove excess liquidity from the system if
bank deposit growth is increasing too rapidly.
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2.Moral Suasion
- It refers to the range of informal requests andpressure that the authorities may exert overbanking institutions.
- The extent to which this is real power of theauthorities relative to direct controls is open toquestion, since much of the pressure that theauthorities would exert involves the institutionshaving to take actions that might not be in thebanks commercial interest.
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3.Direct Control
-It involves the authorities issuing directives inorder to attain particular immediate targets.
-Example: the monetary authorities might
impose controls on interest rates payable ondeposits, may limit the volume of credit
creation or direct banks to prioritize lending
according to various types of customer.
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4.The decline in use of Portfolio Constraints
These are widely used for following reasons:
a. Deregulation and increasing competition in
the provision of financial services and
products traditionally offered by banks havebroadened.
b. Disintermediation, primarily involving large
companies has undermined portfolio
constraints.
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c. Most countries now maintained a system of
foreign currency exchange control.
d. Portfolio constraints are regarded as
unfavorable to competition because they
place restrictions of one kind or another, on
the business freedom and growth of banksand other intermediaries falling within the
constraints.
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Why do banks need a Central Bank?
-Central bank can be thought as super-banks at the center of financial system.
-it is responsible for both macro functionssuch as monetary decisions and micro
functions like the lender of last resort (LOLR)
to banking sector.
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As LORL- Lender of Last Resort
It is the role of the central bank to providereserves to the bank experiencing serious
problems due to either a sudden withdrawal of
funds by depositors or to a situation where thebank has embark on highly risky operations
and thus cannot find liquidity anywhere else.
-The central bank will provide loan to an
illiquid bank to prevent it failure.
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Liquidity- it relates to the banks ability of tomeet short-term obligations (expected andunexpected) . It has something to do also withits ability to convert its assets into cash when
they fall due.Solvency- is the ability of the bank to
ultimately meet its all obligations. It meansthat the value of assets are greater thanliability.
Relationship between Liquidity & Solvency
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Should Central Bank be Independent?
Central Bank Independence-it can be defined as independence from
political influence and pressures in the
conduct of its functions, in particular monetarypolicy.
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2types of Banks Independence:
1.Goal Independence- ability of the centralbank to set its own goals for monetary policy
like: low inflation, and high production levels.
2.Instrument Independence- ability of the
central bank to independently set the
instruments of monetary policy to achieve
these goals.