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Role of Central Banking

Chapter 4 Part 1

1. Functions of Central bankThe need for a central bankShould central bank be independent from governmentMonetary policy functions of a central bank

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Theory of Central Banking

Introduction

• What are monetary policy functions of a central bank?

• Why do banks need a central bank?

Central bank – financial institution responsible for overseeing the monetary system for a nation or group of nations with the goal of fostering economic growth without inflation.

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1. Controls the issue of notes and coins (legal tender)

2. Power to control the amount of credit money created by banks (money supply).

3. Have control over non bank financial intermediary that provides credit.

4. Effectively use the relevant tools and instruments of monetary policy

a. credit expansion b. liquidity c. money supply of an economy

Functions of Central Bank

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5. Oversee the financial sector to prevent financial crises

a. Protect depositors b. Prevent wide-spread panic withdrawal c. Prevent damage to economy due to

collapse of financial institutions.

Functions of Central Bank

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6. Act as government banker a. Holds governments bank accountb. Performs traditional banking operations for

the government.c. Manage and administer country's national

debt

7. Official agent to government in dealing with gold and foreign exchange matters

8. Governments reserves of gold and foreign exchange are held at the central bank.

Functions of Central Bank

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Major forms of economic policy

1. Monetary Policy

2. Fiscal Policy

3. Exchange rate policy

4. Prices and income policy

5. National debt management policy

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Changes in the Money Supply available in the economy

Expansionary Policy

Contractionary Policy

Monetary PolicyMonetary Policy

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Main policy tools used to influence

a. Interest Rate

b. Inflation

c. Credit availability

Monetary PolicyMonetary Policy

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Objectives of Monetary Policy

a. High Employment -not zero employment

b. Price stability - Rising price level creates uncertainty and creates adverse affect in the economy

c. Stable economic growth – increases living standard of the population

d. Interest rate stability – Volatility in the interest rate creates uncertainty about the future and create adverse impact on business and consumer

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Objectives of Monetary Policy

e. Financial market stability – Impact of financial crises

f. Stability in foreign exchange markets – increase or decrease the value of currency which could lead to inflation

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Central banks monetary operations

• Open Market Operations

• Discount Windows

• Reserve Requirements

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Debt Securities and Open Market Operations

• Debt securities represented by Treasury securities (govt. debt)

• Central banks use it in open market operations

• Purchases or sells govt. debt to bank and non bank.

• Sells – Increase Money Supply in the market

• Buys – Decreases Money Supply in the market

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Debt Securities and Open Market Operations

MS increases - Interest rate falls – More MS in the economy creates competition from banks to provide credit facilities

MC decreases – Interest rate increases – Less money supply to provide credit facilities

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Loans to banks and Discount Window (Discount Rate)

• Instrument that allows eligible banking institutions to borrow money from central bank

• Usually to meet short term liquidity needs.

• Higher DR – Lower the amount of funds that banks can borrow – Interest rate increases

• Lower DR – Higher the amount of funds banks can borrow – Interest rate decreases

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Reserve Requirements

Banks need to hold quantity of reserves for prudential purposes.

Generally expressed in percentage term as Required Reserve Ratio

Higher Required Reserve – Lower the amount of funds available to the banks

Lower Required Reserve – Higher the amount of funds available to the banks

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Reserve Requirements

• Strong influence on the money supply

Reserve Requirements

Higher RequiredReserve – Lower the amount of funds availableTo banks

Lower - RequiredReserve – Higher the amount of funds availableTo banks

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Other Instruments

1. Special Deposits – Deposits banking institutions had to make at Central Bank

b. Supplementary special deposits depends on the extent of the economy.

c. No interest payments for special deposits.

d. Main Objective – to remove excess liquidity if bank deposit growth is increasing too rapidly.

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Other Instruments

2. Moral Suasion - Informal requests and pressure Central Bank may exert over banking institutions.

- Involves institutions having to take actions which might not in the banks interests.

- Power of central bank is one effective method

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Other Instruments

3. Direct Controls - Issuing directives to attain particular immediate targets.

Example: Impose controls on interest rates payable on deposits.

Directs bank to prioritize lending according to various types of customers.

May limit the volume of credit creation

Widely used in many developing countries where central bank may force bank to lend to certain priority sectors.

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Portfolio Constraints

Limit the banks portfolio

Discrimination against banks

Unable to generate alternative source of funds

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Portfolio ConstraintsLess widely used in developed world

a. Defining and implementing portfolio constraints would be difficult in an open economy

b. Domestic borrowers have greater scope to seek funds from overseas.

c. Restriction on business freedom

d. Restriction on growth of banks

e. Markets distorted

f. Economic efficiency tends to be undermined

g. Need to influence all relevant parts of the financial system

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Why do banks need central bank?

• Provides reserves to banks experiencing serious financial problems

a. Sudden withdrawal of funds by depositors

b. Encourage bankers to undertake due risks and operate prudentsly

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Central Banks

• The Bank of England

• The European Central Bank

• Federal Reserve Bank

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The Bank of England

Established in 1694

1946 – The bank was nationalised and formally recognised as a Central Bank

1998 – Bank of England act – Bank was granted operational independence.

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Objectives & Functions of Bank of England

a. Maintaining the integrity and value of the currency

b. Maintaining the stability of the financial system domestic and international

c. Seeking to ensure the effectiveness of UK’s financial services industry.

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Responsibility of Bank of England

• The development of a robust financial sector• Safe and efficient payment and settlement

arrangements• Appropriate legal regime• Effective disclosure requirements• Sound principles for prudential regulation• Monitoring current developments in domestic

and international financial system• Efficient means of financial crisis

management

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European Central Bank

Tasks1. Define and implement monetary

policy for the Europeans2. Conduct foreign exchange operations3. Hold and manage the official reserves

of the European countries4. Promote smooth operation of

payment systems

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Federal Reserve Bank

Central bank of the United StatesStructure of FED• Board of directors• Federal Reserve Banks• Federal Open Market Committee• Board of Directors• Member banks

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Functions of FED

• Monetary Policy• Supervision and regulation• Financial Stability• Services to US government