Central Banking & the Monetary Policy

Role of Central Bank

• Central bank plays a critical role in every transaction, business and daily activities, whether it is Economic activity or Individual activity (saving schemes or return matters)

• Central banks monitors the purchase and repurchase so that loss would not be there in the exchange rates.

Role of Central Bank• Central bank gives money to commercial banks

in the time of crises to avoid panic life situations in the markets.

• Reserves are just like savings help to fall back upon from difficult or contingent situations.

• Banks it self has no money , for this there are some legislations required, that are issued in the form of Prudential regulations by central Bank for determining credit policy.

Role of Central Bank• The central bank has a number of policy instruments that can

effect the major objectives of monetary policy:

– Stability of prices

– Stability of exchange rate

• Central banks can focus on:– Quantitative monetary policy: central banks regulate monetary

base

– Qualitative monetary policy: central banks regulate market interest rate and provide monetary base which respond to money demand

Objective of Monetary Policy

• To maintain price stability is the primary objective of the monetary policy. ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment.

Monetary Policy Instruments• The main monetary policy

instruments available to central bank is

• open market operation, • bank reserve requirement, • interest-rate policy, • re-lending and re-discount (including using

the term repurchase market), and • credit policy (often coordinated with trade

policy).

Monetary Policy Instruments

• Direct, administrative instruments:– Credit limits– Interest rates limits– Liquidity rules– Investment regulation

Monetary Policy Instruments

• Indirect, market instruments:– Open - Market Operations– Legal Reserve Requirements– Discount Rate Policy

Legal Reserve Requirements

• All banks are required to hold a minimum percentage of deposits as reserve. Changes in required reserve ratios can have an important influence on the money supply.

• Changes in reserve requirements are made sparingly because they present too large change in monetary policy.

Capital Requirement

• All banks are required to hold a certain percentage of their assets as capital.

• A rate which may be established by

the Central bank or banking supervisor.

Capital Adequacy

• Capital adequacy is important, it is defined and regulated by the Bank for International Settlements, and central bank in practice generally apply strict rules.

• To enable open market operations, a central bank must hold foreign exchange reserves.

• It will often have some influence over any official or mandated exchange rates: Some exchange rates are managed, some are market based (free float) and many are somewhere in between ("managed float" ).

Capital Adequacy

Reserve Requirement

• Another significant power that Central bank hold is the ability to establish reserve requirement for other banks.

• The other requirement is that a percentage of liability is being held as cash or deposited with the Central bank or other agency , limits are set on the money supply.

Discount Rate Policy

• Discount rate is the interest rate at which the central bank stands ready to lend reserves to commercial banks.

There are the three key interest rates for the banks: • The interest rate on the main refinancing operations.

• The rate on the deposit facility, which banks may use to make overnight deposits.

• The rate on the marginal lending facility, which offers overnight credit to banks .

Expansionary Monetary Policy

• When the central bank raises the money supply interest rates fall. The economy moves down the money demand schedule. Lower interest rates reduces the costs of investment; thus higher investment raises aggregate demand curve.

Tight Monetary Policy

• Central bank contracts the money supply in response to fears of rising prices. The lower money supply increases interest rates. The result of a tighter monetary policy is lower investment and decrease in the nation’s output.

The Monetary Transmission Mechanism

• The monetary transmission mechanism represents the way by which changes in the supply of money are translated into changes in output, employment, prices and inflation.

Exchange Rate

• Accordingly there are certain exchange requirements to influence the money supply ,some Central Banks may require that some or all foreign exchange receipts generally from exports be exchanged for the local currency ,the rate that is used to purchase local currency may be market based or arbitrarily set by bank.

Open - Market Operations

• Open-market operations represent purchases or sale of government securities and treasuries to influence the money supply.

• These operations are a central bank the most important stabilizing instruments.

• Open market operations serve the purpose of managing interest rate, the liquidity situation in the market and signaling the stance of monetary policy.

Open Market Operations

• Through open market operations, a central bank influences the money supply in an economy directly. Each time it buys securities, exchanging money for the security, it raises the money supply.

Open Market Operations

• Conversely, selling of securities lowers the money supply.

• Buying of securities thus amounts to printing new money while lowering supply of the specific security.

Open Market Operations• Temporary lending of money for collateral

securities ("Reverse Operations" or "repurchase operations", otherwise known as the "repo" market).

• These operations are carried out on a regular basis, with fixed maturity time periods.