CENTRAL BANKS

SB_FDI_EMProf. Dr. John JA Burke

Major Activities

Supervision of banking system Often not true

Monetary Policy Printing of notes and coins Banker to other banks Banker to government Raising money for government Controlling nation’s official reserves Lender of last resort International liaison

Government Bank

Central banks historically were bankers to governments Governments have financial needs of their

own Central bank occupies privileged position

It has monopoly over the money supply It controls the printing press

Central bank can control money in supply of economy

Activity of adjusting money supply is called “monetary policy”

Monetary Policy

Modern function Stabilise economic growth Control inflation

Expansionary policy Lower interest rates Raises both growth and inflation Puts more money into system

Restrictive Policy Raise interest rates Reduce money supply Contraction

Primary Reason to Create Central Bank

Ensure control over currency E.g., Collapse of Soviet Union

Central Bank of Russia controlled the money supply

Inflation rate in 1992 in ruble zone reached 1000% per year

Result Monetary system collapsed

Bankers’ bank

Guarantees that sound banks can do business by lending to them, especially in crises

Operate a payment system for interbank payments

Oversee financial institutions to ensure confidence As stated, Consolidated Financial Regulator

now performs this service Lender of last resort

Avoid runs on bank deposits

Objectives

Low stable inflation Inflation creates confusion and makes planning difficult High inflation/low growth

High Stable Growth Stable, predictable growth

Financial system stability Necessity for economy to run efficiently

Stable interest rates Interest rate volatility creates risks for lenders and

borrowers

Stable exchange rates Variable exchange rates make revenues from foreign sales

and cost of purchasing imported goods/services hard to predict

Central Bank Design

Independence To keep inflation law, monetary policy must

be free from political influence Decision making by committee

Pooling knowledge yields better decisions Accountability and Transparency

Held accountable to public Communicate objectives

Policy framework Clearly state policy and identify trade-offs

European Central Bank

Created in 1998 by Protocol entitled [But Treaty of Lisbon has amended Provisions] Statute of the European System of Central Banks and of the

European Central Bank Design

ECB in Frankfurt oversees monetary policy National Central Banks [NCBs] that belong to EU are members,

but not all equal ESCB

Eurosystem ECB plus NCBs that have EURO

ECB Executive Board 6 member body that implements policy

Governing Council 16 member committee that makes monetary policy for common

currency area

ECB: Treaty of Lisbon

Article 282 establishes the European Central Bank and the ESCB

Monetary Policy provisions are set forth in Articles 127 to 133 and 138

Article 283 Governing Council

Executive Board [Six members] Governors of NCBs that have EU European Council appoints members of the

Executive Board – Term of office 8 years not renewable

ECB: Treaty of Lisbon

Protocol Nr. 4 of the Treaty sets forth ESCB Statute

Primary objective is price stability Basic tasks

Define and implement monetary policy for EU

Conduct foreign exchange operations Hold and manage official reserves of

Member States Promote operation of payment systems

ECB: Treaty of Lisbon

Article 7 of Protocol ECB is totally independent from EU

government institutions Has legal personality Minimum capital 5,000 million EURO

[Art. 28]

ECB: Treaty of Lisbon

Article 18 Open Market and Credit Operations

Buy and sell [spot and forward] outright or under repurchase agreements

Lending and borrowing claims and marketable instruments in EURO or other countries

Conduct credit operations with credit institutions and other market participants with lending backed by collateral

Treaty of Lisbon

Article 19 ECB may require all credit institutions

established in the Member States to hold minimum reserves with the ECB and NCBs

Fundamental Tools

Regulate interest rates through money supply Reserve requirements Lending to banks Open market operations

Negatively Sloped Money Demand Curve

IR

Money

Equilibrium Interest Rate

R~

R1

MD

MS MS1

M1M

Demand for Money

Transaction demand Day to day needs

IR of no effect

Precautionary demand Unanticipated payments

Affects real GDP

Speculative demand Holding money in belief interest rates

will rise