CENTRAL BANKING

Traditional Functions
(Primary)
Sole Authority to Issue Notes
Conduct of Monetary and Credit
Policies
Regulation and Supervision of the
Financial System
Off-site & On-site monitoring
Prudential Regulations

Traditional Functions
(Primary)..
Bankers' Bank
remittances facilities
operations of clearing houses

Lender of the Last Resort

Banker to Government

Traditional Functions
(Secondary)
Public Debt Management
Subscribing Federal and Provincial
governments securities at the time of
their issue
Sale/purchase of such securities in the
Money Market (through auction, OMO or
discount window)
Payments of interest to holders of public
debt instruments

Traditional Functions
(Secondary)
Management of Foreign Exchange
to maintain competitiveness of our
exports and maintain stability in the
foreign exchange market

Advisor to Government
Relationships with International
Financial Institutions

Non-traditional Functions
Development of the Banking System
Commercial banking
Micro Finance
Promotion of Islamic Banking

Training Facilities to Bankers

Development of Specialized Financial
Institutions
Credit to Priority Sectors

How CB Controls the Money

Supply
Three tools are available to the
Fed for changing the money
supply:
1. changing THE REQUIRED
RESERVE RATIO;
2. changing the DISCOUNT RATE
3. engaging in OPEN MARKET
OPERATIONS.
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The Required Reserve Ratio

The required reserve ratio establishes
a link between the reserves of the
commercial banks and the deposits
(money) that commercial banks are
allowed to create.
If the Fed wants to increase the money
supply, the Fed can decrease the
required reserve ratio, which allows
the bank to create more deposits by
making loans.
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The Required Reserve Ratio

A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent
Increases the Supply of Money (All Figures in Billions of Dollars)
PANEL 1: REQUIRED RESERVE RATIO = 20%
Federal Reserve
Assets
Government

Commercial Banks

Liabilities
$200

securities

Assets

$100 Reserves

Reserves

$100

$100 Currency

Loans

$400

Liabilities
$500 Deposits

Note: Money supply (M1) = Currency + Deposits = $600.

PANEL 2: REQUIRED RESERVE RATIO = 12.5%

Federal Reserve
Assets
Government
securities

Commercial Banks

Liabilities
$200

Assets

$100 Reserves

Reserves

$100

$100 Currency

Loans
(+ $300)

$700

Note:
Money supply (M1) = Currency + Deposits = $900.
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Liabilities
$800 Deposits
(+ $300)

The Discount Rate

The discount rate is the interest
rate that banks pay to the Fed to
borrow from it.
Bank borrowing from the Fed leads
to an increase in the money supply.
The higher the discount rate, the
higher the cost of borrowing, and
the less borrowing banks will want
to do.
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The Discount Rate

The Effect On the Money Supply of Commercial Bank Borrowing from the Fed
(All Figures in Billions of Dollars) (RRR= 20%)
PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED
Federal Reserve
Assets
Liabilities
Securities

$160

Commercial Banks
Assets
Liabilities

$80 Reserves

Reserves

$80 Currency

Loans

$80

$400 Deposits

$320

Note: Money supply (M1) = Currency + Deposits = $480.

PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED

Federal Reserve
Assets
Liabilities
Securities
Loans

Commercial Banks
Assets
Liabilities

$160

$100 Reserves
(+ $20)

Reserves
(+ $20)

$100

$20

$80 Currency

Loans
(+ $100)

$420

Note:
Money supply (M1) = Currency + Deposits = $580.
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$500 Deposits
(+ $300)
$20 Amount owed
to Fed (+ $20)

Open Market Operations

Open market operations is the
purchase and sale by the Fed of
government securities in the open
market; a tool used to expand or
contract the amount of reserves in the
system and thus the money supply.
Open market operations is by far the
most significant tool of the Fed for
controlling the supply of money.
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The Mechanics of
Open Market Operations
Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the
Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars)
PANEL 1
Federal Reserve

Commercial Banks

Assets
Securities $100

Liabilities
Assets
$20 Reserves
Reserves
$20
$80 Currency
Loans
$80
Note: Money supply (M1) = Currency + Deposits = $180.

Liabilities
$100 Deposits

Jane Q. Public
Assets
Deposits

$5

Liabilities
$0 Debts
$5 Net Worth
$80 Currency

PANEL 2
Federal Reserve
Assets
Securities
$95
( $5)

Liabilities
$15 Reserves
( $5)
$80 Currency

Commercial Banks
Assets
Reserves
( $5)
Loans

$15

Liabilities
$95 Deposits
( $5)

$80

Jane Q. Public
Assets
Deposits
( $5)
Securities
(+ $5)

$0

Liabilities
$0 Debts

$5

$5

Net Worth

Note: Money supply (M1) = Currency + Deposits = $175.

PANEL 3
Federal Reserve
Assets
Liabilities
Securities
$95 $15 Reserves
( $5)
( $5)
$80 Currency

Commercial Banks
Assets
Liabilities
Reserves
$15
$75 Deposits
( $5)
( $25)
Loans
$60
( $20)
Note:
supply (M1) = Currency + Deposits = $155.
14 of Money
42

Jane Q. Public
Assets
Liabilities
Deposits
$0 $0 Debts
( $5)
Securities
$5 $5 Net Worth
(+ $5)

Open Market Operations

An
open
market
purchase
of
securities by the Fed results in an
increase in reserves and an increase
in the supply of money by an amount
equal to the money multiplier times
the change in reserves.

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Open Market Operations

An open market sale of securities by
the Fed results in a decrease in
reserves and a decrease in the
supply of money by an amount
equal to the money multiplier times
the change in reserves.

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Open Market Operations

Open market operations are the
Feds preferred means of controlling
the money supply because:
they can be used with some precision,
are extremely flexible, and
are fairly predictable.

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Goals of Monetary Policy

Interest-Rate Stability
High Employment
Price Stability
Inflation creates uncertainty

Economic Growth
Stability of Financial Markets
Stability in Foreign Exchange Markets

Principles and forms of lending

in Commercial Banks

Banking Credit Management

Purpose of banking business:
Maximizing spread
loans are the dominant asset in a
commercial bank