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Chapter 8

Central banking &


Monetary Policy
The Central Bank
central banks are governmental institutions that are
not concerned with maximizing their profits, but
with achieving certain goals for the entire economy
such as stable prices, full employment, and
economic growth.

The central bank of any country can be defined as a


government authority in charge of regulating the
country’s financial system, controlling the quantity
of money and conducting monetary policy to
achieve the above mentioned goals.

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The Central Bank
The central bank is a "bank" in the sense that it holds assets
(foreign exchange, gold, and other financial assets) and liabilities.

A central bank's primary liabilities are the currency outstanding, and


these liabilities are backed by the assets the bank owns.
• The central bank is the bank of government.
It does not provide general banking services to individual citizens and
business firms.
• The central bank is the bank of the banks and acts as a lender of
last resort to the banking sector during times of financial crisis
• The central bank has supervisory powers, to ensure that banks and
other financial institutions do not behave recklessly or fraudulently.

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Roles of Central Banks
The central bank (CB) regulates and supervises
depository institutions.
The main roles of central banks are:
• To ensure monetary stability through monetary
policy tools that keep inflation low and stable, and,
hence, preserving local currency purchasing power
and promoting economic activity
• To ensure financial stability and to have resilient
and efficient financial system
• To have effective policy for risk management and
control supervision
• To issue and enforce anti-money laundering and
fraud laws
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Roles of Central Banks (Cont…)

• To enhance the economic developmental through


institutional building and market infrastructure and
through ensuring healthy competition and efficient
financial markets
• To create a sound payments system through
efficient means of transferring funds between
parties and for commercial transactions
• To have a real time gross settlement system and
check clearing system
• To play the role of economic and financial adviser to
the government.
• To help in managing government borrowing

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Roles of Central Banks (Cont…)

• To represent the government in international


agencies and meetings
• To strengthen cooperation with international
financial community
• To manage the country's foreign exchange and gold
reserves
• To issue new currency and withdraw damaged one
• To collect data and make economic forecasting and
policy
• To review and approve annual accounts of all banks
and conduct regular onsite inspection
• To evaluate and approve proposed mergers and
expansions
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Monetary Policy & Its Instruments

• The purpose of the central bank is to help achieve


stable prices, full employment, and economic
growth through the regulation of the supply of
money and credit in the economy.

• Changing the money supply and credit to achieve


these goals is called monetary policy.

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CBB’s Objectives
• Monetary policy is the management of the money
supply for the purpose of maintaining stable prices,
full employment, and economic growth.

• The main monetary policy instruments are:

- Open market operation,


- bank reserve requirement,
- interest rate policy (discount rate)
- capital adequacy it is defined and regulated
by the Bank for international Settlements (BIS).

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Open Market Operations (OMO)

• Through open market operations, a central


bank influences the money supply in an
economy directly.

• An open market operation is the purchase


or sale of government securities by the
central bank in the open market.

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Open Market Operations

• To reduce inflation, the central bank conducts a


contractionary monetary policy using the open
market operation.

• Central bank sells government securities people


pay money to buy government securities from the
central bank banks deposit decreases banks
reserves decrease Loans decrease money
supply (MS) decreases AD decreases AD
curve shifts leftward.

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Open Market Operations

To reduce unemployment, the central bank


conducts an expansionary monetary policy
using the open market operation.

• Central bank buys government securities


people receive money from the central bank
banks banks deposit increases banks
reserves increases Loans increases
supply (MS) increases AD increases
AD curve shifts rightward.
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Open Market Operations – Advantages

1. The CB has complete control over the volume.

2. Flexible and precise.

3. Easily reversed.

4. Quickly implemented

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Discount Policy –3 types of loans

1. Primary credit:
Standing lending facility
Provides backup source of liquidity

2. Secondary credit
credit given to the banks in financial trouble
i is higher than by 0.5% (50 basis points) as a penalty

3. Seasonal credit
To meet the needs of limited number of small banks in vacation and
agriculture areas that have seasonal pattern of deposits.

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Discount Rate

• The discount rate is the interest rate that


the central bank charges the commercial
banks and other depository institutions
when they borrow reserves from it.

• To reduce inflation, the central bank


conducts a contractionary monetary policy
using the discount rate.

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Discount Rate (reduce inflation)…

It increases the discount rate higher cost


of borrowing reserves banks borrow less
reserves from central bank but with a
given required reserves banks decrease
their lending to decrease their borrowed
reserves Loans decrease money
supply decreases AD decreases AD
curve shifts leftward.

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Discount Rate (reduce unemployment)…

To reduce unemployment, the central


bank conducts an expansionary monetary
policy, using the discount rate.

• It decreases the discount rate lower cost


of borrowing reserves banks borrow more
reserves from central bank banks increase
their lending Loans increase money
supply (MS) increases AD increases
AD curve shifts rightward.

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Discount Policy
–Advantages & Disadvantages
Used to perform role of lender of last resort Important during the
subprime financial crisis of 2007-2008.

Cannot be controlled by the CB; the decision maker is the bank.

Discount facility is used as a backup facility to prevent the CB funds


rate from rising too far above the target.

Changing discount rate is the weakest Fed tool. Why?


1. Weak expansionary tool since the CBs cannot force Banks to
borrow from it
2. Weak contractionary tool since Banks can borrow elsewhere .

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Advantages:

1. No announcement effect.

2. Discount rate will be more relevant to underlying


economic conditions.

3.The penalty aspect means Banks would view CB again


as lender of last resort, not a lender of best resort

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Reserve Requirements:

• Another significant power that central banks


hold is the ability to establish reserve
requirements for other banks.
• All depository institutions in the country are
required to hold a minimum percentage of
deposits as reserves (cash or deposited with
the central bank). This minimum percentage
is known as a required reserve ratio.
• Least frequently used by the CB.

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Reserve Requirements:

• To reduce inflation, the central bank


conducts a contractionary monetary policy
using the required reserve ratio.
• It requires depository institutions to hold
more reserves, which results in increasing
the reserves and thus reducing the amount
they are able to lend Loans decrease
money supply (Ms) decreases AD
decreases AD curve shifts leftward.
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Reserve Requirements:
• To reduce unemployment, the central
bank conducts an expansionary monetary
policy using the required reserve ratio.

Required reserves decrease loans


increase Ms increase AD increase
AD curve shifts rightward.

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In conclusion

• To increase commercial bank lending the


central bank can lower reserve requirements,
lower capital requirements, lower the discount
rate, or buy government securities.

• To decrease commercial bank lending the


central bank can raise the reserve
requirements, raise the capital requirements,
raise the discount rate, or sell government
securities.
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DESIRABLE CRITERIA FOR CHOOSING MONETARY
POLICY STRATEGIES
There are 2 desirable criteria, but they sometimes
come into conflict with each other.
1. Ideally, the strategy should be transparent to the
public. This allows markets to assess whether or
not the central bank is “doing what it says it was
going to do”.

2. The strategy should be effective in achieving the


stated goals of the Central Bank.

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Money Supply Growth Targets

This strategy is transparent. There is reliable data on the


money supply that is published every week.

If inflation was always very closely linked with the money


supply growth rate, this strategy would also achieve the
goals of the Central Bank.

In this case, a money supply growth rule would be an ideal


strategy. Markets would form reliable estimates of future
inflation.

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Central Banks Independence
• Although central banks are part of the
government, they usually have much more
independence than other government
agencies.

• The literature on central bank independence


has defined a number of types of
independence.

• The most important ones are:

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Central Banks Independence
• The central bank has the ability to set its monetary
policy goals, whether inflation targeting, control of
the money supply, or maintaining a fixed exchange
rate.

• While this type of independence is more common,


many central banks prefer to announce their policy
goals in partnership with the appropriate
government authority.

• The setting of common goals by the central bank


and the government helps to avoid situations where
monetary and fiscal policy are in conflict.

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Central Banks Independence
2. Instrument (Operational) Independence:
The central bank has the ability to determine
the best way of achieving its policy goals,
including the types of instruments used and
the timing of their use.

• This is the most common form of central


bank independence.

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Central Banks Independence
3. Management Independence:
• The central bank has the authority to run its
own operations (appointing staff, setting
budgets, etc) without excessive involvement
of the government.
• the aim of independence is primarily to
prevent short-term interference.
• Governments generally have some degree of
influence over even "independent“ central
banks;

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Central Banks Independence
• International organizations such as the World
Bank, the BIS and the IMF are strong
supporters of central bank independence.

• Increased independence for the central bank


increases transparency in the policy-making
process.

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