CHAPTER

55 Monetary Policy&

Central Bank

Central Bank of Bangladesh:Central Bank of Bangladesh:

The most important players in financial markets throughout the world are Central Banks- the Government authorities in charge of monetary policy.

Central Banks’ action affect

Financial Market as well as on aggregate output and inflation

1. Interest rate,2. the amount of credit,3. and the money supply, all of which effect on

Central Bank of Bangladesh:Central Bank of Bangladesh:

•After the liberation war, and the eventual independence of Bangladesh, the Government of Bangladesh reorganized the Dhaka branch of the State Bank of Pakistan as the central bank of the country, and named it Bangladesh Bank.

•This reorganization was done pursuant to Bangladesh Bank Order, 1972, and the Bangladesh Bank came into existence with retrospective effect from 16 December 1971.

•At present it has nine offices located at Motijheel, Sadarghat, Chittagong, Khulna, Bogra, Rajshahi, Sylhet, Barisal and Rangpur in Bangladesh; total manpower stood at 5071 (officials 3914, subordinate staff 1157) as of end FY 2010.

Central Bank of Bangladesh:Central Bank of Bangladesh:

Functions:

The major functional areas include : Formulation and implementation of monetary and credit policies.

1.Regulation and supervision of banks and non-bank financial institutions, promotion and development of domestic financial markets. “Lender of the Last Resort”.

2.Management of the country's international reserves.

3.Issuance of currency notes- like most of the central banks of different countries, exercising monopoly over the issue of currency and the banknotes. Except for the 1 and 2 taka notes, it issues all other denominations of Bangladeshi Taka.

4.Regulation and supervision of the payment system.

Central Bank of Bangladesh:Central Bank of Bangladesh:

Functions:

1.Acting as banker to the government -

2.Money Laundering Prevention.

3.Collection and furnishing of credit information.

4.Implementation of the Foreign exchange regulation Act.

5.Managing a Deposit Insurance Scheme .

Central Bank of Bangladesh:Central Bank of Bangladesh:

Objectives:

1.Formulating monetary and credit policies;

2.Managing currency issue and regulating payment system;

3.Managing foreign exchange reserves and regulating the foreign exchange

market;

4.Regulating and supervising banks and financial institutions, and advising the

government on interactions and impacts of fiscal, monetary and

other economic policies.

Central Bank of Bangladesh:Central Bank of Bangladesh:

Objectives:

1.Formulating monetary and credit policies;

2.Managing currency issue and regulating payment system;

3.Managing foreign exchange reserves and regulating the foreign exchange

market;

4.Regulating and supervising banks and financial institutions, and advising the

government on interactions and impacts of fiscal, monetary and

other economic policies.

Central Bank of Bangladesh and Monetary Central Bank of Bangladesh and Monetary policy:policy:

Monetary Policy

the policy adopted by the central bank for control of the supply of money as an

instrument for achieving the objectives of general economic policy.

Monetary Policy refers to all those policy guidelines and supportive money

supply related mechanism that are used by the central banks to maintain money

supply at desired volume so that level of a country’s economic activities remain

pacified.

MoneyMoney

Generally Money is any accepted means of payment for deliveryof goods, receipt of services and settlement of debt.

Functions of Money:– A means of payment for goods and services and settlement of debt.– Unit of measurement of value and basis of pricing goods and services.– Store of value over time, but subject to inflation erosion.– Means of deferred payments.

MoneyMoney

Characteristics of Money Portability Divisibility Durability Stability

Functions of Money Medium of

Exchange Store of Value Unit of Account

Monetary AggregatesMonetary Aggregates

Narrow definitions of money include items that can be spend directly (cash, current accounts).

Broad definitions of money include items that cannot be spent directly but can be readily converted into cash.

Monetary AggregatesMonetary Aggregates

1. Monetary Base: Currency in circulation Currency and coins plus total reserves

2. M1 Money Supply Currency plus demand deposits

3. M2 Money Supply M1 plus short-term time deposits

4. M3 Money Supply M2 plus long-term time deposits

General versus Selective Credit ControlsGeneral versus Selective Credit Controls

General credit controls affect the entire banking and financial system.

Examples: reserve requirements, the discount rate, open market operations

Selective credit controls affect specific groups or sectors of the financial system.

Examples: moral suasion, margin requirements on the purchase of listed securities

Instruments of monetary policy:Instruments of monetary policy:

Open market operations:Open market operations: interest ratesinterest rates

monetary basemonetary base Reserve requirementsReserve requirements Discount window lendingDiscount window lending

Instruments of monetary policy:Instruments of monetary policy:

Open market operations:Open market operations:

A relatively fine tool that can be used to make small adjustments. These adjustments can be daily and often occur without much fanfare.

Targeted Interest Rates A relatively blunt tool that can be used to make large

adjustments. In typical years, changes in targeted interest rates a few times per year.

Reserve Ratio A rather blunt tool that is only used when very large

adjustments are in order.

Open Market OperationsOpen Market Operations

Buying Treasury securities: When the Central Bank purchases securities through the

government securities dealers, the account balances of the dealers are credited with the

amount the total amount of fund at the dealer’s bank increases Increased money supply.

Centralbank

Central Bank buys securities

Dealer

Dealer’s bank

Securities

Reserves

Open Market OperationsOpen Market Operations Selling Treasury securities

When the Central Bank sells securities (obtained from previous purchases) to the government securities dealers,

the account balances of the dealers are debited with the amount

the total amount of fund at the dealer’s bank reduces by the market value of the securities

Reduced money supply growth.

Centralbank

Central Bank buys securities

Dealer

Dealer’s bank

Securities

Reserves

Types of Central Bank Open Market Types of Central Bank Open Market TransactionsTransactions

RP or Reverse RP Transaction(temporary change in the level of reserves held by

depository institutions)

RP: Central Bank buys securities temporarily

Centralbank

Dealer

Dealer’s bank

Securities

Reserves

Later on:

Reserves

Securities returned

Reverse RP: Central Bank sells securities temporarily

Centralbank

Dealer

Dealer’s bank

Securities

Reserves

Later on:

Reserves

Securities returned

Reserve RequirementsReserve Requirements

When a bank takes a deposit into an account on which a check can be written, it must place a percentage of that deposit on reserve at a Federal Reserve bank. That percentage is called the reserve ratio.

RR raised - banks reduce lendingRR raised - banks reduce lending

RR lowered - banks increase lendingRR lowered - banks increase lending

Reserve RequirementsReserve Requirements

An increase in deposit reserve requirements decreases the deposit and money multipliers,

slowing the growth of money, deposits and loans reduces the amount of excess legal reserves -

institutions deficient in required legal reserves will have to sell securities, cut back on loans, or borrow reserves

increases interest rates, particularly in the money market, as depository institutions scramble to cover any reserve deficiencies

The Discount RateThe Discount Rate

The discount rate is the annual percentage interest charge levied against those institutions choosing to borrow reserves from the discount window of the Central Bank.

Frequent borrowing is discouraged and may be penalized with a higher interest rate.

The Discount RateThe Discount Rate

An increase in the discount rate reduces the volume of loans from the discount

window (cost effect) makes borrowing from the Fed less attractive

(substitution effect) signals that the Fed is pushing for tighter credit

conditions (announcement effect), and market participants may respond by curtailing their spending plans or by accelerating their borrowings (to secure the credit they need before interest rates move even higher - negative psychological effect)

Monetary PolicyMonetary Policy

If the Central Bank wants to expand the economy it can buy bonds decrease the Discount Rate lower the reserve ratio. This increases the supply of loanable funds. This lowers

interest rates which increases aggregate demand. If the central bank wants to contract the economy it can

sell bonds increase the Discount Rate raise the reserve ratio. This decreases the supply of loanable funds. This raises

interest rates which decreases aggregate demand.