11

Major Duties and Responsibilities Major Duties and Responsibilities of of Central BankCentral Bank

Conducting monetary policyConducting monetary policy Supervising and regulating depository Supervising and regulating depository

institutionsinstitutions Maintaining the stability of the financial Maintaining the stability of the financial

systemsystem Providing payment and other financial Providing payment and other financial

services to the government, the public, FIs services to the government, the public, FIs and foreign official institutionsand foreign official institutions

Conducting monetary policyConducting monetary policy Supervising and regulating depository Supervising and regulating depository

institutionsinstitutions Maintaining the stability of the financial Maintaining the stability of the financial

systemsystem Providing payment and other financial Providing payment and other financial

services to the government, the public, FIs services to the government, the public, FIs and foreign official institutionsand foreign official institutions

22

Functions Performed by the Functions Performed by the CentralCentral Banks Banks

Assistance in the Conduct of Monetary Assistance in the Conduct of Monetary PolicyPolicy

Supervision and RegulationSupervision and Regulation Government ServicesGovernment Services New Currency IssueNew Currency Issue Check ClearingCheck Clearing Wire Transfer ServicesWire Transfer Services Research ServicesResearch Services

Assistance in the Conduct of Monetary Assistance in the Conduct of Monetary PolicyPolicy

Supervision and RegulationSupervision and Regulation Government ServicesGovernment Services New Currency IssueNew Currency Issue Check ClearingCheck Clearing Wire Transfer ServicesWire Transfer Services Research ServicesResearch Services

33

Place of Central Bank in the Place of Central Bank in the Monetary SystemMonetary System

Central BankFederal Reserve Sytem

Defines and regulates money supply

Facilitates transfer of money through check processing/clearing

Banking System:1. Creates money2. Transfers money3. Provides financial intermediation4. Processes/clears checks

Other Banks

First Bank

Last Bank

Lender of last Resort

44

Balance Sheet of the Federal ReserveBalance Sheet of the Federal Reserve(in billions of dollars, 2002)(in billions of dollars, 2002)

Assets Liabilities and Equity

Gold and foreign exchange $ 25.5 Depository institution reserves $ 17.5SDR certificates 2.2 Vault cash of commercial banks 47.3Treasury currency 33.2 Deposits due to federal government 7.1Federal Reserve Float 0.0 Deposits due to rest of the world 0.1FR loans to domestic banks 0.0 Currency outside banks 596.2Security repurchase agreements 50.3 Miscellaneous liabilities 7.8U.S. Treasury securities 551..7 FR Bank stock 7.2U.S. government securities 0.0Miscellaneous assets 20.3

Total assets $683.2 Total liabilities and equity $683.2

Assets Liabilities and Equity

Gold and foreign exchange $ 25.5 Depository institution reserves $ 17.5SDR certificates 2.2 Vault cash of commercial banks 47.3Treasury currency 33.2 Deposits due to federal government 7.1Federal Reserve Float 0.0 Deposits due to rest of the world 0.1FR loans to domestic banks 0.0 Currency outside banks 596.2Security repurchase agreements 50.3 Miscellaneous liabilities 7.8U.S. Treasury securities 551..7 FR Bank stock 7.2U.S. government securities 0.0Miscellaneous assets 20.3

Total assets $683.2 Total liabilities and equity $683.2

55

Objective of Monetary PolicyObjective of Monetary Policy

To influence the amount of reserve in the To influence the amount of reserve in the banking system…banking system…

which affects interest rates and which affects interest rates and availability of credit and…availability of credit and…

ultimately affects the levels of ultimately affects the levels of employment, output, prices and inflationemployment, output, prices and inflation

To influence the amount of reserve in the To influence the amount of reserve in the banking system…banking system…

which affects interest rates and which affects interest rates and availability of credit and…availability of credit and…

ultimately affects the levels of ultimately affects the levels of employment, output, prices and inflationemployment, output, prices and inflation

66

Money StockMoney Stock

There are a number of measures of a There are a number of measures of a nation’s money stock (M).nation’s money stock (M).

The narrowest measureThe narrowest measure is is the sum of the sum of currency in circulation and the amount of currency in circulation and the amount of transactions deposits (TD) in the banking transactions deposits (TD) in the banking system.system.

There are a number of measures of a There are a number of measures of a nation’s money stock (M).nation’s money stock (M).

The narrowest measureThe narrowest measure is is the sum of the sum of currency in circulation and the amount of currency in circulation and the amount of transactions deposits (TD) in the banking transactions deposits (TD) in the banking system.system.

77

Money MultiplierMoney Multiplier

Most nations require that a fraction of Most nations require that a fraction of transactions deposits be held as reserves.transactions deposits be held as reserves.

The required fraction is determined by the The required fraction is determined by the reserve requirement (rr).reserve requirement (rr).

This fraction determines the maximum This fraction determines the maximum change in the money stock that can result change in the money stock that can result from a change in total reserves.from a change in total reserves.

Most nations require that a fraction of Most nations require that a fraction of transactions deposits be held as reserves.transactions deposits be held as reserves.

The required fraction is determined by the The required fraction is determined by the reserve requirement (rr).reserve requirement (rr).

This fraction determines the maximum This fraction determines the maximum change in the money stock that can result change in the money stock that can result from a change in total reserves.from a change in total reserves.

88

Money MultiplierMoney Multiplier

Under the assumption that the monetary Under the assumption that the monetary base is comprised of transactions deposits base is comprised of transactions deposits only, the multiplier is determined by the only, the multiplier is determined by the reserve requirement only.reserve requirement only.

In this case, the money multiplier (m) is In this case, the money multiplier (m) is equal to 1 divided by the reserve equal to 1 divided by the reserve requirement,requirement,

m = 1/rr.m = 1/rr.

Under the assumption that the monetary Under the assumption that the monetary base is comprised of transactions deposits base is comprised of transactions deposits only, the multiplier is determined by the only, the multiplier is determined by the reserve requirement only.reserve requirement only.

In this case, the money multiplier (m) is In this case, the money multiplier (m) is equal to 1 divided by the reserve equal to 1 divided by the reserve requirement,requirement,

m = 1/rr.m = 1/rr.

99

Relating the Monetary Base and the Money StockRelating the Monetary Base and the Money Stock

Under the assumptions above, we can Under the assumptions above, we can write the money stock as the monetary write the money stock as the monetary base times the money multiplier.base times the money multiplier.

M = mM = mMB = m(C + TR).MB = m(C + TR). TThe change in the money stock is he change in the money stock is

expressed asexpressed as

M = m(M = m(C + C + TTR).R).

Under the assumptions above, we can Under the assumptions above, we can write the money stock as the monetary write the money stock as the monetary base times the money multiplier.base times the money multiplier.

M = mM = mMB = m(C + TR).MB = m(C + TR). TThe change in the money stock is he change in the money stock is

expressed asexpressed as

M = m(M = m(C + C + TTR).R).

1010

Example - BOJ InterventionExample - BOJ Intervention

Suppose the Bank of Japan (BOJ) Suppose the Bank of Japan (BOJ) intervenes to strengthen the yen by selling intervenes to strengthen the yen by selling ¥1 million of US dollar reserves to the ¥1 million of US dollar reserves to the private banking system.private banking system.

This action reduces the foreign exchange This action reduces the foreign exchange reserves and total reserves component of reserves and total reserves component of the BOJ’s balance sheet.the BOJ’s balance sheet.

Suppose the Bank of Japan (BOJ) Suppose the Bank of Japan (BOJ) intervenes to strengthen the yen by selling intervenes to strengthen the yen by selling ¥1 million of US dollar reserves to the ¥1 million of US dollar reserves to the private banking system.private banking system.

This action reduces the foreign exchange This action reduces the foreign exchange reserves and total reserves component of reserves and total reserves component of the BOJ’s balance sheet.the BOJ’s balance sheet.

1111

BOJ Balance SheetBOJ Balance Sheet

Assets Liabilities

FER TR

-¥1 million

-¥1 million

Result: Result: RR ¥1 million, ¥1 million, MBMB ¥1 million¥1 million

1212

BOJ InterventionBOJ Intervention

Because the monetary base declined, so Because the monetary base declined, so will the money stock. will the money stock.

Suppose the reserve requirement is 10 Suppose the reserve requirement is 10 percent. The change in the money stock percent. The change in the money stock isis

M = m(M = m(DC + DC + FER),FER),

M = (1/.10)(-¥1 million) = -¥10 M = (1/.10)(-¥1 million) = -¥10 million.million.

Because the monetary base declined, so Because the monetary base declined, so will the money stock. will the money stock.

Suppose the reserve requirement is 10 Suppose the reserve requirement is 10 percent. The change in the money stock percent. The change in the money stock isis

M = m(M = m(DC + DC + FER),FER),

M = (1/.10)(-¥1 million) = -¥10 M = (1/.10)(-¥1 million) = -¥10 million.million.

1313

Monetary Policy ToolsMonetary Policy Tools

Open Market OperationsOpen Market Operations primary determinate of changes in excess primary determinate of changes in excess

reserves in the banking system impacting the size reserves in the banking system impacting the size of the money supply and/or interest ratesof the money supply and/or interest rates

The Discount RateThe Discount Rate the rate of interest the rate of interest CentralCentral Bank charge on Bank charge on

emergency loans to depository institutionsemergency loans to depository institutions Reserve RequirementsReserve Requirements

determine the minimum amount of reserve assets that determine the minimum amount of reserve assets that depository institutions must maintain by law to back depository institutions must maintain by law to back transaction deposits held as liabilitiestransaction deposits held as liabilities

Open Market OperationsOpen Market Operations primary determinate of changes in excess primary determinate of changes in excess

reserves in the banking system impacting the size reserves in the banking system impacting the size of the money supply and/or interest ratesof the money supply and/or interest rates

The Discount RateThe Discount Rate the rate of interest the rate of interest CentralCentral Bank charge on Bank charge on

emergency loans to depository institutionsemergency loans to depository institutions Reserve RequirementsReserve Requirements

determine the minimum amount of reserve assets that determine the minimum amount of reserve assets that depository institutions must maintain by law to back depository institutions must maintain by law to back transaction deposits held as liabilitiestransaction deposits held as liabilities

1414

Tools of Monetary PolicyTools of Monetary Policy

Open Market OperationsOpen Market Operations TTo change Reserveso change Reserves TTo offset other factors affecting Reserveso offset other factors affecting Reserves

Typically uses repos Typically uses repos && reverse repos reverse repos: Open market : Open market transactions to purchase gov. Securities with an transactions to purchase gov. Securities with an aggrement that seller will repurchase them in a aggrement that seller will repurchase them in a predetermined time period.predetermined time period.

Advantages of Open Market OperationsAdvantages of Open Market Operations 1. 1. Central BankCentral Bank has complete control has complete control 2. Flexible and precise2. Flexible and precise 3. Easily reversed3. Easily reversed 4. Implemented quickly4. Implemented quickly

Open Market OperationsOpen Market Operations TTo change Reserveso change Reserves TTo offset other factors affecting Reserveso offset other factors affecting Reserves

Typically uses repos Typically uses repos && reverse repos reverse repos: Open market : Open market transactions to purchase gov. Securities with an transactions to purchase gov. Securities with an aggrement that seller will repurchase them in a aggrement that seller will repurchase them in a predetermined time period.predetermined time period.

Advantages of Open Market OperationsAdvantages of Open Market Operations 1. 1. Central BankCentral Bank has complete control has complete control 2. Flexible and precise2. Flexible and precise 3. Easily reversed3. Easily reversed 4. Implemented quickly4. Implemented quickly

1515

Open Market OperationsOpen Market Operations

Monetary Base = Currency + ReservesMonetary Base = Currency + Reserves

Open Market Purchase from BankOpen Market Purchase from Bank

The Banking SystemThe Banking System The FedThe Fed

Assets Liabilities Assets Assets Liabilities Assets LiabilitiesLiabilities

Securities Securities Securities Reserves Securities Reserves

- $100- $100 + $100+ $100 +$100 +$100 Reserves Reserves

+ $100 + $100

Result: Result: RR $100, $100, MBMB $100 $100

1616

Open Market Purchase from PublicOpen Market Purchase from Public

PublicPublic The FedThe Fed

AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities

Securities Securities Securities Securities Reserves Reserves

- $100- $100 + $100 + $100 +$100 +$100 Deposits Deposits

+ $100+ $100

Banking SystemBanking System

AssetsAssets LiabilitiesLiabilities

Reserves DepositsReserves Deposits

+ $100+ $100 + $100 + $100 Result: Result: RR $100, $100, MBMB $100 $100

Open Market OperationsOpen Market Operations

1717

Discount Discount RateRate

The rate on loans to depository instituionsThe rate on loans to depository instituions Ambiguous effect on money supplyAmbiguous effect on money supply Signalling function: used to send a Signalling function: used to send a

message to financial marketsmessage to financial marketsLender of Last Resort FunctionLender of Last Resort Function1. To prevent banking panics 1. To prevent banking panics

2. To prevent non-bank financial panics2. To prevent non-bank financial panics Moral Hazard ProblemMoral Hazard Problem

The rate on loans to depository instituionsThe rate on loans to depository instituions Ambiguous effect on money supplyAmbiguous effect on money supply Signalling function: used to send a Signalling function: used to send a

message to financial marketsmessage to financial marketsLender of Last Resort FunctionLender of Last Resort Function1. To prevent banking panics 1. To prevent banking panics

2. To prevent non-bank financial panics2. To prevent non-bank financial panics Moral Hazard ProblemMoral Hazard Problem

1818

Discount LoansDiscount Loans

Banking SystemBanking System The FedThe Fed

Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities

Reserves Reserves Discount Discount DiscountDiscount Reserves Reserves

+ $100+ $100 loan + $100 loan + $100 loan + $100 + $100 loan + $100 + $100

Result: Result: RR $100, $100, MBMB $100 $100

1919

Reserve RequirementsReserve Requirements

AdvantagesAdvantages 1. Powerful effect1. Powerful effect on money supply on money supply

DisadvantagesDisadvantages 1. Small changes have very large effect on M1. Small changes have very large effect on MSS 2. Raising reserve requirement ratio causes 2. Raising reserve requirement ratio causes

liquidity problems for banksliquidity problems for banks 3. Frequent changes cause uncertainty for 3. Frequent changes cause uncertainty for

banks banks

AdvantagesAdvantages 1. Powerful effect1. Powerful effect on money supply on money supply

DisadvantagesDisadvantages 1. Small changes have very large effect on M1. Small changes have very large effect on MSS 2. Raising reserve requirement ratio causes 2. Raising reserve requirement ratio causes

liquidity problems for banksliquidity problems for banks 3. Frequent changes cause uncertainty for 3. Frequent changes cause uncertainty for

banks banks

2020

Goals of Monetary PolicyGoals of Monetary Policy

GoalsGoals

1. Price Stability1. Price Stability

2. High Employment2. High Employment

3. Economic Growth3. Economic Growth

4. Interest Rate Stability4. Interest Rate Stability

5. Financial Market Stability5. Financial Market Stability

6. Foreign Exchange Market Stability6. Foreign Exchange Market Stability Goals often in conflictGoals often in conflict

““The primary objective of the Bank shall be to achieve and The primary objective of the Bank shall be to achieve and maintain price stability.”maintain price stability.”

Cental Bank of the Republic of Cental Bank of the Republic of TurkeyTurkey

GoalsGoals

1. Price Stability1. Price Stability

2. High Employment2. High Employment

3. Economic Growth3. Economic Growth

4. Interest Rate Stability4. Interest Rate Stability

5. Financial Market Stability5. Financial Market Stability

6. Foreign Exchange Market Stability6. Foreign Exchange Market Stability Goals often in conflictGoals often in conflict

““The primary objective of the Bank shall be to achieve and The primary objective of the Bank shall be to achieve and maintain price stability.”maintain price stability.”

Cental Bank of the Republic of Cental Bank of the Republic of TurkeyTurkey

2121

A. Price StabilityA. Price Stability Unanticipated inflation leads to lender losses. Nominal contracts attempt to Unanticipated inflation leads to lender losses. Nominal contracts attempt to

account for inflation. account for inflation. Effort successful if monetary policy able to maintain steady rate of inflation.Effort successful if monetary policy able to maintain steady rate of inflation.

B. High EmploymentB. High Employment The movement of workers between jobs is referred to as frictional The movement of workers between jobs is referred to as frictional

unemployment. unemployment. All unemployment beyond frictional unemployment is classified as unintended All unemployment beyond frictional unemployment is classified as unintended

unemployment. Reduction in this area is the target of macroeconomic policy.unemployment. Reduction in this area is the target of macroeconomic policy.

C. Economic GrowthC. Economic Growth Economic growth is enhanced by investment in technological advances in Economic growth is enhanced by investment in technological advances in

production.production. Encouragement of savings supplies funds that can be drawn upon for Encouragement of savings supplies funds that can be drawn upon for

investment.investment.

D. Interest Rate and Exchange Rate StabilityD. Interest Rate and Exchange Rate Stability Volatile interest and exchange rates generate costs to lenders and borrowers. Volatile interest and exchange rates generate costs to lenders and borrowers.

Unexpected changes that cause damage, making policy formulation difficult. Unexpected changes that cause damage, making policy formulation difficult.

E. Conflicts Among GoalsE. Conflicts Among Goals Goals frequently cannot be separated from each other and often conflict. Goals frequently cannot be separated from each other and often conflict.

Costs must therefore be carefully weighed before policy implementation.Costs must therefore be carefully weighed before policy implementation.

A. Price StabilityA. Price Stability Unanticipated inflation leads to lender losses. Nominal contracts attempt to Unanticipated inflation leads to lender losses. Nominal contracts attempt to

account for inflation. account for inflation. Effort successful if monetary policy able to maintain steady rate of inflation.Effort successful if monetary policy able to maintain steady rate of inflation.

B. High EmploymentB. High Employment The movement of workers between jobs is referred to as frictional The movement of workers between jobs is referred to as frictional

unemployment. unemployment. All unemployment beyond frictional unemployment is classified as unintended All unemployment beyond frictional unemployment is classified as unintended

unemployment. Reduction in this area is the target of macroeconomic policy.unemployment. Reduction in this area is the target of macroeconomic policy.

C. Economic GrowthC. Economic Growth Economic growth is enhanced by investment in technological advances in Economic growth is enhanced by investment in technological advances in

production.production. Encouragement of savings supplies funds that can be drawn upon for Encouragement of savings supplies funds that can be drawn upon for

investment.investment.

D. Interest Rate and Exchange Rate StabilityD. Interest Rate and Exchange Rate Stability Volatile interest and exchange rates generate costs to lenders and borrowers. Volatile interest and exchange rates generate costs to lenders and borrowers.

Unexpected changes that cause damage, making policy formulation difficult. Unexpected changes that cause damage, making policy formulation difficult.

E. Conflicts Among GoalsE. Conflicts Among Goals Goals frequently cannot be separated from each other and often conflict. Goals frequently cannot be separated from each other and often conflict.

Costs must therefore be carefully weighed before policy implementation.Costs must therefore be carefully weighed before policy implementation.

2222

Impact of Monetary PolicyImpact of Monetary Policyon Various Economic Variableson Various Economic Variables

ExpansionaryActivities

ContractionaryActivities

Impact on Reserves Credit availability Money supply Interest rates Security prices

2323

AlternativeAlternative Monetary Monetary PoliciesPolicies

Interest Rate

Quantity of Money(in billions)

i’=8%

i*=6%

i’’=4%

MS

MD’

MD’’

MD

InterestRate

Quantity of Money(in billions)

i* = 6%

i’’= 5%

MS’ MS

MD’

MD

MD’’

2424

International Monetary PoliciesInternational Monetary Policiesand Strategiesand Strategies

Foreign Exchange InterventionForeign Exchange Intervention1.1. Controlled exchange rate regimes Controlled exchange rate regimes

under ERBS Programsunder ERBS Programs

2.2. To stabilize the unstable FX market To stabilize the unstable FX market similar to open market purchases and similar to open market purchases and

sales of Treasury securitiessales of Treasury securities

Foreign Exchange InterventionForeign Exchange Intervention1.1. Controlled exchange rate regimes Controlled exchange rate regimes

under ERBS Programsunder ERBS Programs

2.2. To stabilize the unstable FX market To stabilize the unstable FX market similar to open market purchases and similar to open market purchases and

sales of Treasury securitiessales of Treasury securities

2525

Institutional Framework for a Credible Central Institutional Framework for a Credible Central BankBank

IndependenceIndependence

AccountabilityAccountability

TransparencyTransparency

IndependenceIndependence

AccountabilityAccountability

TransparencyTransparency