AMBO UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

TERM PAPER OF CENTRAL BANKING AND THE CONDUCT OF

MONETARY POLICY

COURSE TITLE: FINANCIAL MARKET AND INSTITUTION

IN PARTIAL FULFILLMENT FOR THE REQUIREMENT OF MSC OF

DEGREE IN ACCOUNTING AND FINANCE.

BY

ITENA AJEMA

ID NO: PGE/58002/14

INSTRUCTOR: KOKOBE SEYOUM (PHD)

OCT, 2022

HOLETA, ETHIOPIA

1
Table of Contents
Introduction ................................................................................................................................................... 3

Central Banking ........................................................................................................................................ 3

Monetary policy ........................................................................................................................................ 4

Foreign exchange regimes and policies .................................................................................................... 5

1. Structures of central bank ......................................................................................................................... 6

2. Multiple deposit creation and the money supply process ......................................................................... 6

2.1 Players in the money supply process .................................................................................................. 7

3. Determinants of the money supply ........................................................................................................... 7

4. Tools and conduct of monetary policy ...................................................................................................... 8

5. Monetary policy goals and targets ............................................................................................................ 9

5.1.Monetary policy goals......................................................................................................................... 9

5.2. Monetary policy targets ................................................................................................................... 10

Conclusion .................................................................................................................................................. 12

Reference .................................................................................................................................................... 13

2
Central Banking and the Conduct of Monetary Policy
Monetary Policy and Central Banking

Introduction

Central banks play a crucial role in ensuring economic and financial stability. They conduct
monetary policy to achieve low and stable inflation. In the wake of the global financial crisis,
central banks have expanded their toolkits to deal with risks to financial stability and to manage
volatile exchange rates. Central banks need clear policy frameworks to achieve their objectives.
Operational processes tailored to each country’s circumstances enhance the effectiveness of the
central banks’ policies. The IMF supports countries around the world by providing policy advice
and technical assistance.

The central bank has to be protected from risks of political capture, by being granted functional,
personal, operational and financial independence from government. This high independence
finds its mirror, and is in fact enhanced and rendered sustainable, by ensuring that the central
bank is strictly accountable on its actions in the pursuit of its mandate vis-à-vis the legislative
and the public at large, which is ensured through a number of provisions ensuring transparency
and regular and formalized reporting procedures.

Central Banking

Central bank is a financial institution that is responsible for overseeing monetary system and
policy of a nation or group of nations, regulating its money supply and setting interest rates.

Central bank enacts monetary policy, by easing or tightening the monetary supply and
availability of credit, central bank seeks to keep a nation’s economy on an even keel.

A central bank sets requirements for the banking industry, such as the amount of cash reserves
banks must maintain vis-à-vis their deposits.

A central bank can be a lender of last resort to troubled financial institutions and even
government.

3
Monetary policy

A key role of central banks is to conduct monetary policy to achieve price stability (low and
stable inflation) and to help manage economic fluctuations. The policy frameworks within which
central banks operate have been subject to major changes over recent decades.

Since the late 1980s, inflation targeting has emerged as the leading framework for monetary
policy. Central banks in Canada, the euro area, the United Kingdom, New Zealand, and
elsewhere have introduced an explicit inflation target. Many low-income countries are also
making a transition from targeting a monetary aggregate (a measure of the volume of money in
circulation) to an inflation targeting framework.

Central banks conduct monetary policy by adjusting the supply of money, generally through
open market operations. For instance, a central bank may purchase government debt from
commercial banks and thereby increase the money supply (a technique called ―monetary
easing‖). The purpose of open market operations is to steer short-term interest rates, which in
turn influence longer term rates and overall economic activity. In many countries, especially
low-income countries, the monetary transmission mechanism is not as effective as it is in
advanced economies. Before moving from monetary to inflation targeting, countries should
develop a framework to enable the central bank to target short-term interest rates.

Following the global financial crisis, central banks in advanced economies eased monetary
policy by reducing interest rates until short-term rates came close to zero, which limited the
option to cut policy rates further (i.e., conventional monetary options). With the danger of
deflation rising, central banks undertook unconventional monetary policies, including buying
bonds (especially in the United States, the United Kingdom, the euro area, and Japan) with the
aim of further lowering long term rates and loosening monetary conditions. Some central banks
even took short-term rates below zero.

4
Foreign exchange regimes and policies

The choice of a monetary framework is closely linked to the choice of an exchange rate regime.
A country that has a fixed exchange rate will have limited scope for an independent monetary
policy compared with one that has a more flexible exchange rate. Although some countries do
not fix the exchange rate, they still try to manage its level, which could involve a trade-off with
the objective of price stability. A fully flexible exchange rate regime supports an effective
inflation targeting framework.

The main features of the monetary policy we are implementing can be summarized under
five headings.

 The Central Bank aims to limit the growth of domestic assets.

 The Central Bank wants reserve money to increase as much as its demand. The excess
liquidity caused by the rise.
 The Central Bank continues its close surveillance over the exchange rate and pays special
attention to the maintenance of stability in the foreign exchanges markets. in net foreign
assets is absorbed by open market operations.
 Coordination between the Treasury and the Central Bank and the continuous borrowing
of the Treasury from the domestic financial markets has contributed to this outcome.
 Domestic interest rates are largely determined by the domestic borrowing strategy of the
Treasury. The Central Bank is an observer, rather than a player, in the process by which
the level of interest rates is determined.

5
1. Structures of central bank

The central banks carry out a nation’s monetary policy and control its money supply, often
mandated with maintaining low inflation and stead GDP growth.

On a macro basis, central banks influence interest rates and participate in open market operation
to control the cost of borrowing and lending throughout an economy.

In keeping with the institutional role defined by articles of association, the organization structure
of the central bank is based on a three level hierarchical model: Department, service and office.

There are three key entities in the federal reserve system: the board of governors, the federal
reserve banks (Reserve Banks), and the federal open market committee (FOMC).

2. Multiple deposit creation and the money supply process

Multiple deposit creation is the process of whereby, when the feed supplies the banking system
with $1 of additional reserve, deposits increase by a multiple of this amount.

Deposit creation is the ability of the commercial bank system to create new bank.

The multiple deposit creation process works like this: say that the central bank buys $100 of
securities from bank 1, which lends the $100 in cash it receives to some borrower. Said borrower
writes checks against the $100 in deposit created by the loan until all the money rests in bank 2.

Process of money supply is by purchasing bonds (or anything else for that matter), the central
bank increase the monetary base and hence, by some multiple, the money supply.

Money supply the movements in money supply affect interest rates and inflation in fact the entire
economy.

6
The central bank, depository institution of every stripe borrowers, and depositors all help to
determine the money supply. The central bank helps to determine the money supply by
controlling the monetary base (MB) aka high –powered money or its monetary liabilities.

Players in the money supply process

 Central bank:-The government agency that oversees the banking system and is
responsible for the conduct of monetary policy.
 Banks :-( Depository institutions)-financial intermediaries that accept deposits from
individual and institutions and make loans: commercial banks, saving and loan
association, mutual saving banks, and credit unions.
 Depositors (individuals and institutions)
 Borrowers (individuals and institutions

3. Determinants of the money supply

A lot of factors determine money supply. For instance, in the traditional or classical model of
money supply determination, to control the level of money supply, there are array of options,
which includes alteration of the cash reserve requirement. Raising or lowering the cash reserve
requirements or the deposits that are required of the commercial banks’ to keep with the central
bank or monetary authority can change the quantity of money supply.

It is to be noted that the larger the commercial banks’ deposit, the stronger is its capacity to
generate more money. Therefore, the apex bank normally targets the deposit money/commercial
banks deposit balances by raising the cash reserve requirement to regulate the growth of money
stock that may possibly generate inflation in the economy.

Fractional reserve banking is also believed to determine money stock: ―if only a small part of
deposits is withdrawn from a bank during a period, the bank does not have to maintain reserves

7
equal to deposits, but could increase its revenues by lending out a part or most of its deposits‖
(Handa, 2009).

Nonetheless, a crucial factor that is also important in the determination of the quantity of money
supply in addition to the aforementioned theoretically justified determinants but yet to be given
considerable attention to is the influence of structural economic transformation or reform
particularly the effect of financial liberalization reform. For example, according to Shaw (1973)
and McKinnon (1973), a restriction on the financial sector in the form of a high reserve
requirement, interest rate and direct credit ceiling hinders money flows, financial development
and economic activities.

Previous studies on the determinants of money supply centred largely around high-powered
money and money multiplier (Lodha & Lodha, 2012; Lone & Yadav, 2016; Odior, 2013),
reserve money, bank rate, and currency ratio (Tiwari, 2016; Shrestha, 2013; Muhammad & Islam,
2010), income or GDP and interest rate (Ifionu & Akinpelumi, 2013; Chigbu & Okorontah,
2013) and other variables of the same or similar characteristics. Studies like Khan and Hye
(2013) consider financial liberalization but as a determinant of money demand. In the classical or
traditional model of money supply determination, a cluster of economic variables like minimum
cash reserve ratio, currency ratio, bank reserve and liquidity ratio are the fundamental
determinants of money supply (Handa, 2009). In the Monetarists view, the primate factors are
the important variables to be considered in the money supply determination. In contrast, the Post-
Keynesians hold that the rate of interest and real output or economic activities which affect the
desire of the people to hold currency rather than deposits are what determine the level of money
supply at a point in time (Fontana, 2003).

4. Tools and conduct of monetary policy

The fed has traditionally used three tools to conduct monetary policy: reserve requirements, the
discount rate, and open market operation. In 2008, the fed added paying interest on reserve
balances held at reserve banks to its monetary policy toolkit.

8
  The main three tools of monetary policy are;-

1. Open market operation:-it is when central bank buys or sells securities. These are bought
from or sold the countries private banks. When the central bank buys securities, it adds cash to
the banks reserves. That gives them more money to lend.

2. Reserve requirements: - The U.S. Federal reserve uses open market operation to manage the
fed funds rate. Here’s how the fed funds rate works. If a bank cannot meet the reserve
requirement, it borrows from another bank that has excess cash.

3. The discount rates:-the rate that central banks charge their member banks to borrow at its
discount window. Because it’s higher than the fed funds rates, banks only use this if they can’t
borrow funds from other banks.

 The types of monetary operation tools:-

 Reserves
 Deposit and borrowing facilities
 Central bank bills
 Repurchase operations
 FX market operations

Tools of monetary policy for example, if a central bank increases the discount rate, the cost
borrowing for the banks increases. Subsequently, the banks will increase the interest rate they
charge their customers. Thus, the cost of borrowing in the economy will increase, and the
monetary supply will decrease. Tools of monetary policy also known as instruments of monetary
policy.

5. Monetary policy goals and targets

5.1.Monetary policy goals
The monetary policy goals are continually mentioned by personal at the federal reserve and other
central banks when they discuss the objectives of monetary policy:- 1) high employment, 2)
economic growth, 3) price stability, 4) interest-rate stability,5) stability of financial markets and
6) stability in foreign exchange markets.

9
1) High employment: - The Employment Act of 1946 and the Full Employment and Balanced
Growth Act of 1978 (more commonly called the Humphrey-Hawkins Act) commit the U.S.
government to promoting high employment consistent with a stable price level.
2) Economic growth:- The goal of steady economic growth is closely related to the high-
employment goal because businesses are more likely to invest in capital equipment to
increase productivity and economic growth when unemployment is low. Conversely, if
unemployment is high and factories are idle, it does not pay for a firm to invest in additional
plants and equipment.
3) Price stability:- Over the past few decades, policymakers in the United States have become
increasingly aware of the social and economic costs of inflation and more concerned with a
stable price level as a goal of economic policy. Indeed, price stability is increasingly viewed
as the most important goal for monetary policy.
4) Interest-rate stability:- Interest-rate stability is desirable because fluctuations in interest
rates can create uncertainty in the economy and make it harder to plan for the future.
Fluctuations in interest rates that affect consumers’ willingness to buy houses, for example,
make it more difficult for consumers to decide when to purchase a house and for construction
firms to plan how many houses to build.
5) Stability of financial markets:- The financial crises can interfere with the ability of
financial markets to channel funds to people with productive investment opportunities,
thereby leading to a sharp contraction in economic activity. The promotion of a more stable
financial system in which financial crises are avoided is thus an important goal for a central
bank.
6) Stability in foreign exchange markets:- With the increasing importance of international
trade to the U.S. economy, the value of the dollar relative to other currencies has become a
major consideration for the Fed. A rise in the value of the dollar makes American industries
less competitive with those abroad, and declines in the value of the dollar stimulate inflation
in the United States.

5.2. Monetary policy targets

The central bank’s problem is that it wishes to achieve certain goals, such as price stability
with high employment, but it does not directly influence the goals. It has a set of tools to
employ (open market operations, changes in the discount rate, and changes in reserve

10
 requirements) that can affect the goals indirectly after a period of time (typically more than a
year).

The rationale behind a central bank’s strategy of using targets suggests three criteria for
choosing an intermediate target: It must be measurable, it must be controllable by the central
bank, and it must have a predictable effect on the goal.

1. Measurability:- Quick and accurate measurement of an intermediate-target variable is

necessary, because the intermediate target will be useful only if it signals rapidly when policy
is off track.
Data on the monetary aggregates are obtained after a two-week delay, and interest-rate
data are available almost immediately. Data on a variable like GDP that serves as a goal,
by contrast, are compiled quarterly and are made available with a month’s delay. In
addition, the GDP data are less accurate than data on the monetary aggregates or interest
rates.
2. Controllability: - A central bank must be able to exercise effective control over a variable if it
is to function as a useful target. If the central bank cannot control an intermediate target,
knowing that it is off track does little good, because the central bank has no way of getting
the target back on track. Some economists have suggested that nominal GDP should be used
as an intermediate target, but since the central bank has little direct control over nominal
GDP, it will not provide much guidance on how the Fed should set its policy tools. A central
bank does, however, have a good deal of control over the monetary aggregates and interest
rates.
3. Predictable Effect on Goals: - The most important characteristic a variable must have to be
useful as an intermediate target is that it must have a predictable impact on a goal. If a central
bank can accurately and quickly measure the price of tea in China and can completely control
its price, what good will it does? The central bank cannot use the price of tea in China to
affect unemployment or the price level in its country.
Because the ability to affect goals is so critical to the usefulness of an intermediate-target
variable, the linkage of the money supply and interest rates with the goals—output,
employment, and the price level—is a matter of much debate.

11
Conclusion

A major innovation in modern monetary policy was the progressive merger of the analysis of the
macroeconomic effects of public choices of monetary policy makers with the study of the
structural features that characterize the policy makers (governments and central bankers), as well
as the rules and institutions that shape goals and incentives of central bankers and economic
agents.

Central banks need clear policy frameworks to achieve their objectives. Operational processes
tailored to each country’s circumstances enhance the effectiveness of the central banks’ policies.
The central bank has to be protected from risks of political capture, by being granted functional,
personal, operational and financial independence from government.

The current debate on central bank governance and monetary policy in advanced economies is at
a crossroads. For one thing, since 2008 central banks have pursued ultra-easy monetary policies,
designing and implementing conventional and unconventional strategies. For another, central
banks’ involvement in banking supervision and financial stability have strongly increased. On
top of that also the set of macroeconomic variables that may need to be considered by central
banks – beside consumer price inflation, also growth and employment, financial stability,
inequality – is being discussed.

12
Reference
1. (Tiwari, 2016; Shrestha, 2013; Muhammad & Islam, 2010), income or GDP and interest rate
(Ifionu & Akinpelumi, 2013; Chigbu & Okorontah, 2013).

2. (Lodha & Lodha, 2012; Lone & Yadav, 2016; Odior, 2013), reserve money, bank rate, and
currency ratio (Tiwari, 2016; Shrestha, 2013; Muhammad & Islam, 2010), income.

3. BAYOUMI, T., DELL’ ARICCIA, G., HABERMEIER, K., MANCINI-GRIFFOLI, T. and

VALENCIA, F., 2014, Monetary policy in the new normal, IMF staff discussion note, April.

4. BEKAERT, G., HOEROVA, M. and LO DUCA, M., 2013, ―Risk, uncertainty and monetary
policy‖, Journal of Monetary Economics, 60(7), 771-788.

5.WILLIAMS, J. C., 2014, Monetary Policy and the Zero Lower Bound: Putting Theory into
Practice, Washington, D.C., Hutchins Center for Fiscal and Monetary Policy at the Brookings
Institution.

13