CENTRAL BANKING

Central Bank ( reserve bank, or monetary authority)

- an institution that manages a state's currency, money supply, and interest rates.
Other roles:
- oversee the commercial banking system of their respective countries
- (In contrast to a commercial bank), a CB possesses a monopoly on increasing the monetary base in
the state
- - usually also prints the national currency which usually serves as the state's legal tender.

Primary function
- to control the nation's money supply (monetary policy)
Through active duties such as:
a. managing interest rates;
b. setting the reserve requirement
c. acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis.
- Central banks usually also have supervisory powers
to prevent bank runs, and to reduce the risk that commercial banks and other financial institutions engage in reckless or
fraudulent behavior.

Central banks in most developed nations are institutionally designed to be independent from political interference.

 Still, limited control by the executive and legislative bodies usually exists.

developed - Japan, Singapore, Germany, US, Australia

developing - Philippines , Indonesia,

underdeveloped –

The central bank has been described as "the lender of last resort“

- which means that it is responsible for providing its economy with funds when commercial banks cannot cover a supply
shortage
- to prevents the country's banking system from failing.
- However, the primary goal of central banks is to provide their countries' currencies with price stability by
controlling inflation.

The central bank also acts as the regulatory authority of a country's monetary policy 
-is the sole provider and printer of notes and coins (mint) in circulation.
Time has proved that the central bank can best function in these capacities by remaining independent from
government fiscal policy and therefore uninfluenced by the political concerns of any regime. The central bank should also
be completely divested of any commercial banking interests.

Real gross domestic product (real GDP)

is an inflation-adjusted measure that reflects the value of all goods and services produced by an
economy in a given year (expressed in base-year prices). and is often referred to as "constant-price,"
"inflation-corrected", or "constant dollar" GDP.
GDP is important because it gives information about the size of the economy and how an economy is performing. The
growth rate of real GDP is often used as an indicator of the general health of the economy. In broad terms, an increase in
real GDP is interpreted as a sign that the economy is doing well.
Formula

R = real GDP

{N} = nominal GDP

{D} = GDP deflator

In general, calculating real GDP is done by dividing nominal GDP by the GDP deflator (R). For example, if an economy's
prices have increased by 1% since the base year, the deflating number is 1.01. If nominal GDP was $1 million, then real
GDP is calculated as $1,000,000 / 1.01, or $990,099.

1000000 1.15 869565.2174

1.01 990099.0099
1.1 909090.9091
What is nominal GDP? Nominal GDP measures a country's gross domestic product using current prices, without
adjusting for inflation. Contrast this with real GDP, which measures a country's economic output adjusted for the impact
of inflation.

Do central banks play an important role in the global economy?

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 carry out a nation's monetary policy and control its money supply, often mandated with maintaining low
inflation and steady GDP growth.
On a macro basis, central banks influence interest rates and participate in open market operations to control the cost of
borrowing and lending throughout an economy.

The role of central banks in a globalised economy

Jean-Claude Trichet, President of the ECB on the occasion of the 13th Conférence de MontréalMontreal, 18 June 2007
(European Central Bank – ECB )
1. Globalisation and some of its underlying trends
2. The integration of the euro area within a globalised economy
3. The implications of globalisation for central banks
- Globalisation and monetary policy.
- Role of central banks in mitigating risks to financial stability stemming from globalisation.

• Monetary policy

- is the process by which the monetary authority of a country, typically the central bank or currency board, controls
either the cost of very short-term borrowing or the monetary base, often targeting an inflation rate or interest rate to
ensure price stability and general trust in the currency.
 • Monetary policy
• Further goals of a monetary policy are:

- usually to contribute to the stability of gross domestic product, to achieve and maintain low unemployment, and to
maintain predictable exchange rates with other currencies.
• Monetary economics provides insight into how to craft an optimal monetary policy.
• In developed countries, monetary policy has generally been formed separately from fiscal policy, which
refers to taxation, government spending, and associated borrowing.[4]
• US, Japan, Australia, Euro (UK. . Norway, Netherlands, Belgium, Germany, Luxemburg, France. Switzerland,)

• Monetary policy
• Monetary policy is referred to as being either expansionary or contractionary. Expansionary policy is when a
monetary authority uses its tools to stimulate the economy. An expansionary policy maintains short-term
interest rates at a lower than usual rate or increases the total supply of money in the economy more rapidly
than usual.
• It is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope
that less expensive credit will entice businesses into expanding. This increases aggregate demand (the overall
demand for all goods and services in an economy), which boosts short-term growth as measured by gross
domestic product (GDP) growth. Expansionary monetary policy usually diminishes the value of the currency
relative to other currencies (the exchange rate).[5]

• Monetary policy
• The opposite of expansionary monetary policy is contractionary monetary policy, which maintains short-term
interest rates higher than usual or which slows the rate of growth in the money supply or even shrinks it.
This slows short-term economic growth and lessens inflation.
• Contractionary monetary policy can lead to increased unemployment and depressed borrowing and
spending by consumers and businesses, which can eventually result in an economic recession if
implemented too vigorously.[6]

Inc demand = result to less supply = inc Price =

Low demand = inc supply = lower the price
Hyperinflation = too much money in circulation = super high price of goods and services

P D S
P D S

• History
• Monetary policy is associated with interest rates and availability of credit. Instruments of monetary policy
have included short-term interest rates and bank reserves through the monetary base.[7]
• For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions
to print paper money to create credit. Interest rates, while now thought of as part of monetary authority,
were not generally coordinated with the other forms of monetary policy during this time.
• Monetary policy was seen as an executive decision, and was generally in the hands of the authority with
seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the
price between gold and silver, and the price of the local currency to foreign currencies. This official price
could be enforced by law, even if it varied from the market price.
• MINTING THE COIN = MINT

• History
• Paper money originated from promissory notes called "jiaozi" in 7th century China. Jiaozi did not replace
metallic currency, and were used alongside the copper coins. The successive Yuan Dynasty was the first
government to use paper currency as the predominant circulating medium. In the later course of the
dynasty, facing massive shortages of specie to fund war and their rule in China, they began printing paper
money without restrictions, resulting in hyperinflation.
• With the creation of the Bank of England in 1694,[8] which acquired the responsibility to print notes and
back them with gold, the idea of monetary policy as independent of executive action began to be
established.[9] The goal of monetary policy was to maintain the value of the coinage, print notes which
would trade at par to specie, and prevent coins from leaving circulation.

• History
• The establishment of central banks by industrializing nations was associated then with the desire to
maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed
currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates
that they charged, both their own borrowers, and other banks who required liquidity.
• The maintenance of a gold standard required almost monthly adjustments of interest rates. The gold
standard is a system under which the price of the national currency is measured in units of gold bars and is
kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base currency.
The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of
 commodity price level targeting. Nowadays this type of monetary policy is no longer used by any country.
[10]
• History
• During the period 1870–1920, the industrialized nations set up central banking systems, with one of the last being
the Federal Reserve in 1913.[11] By this point the role of the central bank as the "lender of last resort" was
understood.
• It was also increasingly understood that interest rates had an effect on the entire economy, in no small part
because of the marginal revolution in economics, which demonstrated how people would change a decision based
on a change in the economic trade-offs.

• History
• Monetarist economists long contended that the money-supply growth could affect the macroeconomy.
These included Milton Friedman who early in his career advocated that government budget deficits during
recessions be financed in equal amount by money creation to help to stimulate aggregate demand for
output.[12] Later he advocated simply increasing the monetary supply at a low, constant rate, as the best
way of maintaining low inflation and stable output growth.[13]
• However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was
found to be impractical, because of the highly unstable relationship between monetary aggregates and other
macroeconomic variables.[14] Even Milton Friedman later acknowledged that direct money supply targeting
was less successful than he had hoped.[15]

• History
• Therefore, monetary decisions today take into account a wider range of factors, such as:
• short-term interest rates;
• long-term interest rates;
• velocity of money through the economy;
• exchange rates;
• credit quality;
• bonds and equities (debt and corporate ownership);
• government versus private sector spending/savings;
• ·nternational capital flows of money on large scales;
• financial derivatives such as options, swaps, futures contracts, etc.

• Monetary policy instruments

• Main article: Central bank § Policy instruments
• Conventional instrument
• The central bank influences interest rates by expanding or contracting the monetary base, which consists of
currency in circulation and banks' reserves on deposit at the central bank. Central banks have three main
tools of monetary policy: open market operations, the discount rate and the reserve requirements.

• Monetary policy instruments

• An important tool with which a central bank can affect the monetary base is open market operations, if its
country has a well developed market for its government bonds. This entails managing the quantity of money
in circulation through the buying and selling of various financial instruments, such as treasury bills, company
bonds, or foreign currencies, in exchange for money on deposit at the central bank. Those deposits are
convertible to currency, so all of these purchases or sales result in more or less base currency entering or
leaving market circulation.
• For example, if the central bank wishes to lower interest rates (executing expansionary monetary policy), it
purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve
accounts.

• Monetary policy instruments

• Commercial banks then have more money to lend, so they reduce lending rates, making loans less expensive.
Cheaper credit card interest rates boost consumer spending. Additionally, when business loans are more
affordable, companies can expand to keep up with consumer demand. They ultimately hire more workers,
whose incomes rise, which in its turn also increases the demand. This tool is usually enough to stimulate
demand and drive economic growth to a healthy rate. Usually, the short-term goal of open market
operations is to achieve a specific short-term interest rate target.
• In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to
some foreign currency or else relative to gold. For example, in the case of the United States the Federal
Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight;
however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a
basket of foreign currencies.

• Monetary policy instruments

 • If the open market operations do not lead to the desired effects, a second tool can be used: the central bank
can increase or decrease the interest rate it charges on discounts or overdrafts (loans from the central bank
to commercial banks, see discount window). If the interest rate on such transactions is sufficiently low,
commercial banks can borrow from the central bank to meet reserve requirements and use the additional
liquidity to expand their balance sheets, increasing the credit available to the economy.
• Monetary policy instruments
• Unconventional monetary policy at the zero bound
• Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are concerns
about deflation or deflation is occurring, are referred to as unconventional monetary policy. These include credit
easing, quantitative easing, forward guidance, and signaling.[16]
• In credit easing, a central bank purchases private sector assets to improve liquidity and improve access to credit.
Signaling can be used to lower market expectations for lower interest rates in the future. For example, during the
credit crisis of 2008, the US Federal Reserve indicated rates would be low for an "extended period", and the Bank
of Canada made a "conditional commitment" to keep rates at the lower bound of 25 basis points (0.25%) until the
end of the second quarter of 2010.

• Monetary policy instruments

• Unconventional monetary policy at the zero bound
• Further heterodox monetary policy proposals include the idea of helicopter money whereby central banks
would create money without assets as counterpart in their balance sheet. The money created could be
distributed directly to the population as a citizen's dividend. This option has been increasingly discussed
since March 2016 after the ECB's president Mario Draghi said he found the concept "very interesting".[17]

• Monetary policy instruments

• Unconventional monetNominal anchors
• A nominal anchor for monetary policy is a single variable or device which the central bank uses to pin down
expectations of private agents about the nominal price level or its path or about what the central bank might
do with respect to achieving that path. Monetary regimes combine long-run nominal anchoring with
flexibility in the short run. Nominal variables used as anchors primarily include exchange rate targets, money
supply targets, and inflation targets with interest rate policy.[18] ary policy at the zero bound

• Monetary policy instruments

• Types
• In practice, to implement any type of monetary policy the main tool used is modifying the amount of base
money in circulation. The monetary authority does this by buying or selling financial assets (usually
government obligations). These open market operations change either the amount of money or its liquidity
(if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies
the effects of these actions.

• Monetary policy instruments

• Types
• Constant market transactions by the monetary authority modify the supply of currency and this impacts
other market variables such as short-term interest rates and the exchange rate.
• The distinction between the various types of monetary policy lies primarily with the set of instruments and
target variables that are used by the monetary authority to achieve their goals.

Policy: Target Market Variable: Long Term Objective:

Interest rate on overnight A given rate of change in

Inflation Targeting
Price Level Targeting
Monetary Aggregates
Fixed Exchange Rate
Gold Standard
debt the CPI
Interest rate on overnight
A specific CPI number
debt
A given rate of change in
The growth in money supply
the CPI
The spot price of the The spot price of the
currency currency
Low inflation as measured by
The spot price of gold
the gold price

Mixed Policy Usually interest rates Usually unemployment + CPI

 change

Target Market
Monetary Policy: Long Term Objective:
Variable:
Interest rate on A given rate of change in
Inflation Targeting
overnight debt the CPI
Interest rate on
Price Level Targeting A specific CPI number
overnight debt
The growth in money A given rate of change in
Monetary Aggregates
supply the CPI
The spot price of the The spot price of the
Fixed Exchange Rate
currency currency
Low inflation as
Gold Standard The spot price of gold measured by the gold
price
Usually unemployment +
Mixed Policy Usually interest rates
CPI change

• What are the 3 main tools of monetary policy?

• The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy. The
Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and
reserve requirements.