University of Hargeisa

Faculty of Business and Public Administration

Course Title: Banking Principles and Practice

Chapter five; The Role central bank in macro economy

Introduction
This chapter begins to explain the role of central banks in
our economic and financial system.
It will describe the origins of modern central banking.
It will examine the complexities policymakers now face in
meeting their responsibilities.
It will highlight a central question that has become
politically debatable: what is the proper relationship
between a central bank and the government?

15-2
The basics: How Central Banks Originated
and their Role Today
The central bank started out as the government’s bank
and over the years added various other functions.
A modern central bank not only manages the
government’s finances but provides an array of services
to commercial banks.

15-3
The Government’s Bank
In 1900, only 18 countries had a central bank.
The U.S. Federal Reserve began operation in 1914.
As the importance of a government and the financial
system grew, the need for a central bank grew along
with it.

15-4
The Government’s Bank
As the government’s bank, the central bank has a
privileged position.
It has the monopoly on the issuance of currency.
The central bank creates money.
Early central banks kept sufficient reserves to redeem
their notes in gold.
Today, the Fed has the sole legal authority to issue U.S.
dollar bills.

15-5
 The Central Bank
 Why would a country want to have its own monetary
policy?
 The primary reason for a country to create its own central
bank, then, is to ensure control over its currency.
1. At its most basic level, printing money is a very profitable
business.
 A bill only costs a few cents to print.
2. Government officials also know that losing control of the
printing presses means losing control of inflation.
 A high rate of money growth creates a high inflation rate.

15-6
Objectives of Central bank
A central bank is an independent national authority that
conducts monetary policy, regulates banks, and provides
financial services including economic research.
Its goals are:-
1. Low and stable inflation.
2. High and stable real growth, together with high
employment.
3. Stable financial market and institutions.
4. Stable interest rates.
5. A stable exchange rate.
 Conti-------
Monetary Policy
Central banks affect economic growth by controlling
the liquidity in the financial system. They have many 
tools of monetary policy to achieve this aim
First, they set a reserve requirement. That tells their
network of private banks how much cash to have on
hand each night. That controls how much banks can
lend.
Second, they use open market operations to buy and
sell securities from member banks. It changes the
amount of cash on hand without changing the reserve
requirement. They used this tool during the 2008
financial crisis. Banks bought government bonds and
mortgage-backed securities to stabilize the banking
system.
Low, Stable Inflation
Many central banks take their primary job as the
maintenance of price stability.
They strive to eliminate inflation.
The consensus is that when inflation rises, the central
bank is at fault.
The purchasing power of one dollar, one yen, or one
euro should remain stable over long periods of time.
Maintaining price stability enhances money’s
usefulness both as a unit of account and as a store of
value.

15-10
 Conti…..
Prices provide the information individuals and firms
need to ensure that resources are allocated to their
most productive uses.
But, inflation degrades the information content of
prices.
If the economy is to run efficiently, we need to be able
to tell the reason why prices are changing. The higher
inflation is, the less predictable it is, and the more
systematic risk it creates.
High inflation is also bad for growth.

15-11
High & Stable Real Growth
The idea is that there is some long-run sustainable level of
production called potential output, which depends on things
like
Technology,
The size of the capital stock, and
The number of people who can work.
Growth in these inputs leads to growth in potential output --
sustainable growth.
In the long run, stability leads to higher growth.
The greater the uncertainty about future business conditions,
the more cautious people will be in making investments of all
kinds.
15-12
 Conti….

Fluctuations in general business conditions are the

primary source of systematic risk, so stability is
important.
Uncertainty about the future make planning more
difficult, so less uncertainty makes everyone better off.

15-13
 Financial System Stability
The Fed was founded to stop the financial panics that
plagued the U.S. during the late 19th and early 20th
centuries.
Accordingly, financial system stability is an integral part of
every modern central banker’s job.
If people lose faith in financial institutions and markets,
they will rush to low-risk alternatives.
Intermediation will stop.
The possibility of a severe disruption in the financial
markets is a type of systematic risk.
Central banks must control this risk.
The value at risk is the important measure here.
This measures the risk of the maximum potential loss. 15-14
Interest-Rate and Exchange-Rate Stability
These goals are secondary to those of low inflation,
stable growth, and financial stability.
In the hierarchy, interest-rate stability and exchange-
rate stability are means for achieving the ultimate
goal of stabilizing the economy.

15-15
 Conti…….
Why is interest-rate volatility a problem?
1. Most people respond to low interest rates by
borrowing and spending more and vice versa.
 Interest-rate volatility makes output unstable.
2. Interest-rate volatility means higher risk and
therefore a higher risk premium.
 Risk makes financial decisions more difficult, lower
productivity, and lessen efficiency.

15-16
 Conti….
The value of a country’s currency affects the
cost of imports to domestic consumers and the
cost of exports to foreign buyers.
When the exchange rate is stable, the dollar
price of goods is predictable and planning ahead
is easier for everyone.
Stable exchange rates are very important.

15-17
Central bank and Commercial Bank
Differences
 central bank does not work for profits though it might
secure profits. While Commercial banks aim at securing
maximum profit for their shareholders, the central bank
aims at controlling the banking system and supporting
the economic policy of the government
 central bank is generally an organ of the government
and forms part of the govt. commercial banks may be
owned by the govt. or are privacy owned.
 The organization and management of the central bank
is fully controlled by the govt.
Meeting the Challenge: Creating a Successful
Central Bank
In the past several decades, overall economic
conditions improved nearly everywhere.
This was especially true in rapidly growing emerging
economics such as Brazil, China and India.
Growth was higher, inflation was lower, and both
were more stable than in the 1980s.
What explains this long period of stability?

15-19
 Conti…….
 A prime candidate is that technology generated a
boom just as central banks became better at their
jobs.
1. Monetary policymakers realized that sustainable
growth had gone up, so they could keep interest rates
low without worrying about inflation.
2. Central banks were redesigned.
 Many believes that improvements in economic
performance during the 1990s were related at least in
part to the policy followed by these restructured
central banks.

15-20
 Conti……...
 Today economists are exploring how to improve financial
regulation, and reconsidering the role that central banks
should play in financial supervision.
 To be successful, a central bank must:
1. Be independent of political pressure,
2. Make decisions by committee,
3. Be accountable to the public and transparent in communicating
its policy actions, and
4. Operate within an explicit framework that clearly states its goals.

15-21
The Need for Independence
The idea of central bank independence, that central
banks should be independent of political pressure, is a
new one.
After all, the central bank originated as the
government's bank.
 Independence has two operational components.
1. Monetary policymakers must be free to control their
own budgets.
2. The bank’s policies must not be reversible by people
outside the central bank.
15-22
Decision Making by Committee
Monetary policy decisions are made deliberately, after
significant amounts of information are collected and
examined.
Crises do occur, requiring someone to be in charge.
During normal operations, however, it is better to rely
on a committee than an individual.
Sharing the knowledge, experience, and opinions of a
group of people reduces the risk that policy will be
dictated by an individual’s quirks.
Therefore, monetary policy decisions are made by
committee in all major central banks in the world.
15-23
The Need for Accountability and
Transparency
Central bank independence is inconsistent with
representative democracy.
How can we have faith in our financial system if there
are no checks on what the central bankers are doing?
Proponents of central bank independence had a two
fold solution.

15-24
 Conti……….
1. Politicians would establish a set of goals.
2. The policymakers would publicly report their
progress in pursuing those goals.
 Explicit goals foster accountability and disclosure
requirements create transparency.
 The institutional means for assuring accountability
and transparency differ from one country to the
next.

15-25
 Conti…
Today every central bank announces its policy actions
almost immediately.
However the extent of the statements that accompany the
announcement and the willingness to answer questions vary.
 Central bank statements are very different today than they were in
the early 1990s.
Secrecy is now understood to damage both the
policymakers and the economies they are trying to
manage.
The economy and financial markets should respond to
information that everyone received, not to speculation
about what policymakers are doing.
Policy makers need to be as clear as possible.

15-26
Meaning and Definition of Monetary
policy
Monetary policy is the process by which the government,
central bank or monetary authority manages the supply of
money, or trading in foreign exchange markets.
 Monetary policy is the exercise of the central bank’s control
over conditions governing the quantity of money or money
supply. It is an instrument for achieving the objective of
general economic policy as set out by the national economic
goals i.e. economic growth, full employment and price
stability by influencing the level of aggregate demand and
there by the level of money income. Monetary policy
influences the behavior of expenditures, output, employment
and prices.
Fitting Everything Together:
Central Banks and Fiscal Policy

Fiscal policy involves decisions about government

spending and taxation. A budget deficit is the excess
of government expenditures over tax revenues for a
particular time period, typically a year, while a budget
surplus arises when tax revenues exceed government
expenditure.

15-28
 Conti…...
Both these policies must be reversed to prevent a large
future inflation.
When faced with a fiscal crisis, politicians often look
for the easiest way out.
If that way is inflating the value of the currency today,
they will worry about the consequences tomorrow.
Monetary policy can meet its objective of price stability
only if the government exists within its budget and
never forces the central bank to finance a fiscal deficit.

15-29
 Conti………
Responsible fiscal policy is essential to the success of
monetary policy.
There is no way for a poorly designed central bank to
stabilize prices, output, the financial system, and interest
and exchange rates, regardless of the government’s
behavior.
To be successful, a central bank must be independent,
accountable, and clear about its goals.
It must also have a well communications strategy and a
sound decision-making mechanism.

15-30
End OF THE CHAPTER

Thank You.