Major Duties and Responsibilities of Central Bank

Conducting

monetary policy Supervising and regulating depository institutions Maintaining the stability of the financial system Providing payment and other financial services to the government, the public, FIs and foreign official institutions
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Functions Performed by the Central Banks

Assistance

in the Conduct of Monetary

Policy Supervision and Regulation Government Services New Currency Issue Check Clearing Wire Transfer Services Research Services
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Place of Central Bank in the Monetary System

Central Bank
Federal Reserve Sytem

Defines and regulates money supply

Lender of last Resort

Facilitates transfer of money through check processing/clearing

Banking System: 1. Creates money 2. Transfers money 3. Provides financial intermediation 4. Processes/clears checks
First Bank Other Banks Last Bank
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Balance Sheet of the Federal Reserve (in billions of dollars, 2002)

Assets Gold and foreign exchange SDR certificates Treasury currency Federal Reserve Float FR loans to domestic banks Security repurchase agreements U.S. Treasury securities U.S. government securities Miscellaneous assets Total assets $ 25.5 2.2 33.2 0.0 0.0 50.3 551..7 0.0 20.3 $683.2 Liabilities and Equity Depository institution reserves $ 17.5 Vault cash of commercial banks 47.3 Deposits due to federal government 7.1 Deposits due to rest of the world 0.1 Currency outside banks 596.2 Miscellaneous liabilities 7.8 FR Bank stock 7.2

Total liabilities and equity

$683.2

Objective of Monetary Policy

To

influence the amount of reserve in the banking system which affects interest rates and availability of credit and ultimately affects the levels of employment, output, prices and inflation

Money Stock
There

are a number of measures of a nations money stock (M). The narrowest measure is the sum of currency in circulation and the amount of transactions deposits (TD) in the banking system.

Money Multiplier
Most

nations require that a fraction of transactions deposits be held as reserves. The required fraction is determined by the reserve requirement (rr). This fraction determines the maximum change in the money stock that can result from a change in total reserves.

Money Multiplier
Under

the assumption that the monetary base is comprised of transactions deposits only, the multiplier is determined by the reserve requirement only. In this case, the money multiplier (m) is equal to 1 divided by the reserve requirement, m = 1/rr.
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Relating the Monetary Base and the Money Stock

Under

the assumptions above, we can write the money stock as the monetary base times the money multiplier. M = mMB = m(C + TR). The change in the money stock is expressed as M = m(C + TR).

Example - BOJ Intervention

Suppose

the Bank of Japan (BOJ) intervenes to strengthen the yen by selling 1 million of US dollar reserves to the private banking system. This action reduces the foreign exchange reserves and total reserves component of the BOJs balance sheet.

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BOJ Balance Sheet

Assets
FER -1 million

Liabilities
TR -1 million

Result: R

1 million, MB

1 million

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BOJ Intervention
Because

the monetary base declined, so will the money stock. Suppose the reserve requirement is 10 percent. The change in the money stock is M = m(DC + FER), M = (1/.10)(-1 million) = -10 million.

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Monetary Policy Tools

Open Market Operations

primary determinate of changes in excess reserves in the banking system impacting the size of the money supply and/or interest rates the rate of interest Central Bank charge on emergency loans to depository institutions
determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities
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The Discount Rate

Reserve Requirements

Tools of Monetary Policy

Open Market Operations

To change Reserves To offset other factors affecting Reserves Typically uses repos & reverse repos: Open market transactions to purchase gov. Securities with an aggrement that seller will repurchase them in a predetermined time period. Advantages of Open Market Operations 1. Central Bank has complete control 2. Flexible and precise 3. Easily reversed 4. Implemented quickly

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Open Market Operations

Monetary Base = Currency + Reserves

Open

Market Purchase from Bank

The Fed Assets Securities + $100 Liabilities Reserves +$100 Liabilities

The Banking System Assets Securities - $100 Reserves + $100

Result: R $100, MB $100

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Open Market Operations

Open Market Purchase from Public Public Assets Liabilities
Securities - $100 Deposits + $100 Banking System Assets Liabilities Reserves + $100 Deposits + $100

The Fed Assets

Securities + $100 Liabilities Reserves +$100

Result: R $100, MB $100

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Discount Rate

The rate on loans to depository instituions Ambiguous effect on money supply Signalling function: used to send a message to financial markets Lender of Last Resort Function 1. To prevent banking panics 2. To prevent non-bank financial panics

Moral Hazard Problem

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Discount Loans
Banking System Assets
Reserves + $100

The Fed Assets

Discount loan + $100

Liabilities
Discount loan + $100

Liabilities
Reserves + $100

Result: R $100, MB $100

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Reserve Requirements

Advantages 1. Powerful effect on money supply Disadvantages 1. Small changes have very large effect on MS 2. Raising reserve requirement ratio causes liquidity problems for banks 3. Frequent changes cause uncertainty for banks

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Goals of Monetary Policy

Goals 1. Price Stability 2. High Employment 3. Economic Growth 4. Interest Rate Stability 5. Financial Market Stability 6. Foreign Exchange Market Stability Goals often in conflict The primary objective of the Bank shall be to achieve and maintain price stability. Cental Bank of the Republic of Turkey
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A. Price Stability Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for inflation. Effort successful if monetary policy able to maintain steady rate of inflation. B. High Employment The movement of workers between jobs is referred to as frictional unemployment. All unemployment beyond frictional unemployment is classified as unintended unemployment. Reduction in this area is the target of macroeconomic policy. C. Economic Growth Economic growth is enhanced by investment in technological advances in production. Encouragement of savings supplies funds that can be drawn upon for investment. D. Interest Rate and Exchange Rate Stability Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected changes that cause damage, making policy formulation difficult. E. Conflicts Among Goals Goals frequently cannot be separated from each other and often conflict. Costs must therefore be carefully weighed before policy implementation.
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Impact of Monetary Policy on Various Economic Variables

Expansionary Activities

Contractionary Activities

Impact on Reserves Credit availability Money supply Interest rates Security prices

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Alternative Monetary Policies

Interest Rate Interest Rate MS MS

i=8% i*=6% i=4%

i* = 6% i= 5%

MD MD MD
Quantity of Money (in billions)

MD MD MD
MS

Quantity of Money (in billions)

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International Monetary Policies and Strategies

Foreign Exchange Intervention

1.

2.

Controlled exchange rate regimes under ERBS Programs To stabilize the unstable FX market similar to open market purchases and sales of Treasury securities
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Institutional Framework for a Credible Central Bank

Independence Accountability

Transparency

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