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CENTRAL BANKING AND

MONETARY POLICY

GD20503

Financial Markets and Institutions

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OUTLINES Central Banks (CBs)i. Introductionii. Central Bank’s Balance Sheetiii. How Central Bank Controls the Money

Supply Mechanics of Monetary Policy Impact of Monetary Policy Global Monetary Policy

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INTRODUCTION A central bank, reserve bank, or monetary

authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country.

The primary function of a central bank is to provide the nation's money supply, but more active duties include controlling interest rates (via monetary policy), and acting as a lender of last resort to the banking sector.

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CENTRAL BANK’S BALANCE SHEET The conduct of monetary policy by central

bank (CB) involves actions that affect its balance sheet. This is a simplified version of its balance sheet, which we will use to illustrate the effects of CB actions.

Assets Liabilities

Government securities Currency in circulation

Discount loans Reserves

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CENTRAL BANK’S BALANCE SHEET The monetary liabilities of the CB include:

Currency in circulation: the physical currency in the hands of the public, which is accepted as a medium of exchange worldwide.

Reserves: All banks maintain deposits with the central bank, known as reserves. The required reserve ratio, set by the CB, determines the required reserves that a bank must maintain with the CB.

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CENTRAL BANK’S BALANCE SHEET The monetary assets of the CB include:

Government Securities: These are government Treasury bills and bonds that the CB has purchased in the open market. As we will show, purchasing Treasury securities increases the money supply.

Discount Loans: These are loans made to member banks at the current discount rate. Again, an increase in discount loans will also increase the money supply.

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HOW CENTRAL BANK CONTROLS THE MONEY SUPPLY:1. Open Market Operations

a. Purchase of securitiesb. Sale of securities

2. Adjusting the Reserve Requirement Ratioa. Reserve requirement adjustments affect

money growth because higher reserves lead to less borrowing and lower reserves lead to more borrowing

3. Adjusting the CB’s Loan Rate (discount rate)a. An increase in discount loans will

increase the money supply and vice versa.

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MECHANICS OF MONETARY POLICY The monetary policy goals of most central banks are

to achieve a low level of inflation, a low level of unemployment and economic growth.

They assess indicators of the above mentioned economic variables before they determine their monetary policy:

1. Indicators of Economic Growtha. Central bank monitors

i. GDP ii. Industrial production indexiii. Unemployment rateiv. National Income

2. Indicators of Inflationa. Producer and consumer price indexesb. Other inflation indicators

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MECHANICS OF MONETARY POLICY How Monetary Policy Corrects the Economy:

1. Correcting a Weak Economy: (see Exhibits 5.2 and 5.4)a. CB can increase the level of spending to

stimulate the economyb. Use open market operations to increase

the money supply2. Correcting High Inflation (see Exhibits 5.3

and 5.4)a. CB can institute a tight-money policy

using open market operations to reduce money supply growth.

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EXHIBIT 5.4 HOW MONETARY POLICY CAN AFFECT ECONOMIC CONDITIONS

Correcting a weak economy

Correcting high inflation

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EXHIBIT 5.2: EFFECTS OF AN INCREASED MONEY SUPPLY

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EXHIBIT 5.3 EFFECTS OF A REDUCED MONEY SUPPLY

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MECHANICS OF MONETARY POLICY Limitations of Monetary Policy:

1. Impact of a Credit Crunch: even if CB increases the level of bank funds, banks may be unwilling to extend credit.

2. Lagged Effects of Monetary Policy: a monetary policy may have an immediate impact on the

economy to some degree, but its full impact may not occur until year or so after the implementation.

a. Recognition lag – the lag between the time a problem arises and the time it is recognized

b. Implementation lag – the lag from the time a serious problem is recognized until the time the CB implements a policy

c. Impact lag – the lag from the time the policy is implemented until the policy has its full impact on the economy

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MECHANICS OF MONETARY POLICY3. Impact of a Stimulative Policy on Expected

Inflation (see Exhibit 5.5): Effect of increase in money supply growth

may be disrupted due to an increase in inflationary expectations.

Theory of Rational Expectations:Business and households expect that an increase in money growth will cause higher inflation

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EXHIBIT 5.5 EFFECTS OF AN INCREASED MONEY SUPPLY ACCORDING TO THE RATIONAL EXPECTATIONS THEORY

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MECHANICS OF MONETARY POLICY

Tradeoff in Monetary Policy:

1. Inverse relationship between inflation and unemployment. a. Strong economic condition:

high inflation, low unemployment

b. Weak economic condition: low inflation, high unemployment

The CB may not be able to solve both problems simultaneously. Thus, the CB must determine whether unemployment or inflation is the more serious problem.

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MECHANICS OF MONETARY POLICY

2. Impact of other forces on the tradeoff

Historical data on annual inflation and unemployment rates show that when one of these problems worsens, the other does not automatically improve.

Both variables can rise or fall simultaneously over time.

For example, (i) a rise in oil prices lead to higher inflation and (ii) various training centers for unskilled workers have been closed. Assume that both (i) and (ii) happen at the same time.

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MECHANICS OF MONETARY POLICY

4. How Monetary Policy Responds to Fiscal Policy

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IMPACT OF MONETARY POLICY1. Impact on Financial Markets (see Exhibits

5.9 and 5.10)

2. Impact on Financial Institutions (see Exhibits 5.9 and 5.10)

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EXHIBIT 5.9 HOW MONETARY POLICY AFFECTS FINANCIAL CONDITIONS

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EXHIBIT 5.10 IMPACT OF MONETARY POLICY ACROSS FINANCIAL MARKETS

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GLOBAL MONETARY POLICY1. Impact of domestic currency

a. If economic conditions are weak, a strong domestic currency will not provide the stimulus needed to improve conditions

b. CB may need to implement a stimulative monetary policy.

2. Impact of global economic conditionsa. As economic conditions are strongly integrated

across countries, CB usually considers prevailing global economic conditions when conducting monetary policy.

b. For example, the Fed’s decision to lower U.S. interest rates during the 2008 credit crisis and stimulate the U.S. economy was partially driven by weak global economic conditions.

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GLOBAL MONETARY POLICY3. Transmission of Interest Rates

a. Global interest rates will vary between countries

b. Countries with higher interest rates will attract investors from countries with lower interest rates

c. If investors leave due to falling domestic interest rates, the CB may believe it should act to prevent rates from falling lower