1
CENTRAL BANK AND ITS
ROLE IN FINANCIAL SYSTEM
______________________
1
Marijana Ćurak - University of Split, Faculty of Economics
Undergraduate study program: Business study
Financial institutions and markets
Academic year 2014/2015
10/21/2014
These lecture slides are based on the
book:
Mishkin F. S., Eakins, S. G. (2012), Financial
Markets + Institutions, Addison Wesley
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
2
AGENDA
Introduction
Independence of central banks
Central bank’s balance sheet
Conduct of monetary policy: tools, goals, strategy, and
tactics
Review points
Marijana Ćurak - University of Split, Faculty of Economics
3
10/21/2014
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INTRODUCTION (1)
Central banks are among the most
important players in financial markets
throughout the world
The banks are the government authorities
in charge of monetary policy
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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INTRODUCTION (2)
Monetary policy involves the management of
interest rates and the quantity of money
Central banks’ actions affect
interest rates
the amount of credit
and the supply of money
all of which have direct impacts not only on
financial markets, but also on aggregate output
and inflation
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Marijana Ćurak - University of Split, Faculty of Economics
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INDEPENDENCE OF CENTRAL BANKS (1)
An increasing number of nations have been giving more
independence to their central banks
Politicians who strongly oppose a central bank policy
often want to bring it under their supervision so as to
impose a policy more to their liking
Should the central bank be independent, or would we be
better of with a central bank under the control of the
president or the parliament?
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Marijana Ćurak - University of Split, Faculty of Economics
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THE CASE FOR INDEPENDENCE (1)
1. The strongest argument for an independent central
bank rests on the view that subjecting the central banks
to be more political pressures would impart an
inflationary bias to monetary policy
Politicians may be shortsighted because they are driven
by the need to win their next election
They are unlikely to focus on long-run objectives, such
as promoting stabile price level
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Marijana Ćurak - University of Split, Faculty of Economics
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THE CASE FOR INDEPENDENCE (2)
2. The political process in democratic societies
could lead to a political business cycle, in which
just before an election, expansionary policies are
pursued to lower unemployment and interest
rates
After the election, the bad effects of these
policies – high inflation and high interest rates –
cause problems
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Marijana Ćurak - University of Split, Faculty of Economics
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THE CASE FOR INDEPENDENCE (3)
3. Dangerous in case in which the central bank
can be used to facilitate financing of large
budget deficits by its purchases of government
securities
Government pressure on the central bank to
“help out” might lead to more inflation in the
economy
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Marijana Ćurak - University of Split, Faculty of Economics
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THE CASE FOR INDEPENDENCE (4)
4. Control of monetary policy is too
important to leave to politicians, a group
that has repeatedly demonstrated a lack
of expertise at making hard decisions on
issues of great economic importance, such
as reducing the budget deficit or
reforming the banking system
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Marijana Ćurak - University of Split, Faculty of Economics
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THE CASE AGAINST INDEPENDENCE (1)
1. It is undemocratic to have monetary policy
(which affects almost everyone in the economy)
controlled by an elite group that is responsible
to no one
2. To achieve a cohesive program that will
promote economic stability, monetary policy
must be coordinated with fiscal policy
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Marijana Ćurak - University of Split, Faculty of Economics
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THE CASE AGAINST INDEPENDENCE (2)
3. An independent central bank has not
always used its freedom successfully (the
FED failed in its stated role as lender of
last resort during the Great Depression)
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Marijana Ćurak - University of Split, Faculty of Economics
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INDEPENDENCE OF CENTRAL BANKS (2)
There is yet no consensus on whether
central bank independence is a good
thing, although public support for
independence of the central bank seems
to have been growing
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Marijana Ćurak - University of Split, Faculty of Economics
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CENTRAL BANK BALANCE SHEET (1)
The conduct of monetary policy involves
actions that affect the central bank
balance sheet
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Marijana Ćurak - University of Split, Faculty of Economics
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CENTRAL BANK BALANCE SHEET (2)
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Marijana Ćurak - University of Split, Faculty of Economics
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ASSETS
LIABILITIES
Government securities
Discount loans
Currency in circulation
Reserves
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LIABILITIES (1)
Currency in circulation
The amount of currency in the hands of the
public (outside of banks) – an important
component of the money supply
Reserves
Deposits at the central bank plus currency
that is physically held by banks
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Marijana Ćurak - University of Split, Faculty of Economics
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LIABILITIES (2)
Reserves are assets for the banks but
liabilities for the central banks
Total reserves:
Required reserves – reserves that the central
bank requires banks to hold
Excess reserves: any additional reserves the
banks choose to hold
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Marijana Ćurak - University of Split, Faculty of Economics
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LIABILITIES (3)
The liabilities are an important part of the
money supply
The sum of the central bank’s monetary
liabilities (currency in circulation and
reserves) and the Treasury's monetary
liabilities is the monetary base
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Marijana Ćurak - University of Split, Faculty of Economics
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ASSETS
Government securites
The assets that covers the central bank’s
holdings of securites by the Treasury
Discount loans
Loans that are provided by the central bank
to banks
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Marijana Ćurak - University of Split, Faculty of Economics
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TOOLS OF MONETARY POLICY
Open market operations
Discount policy
Reserve requirements
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Marijana Ćurak - University of Split, Faculty of Economics
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OPEN MARKET OPERATIONS (1)
The central bank’s purchase or sale of
bonds in the open market
The most important monetary policy tool
because they are the primary determinant
of changes of reserves in the banking
system and interest rates
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Marijana Ćurak - University of Split, Faculty of Economics
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EXAMPLE OF OPEN MARKET OPERATION (1)
The central bynk purchase 100 EUR of
bonds from the publilc
The person/corporation that sels the 100
EUR bonds to the central bank deposit the
central bank money in the local bank
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NONBANK PUBLIC
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ASSETS
LIABILITIES
Securities
- 100
Deposits
+ 100
EXAMPLE OF OPEN MARKET OPERATION (2)
When the bank receives the money, it
evidence it on the depositor’s account with
100 EUR and then deposits it in its
account with the central bank, thereby
adding to its reserves
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BANKING SYSTEM
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ASSETS
LIABILITIES
Reserves
+ 100
Deposits
+ 100
EXAMPLE OF OPEN MARKET
OPERATION (3)
The central bank has gained 100 EUR of
securities, while reserves have increased
by 100 EUR
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CENTRAL BANK
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ASSETS
LIABILITIES
Securities
+ 100 Reserves
+ 100
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OPEN MARKET OPERATIONS (2)
An open market purchase leads to an expansion
of reserves and deposits in the banking system
and hence to an expansion of the money supply
An open market sale leads to a contraction of
reserves and deposits in the banking system and
hence to a decline in the money supply
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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OPEN MARKET OPERATIONS (3)
There are to basic types of transactions:
Repurchase agreement (repo) – the central bank
purchases securities with an agreement that the seller
will repurchase them in a short period of time,
anywhere from 1 to 15 days from the original date of
purchase
Matched sale-purchase transaction (reverse repo) –
the central bank sells securities and the buyer agrees
to sell them to the central bank in the near future
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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DISCOUNT LENDING (1)
The central bank’s loan a bank
The discount window – the facility at which
banks can borrow reserves from the central
bank
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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EXAMPLE OF DISCOUNT LENDING
The central bank makes 100 EUR discount
loan to the Bank A
The central bank credits 100 EUR to the
bank’s reserve account
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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BANKING SYSTEM
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Marijana Ćurak - University of Split, Faculty of Economics
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ASSETS
LIABILITIES
Reserves
+ 100
Discount loans
+ 100
CENTRAL BANK
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Marijana Ćurak - University of Split, Faculty of Economics
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ASSETS
LIABILITIES
Discount loans
+ 100
Reserves
+ 100
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DISCOUNT LENDING (2)
A discount loan leads to an expansion of
reserves, which can be lent out as
deposits, thereby leading to an expansion
of the money supply
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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DISCOUNT LENDING (3)
When a bank repays its discount loan and
so reduces the total amount of discount
lending, the amount of reserves decreases
along with the money supply
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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DISCOUNT LENDING (4)
Lender of last resort
In addition to its use as a tool to influence
reserves the money supply, discounting is
important in preventing and coping with
financial panics
The central bank prevent bank failures
spinning out of control
The central bank provides reserves to bank
when no one else would, preventing bank and
financial panics
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Marijana Ćurak - University of Split, Faculty of Economics
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TYPES OF DISCOUNT LOANS
Primary credit
Secondary credit
Seasonal credit
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PRIMARY CREDIT
Standing lending facility
It allows healthy banks to borrow at very short
maturities
It is intended to be a backup source of liquidity for
sound banks
The interest rate on these loans is the discount rate
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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DISCOUNT RATES
Country/Central bank
Percentage
Japan
0.1
USA
0.5
ECB
0.75
UK
0.5
Poland
2.0
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Marijana Ćurak - University of Split, Faculty of Economics
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Souce: http://www.cbrates.com
and
http://mecometer.com/topic/central-bank-discount-rate/
(Assessed: October 18, 2014)
14
SECONDARY CREDIT
Is given to banks that are in financial
trouble and are experiencing severe
liquidity problems
The interest rate on these loans is set at a
higher, penalty rate to reflect the less-
sound condition of these borrowers
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Marijana Ćurak - University of Split, Faculty of Economics
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SEASONAL CREDIT
It is given to meet the need of a limited
number of small banks in vacation and
agricultural areas that have a seasonal
pattern of deposits
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Marijana Ćurak - University of Split, Faculty of Economics
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RESERVE REQUIREMENTS (1)
The regulations make it obligatory for
depository institutions to keep a certain
fraction of their deposits as reserves with
the central banks
Changes in reserves requirements affect
the demand for reserves
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Marijana Ćurak - University of Split, Faculty of Economics
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RESERVE REQUIREMENTS (2)
A rise in reserve requirements means that
banks must hold more reserves, and a
reduction means that they are required to
hold less
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Marijana Ćurak - University of Split, Faculty of Economics
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GOALS OF MONETARY POLICY (1)
The most important goal of monetary policy is
price stability – low and stabile inflation
Price stability is desirable because a rising price
level (inflation) creates uncertainty in the
economy, and that uncertainty might hamper
economic growth
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Marijana Ćurak - University of Split, Faculty of Economics
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GOALS OF MONETARY POLICY (2)
Other goals:
High employment
Economic growth
Stability of financial markets
Interest-rate stability
Stability in foreign exchange markets
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Marijana Ćurak - University of Split, Faculty of Economics
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INFLATION TARGETING (1)
It has become the most common
monetary policy strategy that countries
use to achieve price stability
Inflation targeting involves several
elements:
Public announcement of medium-term
numerical targets of inflation
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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INFLATION TARGETING (2)
An institutional commitment to price stability
as the primary, long-run goal of monetary
policy and a commitment to achieve the
inflation goal
An information-inclusive approach in which
many variables are used in making decisions
about monetary policy
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Marijana Ćurak - University of Split, Faculty of Economics
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INFLATION TARGETING (3)
Increased transparency of the monetary
policy strategy through communication with
the public and the markets about the plans
and objectives of monetary policy makers
Increased accountability of the central bank
for attaining its inflation objectives
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TACTICS: CHOOSING THE POLICY INSTRUMENT (1)
The policy instrument (operating instrument) is
a variable that responds to the central bank’s
tool and indicates the stance (easy or tight) of
monetary policy
There are two basic types of policy instruments
Reserve aggregates (total reserves, non-borrowed
reserves, the monetary base, and the non-borrowed
base)
Interest rates (central bank funds rate and other
short-term interest rate)
10/21/2014
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TACTICS: CHOOSING THE POLICY INSTRUMENT (1)
Central banks in small countries can choose
another policy instrument, the exchange rate
The policy instrument might be linked to an
intermediate target, such as a monetary
aggregate like M2 or a long-term interest rate
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Marijana Ćurak - University of Split, Faculty of Economics
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TACTICS: CHOOSING THE POLICY INSTRUMENT (3)
Intermediate targets stand between the
policy instrument and the goals of
monetary policy (e.g. price stability,
output growth)
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Marijana Ćurak - University of Split, Faculty of Economics
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CRITERIA FOR CHOOSING THE POLICY
INSTRUMENT
Observability and measurability
Controllability
Predictable effect on goals
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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REVIEW POINTS (1)
Central banks are the government
authorities in charge of monetary policy
Tools of monetary policy:
Open market operations
Discount policy
Reserve requirements
10/21/2014
Marijana Ćurak - University of Split, Faculty of Economics
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REVIEW POINTS (2)
The price stability is the main goal of
monetary policy
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Marijana Ćurak - University of Split, Faculty of Economics
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REFERENCES
Mishkin F. S., Eakins, S. G. (2012), Financial
Markets + Institutions, Addison Wesley
Marijana Ćurak - University of Split, Faculty of Economics
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10/21/2014
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