Introduction to Banking Finance Introduction to central banking
Introduction to Banking & Finance Introduction to central banking
Today’s objectives Ø To identify the main functions of a central bank Ø To understand the monetary policy functions of central banks Ø To understand the arguments put forward by the free banking theorists Ø To discuss the arguments for and against an independent central bank Ø To understand the relevance of central banks during financial crises
What is a central bank? “Financial institution responsible for overseeing the national / supra national monetary system in support of economic growth with managed inflation”. 1. 2. 3. 4. 5. ֎ Control of the supply of cash Control of the terms and availability of credit Control credit issuing NBFIs Oversight & lender of last resort Banker to the government The Money supply
Policy and policy tools There are 5 main elements of macro economic policy 1. Monetary policy: effectively control of cash and credit 2. Fiscal policy: government taxation and spending 3. Exchange rate policy: Market intervention I. Free float Exchange controls II. Dirty float / pegged Import tariffs III. Fixed Quotas 4. National debt management policy 5. Prices & incomes policy ֎
Monetary policy Ø The process by which the CB controls the cost of very short-term borrowing and /or the money supply. Ø Often targets an inflation rate or interest rate to ensure price stability and general trust in the currency by maintaining predictable exchange rates with other currencies. Ø Also aims to contribute to the stability of gross domestic product, to achieve and maintain low unemployment. In developed countries, monetary policy has generally been formed separately from fiscal policy Ø It is normally either expansionary or contractionary.
Monetary policy Ø Expansionary policy v Stimulates the economy. v Short-term interest rates are lower than usual v Grows the total supply of money v Combats unemployment by lowering interest rates: cheaper credit encourages businesses to expand. This increases aggregate demand, which boosts growth. v Expansionary monetary policy usually causes the exchange rate to fall against other currencies. Ø Contractionary policy: v Increases interest rates higher which slows the rate of growth in the money supply. v This slows short-term economic growth inflation. v Can lead to increased unemployment and lower borrowing and spending by consumers and businesses. ֎
Monetary aggregates NB: UK also uses additional measures: M 0 (narrow) and M 4 (Broad)
Instruments, targets & goals ֎
Open Market Operations Ø Open market operations: Basically: if the CB sells bonds, money supply drops, if they buy back money supply increases. This impacts liquidity and interest rates, if only via liquidity preference.
The discount window Ø The discount window allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions. In simple terms: increase the discount rate, banks will borrow less, M 1, liquidity and thus lending will contract, and this will force the interest rate up.
Reserve requirements By increasing the reserve requirement, the CB is essentially taking money out of the money supply and increasing the cost of credit. Lowering the reserve requirement pumps money into the economy by giving banks excess reserves, which promotes the expansion for bank credit and lowers rates. ֎
Monetary policy: Summary
Other options Ø Special deposits v. Requirement by the central bank for specific institutions to place additional funds, at 0% with the CB and thus take them out of the lending reserve base. Sometimes called the corset , the main aim is to take excess liquidity out of the market. Ø Moral suasion (Informal) v. Requests to BNBFIs regarding, e. g. Lending priorities. v. Mixed results nowadays Ø Direct controls (Formal) v. More common in developing / emerging markets v. Again, sectorally targeted
Portfolio constraints Ø These effectively limit the asset classes or size of exposures that (normally) banks can hold. Less popular nowadays, but do still get used in emerging markets. Ø Pros: v. May help to constrain bank speculation v. May add to depositor confidence Ø Cons: v. Difficult to enforce or define in deregulated markets v Disintermediation limits their effectiveness v. Only really work where exchange controls are in place v. Discriminatory / anti-competitive in nature
Policy transmission
Subjectivity Vs Fixed rules
Unconventional monetary policy Ø Used when interest rates are at or near the zero bound Ø Aim is to stop deflation Ø Types include: v. Credit easing v. Quantitative easing v. Forward guidance v. Signalling ֎
Do we need central banks? Ø Ø Ø LOLR Liquidity & Solvency Reputation Efficiency in the market CB Vs “Free Banking” Independence Vs State Control v. Instrument independence v. Goal Independence
Central Bank independence
- Slides: 19