Central Banking and Monetary Policy Overview

Central Bank Overview

• A central bank oversees a nation's or group of nations' monetary system and policy.
• It regulates money supply and sets interest rates.
• Central banks use monetary policy to keep the economy balanced.
• They set requirements for the banking industry, such as reserve requirements.
• Central banks can act as lenders of last resort to troubled financial institutions or governments.

What is Monetary Policy?

• Monetary policy is the set of financial policies adopted by a country's monetary authority (e.g., Federal Reserve) to achieve economic goals.
• It pertains to the actions a central bank takes to manage the money supply and interest rates in an economy, aiming to promote growth and stability.

Roles and Functions of a Central Bank

• Dictates monetary policy.
• Controls inflation, unemployment, and economic growth.
• Influences currency exchange rates.
• Adjusts interest rates (discount rate).
• Changes reserve requirements.
• Conducts open market operations (buying/selling government securities).
• Regulates the financial system.
• Provides banking services.
• Acts as a lender of last resort.
• Monitors economic data.

Monetary Policy Objectives

• Promote low and stable inflation for balanced and sustainable economic growth.
• Manage inflation, unemployment, and currency exchange rates.

Monetary Policy Tools

• Interest rate adjustment: Central banks influence interest rates by changing the discount rate (base rate).
  • Increasing the discount rate raises borrowing costs, decreasing the money supply in the economy.
  • Decreasing the discount rate lowers borrowing costs, increasing the money supply.
• Change reserve requirements: Central banks set minimum reserve requirements for commercial banks.
  • Increasing reserve requirements reduces the amount of money banks have available to lend.
  • Decreasing reserve requirements increases the amount of money banks have available to lend.
• Open market operations: Central banks buy or sell government securities to influence the money supply.
  • Buying securities injects more money in the economy, increasing the money supply.
  • Selling securities withdraws money from the economy, decreasing the money supply.

Capital Requirements and Capital Adequacy

• Capital requirements: Standardized regulations for banks and depository institutions, determining the amount of liquid capital (easily sold securities) held relative to assets.
• Capital adequacy ratio (CAR): Measures a bank's ability to pay its debts if borrowers are unable to repay loans. It's a capital-to-risk-weighted assets ratio (CRAR).
  • A higher CAR suggests lower risk of bank failure.

Reserve Requirement & Discount Rate Policy

• Reserve requirement: Percentage of a commercial bank's deposits kept in cash as reserves to cover customer withdrawals.
• Discount rate: Interest rate a central bank charges commercial banks for short-term loans.

Expansionary and Contractionary Monetary Policy

• Expansionary: Increases money supply to stimulate spending and economic growth during recessions. This often means lower interest rates.
• Contractionary: Decreases money supply to fight inflation by reducing spending. This often means higher interest rates.

Monetary Transmission Mechanism

• Process of monetary policy decisions affecting the economy's overall activity and price levels.
• Two stages:
  • Changes to monetary policy affect interest rates in the economy.
  • Changes in interest rates affect economic activity and inflation.

Channels of Monetary Policy Transmission

• Saving and investment channel: Lower interest rates stimulate spending.
• Cash flow channel: Reduced lending rates increase available cash.
• Asset prices and wealth channel: Lower rates boost asset values.
• Exchange rate channel: Lower rates devalue currency, impacting exports.

Aggregate Demand

• Aggregate demand is the total spending in an economy.
• Policies to affect aggregate demand influence spending.

Discussion Questions

1. Channels of Monetary Policy: Monetary policy has various channels because it impacts different parts of the economy (e.g., interest rates, investment, consumption). This can be an advantage because it can address several economic problems through numerous avenues. However, such a complex system can also be disadvantageous because of the numerous factors influencing the extent to which the intervention works.

2. Required Reserves Ratio:

   • An expansionary policy would lower the reserve ratio, freeing up funds for loans and stimulating the economy.
   • A contractionary policy would increase the reserve ratio to reduce lending, curbing inflation and spending.