Central Bank Overview PDF

CENTRAL BANK: An overview Prepared by MVB What is a Central Bank? A financial institution that is responsible for overseeing the monetary system and policy of a nation or group of nations, regulating its money supply, and setting interest rates. Central banks enact monetary policy, by e...

CENTRAL BANK: An overview Prepared by MVB What is a Central Bank? A financial institution that is responsible for overseeing the monetary system and policy of a nation or group of nations, regulating its money supply, and setting interest rates. Central banks enact monetary policy, by easing or tightening the money supply and availability of credit, central banks seek to keep a nation's economy well-balanced. A central bank sets requirements for the banking industry, such as the amount of cash reserves banks must maintain vis-à-vis their deposits. A central bank can be a lender of last resort to troubled financial institutions and even governments. What is Monetary Policy? It refers to the financial policies adopted by the monetary authority of a country, such as the Federal Reserve, to achieve the country's economic goals. It refers to the actions taken by a central bank or monetary authority to manage the supply of money and interest rates in an economy, with the aim of promoting economic growth and stability. Roles and Functions of a Central Bank Dictates Monetary Policy Important to Control: Inflation Unemployment Growth Other mandates Influence currency exchange rates Interest rates adjustments – Discount rate charged to banks for short-term borrowings Changes to reserve requirements – Banks set aside a percentage of their deposits as reserves Open market operations – Buying and selling government securities Regulate the financial system Provide banking services Lenders of last resort Monitor economic data Monetary Policy Objectives & Instruments Examples of Objectives: 1. To promote a low and stable inflation conducive to a balanced and sustainable economic growth. (www.bsp.gov.ph) 2. To manage inflation, unemployment and maintenance of currency exchange rates. (https://corporatefinanceinstitute.com/) I. Inflation II. Unemployment III. Currency exchange rates Monetary Policy Objectives & Instruments Tools of Monetary Policy Central banks use various tools to implement monetary policies. The widely utilized policy tools include: 1. Interest rate adjustment - A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease. Monetary Policy Objectives & Instruments 2. Change reserve requirements Central banks usually set up the minimum amount of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients, and thus, money supply decreases. Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves). Monetary Policy Objectives & Instruments 3. Open market operations The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy. Capital Requirement and Capital Adequacy Capital Requirement - are standardized regulations in place for banks and other depository institutions that determine how much liquid capital (that is, easily sold securities) must be held in relation to a certain level of their assets. Example: (www.bworldonline.com) As of September 2022, the BSP raised the minimum capital requirement for rural banks to at least P50 million, as it seeks to further strengthen the local banking industry. 6 to 10 branches – minimum capital, P120 million. More than 10 branches – minimum capital, P200 million Capital Requirement and Capital Adequacy Capital Adequacy – A measure of a bank’s or other financial institution’s ability to pay its debts if people or organizations are unable to pay back the money they have borrowed from the bank. Capital Adequacy Ratio (CAR) - an indicator of how well a bank can meet its obligations. Also known as the capital-to-risk weighted assets ratio (CRAR), the ratio compares capital to risk-weighted assets and is watched by regulators to determine a bank's risk of failure. It's used to protect depositors and promote the stability and efficiency of financial systems around the world. Capital Adequacy Ratio (CAR) continued… Given: Tier 1 – P20M; Tier 2 – P5M; Loans – P65M (Minimum CAR of BSP – 10%) Where: Tier-1 capital, core funds on hand to manage losses so that a bank can continue operating Tier-2 capital, a secondary supply of funds available from the sale of assets once a bank closes down Risk Weighted Assets are the loans and other assets of a bank Reserve Requirement & Discount Rate Policy Reserve Requirement – The percentage of a commercial bank’s deposits that it must keep in cash as a reserve in case of mass customer withdrawals. Example: Reserve Requirement & Discount Rate Policy Discount Rate Policy –A tool taken by the central bank to control the money circulation by raising or lowering interest rates. If the Central Bank raised bank rates, the aim is to reduce money supply in the economy. With the high rates, people are expected to not take out loans and save their money in bank. Example: $100 invested today in a savings scheme that offers a 10% interest rate will grow to $110. In other words, $110, which is the future value (FV), when discounted by the rate of 10% is worth $100 (present value) as of today. Expansionary and Contractionary Expansionary Monetary Policy – It fosters inflationary pressure and increases the amount of money in circulation. When there is “too little money” in the economy which dampens overall demand for goods and services, the Central Bank “loosens” the faucet to expand money supply. Also known as “loose monetary policy.” Contractionary Monetary Policy - Use to temper inflation and reduce the level of money circulating in the economy. When there is “too much money” in the economy supporting overall demand for goods and services which, in turn, increases inflationary pressures, the Central Bank “tightens” the faucet to reduce the money supply. This action dampens demand which could lead to lower inflation. Also known as “tight monetary policy.” Expansionary and Contractionary The Monetary Transmission Mechanism The process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission of monetary policy describes how changes made by the Reserve Bank to its monetary policy settings flow through to economic activity and inflation. This process is complex and there is a large degree of uncertainty about the timing and size of the impact on the economy. The Monetary Transmission Mechanism In simple terms, the transmission can be summarized in two stages. 1. Changes to monetary policy affect interest rates in the economy. 2. Changes to interest rates affect economic activity and inflation. The Monetary Transmission Mechanism 1ST Stage:  The cash rate is the market interest rate for overnight loans between financial institutions.  It has a strong influence over other interest rates, such as deposit and lending rates for households and businesses. The Reserve Bank’s other monetary policy tools work primarily by affecting longer-term interest rates in the economy. There are other determinants such as conditions in financial markets, changes in competition, and risk associated with different types of loans – It can impact interest rates. The Monetary Transmission Mechanism 2nd Stage:  Changes to monetary policy influence economic activity and inflation.  Low interest rates for households and businesses affect aggregate demand and inflation (vice-versa). Aggregate Demand Lower interest rates increases aggregate demand by stimulating spending.  It can take a while for the supply of goods and services to respond because more workers, equipment and infrastructure may be required to produce them.  As businesses increase their prices more rapidly in response to higher demand, this leads to higher inflation. Aggregate demand is the amount of total spending on domestic goods and services in an economy. Aggregate supply is the total quantity of output firms will produce and sell—in other words, the real GDP. Aggregate Demand  There is a lag between changes to monetary policy and its effect on economic activity and inflation because households and businesses take time to adjust their behavior. Some estimates suggest that it takes between one and two years for monetary policy to have its maximum effect.  There is a large degree of uncertainty about these estimates because the structure of the economy changes over time, and economic conditions vary. Because of this, the overall effects of monetary policy and the length of time it takes to affect the economy can vary. Inflation Expectations Inflation expectations matter for the transmission of monetary policy. For example, if workers expect inflation to increase, they might ask for larger wage increases to keep up with the changes in inflation. Higher wage growth would then contribute to higher inflation. By having an inflation target, the central bank can anchor inflation expectations. This should increase the confidence of households and businesses in making decisions about saving and investment because uncertainty about the economy is reduced. Channels of Monetary Policy Transmission Saving and Investment Channel Monetary policy influences economic activity by changing the incentives for saving and investment. This channel typically affects consumption, housing investment and business investment. Lower interest rates on bank deposits reduce the incentives households have to save their money. Instead, there is an increased incentive for households to spend their money on goods and services. Lower interest rates for loans can encourage households to borrow more as they face lower repayments. Because of this, lower lending rates support higher demand for assets, such as housing. Lower lending rates can increase investment spending by businesses (on capital goods like new equipment or buildings). This is because the cost of borrowing is lower, and because of increased demand for the goods and services they supply. Channels of Monetary Policy Transmission Cash-flow Channel Monetary policy influences interest rates, which affects the decisions of households and businesses by changing the amount of cash they have available to spend on goods and services. A reduction in lending rates reduces interest repayments on debt, increasing the amount of cash available for households and businesses to spend on goods and services. A reduction in interest rates reduces the amount of income that households and businesses get from deposits, and some may choose to restrict their spending. Channels of Monetary Policy Transmission Asset Prices and Wealth Channel Lower interest rates support asset prices (such as housing and equities) by encouraging demand for assets. One reason for this is because the present discounted value of future income is higher when interest rates are lower. Higher asset prices also increases the equity (collateral) of an asset that is available for banks to lend against. This can make it easier for households and businesses to borrow. An increase in asset prices increases people's wealth. This can lead to higher consumption and housing investment as households generally spend some share of any increase in their wealth Channels of Monetary Policy Transmission Exchange Rate Channel The exchange rate can have an important influence on economic activity and inflation in a small open economy. It is typically more important for sectors that are export oriented or exposed to competition from imported goods and services. If the central bank lowers the cash rate it means that interest rates have fallen compared with interest rates in the rest of the world (all else being equal). Lower interest rates reduce the returns investors earn from assets (relative to other countries). Lower returns reduce demand for assets with investors shifting their funds to foreign assets (and currencies) instead. A reduction in interest rates (compared with the rest of the world) typically results in a lower exchange rate, making foreign goods and services more expensive compared with those produced in your country. This leads to an increase in exports and domestic activity. A lower exchange rate also adds to inflation because imports become more expensive in your country. The Monetary Transmission Mechanism (Philippines) (319) Understanding Monetary Policy Transmission Mechanism – YouTube End of slide Sources Michael W. Brandl (2017) Money, Banking, Financial Markets & Institutions: The Ohio State University www.investopedia.com www.indiacharts.com www.oecd.org www.investing.com www.financestrategists.com https://pressbooks-dev.oer.hawaii.edu/principlesofeconomics www.rba.gov.au, rba.gov.au/education Understanding Monetary Policy Transmission Mechanism - YouTube Discussion Questions 1. Explain why the monetary policy has various different channels through which it can operate? Is this an advantage or disadvantage? Explain. 2. If a central bank wants to pursue an expansionary monetary policy (contractionary monetary policy), what happens to the required reserves ratio?