Central Banks & Monetary Policy PDF

GROUP 1 CENTRAL BANKS AND MONETARY POLICY Central Bank and it’s Origin A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. A central bank is a public institution that manages the currency of a country or gr...

GROUP 1 CENTRAL BANKS AND MONETARY POLICY Central Bank and it’s Origin A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. A central bank is a public institution that manages the currency of a country or group of countries and controls the money supply – literally, the amount of money in circulation. The main objective of many central banks is price stability. A central bank is not a commercial bank. An individual cannot open an account at a central bank or ask it for a loan and, as a public body, it is not motivated by profit. Commercial banks can turn to a central bank to borrow money, usually to cover very short-term needs. To borrow from the central banks they have to give collateral – an asset like a government bond or a corporate bond that has a value and acts as a guarantee that they will repay the money. Origin: – Early Banking Practices Ancient Civilizations *Banking activities, including deposit and loan management, were prevalent in ancient civilizations like Mesopotamia, Greece, and Rome, but not central banks but temple or merchant banks. Medieval Europe *During the Middle Ages, money lending and deposit-taking became more structured, with institutions like the Medici Bank emerging in Italy, but no central institution overseeing the broader financial system. – Formation of Early Central Banks Bank of Amsterdam (1609) *Facilitate trade and manage the city’s finances, it is considered one of the first examples of a central bank. Bank of Sweden (1668) *The Sveriges Riksbank, or Bank of Sweden, is often recognized as the world’s oldest central bank. – The Rise of Modern Central Banks Bank of England (1694) *The Bank of England, established to finance the war against France, played a crucial role in managing national debt and became a model for other central banks. Banque de France (1800) *Founded to stabilise the French economy after the turmoil of the French Revolution, it was tasked with managing the national debt and providing financial stability. 19th Century Developments Central Banking in the U.S *Two Central banks were established before the Federal Reserve System (1913). The First Bank of the United States (1791) and the Second Bank of the United States (1816) were both short-lived. Other European Central Banks *Influenced by the model set by the Bank of England. These institutions played critical roles in managing national finances and stabilising economies. 20th Century and Beyond Federal Reserve System (1913) *The Federal Reserve revolutionised U.S. monetary policy, introducing a safer, more flexible, and stable system through open market operations, discount rates, and reserve requirements. Post-World War II *Post-WWII, global central banks expanded to economic stabilisation and management, establishing institutions like the IMF and World Bank to support global economic development. Late 20th Century and 21st Century  *Central banks prioritised inflation management and financial stability amid 2008 and COVID-19 crises, demonstrating their ability to implement unconventional monetary policies like quantitative easing. 1. Issue Money The central bank has the exclusive authority to print and distribute the nation's currency. 2. Monetary Policy The central bank manages the economy's money supply and interest rates to achieve macroeconomic objectives, such as controlling inflation and promoting economic growth. 3. Ensure Stability of the Banking System The central bank regulates and supervises commercial banks to maintain the stability and soundness of the financial system. 4. Lender of Last Resort to Commercial Banks The central bank provides emergency funding to commercial banks facing liquidity crises to prevent bank runs and financial panic. 5. Lender of Last Resort to Government The central bank may provide funds to the government in times of financial crisis when other sources of funding are unavailable. Structure of Central Banking 1. Monetary Board This is the highest policy making body in the central bank. It is formulated to establish policies on monetary, banking, and credit matters to attain price and economic growth. 2. Governor The Governor is responsible for the execution of the policies determined by the Monetary Board, managing the overall internal affairs and acting as its official representative in all meetings at home and abroad. 3. Monetary and Economic Sector (MES) The MES is the part of an economy that is responsible for the design and implementation of monetary policy. 4. Financial Supervision Sector (FSS) The FSS is a sector governing the regulation and supervision of banks and other financial institutions. The sector regulates the banking laws and maintains standards for prudent banking practice to ensure the stability and soundness of the banking sector. 5. Corporate Services Sector (CSS) The CSS provides administrative and operational support. Human resources, information technology, finance, and other supporting services that have been important and helpful in the smooth running of the Operations. 6. Payments and Currency Management Sector (PCMS) : PCMS is responsible for the management of currency issuance and circulation in the country. The sector is responsible for heading across the national circulation of payment. 7. Regional Operations and Advocacy Sector, ROAS It does so through setting and implementing policy in areas such as currency issues, banking operations, and information and awareness campaigns in the country's regions. 2.3 The Creation of Money : What is Money? What is Money ? Money is commonly accepted by general consent as a medium of economic exchange It is the medium In which prices and values are expressed. It circulates from person to person and country to country facilitating trade and it is the principal measure of wealth. Functions of Money Money is a medium of exchange - Money is widely accepted as a method of payment. For example : Goods and services can be bought and sold with the use of money. Someone who wants shoes can buy it with money and if someone wants to sell shoes, that can also be done by receiving money. Store of Value - Store of value is an asset that can retain its purchasing power into the future and can be retrieved to be used again at a later time. For Example : Someone earning money on their paycheck and then depositing it in the bank later. Unit of Account - A unit of account is something that can be used to value goods and services, record debts, and make calculations. For Example: Money is a common example of a unit of account.Other units of account include gold and other precious metals, and cryptocurrency. The Barter System The barter system is an ancient method of trade where goods and services are exchanged directly without the use of money. It requires both parties to have what the other wants, making transactions difficult and inefficient. The barter system is the oldest form of trade, where goods and services are exchanged directly without the use of money. It required a "double coincidence of wants," meaning both parties had to have what the other wanted and be willing to trade. The Needs for Money Problems for Barter  Lack of a common measure of value In a barter system, there is no standard way to compare the value of different goods and services, which makes determining fair trades difficult. For example, deciding how many chickens are worth a cow can be subjective and vary between traders. This lack of a common measure leads to disagreements and inefficiencies in trading. Inconvenience of carrying goods: Transporting large or heavy goods for barter is often impractical, especially over long distances. For instance, trading livestock or bulky items like grain or pottery requires significant effort and resources just to move the goods. This physical inconvenience limits the scale of trade and makes transactions cumbersome. The need for more efficient As trade expanded and economies grew, there was a need for a more convenient and standardised medium of exchange. Money provided a solution by offering a universally accepted method to value and exchange goods and services, facilitating smoother and more efficient trade. The Early Forms of Money Commodity Money Commodity money refers to money that has intrinsic value, meaning it is valuable in and of itself, aside from its use as a medium of exchange. This type of money is typically made from a commodity that is widely desired and accepted for trade, such as gold, silver, copper, or other precious metals. The First Coins The first coins were created in Lydia (modern-day Turkey) around 600 BCE. These coins had standardised weights and were stamped with official symbols, ensuring their authenticity and value, which made trade easier and more reliable. Impact on trade - Coins made trading much faster and easier because they provided a standard value that everyone agreed on. - The use of coins increased trust in trade because each coin was backed by a government or authority, guaranteeing its value. The Introduction of Paper Money Paper money was first introduced in China during the Tang Dynasty as a way to simplify and facilitate trade. It was developed to address the inconvenience of carrying large amounts of metal coins. Benefits: Lighter, Easier to Transport, and Manage in Large Sums - Paper money was much lighter than metal coins, making it easier to carry and handle large amounts. Spread to the West - Paper money gradually spread to Europe in the 17th century, where it was adapted to fit Western economic systems. The Evolution of Modern Currency Fiat Money - Fiat money is currency that has no intrinsic value of its own; its value comes solely from government endorsement. Unlike commodity money, which is valuable in itself, fiat money is valuable because people trust and accept it as a means of payment. Digital Money - Digital money includes both electronic banking and cryptocurrencies, reflecting the latest evolution in financial transactions. The role of Central Banks Central banks manage a country's money supply, control inflation, and set interest rates to stabilize the economy. They regulate and supervise the banking system to ensure financial stability and trust in the currency. The European Central Bank (ECB) and the Monetary Policy The ECB is the central bank of the European Union countries which use the euro. Its main task is to maintain price stability. They do this by making sure that inflation remains low, stable and predictable. In this way, they seek to help you plan your saving and spending. Overview -Role: To manage the euro, keep prices stable and conduct EU economic & monetary policy -President: Christine Lagarde -Members: ECB President and -Vice-President and governors of national central banks from all EU countries -Established in: 1998 -Location: Frankfurt (Germany) -Website: European Central Bank What does the ECB do? -sets the interest rates at which it lends to commercial banks in the eurozone (also known as the euro area), thus controlling money supply and inflation -manages the eurozone's foreign currency reserves and the buying or selling of currencies to balance exchange rates -ensures that financial markets & institutions are well supervised by national authorities, and that payment systems work well -ensures the safety and soundness of the European banking system -authorizes production of euro banknotes by eurozone countries -monitors price trends and assesses risks to price stability. Composition The ECB President represents the Bank at high-level EU and international meetings. The ECB has the 3 following decision-making bodies: -Governing Council – the main decision-making body. Consists of the Executive Board (see below) plus the governors of the national central banks from eurozone countries. -Executive Board – handles the day-to-day running of the ECB. Consists of the ECB President and Vice-President and 4 other members appointed for 8-year terms by the leaders of the eurozone countries. -General Council – has more of an advisory & coordination role. Consists of the ECB President and Vice-President and the governors of the central banks from all EU countries. How does the ECB work? The ECB works with the national central banks of all EU countries. Together they form the European System of Central Banks. It leads to cooperation between central banks in the eurozone. This is referred to as the Eurosystem. -Governing Council – assesses economic and monetary developments, defines eurozone monetary policy and fixes the interest rates at which commercial banks can borrow from the ECB. -Executive Board – implements monetary policy, manages day-to-day operations, prepares Governing Council meetings and exercises powers delegated to it by the Governing Council. -General Council – contributes to advisory and coordination work and helps to prepare for new countries joining the euro. The Eurosystem is responsible for: -defining and implementing monetary policy -conducting foreign exchange operations -holding and managing the euro area’s foreign currency reserves -promoting the smooth operation of payment systems The ECB carries out specific tasks in the areas of banking supervision, banknotes, statistics, macroprudential policy and financial stability as well as international and European cooperation. What Is Monetary Policy? -Monetary policy is a set of tools used by a nation's central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements. Monetary policy is the control of the quantity of money available in an economy and the channels by which new money is supplied. Economic statistics such as gross domestic product (GDP), the rate of inflation, and industry and sector-specific growth rates influence monetary policy strategy. Types of Monetary Policy Contractionary Policy increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money. Expansionary Policy grows economic activity by lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase. Goals of Monetary Policy Inflation Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation. Unemployment An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market. Exchange Rates The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange. Central banks have four main monetary policy tools: the reserve requirement, open market operations, the discount rate, and interest on reserves. Most central banks also have a lot more tools at their disposal. These additional tools can include forward guidance, inflation targeting, and special lending programs. By utilizing a combination of these methods, central banks aim to influence economic activity and maintain financial stability. Supply and Demand: Monetary Base The monetary base, also known as the base money or the money base, represents the total amount of a currency in circulation or in commercial bank deposits in the central bank. It is a critical component in understanding the broader supply and demand dynamics within an economy, as it serves as the foundation upon which other forms of money are created through the banking system. Understanding the Monetary Base The monetary base (MB) consists of: Currency in circulation - This includes all paper money and coins used by the public. Reserves held by banks - These are the deposits that commercial banks hold in the central bank, which can be either required reserves (mandated by regulation) or excess reserves. Supply of the Monetary Base The supply of the monetary base is largely controlled by the central bank (e.g., the Federal Reserve in the United States). The central bank can influence the monetary base through: Open Market Operations (OMOs) The central bank buys or sells government securities in the open market. For example, when the central bank buys securities, it injects money into the economy, increasing the monetary base. Conversely, selling securities withdraws money from circulation, decreasing the monetary base. Discount Rate - The interest rate charged by the central bank to commercial banks for borrowing reserves. Lowering the discount rate encourages banks to borrow more, increasing the monetary base. Raising the discount rate has the opposite effect. Reserve Requirements - By altering the reserve requirements, the central bank can directly influence how much money banks can lend. A lower reserve requirement increases the money multiplier effect, expanding the monetary base indirectly. Demand for the Monetary Base The demand for the monetary base is driven by: Public Demand for Cash - People and businesses require cash for transactions and safety purposes, which is a direct demand on the monetary base. Banking System's Demand for Reserves - Banks need reserves to meet regulatory requirements and to manage daily transactions. An increase in economic activity typically raises the demand for reserves. Economic Conditions - During times of uncertainty or economic downturns, the demand for cash and reserves may increase as people and banks seek liquidity. Equilibrium in the Monetary Base Market Supply = Demand - Equilibrium in the monetary base market is achieved when the supply of the monetary base equals the demand from the public and banks. Impact on Interest Rates Excess Supply - If the supply of the monetary base exceeds demand, it leads to lower interest rates as banks have excess reserves that they are willing to lend at lower rates. Excess Demand - Conversely, if the demand exceeds supply, interest rates rise as banks compete for limited reserves. Impact of Central Bank Policies on the Monetary Base Central banks use various tools to influence the monetary base as part of their monetary policy to achieve macroeconomic objectives such as controlling inflation, managing unemployment, and stabilizing the currency. Expansionary Monetary Policy - The central bank increases the monetary base to stimulate economic activity. This can be done through lowering interest rates, purchasing government securities, and lowering reserve requirements. Contractionary Monetary Policy - The central bank decreases the monetary base to curb inflation. This involves selling government securities, raising interest rates, and increasing reserve requirements. The Money Multiplier Effect The monetary base is only a part of the total money supply in an economy. The money multiplier effect describes how banks create money through lending. For instance, if the reserve requirement is 10%, a bank that receives a $100 deposit can lend out $90, creating new money in the process. The original $100 is part of the monetary base, but through the multiplier effect, the total money supply can expand far beyond the monetary base itself.