Functions of Central Banks PRESENTATION BY KHALID EL-HABASSI

A basic definition of central banks. A central bank is the monetary authority of a country (or union in the case of the EU). Some of its responsibilities include issuing currency and assisting in making the banking system work. The ECB (European central bank), the Federal Reserve, the Bank of Canada and the Bank of England are examples of central banks. They differ from commercial banks as a central bank has the ability to set monetary policies (e.g. Inflation Targeting), while governments, are in charge of the fiscal policy. Central banks are often private and independent from the government, such as the Fed and the Bank of England. However, as a rule monetary policies of central banks are influenced a lot by government. This means that in reality they are not as independent. A good example is the current ECB. The ECB has been forced to play a more political role since the onset of the crisis and has repeatedly intervened in debates over the EU’s crisis management, resolution and prevention measures.

Maintaining price stability Maintaining price stability, is insuring that there will not be too much inflation or deflation. This policy is also known as inflation targeting and it is achieved through adjustments of the interest rate. This is often one of the key objectives some central banks set while in some cases this is the single target of a central bank. Australia, Brazil, Canada, Norway, Sweden and the UK are some of the countries that currently use this policy. To provide confidence that money will retain its purchasing power is one of the main targets that an inflation targeting approach to monetary policy has.

Inflation targeting in depth However, although a 2% inflation rate is considered low and healthy, over time this creates a visible depreciation of the currency. As you can see at the below image, the Canadian dollar has lost about 50% of its value over the past 20 years even though inflation was at an average of 2.00%. US figures also show loss of currency value due to inflation. As of March 2012 $8.8 trillion was on deposit in American banks. With an inflation rate of 1.5% and an interest rate of 0.12% those DEPOSITS LOST roughly $120 billion in value over the last year. Then when combining the loss of purchasing power of 2013, 2012, 2011 and 2010, the total reaches $635 billion dollars which is equal to the GDP of Ireland, Luxembourg and Denmark.

Tools that control money supply Open market operations Reserve requirements Discount rate

Open market operations The above actions are usually implemented during recessions, as an attempt by Central Banks to assist growth. Central Bank Central bank increases the amount of money in the banking system via purchase of bonds. Banks As the banks have a higher money supply, they reduce interest rates and liquidate the economy by issuing loans. Individual The individual borrows more money resulting in higher consumption and investments.

Open market operations The above actions are usually implemented as an attempt by Central Banks to decrease inflation. Central Bank Central bank decreases the amount of money in the banking system via selling bonds. Commercial Banks As the banks have a reduced money supply, they increase interest rates and thus reducing liquidity in the economy. Individual The individual borrows less money resulting in lower consumption and so a fall of prices would reduce inflation.

= Representing total cash available to issue in the form of loans. = Representing total cash required to reserve. Reserve requirements is basically the minimum amount of cash that banks have to keep as reserves, relative to what they lend out. The pyramids illustrate the amount of cash a commercial bank has. We can understand that the higher the ratio of reserve requirements, the less the cash available for the bank to loan. So since the bank has less to loan, the money supply in the economy is reduced. However, the measure of higher reserve requirements creates more robust banks and thus there is more confidence in the banking system. Reserve requirements

Reserve requirements by country (2010) according to the IMF. CountryRequired reserves in % AustraliaNone CanadaNone SwedenNone ECB (Eurozone)2.00 Russia2.50 Switzerland2.50 Kenya4.50 Georgia5.00 India5.75 Chile6.60 Jordan7.00 Maldives24.50 The Bank of England has a voluntary reserve ratio system, with no minimum reserve requirement set. In theory this means that banks could retain zero reserves, allowing an infinite amount of credit money creation. However, the reserve ratio across the entire United Kingdom banking system is at a 3.1% average as of In the US, banks with net transactions accounts: Of less than $12.4 million have a 0% reserve requirement; Between $12.4 million and $79.5 a 3% reserve requirement and Exceeding $79.5 million must have a ratio of 10%.

Discount rate The discount rate is the rate of interest that the Central Bank charges commercial banks when borrowing. The discount rate may be also be referred to as ‘interest rate’ or ‘ bank rate.’ In the case of a decrease in the discount rate, the banking system borrows more. This additional then flows into the economy via loans. Thus a decrease in the discount rate, increases the money supply. The opposite occurs when discount rates increase. Banks borrow less, therefore they lend less and so there is a lower money supply in the economy.

Role of central banks by ABCT Ineffective central bank policies, such as the unsustainable expansion the money supply, are the predominant cause of most business cycles, as they tend to set interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles", and artificially low savings. –Murray Rothbard focused on the role of central banks in creating an environment of loose credit prior to the Great Depression and the following ineffectiveness of the Fed, which delayed necessary price adjustments and extended market dysfunction. Malinvestments are often caused due to false signals generate by artificially low interest rates by central banks. Thus in a market free of central banks, malinvestments would not cluster simultaneously according to Rothbard. In contrast to the Austrian Business Cycle Theory (ABCT), there is the Neutrality of money idea. Neutrality of money is simply the idea that the change in money supply has absolutely no impact on figures such as the real GDP, employment and real consumption. Therefore, monetary policies do not have an actual impact on the economy.

European Central Bank The ECB’s key monetary policy decision are made by the Governing Council. The council consists of the 17 Euro Area Central Bank Governors, plus a 6 member Executive Board (appointed by leaders of Euro Area countries). It was established in 1998, has its headquarters in Frankfurt and Mario Draghi is the president of the ECB The ECB has a base borrowing rate of 0.50% To strengthen troubled European banks, the ECB has provided them with unlimited liquidity at a low fixed rate and for longer than usual (up to a year). In 2009 and 2010 the ECB purchased €60bn in bonds issued by banks in an attempt to restart the market which had slowed down. As the crisis moved into sovereign debt markets, the ECB began to intervene directly to purchase the debt of Ireland, Portugal and Greece. Total purchases under this Securities Market Program amount to around €74bn.

Federal Reserve Bank The Federal Reserve is the second largest holder of US debt after the US Social Security Fund and thus holds more US debt than China, the third largest holder of US debt. Ben Bernanke is the Chairman Headquarters are in Washington D.C. The Fed’s Base borrowing rate 0%–0.25%