19. Role of the Central Bank 19.1 Role of the Central Bank in a Financial System 19.1.1 Lender of Last Resort Protection against bank panics Provides banks with short-term liquidity needed to offset unexpected deposit withdrawals Short-term liquidity provided through short-term loans Loans are made through the discount window. The discount rate at which banks can borrow from the Central Bank depends on the creditworthiness of the bank.

19.1.2 Ensure the Integrity of the Financial System In some countries such as Germany and the UK, the central bank has a regulatory role In Canada and the US, there are separate regulatory bodies for banks. Still, the central bank must ensure that the payments system works effectively. Concerns over settlement risk or Herstatt risk 19.1.3 Banker’s Bank Holds the reserves of commercial banks and depository institutions Cheque clearing services Government’s bank

19.1.4 Controlling the Money Supply and setting Monetary Policy Of the four roles of the central bank, this is its most important role and the focus of most of its energies Many of the policy objectives of the bank are met through monetary policy. High Employment Economic Growth Price Stability Interest Rate and Exchange Stability Some of the policy objectives may be at odds with one another. For instance, low monetary growth is likely to reduce inflation but at the same time slow the economy and increase unemployment. Before discussing the policies pursued by a central bank, we first discuss how money supply is controlled by the central bank.

19.2 Changing the discount rate Discount rate is the rate at which the central bank loans funds to the individual banks. Note this is different from the fed funds rate which is the rate at which commercial banks loan to one another. Reducing the discount rate will encourage banks to take out more discount loans and indirectly increase the money supply Increasing the discount rate could similarly “tighten” the money supply. Disadvantages: (1) Do not directly control the monetary base since it depends on the amount borrowed by banks. Therefore, it is difficult to determine the size of the the expansion or contraction. (2) Difficult to distinguish between a change in the discount rate resulting from changes in the Fed fund rate or from an actual policy change. A change in the discount rate from Fed fund rate is considered a defensive moves, whereas a change in the discount rate from a policy move is considered a dynamic move.

19.3 Reserve Requirement Recall from our discussion of banking institutions that they have to hold approximately 10% of their transaction based deposits (checking accounts) in reserves with the central bank. Increasing the reserve requirement means more of the money in circulation has to be set aside in reserves thereby reducing the money supply. Because of the multiplier affect (discussed later) of the reserve requirement on money supply, a small change in the reserve requirement will result in an enormous change in the money supply. Increasing the reserve requirement can increase the risk-taking of the bank because more of their assets are earning zero returns.

19.4 Open Market Operations The most common method of controlling the money supply is to increase the monetary base in the country. Two possible policy goals a central bank may choose to pursue--expand or contract the monetary base. Expanding the Money Supply The central bank purchases Treasury bills from individuals and institutions. Individuals trade in their Treasury bills and receive cash for them. The new cash is deposited with banks and adds to the reserves and money supply in central banks. Contracting the Money Supply The central bank sells Treasury bills to individuals and institutions.

19.4 Open Market Operations When deciding on the amount of treasury bills to purchase or sell, several factors are considered. Movements in other factors affecting money supply Cost and current prices of treasury bills (Tbills are usually used because of their liquidity.) Find willing buyers or purchasers of the Treasury bills and order from best to least prices Dynamic operations: Policy oriented operations that are permanently added or subtracted from reserves Defensive operations: Offset temporary changes in the money supply. Use repos and reverse repos to accomplish this goal. Advantages: Direct control over the money supply unlike the discount rate, quick to implement, actions are easy to reverse without drawing attention

19.5 How Open Market Operations affects the Money Supply Individuals Assets Liabilities Tbills -$100 Cash $100 Commercial Bank Reserves $100 Deposits $100 Central Bank Tbills $100 Reserves $100

19.5 The Multiplier affect of an Expansionary Open Market Operation Commercial Bank Assets Liabilities Reserves $100 Deposits$100 Loans $0 Remember the bank only needs to hold 10% in reserves. Reserves $10 Deposits $100 Loans $90 The new loans in the economy will eventually be deposited Reserves $100 Deposits $190 But once again the bank is holding too much in reserves so it lends the excess.

19.5 The Multiplier affect of an Expansionary Open Market Operation (Cont.) The process is completed when Assets Liabilities Reserves $100 Deposits$1000 Loans $900 A small change in the monetary base using open market operations results in a large affect on the money supply. The affect of the change in the monetary base (reserves) on the money supply is determined by the money multiplier. (1/r) The money multiplier is a function of the reserve requirement. For instance, if the reserve requirement was 12%, what would the affect on deposits be for a $100 increase in reserves?

19.6 The Multiplier affect of a Contractionary Open Market Operation Suppose the central bank now sells $50 worth of Tbills to individuals. Assets Liabilities Reserves $50 Deposits $950 Loans $900 Now the bank does not have enough reserves so it has to call in some loans. Reserves $50 Deposits $905 Loans $855 It calls in loans until . . . Reserves $50 Deposits $500 Loans $450 What do you think is more difficult -- expanding or contracting the money supply?

19.7 Extending the model The model of monetary expansion/contraction does not allow for several likely possibilities What if depositors decide to hold currency and not deposit everything? What if the bank decides to hold excess reserves? What if there are different reserve requirements on transaction and non-transaction accounts? What if you want to know the affect of an open market operation on different types of money in circulation--time deposits, currency, checking account? We can extend this simple model to allow for each of these possibilities

19.8 High-powered money Previously, we defined the monetary base (or high-powered money) as the reserves held by the commercial banks. We can extend this to allow for the possibility that some individuals will hold money as currency rather than as a deposit. The monetary base is therefore defined There are three components to reserves The monetary base is therefore

19.9 The affect of changes in the monetary base on checking deposits Suppose the government proceeds with an expansionary open market operation by purchasing bonds from individuals. It purchases $100,000 worth of bonds from individuals. What is the affect on checking deposits if everything is deposited in banks, there is no reserve requirement on savings accounts, there are no excess reserves, and the reserve requirement on checking accounts is 10%? What is the affect on checking deposits if individuals keep 10% of their deposits in currency, there is no reserve requirement on savings accounts, there are no excess reserves, and the reserve requirement on checking accounts is 10%? What is the affect on checking deposits if individuals keep 10% of their deposits in currency, there is no reserve requirement on savings accounts, banks hold and extra 2% of checking deposits aside for extra reserves, and the reserve requirement on checking accounts is 10%?

19.10 Defining Money Supply So far we have defined the monetary base, but not the money supply or the money in circulation. There are several definitions of money supply. Narrow Definition: Transaction accounts (demand deposits, checking accounts, traveler’s cheques) plus currency. Broader Definition: M1 plus savings deposits, money market accounts, retirement savings (RRSPs)

19.11 The affect of changes of the monetary base on the money supply What is the affect on M1 if everything is deposited in banks, there is no reserve requirement on savings accounts, there are no excess reserves, and the reserve requirement on checking accounts is 10%? What is the affect on M1 if depositor hold 10% of their checking deposits in currency, there is no reserve requirement on savings accounts but depositors place 40% of their checking deposits in savings accounts, banks hold 2% extra of checkable deposits in extra reserves, and the reserve requirement on checking accounts is 10%? What is the affect on M2 if depositor hold 10% of their checking deposits in currency, there is no reserve requirement on savings accounts but depositors place 40% of their checking deposits in savings accounts, banks hold 2% extra of checkable deposits in extra reserves, and the reserve requirement on checking accounts is 10%?

19.12 Money multipliers For M1, where c=C/Dc s=Ds/Dc e= Re/Dc For M2,

19.12 Controlling Money Supply Even if the central bank was to keep the reserves constant, changes in the amount of currency held by individuals etc. can affect the money supply. To keep the money supply stable, the central bank recognizes several affects other factors can have on the money supply. An increase in either the reserve ratio on checking or savings accounts will decrease M1 and M2. An increase in currency to checkable deposits with decrease M1 and M2. An increase in excess reserves will decrease M1 and M2 An increase in the savings deposit ration will decrease M1 but will generally increase M2 (uncertain)

19.13 Summary Four roles of a central bank: (1) Lender of last resort; (2) Ensure the integrity of the financial system; (3) Banker’s bank; (4) Control money supply. Three methods of controlling money supply: (1) Adjust the discount rate (2) Adjust the reserve requirement (3) Open market operations With open market operations, a small base of high-powered money (currency and reserves) supports a larger money supply. The affect of changing the monetary base of high-powered money on money supply occurs through a multiplier.