1 Major Duties and Responsibilities of Central Bank  Conducting monetary policy  Supervising and regulating depository institutions  Maintaining the stability of the financial system  Providing payment and other financial services to the government, the public, FIs and foreign official institutions  Conducting monetary policy  Supervising and regulating depository institutions  Maintaining the stability of the financial system  Providing payment and other financial services to the government, the public, FIs and foreign official institutions

2 Functions Performed by the Central Banks  Assistance in the Conduct of Monetary Policy  Supervision and Regulation  Government Services  New Currency Issue  Check Clearing  Wire Transfer Services  Research Services  Assistance in the Conduct of Monetary Policy  Supervision and Regulation  Government Services  New Currency Issue  Check Clearing  Wire Transfer Services  Research Services

3 Place of Central Bank in the Monetary System Central Bank Federal Reserve Sytem Defines and regulates money supply Facilitates transfer of money through check processing/clearing Banking System: 1. Creates money 2. Transfers money 3. Provides financial intermediation 4. Processes/clears checks Other Banks First Bank Last Bank Lender of last Resort

4 Balance Sheet of the Federal Reserve (in billions of dollars, 2002) Assets Liabilities and Equity Gold and foreign exchange $ 25.5 Depository institution reserves $ 17.5 SDR certificates 2.2 Vault cash of commercial banks 47.3 Treasury currency 33.2 Deposits due to federal government 7.1 Federal Reserve Float 0.0 Deposits due to rest of the world 0.1 FR loans to domestic banks 0.0 Currency outside banks Security repurchase agreements 50.3 Miscellaneous liabilities 7.8 U.S. Treasury securities FR Bank stock 7.2 U.S. government securities 0.0 Miscellaneous assets 20.3 Total assets $683.2 Total liabilities and equity $683.2 Assets Liabilities and Equity Gold and foreign exchange $ 25.5 Depository institution reserves $ 17.5 SDR certificates 2.2 Vault cash of commercial banks 47.3 Treasury currency 33.2 Deposits due to federal government 7.1 Federal Reserve Float 0.0 Deposits due to rest of the world 0.1 FR loans to domestic banks 0.0 Currency outside banks Security repurchase agreements 50.3 Miscellaneous liabilities 7.8 U.S. Treasury securities FR Bank stock 7.2 U.S. government securities 0.0 Miscellaneous assets 20.3 Total assets $683.2 Total liabilities and equity $683.2

5 Objective of Monetary Policy  To influence the amount of reserve in the banking system…  which affects interest rates and availability of credit and…  ultimately affects the levels of employment, output, prices and inflation  To influence the amount of reserve in the banking system…  which affects interest rates and availability of credit and…  ultimately affects the levels of employment, output, prices and inflation

6 Money Stock  There are a number of measures of a nation’s money stock (M).  The narrowest measure is the sum of currency in circulation and the amount of transactions deposits (TD) in the banking system.  There are a number of measures of a nation’s money stock (M).  The narrowest measure is the sum of currency in circulation and the amount of transactions deposits (TD) in the banking system.

7 Money Multiplier  Most nations require that a fraction of transactions deposits be held as reserves.  The required fraction is determined by the reserve requirement (rr).  This fraction determines the maximum change in the money stock that can result from a change in total reserves.  Most nations require that a fraction of transactions deposits be held as reserves.  The required fraction is determined by the reserve requirement (rr).  This fraction determines the maximum change in the money stock that can result from a change in total reserves.

8 Money Multiplier  Under the assumption that the monetary base is comprised of transactions deposits only, the multiplier is determined by the reserve requirement only.  In this case, the money multiplier (m) is equal to 1 divided by the reserve requirement,  m = 1/rr.  Under the assumption that the monetary base is comprised of transactions deposits only, the multiplier is determined by the reserve requirement only.  In this case, the money multiplier (m) is equal to 1 divided by the reserve requirement,  m = 1/rr.

9 Relating the Monetary Base and the Money Stock  Under the assumptions above, we can write the money stock as the monetary base times the money multiplier. M = m  MB = m(C + TR).  The change in the money stock is expressed as  M = m(  C +  TR).  Under the assumptions above, we can write the money stock as the monetary base times the money multiplier. M = m  MB = m(C + TR).  The change in the money stock is expressed as  M = m(  C +  TR).

10 Example - BOJ Intervention  Suppose the Bank of Japan (BOJ) intervenes to strengthen the yen by selling ¥1 million of US dollar reserves to the private banking system.  This action reduces the foreign exchange reserves and total reserves component of the BOJ’s balance sheet.  Suppose the Bank of Japan (BOJ) intervenes to strengthen the yen by selling ¥1 million of US dollar reserves to the private banking system.  This action reduces the foreign exchange reserves and total reserves component of the BOJ’s balance sheet.

11 BOJ Balance Sheet AssetsLiabilities FERTR -¥1 million Result: R ¥1 million, MB ¥1 million

12 BOJ Intervention  Because the monetary base declined, so will the money stock.  Suppose the reserve requirement is 10 percent. The change in the money stock is  M = m(  DC +  FER),  M = (1/.10)(-¥1 million) = -¥10 million.  Because the monetary base declined, so will the money stock.  Suppose the reserve requirement is 10 percent. The change in the money stock is  M = m(  DC +  FER),  M = (1/.10)(-¥1 million) = -¥10 million.

13 Monetary Policy Tools  Open Market Operations primary determinate of changes in excess reserves in the banking system impacting the size of the money supply and/or interest rates primary determinate of changes in excess reserves in the banking system impacting the size of the money supply and/or interest rates  The Discount Rate the rate of interest Central Bank charge on emergency loans to depository institutions the rate of interest Central Bank charge on emergency loans to depository institutions  Reserve Requirements determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities  Open Market Operations primary determinate of changes in excess reserves in the banking system impacting the size of the money supply and/or interest rates primary determinate of changes in excess reserves in the banking system impacting the size of the money supply and/or interest rates  The Discount Rate the rate of interest Central Bank charge on emergency loans to depository institutions the rate of interest Central Bank charge on emergency loans to depository institutions  Reserve Requirements determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities determine the minimum amount of reserve assets that depository institutions must maintain by law to back transaction deposits held as liabilities

14 Tools of Monetary Policy Open Market Operations To change Reserves To change Reserves To offset other factors affecting Reserves To offset other factors affecting Reserves  Typically uses repos & reverse repos: Open market transactions to purchase gov. Securities with an aggrement that seller will repurchase them in a predetermined time period. Advantages of Open Market Operations  1. Central Bank has complete control  2. Flexible and precise  3. Easily reversed  4. Implemented quickly Open Market Operations To change Reserves To change Reserves To offset other factors affecting Reserves To offset other factors affecting Reserves  Typically uses repos & reverse repos: Open market transactions to purchase gov. Securities with an aggrement that seller will repurchase them in a predetermined time period. Advantages of Open Market Operations  1. Central Bank has complete control  2. Flexible and precise  3. Easily reversed  4. Implemented quickly

15 Open Market Operations  Monetary Base = Currency + Reserves  Open Market Purchase from Bank The Banking System The Fed The Banking System The Fed Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities Securities Securities Reserves Securities Securities Reserves - $100 + $100 +$100 Reserves - $100 + $100 +$100 Reserves + $100 + $100 Result: R  $100, MB  $100 Result: R  $100, MB  $100

16 Open Market Purchase from Public Public The Fed Public The Fed Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities Securities Securities Reserves - $100 + $100 +$100 - $100 + $100 +$100 Deposits Deposits + $100 + $100 Banking System Banking System Assets Liabilities Assets Liabilities Reserves Deposits + $100 + $100 Result: R  $100, MB  $100 + $100 + $100 Result: R  $100, MB  $100 Open Market Operations

17 Discount Rate The rate on loans to depository instituions  Ambiguous effect on money supply  Signalling function: used to send a message to financial markets Lender of Last Resort Function 1. To prevent banking panics 2. To prevent non-bank financial panics Moral Hazard Problem Moral Hazard Problem The rate on loans to depository instituions  Ambiguous effect on money supply  Signalling function: used to send a message to financial markets Lender of Last Resort Function 1. To prevent banking panics 2. To prevent non-bank financial panics Moral Hazard Problem Moral Hazard Problem

18 Discount Loans Discount Loans Banking System The Fed Banking System The Fed Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities Reserves Discount Discount Reserves Reserves Discount Discount Reserves + $100 loan + $100 loan + $100 + $100 + $100 loan + $100 loan + $100 + $100 Result: R  $100, MB  $100

19 Reserve Requirements  Advantages  1. Powerful effect on money supply  Disadvantages  1. Small changes have very large effect on MS  2. Raising reserve requirement ratio causes liquidity problems for banks  3. Frequent changes cause uncertainty for banks  Advantages  1. Powerful effect on money supply  Disadvantages  1. Small changes have very large effect on MS  2. Raising reserve requirement ratio causes liquidity problems for banks  3. Frequent changes cause uncertainty for banks

20 Goals of Monetary Policy Goals 1. Price Stability 2. High Employment 3. Economic Growth 4. Interest Rate Stability 5. Financial Market Stability 6. Foreign Exchange Market Stability  Goals often in conflict “The primary objective of the Bank shall be to achieve and maintain price stability.” Cental Bank of the Republic of Turkey Goals 1. Price Stability 2. High Employment 3. Economic Growth 4. Interest Rate Stability 5. Financial Market Stability 6. Foreign Exchange Market Stability  Goals often in conflict “The primary objective of the Bank shall be to achieve and maintain price stability.” Cental Bank of the Republic of Turkey

21 A. Price Stability  Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for inflation.  Effort successful if monetary policy able to maintain steady rate of inflation. B. High Employment  The movement of workers between jobs is referred to as frictional unemployment.  All unemployment beyond frictional unemployment is classified as unintended unemployment. Reduction in this area is the target of macroeconomic policy. C. Economic Growth  Economic growth is enhanced by investment in technological advances in production.  Encouragement of savings supplies funds that can be drawn upon for investment. D. Interest Rate and Exchange Rate Stability  Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected changes that cause damage, making policy formulation difficult. E. Conflicts Among Goals  Goals frequently cannot be separated from each other and often conflict. Costs must therefore be carefully weighed before policy implementation. A. Price Stability  Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for inflation.  Effort successful if monetary policy able to maintain steady rate of inflation. B. High Employment  The movement of workers between jobs is referred to as frictional unemployment.  All unemployment beyond frictional unemployment is classified as unintended unemployment. Reduction in this area is the target of macroeconomic policy. C. Economic Growth  Economic growth is enhanced by investment in technological advances in production.  Encouragement of savings supplies funds that can be drawn upon for investment. D. Interest Rate and Exchange Rate Stability  Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected changes that cause damage, making policy formulation difficult. E. Conflicts Among Goals  Goals frequently cannot be separated from each other and often conflict. Costs must therefore be carefully weighed before policy implementation.

22 Impact of Monetary Policy on Various Economic Variables Expansionary Activities Contractionary Activities Impact on Reserves Credit availability Money supply Interest rates Security prices

23 Alternative Monetary Policies Interest Rate Quantity of Money (in billions) i’=8% i*=6% i’’=4% MSMS M D’ M D’’ MDMD Interest Rate Quantity of Money (in billions) i* = 6% i’’= 5% M S’ MSMS M D’ MDMD M D’’

24 International Monetary Policies and Strategies  Foreign Exchange Intervention 1. Controlled exchange rate regimes under ERBS Programs 2. To stabilize the unstable FX market similar to open market purchases and sales of Treasury securities similar to open market purchases and sales of Treasury securities  Foreign Exchange Intervention 1. Controlled exchange rate regimes under ERBS Programs 2. To stabilize the unstable FX market similar to open market purchases and sales of Treasury securities similar to open market purchases and sales of Treasury securities

25 Institutional Framework for a Credible Central Bank  Independence  Accountability  Transparency  Independence  Accountability  Transparency