Chapter 15 Money, Banking, and Financial Markets: Central Banks in the World Today ©2010 McGraw-Hill Ryerson Ltd. Tim Berry, Humber College

Central Banks: The Big Questions 1.What is the role of the central bank? 2.What are the central bank’s objectives? 3.How are successful central bank’s organized? ©2010 McGraw-Hill Ryerson Ltd. 15-2

Central Banks: Roadmap The origins and roles of central banks Central bank objectives Designing a successful central bank ©2010 McGraw-Hill Ryerson Ltd. 15-3

Central Banks: Origins and Roles There are about 170 central banks in the world today. Nearly every country has one. When the Soviet Union collapsed in 1990, 12 of the 15 republics had central banks within a year ©2010 McGraw-Hill Ryerson Ltd. 15-4

Central Banks: Origins and Roles Special type of financial intermediary Origin: – To provide for government finance – Originally private institutions Roles – Government’s bank – Banker’s bank ©2010 McGraw-Hill Ryerson Ltd. 15-5

Central Banks: Origins and Roles Bank of Canada was created in 1934 – during the Great Depression In the US there had been thousands of bank failures and bank runs During this time no bank failures or runs occurred in Canada ©2010 McGraw-Hill Ryerson Ltd. 15-6

Central Banks: Functions of a Central Bank Determines and manages monetary policy Central banks create money - they print currency Control availability of money and credit ©2010 McGraw-Hill Ryerson Ltd. 15-7

Counterfeiting has been used as a weapon in wartime Goal to destabilize enemy’s currency Without a stable currency it is difficult for an economy to run efficiently ©2010 McGraw-Hill Ryerson Ltd. 15-8

Central Banks: Functions of a Central Bank Operate interbank payments network Provide loans during periods of crisis Oversee financial intermediaries to insure safety and soundness ©2010 McGraw-Hill Ryerson Ltd. 15-9

Functions of a Modern Central Bank ©2010 McGraw-Hill Ryerson Ltd

©2010 McGraw-Hill Ryerson Ltd Central Bank Objectives: Stability Low and stable inflation High and stable growth Stable financial markets Interest-rate stability Exchange-rate stability

Central Bank Objectives: Low and Stable Inflation Strives to eliminate inflation A dollar should always be worth a dollar – Prices are central to a market economy. Allocating resources to their best uses – Inflation makes it more difficult to tell – High inflation is less predictable ©2010 McGraw-Hill Ryerson Ltd

High inflation is volatile inflation Volatile inflation means more risk Risk requires compensation High inflation means a higher risk premium, so higher loan rates Volatile inflation makes long-term planning difficult ©2010 McGraw-Hill Ryerson Ltd

Central Bank Objectives: High and Stable Real Growth Support maximum sustainable growth Stable countries grow faster – Unstable growth creates risk – Unstable growth drives up interest rates – Higher interest rates me lower borrowing – Less borrowing means less investment – Less investment means less growth ©2010 McGraw-Hill Ryerson Ltd

Central Bank Objectives: Financial System Stability When the financial system collapses, everything else goes with it. Can’t get car loans or mortgages Banks cease to operate properly (Application of value-at-risk) ©2010 McGraw-Hill Ryerson Ltd

Central Bank Objectives: Interest-Rate Stability Stable interest rates make economic decisions easier Stable short-term interest rates reduce risk premium on long-term interest rates ©2010 McGraw-Hill Ryerson Ltd

Central Bank Objectives: Exchange-Rate Stability The more open an economy, the more important it is Makes cost of imports and revenue from exports more predictable ©2010 McGraw-Hill Ryerson Ltd

Central Bank Objectives: Summary ©2010 McGraw-Hill Ryerson Ltd

Bank of Canada controls short-term interest rates News about future short-term interest rate affects long-term interest rates When long-term interest rates change, so do car loan and mortgage rates YOUR FINANCIAL WORLD Does News about the Bank of Canada Affect Your Daily Life? ©2010 McGraw-Hill Ryerson Ltd

Creating a Successful Central Bank Independence Decision-making framework Accountability, transparency and communication ©2010 McGraw-Hill Ryerson Ltd

Central Bank Design: Independence Central banks need to be independent of political pressure Politicians have an incentive to create short-term prosperity at the expense of inflation tomorrow. Longer time horizon needed to avoid “inflation bias” ©2010 McGraw-Hill Ryerson Ltd

Independent Central Banks Deliver Low Inflation What drove politicians to give up control over monetary policy? Realization that independent central bankers would deliver low inflation. ©2010 McGraw-Hill Ryerson Ltd

Central Bank Design: Decision-Making Framework Should policy be made by an individual or by a committee? - Committees provide safeguards against putting the wrong person in charge ©2010 McGraw-Hill Ryerson Ltd

Central Bank Design: Accountability, Transparency and Communication Central Bank independence is inconsistent with representative democracy Solution: – Give central bankers clear objectives – Public reporting of progress in achieving objectives ©2010 McGraw-Hill Ryerson Ltd

Central Bank Design: Policy Tradeoffs Can’t always have everything at once – Sometimes the economy is hit by a shock that drives inflation and growth in opposite directions – Creates a tradeoff – Central bankers must be honest about the fact that goals are sometimes in conflict ©2010 McGraw-Hill Ryerson Ltd

Central Bank Design: Summary ©2010 McGraw-Hill Ryerson Ltd

Central Banks and Fiscal Policy In emerging market countries like Brazil and Argentina, fiscal policy problems can make it impossible for central bankers to keep inflation low ©2010 McGraw-Hill Ryerson Ltd

Central Banks and Fiscal Policy Fiscal authorities have three sources of funds: – Taxes – Borrowing – Money printing The first two work only up to some limit If the budget is unsustainable, force money printing ©2010 McGraw-Hill Ryerson Ltd

Central Banks and Fiscal Policy: Argentina in 2002 Financial collapse tied to the regional government’s issuance of their own currency Made it so that the Central Bank of Argentina was helpless ©2010 McGraw-Hill Ryerson Ltd

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Chapter 15 Money, Banking, and Financial Markets: Central Banks in the World Today End of Chapter ©2010 McGraw-Hill Ryerson Ltd. Tim Berry, Humber College