Macroeconomics (ECON 1211) Lecturer: Mr S. Puran Topic: Central Banking and the Monetary System

The Central Bank n acts as banker to the commercial banks in a country n and is responsible for setting interest rates. n In the UK, the Bank of England fulfils these roles. n Two key tasks: – to issue coins and bank-notes – to act as banker to the banking system and the government.

The Central Bank n There are two more objectives of the Bank: n To stabilise the level of economic activity and the availability of credit (bank rate, discount rate, reserve requirement) n To regulate the banking system, to ensure its financial health

The Bank and The money Supply n Three ways in which the central bank MAY influence money supply: n Reserve Requirements – central bank sets a minimum ratio of cash reserves to deposits that commercial banks must meet – Higher Reserve Ratio, the lower the amount of loans that can be created – A reduction (rise) in reserve ratio creates an increase (decrease) in money supply

The Bank and The money Supply n Discount rate – The interest rate that the central bank charges when the commercial banks want to borrow by the banks tend to be high, less loans are available. – The banks pass the high interest rate to consumers – When discount rate is high, interest charged – Setting this at a penalty rate may encourage commercial banks to hold more excess reserves – Decrease (increase) discount rate implies (increase) decrease in money supply

The Bank and The money Supply n Open Market Operations – actions to alter the monetary base by buying or selling financial securities in the open market – It is a tool that the Bank use to affect the supply reserves – Buying of bonds: fewer bonds in private hands the monetary base is higher, money supply increases – Selling of bonds implies a fall in monetary base, thus money supply decreases

The Repo Market n A gilt repo is a sale and repurchase agreement – e.g. a bank sells you a gilt with a simultaneous agreement to buy it back at a specified price at a specified future date. – this uses the outstanding stock of long-term assets (gilts) as backing for new short-term loans n Used by the Bank of England in carrying out open market operations

Other functions of the Bank of England n Lender of last resort – the Bank stands ready to lend to banks and other financial institutions when financial panic threatens n Banker to the government – the Bank ensures that the government can meet its payments when running a budget deficit n Setting monetary policy to control inflation – more of this later

The Demand for money n The opportunity cost of holding money is the interest given up by holding money rather than bonds. n People will only hold money if there is a benefit to offset that opportunity cost.

Motives for Holding Money n Transactions – payments and receipts are not perfectly synchronized: n so money is held to finance known transactions n depends upon income and payment arrangements n Precautionary – because of uncertainty: n people hold money to meet unforeseen contingencies n depends upon the (nominal) interest rate

Motives for Holding Money (2) n Asset – people dislike risk – so may hold money as a low-risk component of a mixed portfolio n depends upon opportunity cost (the nominal interest rate) n Speculative – people may hold money rather than bonds – if bond prices are expected to fall – i.e. the interest rate is expected to rise n depends upon the rate of interest and on expectations about bond prices

The Demand for Money: summary n The demand for money is a demand for real money balances n It depends upon: – real income – nominal interest rate (the opportunity cost of holding money) – the price level (currently assumed fixed) – expectations about future interest rates

More on the Speculative Motive n When interest rate falls, the cost of holding money falls. n This fall leads to more money being held both for precautionary motive (to reduce risks caused by uncertainty) and for the speculative motive (to reduce risks associated with fluctuations in the market price of bonds) n Thus, demand for money is negatively related with interest rate

Liquidity Trap n Initially the demand for M is downward sloping, then it is a straight line Ms4 Ms1Ms2Ms3r DD and SS of M The straight line is the Liquidity trap MD = MS yields an interest rate So long DD for M is downward sloping, the interest rate falls when the Bank increases r When the liqudity trap is reached, r does not change, so in order to control r, an understanding of MD is important

Money Market Equilibrium Real money holdings Interest rate LL Other things being equal, the demand for real money balances will be lower when the opportunity cost (the rate of interest) is relatively high. The position of this schedule depends upon real income and the price level. When money supply is L 0, money market equilibrium occurs when the rate of interest is at r 0. L0L0 r0r0

Reaching Money Market Equilibrium Real money holdings Interest rate LL L0L0 r0r0 If the rate of interest is set below the market equilibrium – say at r 1 r1r1 there is excess demand for money (the distance AB) AB This implies an excess supply of bonds – which reduces the price of bonds and thus raises the rate of interest until equilibrium is reached.

Reaching Money Market Equilibrium n Stock of Real Wealth = Real Money (L O )+ Real bonds (B O ) n Individuals divide their wealth into desired holdings (B D ) and desired real money (L P ) n L O + B O = W = B D + L P n B O - B D = W = L P - L O n An excess demand for money exactly matches an excess supply of bonds

Change in Equilibrium n A fall in real money supply leads to an increase in interest rates and therefore reduces quantity of money demanded n An increase in real income shifts demand curve to the right. Interest rates increase n An increase in banking competition through an increase in market interest rates leads to a fall in quantity of money demanded

Monetary Control Real money holdings Interest rate LL L0L0 r0r0 Given the money demand schedule: The central bank can... EITHER set the interest rate at r 0 and allow money supply to adjust to L 0 OR set money supply at L 0 and allow the market rate of interest adjust to r 0 BUT cannot set both money supply and interest rate independently.

Monetary control – some provisos n Monetary control cannot be precise unless the authorities know the shape and position of money demand n Controlling money supply is especially problematic – and the Bank of England has preferred to work via interest rates n The situation is further complicated by the relationship between the interest rate and the exchange rate

Targets and Instruments of Monetary Policy n Monetary instrument: – the variable over which the central bank exercises day to day control – e.g. interest rate n Intermediate target – the key indicator used as an input to frequent decisions about when to set interest rates n The financial revolution has reduced the reliability of money supply as an indicator – and central banks increasingly use inflation forecasts as the intermediate target