Presentation on theme: "The central bank acts as banker to the commercial banks in a country"— Presentation transcript:
0 Chapter 24 Central banking and the monetary system David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,6th Edition, McGraw-Hill, 2000Power Point presentation by Peter Smith
1 The central bank acts as banker to the commercial banks in a country and is responsible for setting interest rates.In the UK, the Bank of England fulfils these roles.Two key tasks:to issue coins and bank-notesto act as banker to the banking system and the government.See the introduction to Chapter 24 of the main text.
2 The Bank and the money supply Three ways in which the central bank MAY influence money supply:Reserve requirementscentral bank sets a minimum ratio of cash reserves to deposits that commercial banks must meetDiscount ratethe interest rate that the central bank charges when the commercial banks want to borrowsetting this at a penalty rate may encourage commercial banks to hold more excess reservesOpen market operationsactions to alter the monetary base by buying or selling financial securities in the open marketSee Section 24-2 of the main text.
3 The repo market 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 loansUsed by the Bank of England in carrying out open market operationsSee Box 24-1 in the main text.
4 Other functions of the Bank of England Lender of last resortthe Bank stands ready to lend to banks and other financial institutions when financial panic threatensBanker to the governmentthe Bank ensures that the government can meet its payments when running a budget deficitSetting monetary policy to control inflationmore of this laterSee Section 24-3 in the main text.
5 The demand for moneyThe opportunity cost of holding money is the interest given up by holding money rather than bonds.People will only hold money if there is a benefit to offset that opportunity cost.See Section 24-4 in the main text.
6 Motives for holding money Transactionspayments and receipts are not perfectly synchronized:so money is held to finance known transactionsdepends upon income and payment arrangementsPrecautionarybecause of uncertainty:people hold money to meet unforeseen contingenciesdepends upon the (nominal) interest rateSee Section 24-4 in the main text.
7 Motives for holding money (2) Assetpeople dislike riskso may hold money as a low-risk component of a mixed portfoliodepends upon opportunity cost (the nominal interest rate)Speculativepeople may hold money rather than bondsif bond prices are expected to falli.e. the interest rate is expected to risedepends upon the rate of interest and on expectations about bond pricesSee Section 24-4 in the main text.The speculative motive does not appear in the main text, but may be useful later in discussing the liquidity trap. NB Japan.
8 The demand for money: summary The demand for money is a demand for real money balancesIt depends upon:real incomenominal interest rate (the opportunity cost of holding money)the price level (currently assumed fixed)expectations about future interest ratesSee Section 24-4 in the main text.
9 Money market equilibrium LLOther things being equal,the demand for real moneybalances will be lower whenthe opportunity cost (the rateof interest) is relatively high.Interest rateWhen money supply is L0, money market equilibriumoccurs when the rate of interest is at r0.L0r0The position of thisschedule depends uponreal income and the pricelevel.See Section 24-5 in the main text, and Figure 24-2.Real money holdings
10 Reaching money market equilibrium Real money holdingsInterest rateLLL0r0If the rate of interest isset below the marketequilibrium – say at r1r1there is excess demand formoney (the distance AB)ABThis implies an excesssupply of bonds– which reduces the priceof bondsSee Section 24-5 in the main text, and Figure 24-2.and thus raises the rate of interest until equilibriumis reached.
11 Monetary control Given the money demand schedule: The central bank can ...EITHER set the interestrate at r0 and allow moneysupply to adjust to L0Interest rater0OR set money supply at L0and allow the market rateof interest adjust to r0LLSee Section 24-6 in the main text and Figure 24-4.BUT cannot set bothmoney supply and interestrate independently.L0Real money holdings
12 Monetary control – some provisos Monetary control cannot be precise unless the authorities know the shape and position of money demandControlling money supply is especially problematicand the Bank of England has preferred to work via interest ratesThe situation is further complicated by the relationship between the interest rate and the exchange rateSee Section 24-6 in the main text.Problems have arisen in particular from the technological advances in the banking sector, which have affected the liquidity of assets, and the ease with which transactions can be undertaken. Amongst other things this has blurred the definition of money supply. The demutualisation of building societies has added to this problem.The relationship between the interest rate and the exchange rate will be explored in Chapter 29, dealing with open economy macroeconomics.
13 Targets and instruments of monetary policy Monetary instrument:the variable over which the central bank exercises day to day controle.g. interest rateIntermediate targetthe key indicator used as an input to frequent decisions about when to set interest ratesThe financial revolution has reduced the reliability of money supply as an indicatorand central banks increasingly use inflation forecasts as the intermediate targetSee Section 24-7 in the main text.