1. 1 Role of Central Banking Chapter 4 Part 1 1.Functions of Central bank The need for a central bank Should central bank be independent from government Monetary policy functions of a central bank

2. 2 Theory of Central Banking Introduction What are monetary policy functions of a central bank? Why do banks need a central bank? Central bank – financial institution responsible for overseeing the monetary system for a nation or group of nations with the goal of fostering economic growth without inflation.

3. 3 1.Controls the issue of notes and coins (legal tender) 2.Power to control the amount of credit money created by banks (money supply). 3.Have control over non bank financial intermediary that provides credit. 4.Effectively use the relevant tools and instruments of monetary policy a. credit expansion b. liquidity c. money supply of an economy Functions of Central Bank

4. 4 5. Oversee the financial sector to prevent financial crises a.Protect depositors b.Prevent wide-spread panic withdrawal c.Prevent damage to economy due to collapse of financial institutions. Functions of Central Bank

5. 5 6. Act as government banker a. Holds governments bank account b. Performs traditional banking operations for the government. c. Manage and administer country's national debt 7. Official agent to government in dealing with gold and foreign exchange matters 8. Governments reserves of gold and foreign exchange are held at the central bank. Functions of Central Bank

6. 6 Major forms of economic policy 1.Monetary Policy 2.Fiscal Policy 3.Exchange rate policy 4.Prices and income policy 5.National debt management policy

7. 7 Changes in the Money Supply available in the economy Expansionary Policy Contractionary Policy Monetary Policy

8. 8 Main policy tools used to influence a.Interest Rate b.Inflation c.Credit availability Monetary Policy

9. 9 Objectives of Monetary Policy a.High Employment -not zero employment b. Price stability - Rising price level creates uncertainty and creates adverse affect in the economy c. Stable economic growth – increases living standard of the population d. Interest rate stability – Volatility in the interest rate creates uncertainty about the future and create adverse impact on business and consumer

10. 10 Objectives of Monetary Policy e. Financial market stability – Impact of financial crises f. Stability in foreign exchange markets – increase or decrease the value of currency which could lead to inflation

11. 11 Central banks monetary operations Open Market Operations Discount Windows Reserve Requirements

12. 12 Debt Securities and Open Market Operations Debt securities represented by Treasury securities (govt. debt) Central banks use it in open market operations Purchases or sells govt. debt to bank and non bank. Sells – Increase Money Supply in the market Buys – Decreases Money Supply in the market

13. 13 Debt Securities and Open Market Operations MS increases - Interest rate falls – More MS in the economy creates competition from banks to provide credit facilities MC decreases – Interest rate increases – Less money supply to provide credit facilities

14. 14 Loans to banks and Discount Window (Discount Rate) Instrument that allows eligible banking institutions to borrow money from central bank Usually to meet short term liquidity needs. Higher DR – Lower the amount of funds that banks can borrow – Interest rate increases Lower DR – Higher the amount of funds banks can borrow – Interest rate decreases

15. 15 Reserve Requirements Banks need to hold quantity of reserves for prudential purposes. Generally expressed in percentage term as Required Reserve Ratio Higher Required Reserve – Lower the amount of funds available to the banks Lower Required Reserve – Higher the amount of funds available to the banks

16. 16 Reserve Requirements Strong influence on the money supply Reserve Requirements Higher Required Reserve – Lower the amount of funds available To banks Lower - Required Reserve – Higher the amount of funds available To banks

17. 17 Other Instruments 1. Special Deposits – Deposits banking institutions had to make at Central Bank b. Supplementary special deposits depends on the extent of the economy. c. No interest payments for special deposits. d. Main Objective – to remove excess liquidity if bank deposit growth is increasing too rapidly.

18. 18 Other Instruments 2. Moral Suasion - Informal requests and pressure Central Bank may exert over banking institutions. -Involves institutions having to take actions which might not in the banks interests. -Power of central bank is one effective method

19. 19 Other Instruments 3. Direct Controls - Issuing directives to attain particular immediate targets. Example: Impose controls on interest rates payable on deposits. Directs bank to prioritize lending according to various types of customers. May limit the volume of credit creation Widely used in many developing countries where central bank may force bank to lend to certain priority sectors.

20. 20 Portfolio Constraints Limit the banks portfolio Discrimination against banks Unable to generate alternative source of funds

21. 21 Portfolio Constraints Less widely used in developed world a.Defining and implementing portfolio constraints would be difficult in an open economy b.Domestic borrowers have greater scope to seek funds from overseas. c.Restriction on business freedom d.Restriction on growth of banks e.Markets distorted f.Economic efficiency tends to be undermined g.Need to influence all relevant parts of the financial system

22. 22 Why do banks need central bank? Provides reserves to banks experiencing serious financial problems a.Sudden withdrawal of funds by depositors b.Encourage bankers to undertake due risks and operate prudentsly

23. 23 Central Banks The Bank of England The European Central Bank Federal Reserve Bank

24. 24 The Bank of England Established in 1694 1946 – The bank was nationalised and formally recognised as a Central Bank 1998 – Bank of England act – Bank was granted operational independence.

25. 25 Objectives & Functions of Bank of England a.Maintaining the integrity and value of the currency b.Maintaining the stability of the financial system domestic and international c.Seeking to ensure the effectiveness of UK’s financial services industry.

26. 26 Responsibility of Bank of England The development of a robust financial sector Safe and efficient payment and settlement arrangements Appropriate legal regime Effective disclosure requirements Sound principles for prudential regulation Monitoring current developments in domestic and international financial system Efficient means of financial crisis management

27. 27 European Central Bank Tasks 1.Define and implement monetary policy for the Europeans 2.Conduct foreign exchange operations 3.Hold and manage the official reserves of the European countries 4.Promote smooth operation of payment systems

28. 28 Federal Reserve Bank Central bank of the United States Structure of FED Board of directors Federal Reserve Banks Federal Open Market Committee Board of Directors Member banks

29. 29 Functions of FED Monetary Policy Supervision and regulation Financial Stability Services to US government