Chapter 58: The central bank and monetary policy (2.5)

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1 Chapter 58: The central bank and monetary policy (2.5) Key concepts Role of central banks o Regulator of commercial banks o Lender of last resort o Government s bank Central bank responsibilities o Interest rate Discount rate Supply of money o Exchange rate policies Interest rate determination and the role of a central bank Describe the role of central banks as regulators of commercial banks and bankers to governments Explain that central banks are usually made responsible for interest rates and exchange rates in order to achieve macroeconomic objectives Explain, using a demand and supply of money diagram, how equilibrium interest rates are determined, outlining the role of the central bank in influencing the supply of money All money is a matter of belief. Adam Smith Role of central banks o Regulator of commercial banks Central banks are charged with regulating commercial bank lending, an example of which is setting minimum levels of cash which commercial banks must keep on hand, so called minimum reserve requirements. o Banks bank One of the most important tasks for central banks is to be the bank s bank, i.e. seeing to it that commercial banks need for cash is met. This is done at an interest rate known as the discount rate 1 which is a key in setting market interest rates. 1 There is a most confusing array of different terms and forms of interest that central banks charge commercial banks for loans. I will simply use discount rate.

2 o Lender of last resort The central bank is in fact where the buck stops. 2 When financial institutions are in financial difficulties and simply cannot obtain loans elsewhere, the central bank can step in as the last resort. The reasoning is pretty straightforward; a collapse of several large financial institutions will have serious repercussions on the economy and will ultimately hit households the hardest as was the case when almost half of the banks went bankrupt during the Great Depression in 1930s USA. o Government s bank Perhaps the most visible role of central banks in terms of media coverage is managing government deficits and debt. When the government needs to finance deficit spending it issues government bills and bonds (IOUs) through the central bank. These are then purchased by financial institutions and to a certain extent households. Central bank responsibilities We will focus on the issue of monetary policy and how it is used to achieve the main macro objectives of price stability (low and stable inflation), growth, employment and exchange rate stability. 3 o Interest rate Central banks implement monetary policy through goals set by government which are often in the form of inflation targets. 2 I am referring to a famous plaque on US President Truman s desk. Passing the buck means to shift responsibility on to somebody else. Truman had a plaque made saying The buck stops here! 3 Note that the core objectives for central banks vary between countries. Most will have a focus on maintaining low inflation and low unemployment.

3 Discount rate Figure 58.1 Central bank and interest rates Central Bank Lending to commercial banks Commercial Banks Lending to firms & households Interest paid to C.B. (discount rate) = 3% Interest paid by households and firms to commercial banks = 7% Firms Deposits from firms & households Interest paid to firms & households = 2% Households If the central bank raises the interest rate at which commercial banks borrow, the discount rate, the profit margins of commercial banks will fall. The commercial banks will therefore raise the lending rate for firms and households borrowing money. The deposit rate at commercial banks what households and firms receive for depositing money will also rise. Supply and demand for money The supply of money is assumed to be vertical (here) in that it is exogenous created outside the system and set by monetary policy. The complete interest inelasticity of the money supply is based on the simplifying (and rather unrealistic) assumption that the supply of money is totally controlled by the Central Bank s monetary policy. Figure 58.2 shows how the supply of money (Sm) and demand for money (Dm) create an equilibrium interest rate of r0 and Qm. Figure 58.2 Supply and demand for money r (%) Sm 2 Sm 0 Sm 1 r 2 r 0 Sm:. An increase in the discount rate, the selling of government securities or an increase in the reserve requirement of commercial banks decreases the supply of money (Sm0 to Sm2) r 1 Dm Qm 2 Qm 0 Qm 1 Qm/t Sm: A decrease in the discount rate, the buying of government securities or a decrease in the reserve requirement of commercial banks increases the supply of money (Sm0 to Sm1)

4 Changing the supply of money: While interest rates are the main instrument in monetary policy, Central Banks can use several other instruments to influence the supply of money and thereby the rate of interest. The Central Bank commonly has a monopoly on printing money, and thereby total control over the amount of outstanding notes and coins, i.e. it is possible to print money (which the Central Bank technically then lends to the government) in order to fund government spending. The three most common methods for controlling the supply of money are discount rate changes, open market operations, and direct controls on lending. Discount rate: As described earlier, the discount rate is the Central Bank s rate of lending to commercial banks. Open market operations: The Central Bank can conduct open market operations on the financial market much like any other financial institution; it can issue government debt, IOUs 4, in the form of interest-bearing bills and bonds (collectively known as government securities). When the government sells securities, they can be purchased by both the financial and non-financial sector (firms, households and other governments). Direct controls on banks lending: A reserve requirement of 5% means that a bank which has maximised its lending capacity and has 100 million in deposits must keep 5 million in cash reserves. An increase in reserve requirements will decrease the supply of money (Sm0 to Sm2) and increase interest rates from r0 to r2. o Exchange rate policies Although it is a main theme of Chapters 67 to 69, I cannot help but briefly bring up the subject of how monetary policy can affect a country s exchange rate and thus the domestic economy. Say the Central Bank of Japan (Bank of Japan, BOJ) raises interest rates. The demand for Yen will rise, since foreigners will have to first purchase Yen to deposit in Japanese banks. This increases demand for the Yen which drives up the value of the Yen. (The price of the Yen is put in terms of other currencies, say the US dollar.) Thus the Yen increases in value vis-à-vis other currencies, it appreciates (increases in price in terms of the US dollar). The effect on the Japanese economy is twofold: o o Japanese exports become more expensive on the foreign goods market since foreigners now have to use more of their domestic currency to buy Yen. Japanese imports on the other hand will increase, seeing as how Japanese consumers get more foreign currency with which to buy foreign goods they will substitute some domestic goods with foreign. 4 An IOU is a layman s (= normal person s) term. It is a bill of debt issued by the lender (creditor) and signed by the borrower (debtor). The debtor now owes money and the creditor has a piece of paper verifying this which basically says; I owe you = IOU.

5 Summary and revision 1. The role of central banks is to regulate commercial banks, be the commercial banks bank, act as lender of last resort and the government s bank. 2. Central banks responsibilities are primarily to implement monetary policy aimed at achieving macro goals such as price stability, growth, low unemployment and exchange rate stability. 3. The main tools of monetary are setting the interest rate and the supply of money. 4. Interest rates are influenced primarily by setting the rate at which commercial banks borrow money (the discount rate) and the money supply. 5. Central banks can adjust the supply of money in three ways: a. Changing the discount rate b. Open market operations (buying or selling government securities) c. Changing commercial banks reserve requirements 6. Another key objective that of stability in exchange rates can be attained by central banks by adjusting the interest rate: a. An increase in the interest rate attracts foreign deposits and thus increases the demand for the Home currency and the Home currency appreciates (rises in value compared to other currencies) b. A decrease in interest rates causes an outflow of Home currency to foreign banks where the interest is relatively higher the supply of the Home currency increases causing a depreciation 7. A key trade-off in monetary policy is that it is impossible to freely set the interest rate while simultaneously setting the exchange rate.