Transcript CH2

Fin 221- Chapter 2: The Central Bank
(The Federal Reserve) and its powers
Purposes and powers of a Central Bank:
• Supervise nation’s money supply and payments system.
• Regulate other financial institutions, especially depository
institutions (Supervise banks more vigorously).
• Serve as “Lender of last resort” when financial system has
liquidity problems.
• National government’s “fiscal agent” (i.e. depository bank)
• Provide an “elastic” currency (currency notes - ability to
adjust money supply to changes in economy)
• Improve payments system (check clearing).
1
The balance sheet of the Central
bank (B/S)
• Changes in the CB’s B/S ultimately results in
changes to the money supply in the economy.
• The CB conducts monetary policy by changing
the monetary base in the economy.
• The monetary base = currency in circulation +
the deposits of financial institutions at the CB.
• An increase in the monetary base ( other things
held unchanged ) will lead to an increase in the
money supply.
2
Liabilities and Assets of the CB
Liabilities include :
1. CB notes in circulation ( The largest single liability ).
2.
Depository institution’s reserves : deposits held (by
law) by the depository institutions at the central bank.
Such deposits are called “Reserves”
- CB deposits are useful in that they can be transferred
from one institution to another through the clearing
system.
- Reserves are also useful to the CB for controlling the
money supply.
3
Liabilities and Assets of……..cont
Total reserves = Required Reserves + Excess Reserves
TR
= RR
+ ER
- RR is a specified percent ( fraction) of the total deposits.
This fraction is called the required reserve ratio or
reserve requirement ( %). For example :
Let reserve ratio( requirement) = k= 10%
Bank deposits
= BD 1000
Therefore RR
= 10% X 10000 = 100
Or ; k
100/ 10000
= 10%
- The depository institution ( bank) could use the excess
reserves to make commercial loans or lend them to other
banks
4
Liabilities and Assets of……..cont
3.Treasury deposits : these are govt. treasury
deposits where the CB acts as the “fiscal agent”
for the treasury department.i.e. the CB acts as a
bank for the treasury which can pay its bills by
writing ckeques from its account at the CB.
4. Deferred availability cash item (DACI): represent
the value of cheques deposited at the central
bank by depository institutions that have not yet
been credited to the institutions account.
5. Capital ;
5
Liabilities and Assets of……..cont
CB Assets include :
1. The CB loan account :changes in the loan accounts lead to
change in the reserve account and hence change in the
money supply. The CB makes loans to banks and other
depository institutions. The rate charged on these loans is
the “ discount rate”.
2. Government securities: a portfolio of the treasury and
government agency securities. The CB can sell and buy
government securities through its open market operations.
Selling securities in the market contracts money supply
while buying securities increases the money supply.
3. Cash items in process of collection (CIPC): These are
items the central bank is clearing but for which it has not
yet obtained funds ( see DACI on the liab. Side)
4. Float: represents a net extension of credit from the CB to
depository institutions ( the difference between CIPC and
DACI).
6
The CB role in Cheque clearing
• The CB plays a major role in cheque
clearing, particularly in clearing cheques
drawn on depository institutions which
hold reserves or clearing deposit balances
with the CB.
• Bank deposits at the CB can be easily
transferred between the accounts of the
depository institutions by making
appropriate entries on the CB books.
7
The tools of monetary policy
The CB has three major tools to either
increase or decrease the money supply:
• Open –Market Operations.
• Changing the Discount Rate.
• Changing the Reserve requirement Ratio.
8
The tools of monetary policy………cont.
1.Open market operations :
- Involves the buying and selling of government
securities in the market.
- The CB changes the amount of reserves in the
banking system through the purchase or sale of
government securities on the open market.
- The purchase of government bonds by the CB
will expand the money supply while the sale of
bonds will result in contraction of the money
supply.
9
The tools of monetary policy………cont
Open market operations….cont:
Example 1: The CB decides to buy $1000 in govt. bonds
from BNB.The T-accounts for the BNB and the CB after
the transaction will be :
BNB
CB
Example 2:The CB decides to sell $1000 bonds to the
BNB.The T-accounts will show:
BNB
CB
10
The tools of monetary policy………cont
2.Changing the discount rate ( discount window borrowing):
-
-
-
The discount rate is the rate of interest that financial
institutions must pay to borrow reserve deposits from the CB.
When the discount rate is low, borrowing becomes inexpensive
and the financial institutions will prudently expand their assets
and deposits more readily.
When the discount rate is high ,the institutions are more
reluctant to borrow reserves and become more careful about
expanding asset and deposit holdings.
Example: when banks borrow from the discount window, the
funds they borrow are paid in reserves by the CB. Suppose
BNB borrows $1000 at the window. The T-account will look as
follows:
BNB
CB
11
The tools of monetary policy………cont
3.Reserve Requirements :
- The CB can establish reserve requirements within
certain limits. Such requirements determine the
amounts of funds financial institutions must hold at
the CB to back their deposits.
- Only the CB can change the reserve requirements
for depository institutions.
- Changing reserve requirements change the money
supply.
- Example: Assume BNB has:
- Demand deposits
= $ 5000
- Reserve requirement = 20%
- The bank is fully loaned up and therefore has no
excess reserves i.e. ER=0
- BNB’s T-account looks as follows:
12
The tools of monetary policy………cont
BNB
Now: The CB decides to reduce reserve requirement on
demand deposits from 20% to 10%.What happens then?
First step: The new requirement lowers the amount of
reserves to $500 and increase the ER by $500.
That is: RR = 10% X $5000 = $500
ER = $1000-$500 = $500
13
The tools of monetary policy………cont
The T-account of BNB will look as follows:
BNB
Second step: what BNB will do with the $500 ER?
-could hold it at CB ( but this will generate no profits !!!)
-make loans and expand deposits o the point where all of
the excess reserves are again absorbed as RR.
- The T-account of BNB will look as follows :
14
The tools of monetary policy………cont
BNB
- The CB expands the amount of bank deposits by
lowering reserve requirements on deposits .
- Similarly, when the CB increases the reserve
requirements ,the banking system will contract
the amount of bank deposits and hence
decrease the money supply.
15
Comparing the Monetary Tools
• The CB does not use all three tools to conduct
monetary policy on a regular basis
• Each tool plays a different and important role In
the CB monetary arsenal.
Advantages of OMO :
- Can be done easily almost instantaneously with
no announcement effect.
- Any changes in the money supply can be easily
reversed without an announcement effect.
16
Comparing the Monetary Tools……cont
Shortcomings of discount rate adjustment:
• Changes in the Discount rate will affect the money
supply only if banks are willing to respond.
• Because the CB scrutinizes borrowing at the discount
window, banks may be reluctant to overuse this privilege.
• Borrowing under the discount window is short-term and it
is difficult to gauge the impact on the money supply for a
given change in the discount rate.
• As a practical matter, changing the discount rate is not a
viable tool for conducting monetary policy.
17
Comparing the Monetary Tools…….cont
Changes to reserve requirements :
• Changes in reserve requirements are not
used as a tool of monetary policy .This is
because it is difficult to make a number of
small adjustments to reserve requirements
and frequent changes are disruptive to the
banking system.
• Changing reserve requirements is typically
done to deal with structural problems in
the banking system.
18
Summary : How tools of monetary policy affect the money supply
Monetary policy tool
Increase in money
supply
Decrease in money
supply
OMO
Purchasing Tsecurities in the
market
Selling T-securities in
the market
Adjusting the
discount rate
CB lowers the
interest rate
CB raises the interest
rate
Adjusting bank
reserve requirement
CB lowers the
CB raises the reserve
reserve ratio to cause ratio to cause a lower
a higher money
money multiplier
multiplier
19