Money & banking lecture 8 (2) (mansoura university)

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AlMoatassem Mostafa

Lecture Eight: 19 November 2016 Money & Banking

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IntroductionCentral banks play a major role in the economy and monetary system. Central banks appeared in order to regulate the monetary system and oversee the activities of commercial banks. In addition, they are the sole issuers of a countrys currency. Another significant function of central banks is monetary policy. They conduct monetary policy as this policy influences money supply in the economy, and therefore, the level of prices in the economy. This function in particular is highly important because the main target of a monetary policy is to achieve price stability and to restrict inflation within an acceptable rate. The Federal Reserve in USA and the Central Bank of Egypt are examples of central banks.

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Central Banks play a major role in the economy

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The Federal Reserve Bank of the United States and the Central Bank of Egypt4

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The Independence of Central BanksCentral banks operate efficiently whenever they perform their functions neutrally. This means they must be independent from the government and its political trends. They must also act without any influence from commercial banks. This explains why central banks in most countries do not constitute a part of finance ministries in these countries.In any case, the relationship between the central bank and the government differs from one country to another and subject to frequent changes over time. Being independent from the government does not change the fact that the central bank is a banker to the government since the central bank undertakes the task buying and selling of government bonds and securities. When it undertakes this task, however, it acts independently from the political decisions of the government 6

Are central banks really independent?7

The Balance Sheet of Central BanksAs the case with commercial banks, central banks have balance sheets that list their assets and liabilities. The assets of central banks generally include:Reserves of vault cash;Foreign exchange reserves;Gold; Government securities; andLoans to commercial banks

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The Balance Sheet of Central BanksIn contrast, the liabilities of central banks include:Deposits of the government;Deposits of commercial banks; andCurrency in circulation.9

The Balance Sheet of Central Banks

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Reserves of Vault CashAs the case with commercial banks, the first item listed as an asset in a central banks balance sheet is vault cash. A central bank must keep cash in its vault because it is the most liquid item on the list.Vault cash facilitates the task of a central bank in conducting monetary policy as it could use this vault cash to buy, for instance, government securities and increase money supply. 11

Foreign Exchange ReservesCentral banks hold foreign exchange reserves mainly in the form of foreign banknotes. These reserves might also include foreign bank deposits, foreign government deposits, bonds, and other government securities. Foreign exchange reserves are also known as forex reserves. All the central banks in the world hold foreign exchange reserves mostly in the U.S. Dollars, which is the dominant currency worldwide. Examples of foreign exchange currencies held by central banks other than the U.S. Dollars include the Euro, the British Sterling Pound, the Chinese Yuan, and the Japanese Yen. Foreign exchange reserves provide resilience to central banks in case of market shocks that result from the fluctuations in the value of currencies.12

Foreign Exchange ReservesThey also provide support to the national currency of a country as this currency is itself worthless, but merely supported by this country. Foreign reserves exchange, accordingly, strengthens this support. Finally, foreign exchange reserves can be used as a tool of monetary policy in countries that adopt a fixed exchange rate as ejecting foreign currencies in the market helps the central banks in these countries to control exchange rates efficiently.13

Foreign Exchange Reserves

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Government SecuritiesSince central banks are bankers to governments, a government can request loans from the central bank. Loans granted by central banks to governments take a slightly different form as compared to loans provided to commercial banks. For instance, when a government wishes to borrow money to finance a megaproject, it issues securities to obtain this money. Government securities are debt instruments issued by the government to finance its borrowings with a promise of repayment upon maturity date.Government securities are regarded as a low-risk lending option because of the trust in the governments ability to repay these debts. 15

Government SecuritiesTreasury bills are one form of government borrowing; they are short-term debt instruments issued by the government to finance its spending. Treasury bills are sold at a discounted price as compared to its face value. The maturity date of these bills ranges between three months, six months, or at most, a year. Upon maturity date, the government pays the holder of a treasury bill its full face value. Consequently, the holder of a treasury bill does not receive interest on this bill, but rather gains from the different (difference) between the discounted price at which he/she bought the bill and the full face value he/she receives upon maturity date.16

A treasury bill issued from the Nigerian Government

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Loans to Commercial BanksCentral banks are also bankers to commercial banks. This explains why the central bank is the lender of last resort. Commercial banks request loans from central banks when they suffer from liquidity shortages. Loans granted from central banks to commercial banks are called discount loans. They are called discount loans because the interest charged on the whole period of the loan is deducted upfront when the loan is granted. A commercial bank that borrowed the loan will then pay the principal fully on the due date of debt repayment. The interest rate charged on discount loans is called discount rate.Central banks may force commercial banks to borrow from them as a part of the monetary policy they conduct and in order to balance their assets and liabilities.

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Loans to Commercial BanksFor example, a discount loan of $1,000 might yield only $930 for the borrower to use. The other $70 would be interest and/or other charges. When it comes time to repay the discount loan, the borrower must pay the full face amount; in our example, this is $1,000.

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The Balance Sheet of Central Banks20

Deposits of the governmentThe central bank is a banker to the government. Funds of the government are, consequently, kept at the central bank in the form of deposits. There are generally two types of government deposits at the central bank: the Exchequer Account and the Paymaster General Account. The Exchequer Account ( ) is an account that incorporates tax funds in addition to other public funds received by the government. The Paymaster General Account ( ) , in contrast, contains commissions, fees, and salaries that are determined to be distributed by the Paymaster General21

Deposits of commercial banksDeposits of commercial banks are also listed as liabilities to central banks. Deposits of commercial banks at central banks are either required reserve accounts or settlement accounts. Commercial banks are required to keep a certain fraction of funds for every currency unit in checkable accounts; these reserves are called required reserves. The settlement account is allocated for interbank transactions, including cash items in process of collection. 22

Settlement accounts at central banks

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Cash items in process of collection24

Currency in circulation25Currency in circulation refers to banknotes and coins used by individuals and businesses in settling transactions in the market; it is also called money in hand. It is important to distinguish here between currency in circulation and currency stored in the various bank deposits; currency in circulation is physically used to settle transactions unlike the currency stored in checking and savings accounts. Currency in circulation constitutes a part of the overall money supply and it could serve as a tool of monetary policy

APPLICATION26Categorize the following as either assets or liabilities in a central banks balance sheet:Currency in circulationGovernment securitiesGoldDeposits of commercial banksReserves of vault cashDeposits of the governmentLoans to commercial banksForeign exchange reserves

Functions of Central Bank27Central banks perform numerous functions on various levels. First, central banks supervise the activities of commercial banks. It is responsible for the injection of liquidity to commercial banks when they suffer from liquidity shortage. This is why central banks are generally known as the lender of last resort as they save the payment system from collapsing. In addition, a central bank is the only authorized entity to issue a countrys currency and coins. This function differs from credit creation by commercial banks, since commercial banks create credit through checkable accounts and not through injecting liquid money as the case with central banks. Another important function of central banks is the designation and implementation of monetary policy.

Functions of Central Bank28Central banks, consequently, performs both macroeconomic and microeconomic functions. The macroeconomic functions are more related to issuing country and conducting monetary policy. The microeconomic functions, in contrast, are related to the central banks relationship with commercial banks, since central banks are deemed as the banker to commercial banks

Functions of Central Bank29

Functions of Central Bank30

Functions of Central Bank31We can conclude, therefore, that the basic functions of central banks can be summarized as follows:Issuing currency;Serving as a banker to the government;Serving as a banker to commercial banks; and Conducting monetary policy

Issuing Currency32

Issuing Currency33A central bank is the sole issuer of currency in the form of notes and coins in a country.Based on this function, a central bank is the only authorized entity by law to manufacture, issue, and change notes and coins in a country. Generally, most central banks worldwide have a coins manufacturing company called a Mint and a banknotes manufacturing company.

Coin minting34

Issuing Currency35Banknotes and coins are issued as a legal tender; this means people are under legal obligation to accept money for debt payment.We, therefore, conclude that fiat money is basically valueless pieces of paper; it does not have an intrinsic value in itself. Its value, however, is derived from a government decree.It must be noted, in addition, that determining the denominations of a currency depends on the rate of inflation; the higher the inflation rates, the higher the denominations of the currency.If, for instance, Egypt experienced high rates of inflation, the denominations of the Egyptian Pound would be 10 Egyptian Pounds, 20 Egyptian Pounds, 50 Egyptian Pounds, 100 Egyptian Pounds, and 200 Egyptian Pounds. In contrast, the lower the inflation rates, the lower the denominations of the currency. In the previous example, if Egypt experienced low inflation rates, the denominations of the Egyptian Pound would start from 1 Egyptian Pound instead of 10 Egyptian Pounds

Issuing Currency36Regarding the design and shape of the currency, they are determined by the mutual agreement between the central bank and the government; the same applies for denominations. Also, issuing banknotes and coins involves that the central bank determines the countrys demand of new banknotes and coins annually, and then it issues the new banknotes and coins according to this demand. Finally, central banks must ensure the quality of banknotes and coins issued in order to reduce the risk of currency counterfeiting, facilitate mechanical counting and sorting of banknotes, and to guarantee the currencys acceptability to the individuals using it.

Issuing Currency37

Issuing Currency38

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