Unit 7 Central Banking _ ESP Int'l Banking and Finance

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Functions of a central bankact as banker to the governmentact as banker to the commercial bankssupervise the banking systemprint and issue banknotesmaintain financial stabilityconduct foreign exchange operationshold and manage foreign exchange

reserves

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The Bank of EnglandTwo core purposes:1. Ensuring monetary stability2. Maintaining the stability of the

financial system

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The Bank of EnglandTasks to ensure monetary stability:Try to meet the government’s inflation

target by raising or lowering the official interest rate when necessary.

Use the UK’s foreign currency and gold reserves to try to influence the exchange rate if needed.

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The Bank of EnglandTasks to maintain the stability of the financial system :

Detect and reduce any threats to the financial stability, and make sure the overall system is safe and secure.

Supervise the clearing system: the settlement of claims between banks

Act as ‘lender of last resort’ to financial institutions in difficulty.

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THE EUROPEAN SYSTEM OF CENTRAL BANKS (ESCB)

Composed of:The European Central Bank, andThe EU national central banks

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THE EUROPEAN SYSTEM OF CENTRAL BANKS (ESCB)ESCB’s primary objective: to maintain price stability

ESCB’s basic tasks:define and implement the monetary policy of

the EU;conduct foreign exchange operations;hold and manage the official foreign reserves

of the Member States; and promote the smooth operation of payment

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THE EUROPEAN CENTRAL BANKS (ECB)Organisation of the ECB executive board

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THE EU NATIONAL CENTRAL BANKS (NCBs)

Having all the functions of a central bank except setting interest rates

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US FEDERAL RESERVE SYSTEM (The Fed)

The Fed has two divisions: Board of Governors, is responsible for

setting monetary policy and managing the nation's money;

12 Regional Reserve Banks, act as the service division that carries out the policy and oversees financial institutions. The regional Reserve Banks represent the private sector.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

Monetary policy refers to the actions the Fed takes to influence financial conditions in order to achieve its goals.In its role as money manager, the Fed has two primary goals:

Maintain stable prices (control inflation) Ensure maximum employment and

production output

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

Inflation: Inflation is not a good thing because it slows down economic growth. For example, when inflation is high, things cost more and people spend less. When people don't buy things (when demand is down), then the supply of goods gets too high, production has to decrease, and unemployment increases.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

When prices are stable (when inflation is low), consumers make more purchases, investments, etc., production output is maintained and employment remains high.

Recession: When production decreases and unemployment increases, recession hits.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

Fed’s tasks to achieve its goals:To achieve its goals, the Fed can indirectly influence demand, which then influences the economy. For example, if interest rates are lowered, borrowing money to make purchases becomes less expensive, and people are more motivated to spend money. Spending money, in turn, stimulates economic growth.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

If there is too much money in the economy, however, people spend more money and demand increases at a faster rate than supply can match. Prices rise too quickly because of the shortage of products, and inflation results. If there is too little money in the economy, people don't have excess spending money, and there is little economic growth.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

Influencing inflation takes a long time and has to be looked at as a long-term goal. Influencing employment and output, however, can be done more quickly and therefore is a short-term goal. Finding the balance between the two is key.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

The Fed’s primary control is influencing short-term interest rates and the amount of money in circulation. In doing this, it uses three tools:

Open market operations The discount rate The reserve requirement

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy1. Open market operations

The most effective tool the Fed has, and the one it uses most often, is the buying and selling of government securities in its open market operations. Government securities include treasury bonds, notes, and bills. The Fed buys securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy1. Open market operations: How does it works?

The Fed purchases securities from a bank and pays for the securities by adding a credit to the bank's reserve. The bank has more money to lend to another bank in the federal funds market. This increases the amount of money in the banking system and lowers the federal funds rate. This ultimately stimulates the economy by increasing business and consumer spending.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy1. Open market operations: How does it

work?When the Fed wants to decrease the money supply, it sells securities. This reduces the amount of money the bank has to lend in the federal funds market and increases the federal funds rate. This move ultimately slows the economy down because it typically reduces consumer and business spending.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy2. The discount rate

The "discount rate" is the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis. Typically, higher discount rates indicate that more restrictive monetary policies are in store, while a lower rate might signal a less restrictive move.

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy2. The discount rate

Changes in the discount rate can affect: Lending rates (by making it either more

or less expensive for banks to get money to lend or hold in reserve)

Other open market interest rates in the economy (because of its "announcement effect")

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

3. The Reserve requirementThis refers to the proportion of deposits a bank must hold in its reserves as it lends the rest out. The amount of a bank's required reserves will fluctuate depending on their account totals (from 3% to 10%).

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US FEDERAL RESERVE SYSTEM (The Fed)Monetary policy

3. The Reserve requirementIf the reserve requirement is raised, then banks have less money to loan and this will have a restraining effect on the money supply. If the reserve requirement is lowered, then banks have more money to loan.

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