Week 4

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CHAPTER 4

Functions of the Central Bank

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CHAPTER 4 OVERVIEW

This chapter will:

A. Overview of objectives and functions of BNM

B. Describe how BNM influences monetary policy

C. Explain how monetary policy is used in other countries

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A. Objectives of Bank Negara Malaysiaa) Issues currency and manages the nation's international

reserves

b) Banker and financial adviser to the Government

c) Promote monetary stability and a sound financial structure

d) Influence the credit situation to Malaysia’s advantage

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(a) Issues currency and manages the nation's international reserves

maintain a minimum cover of 80.59% in external assets against its notes and coins in circulation.

Maintaining a strong reserves position is also important to both the short-term objective of economic recovery as well as the long-term aim to maintain a sustainable external position.

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(a) Issues currency and manages the nation's international reserves

The traditional policy for the Ringgit exchange rate has been for market forces to determine the rate and reflect underlying economic fundamentals. Interventions are conducted only to smooth excessively volatile fluctuations. This is called “managed floating”.

Pegging - fixing of the exchange rate at RM3.80 per US$1 effective September 1, 1998. Ringgit was unpegged on 23rd July 2005.

Managed float against a basket of currencies – 23rd July 2005 until today.

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(b) Banker and financial adviser to the Government

managing the Government’s liabilities.

advises the Government on its loan programmes.

trading, registering, settlement and redemption of Government securities through its computerised trading and settlement system.

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(b) Banker and financial adviser to the Government

to provide temporary advances, known as "ways and means" advances, to the Government to cover any deficit in the budget revenue.

maintains a close relationship with the Ministry of Finance.

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(c) Promote monetary stability and a sound financial structure

goal of attaining monetary or price stability. Price stability is a key prerequisite for sustained economic growth, in the absence of which the mobilisation of resources and the efficient channelling of resources to productive investment would be adversely affected.

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(c) Promote monetary stability and a sound financial structure financial stability.

sound and stable financial system is necessary for the conduct of monetary policy.

Maintaining financial stability, in turn, requires stable monetary conditions so that the balance sheets of corporations and financial institutions are not adversely affected by conditions of macroeconomic stress.

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(c) Promote monetary stability and a sound financial structure Having appropriate policies in place is important to

ensure a sound banking system that provides a mechanism for the intermediation process to enable the economy to function efficiently.

An essential element for promoting financial stability is the existence of a strong and effective prudential framework.

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(d) Influence the credit situation to Malaysia’s advantage BNM is obliged to ensure that the supply of money

and volume of credit are sufficiently elastic to the demands of the domestic economy, without creating undue pressure on resources and prices.

It regulates the volume of money and credit generation by the banking system through a range of instruments, including guidelines on lending to priority sectors and selective credit and administrative measures.

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A. Bank Negara Malaysia’s Functions

a) Bank for Currency Issue

b) Keeper for International Reserves

c) Government’s Bank and Financial Adviser

d) Banker to the Banks

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(a) Bank for Currency Issue

The Central Bank of Malaysia Ordinance 1958 (CBO) provides for the Bank Negara Malaysia (BNM) to be the sole currency issuing authority in the country.

The BNM commenced issuing its own currency on June 12, 1967, thereby replacing the Currency Board as the sole currency issuing authority in Malaysia.

The unit of currency was the Malaysian dollar, which was divided into 100 cents. Under the Malaysian Currency (Ringgit) Act 1978, the Malaysian dollar and cent were renamed "Ringgit" and "sen" respectively.

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(a) Bank for Currency Issue

The par value of the Malaysian Ringgit was defined as equivalent to 0.290299 grammes of fine gold.

The currency was then required under the CBO to

have a minimum cover of 80.59% in gold and foreign exchange.

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(b) Keeper of International Reserves The BNM' s international reserves comprise gold,

foreign exchange, reserve position with the International Monetary Fund and holdings of Special Drawing Rights.

To safeguard the external value of the Ringgit, the CBO provides for the maintenance of a minimum external reserves backing of 80.59% against the currency issue.

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(c) Government’s Banker and Financial Advisor The BNM acts as banker, fiscal agent and financial

advisor to the Government.

Close cooperation between the Government and BNM is also evident from the centralisation of Government deposits with the Bank.

With this arrangement, government receipts, arising mainly from the new issue of Government securities, tax and dividend payments are placed with BNM and managed by the Bank depending on the liquidity situation of the system.

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d) Responsibility for Monetary Policy Responsible to the government for promoting

monetary stability and a sound financial structure, and for influencing the credit situation to help achieve the nation’s overall economic objectives.

To ensure the supply of money and the volume of credit are sufficiently elastic to the demands in the domestic economy.

Regulates the volume of money and the generation of credit by the banking system through a range of instruments.

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(e) Banker to the Banks

The BNM's relationship with the commercial banks, finance companies, merchant banks, discount houses and the Islamic Bank has its legal foundation in three main pieces of legislation, namely: (a) the Central Bank Ordinance 1958; (b) the Banking and Financial Institutions Act (BAFIA) 1989; and (c) the Islamic Banking Act 1983.

The BNM cooperates closely with the financial institutions to promote and maintain a range of banking and other services for the public, enhance efficiency and strengthen the institutions' prudential standards, discipline and moral fibre.

In acting as banker to these institutions, the BNM maintains special accounts for the major financial institutions, inspects them regularly and performs the functions of a lender of last resort.

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B. Monetary Policy Tools

1. Open Market Operationsa. Central bank’s purchase of Securities: increase in money

supply b. Central bank’s sale of Securities: decrease in money

supply

2. Adjusting the Overnight Policy Rate (OPR) influences the market interest rates

3. Adjusting the Statutory Reserve Requirement (SRR) Ratio

Reserve Requirement Adjustments affect Money Growth because higher reserves lead to less borrowing and lower reserves lead to more borrowing (see Exhibit 4.3)

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Exhibit 4.3 Illustration of Multiplier Effect

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B. Monetary Policy Tools

4. BNM’s Control of the Money Supply.

Which form of money to control?

M1 = currency help by the public in checking accounts

M2 = M1 + saving accounts + money market deposit accounts

(MMDA)

M3= M2 + Large time deposits

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C. Global Monetary Policy

Each country has its own central bank that controls the money supply and monetary policy

1. A Single Eurozone Monetary Policya. Impact of the Euro on Monetary Policy

1.) 12 European countries made their currency the euro

2.) European Central Bank based in Frankfurt

3.) Monetary policy set for the 12 members

b. Variations in the Value of the Euro

fluctuated widely since introduced in1999

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CHAPTER 5

Monetary Theory and Policy

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CHAPTER 5 OVERVIEW

This chapter will:

A. Describe the impact of monetary policy

B. Explain the tradeoffs involved in monetary policy

C. Describe how financial market participants monitor and forecast the central bank’s policies

D. Explain how monetary and fiscal policies are related

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What is Monetary Policy?

Monetary policy dictates and regulates the volume of money supply and credit in the economy.

BNM is responsible to the government for promoting monetary stability and a sound financial system, and to help influence the credit situation to achieve the nation’s overall economic objectives.

Long term – BNM to ensure there is sufficient money supply and credit to meet the government’s objective of sustained growth with price stability.

Short term – BNM must ensure that the growth of money supply is sufficiently elastic to counter any inflationary situation that may arise

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What is Monetary Policy?

The goal of most central banks are focused on stabilizing the economy.

Bottom line: to achieve low level of inflation and a low level of unemployment

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A. Impact of Monetary Policy

1. Correcting a Weak Economy

a. BNM can stimulate the economy by creating a loose-money policy and engages in

1.) buying government securities

2.) lowering the OPR

3.) lowering the reserve requirement

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Exhibit 5.1 Effects of an Increased Money Supply

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A. Impact of Monetary Policy

2. Correcting High Inflation

a. The BNM can constrain economic activity when it creates a tight-money policy and

1.) sells government securities

2.) raises the OPR

3.) increases the reserve requirement

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Exhibit 5.2 Effects of a Reduced Money Supply

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Exhibit 5.3 How Monetary Policy Can Affect Economic Conditions

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Exhibit 5.3 How Monetary Policy Can Affect Economic Conditions (continued)

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Exhibit 5.4 Effects of an Increased Money Supply According to the Rational Expectations Theory

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Limitations of Monetary Policy

Impact of credit crunch Loose monetary policy (more loanable funds) does not

translate to more credit by banks (banks do not lend out newly created funds)

Lagged effects of monetary policy Recognition lag Implementation lag Impact lag

Impact of a stimulative policy on expected inflation The effect of an increase in money supply may be disrupted

due to an increase in inflationary expectations.

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B. Tradeoff in Monetary Policy

1. The Tradeoffa. Studies indicate there exists an inverse

relationship between inflation and unemployment

the lower the unemployment, the greater the inflation,

the higher the unemployment, the lower the inflation

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B. Tradeoff in Monetary Policy

2. When inflation is high, tight money policy is considered.

Tradeoff is higher unemployment

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B. Tradeoff in Monetary Policy

3. When unemployment is high, loose-money policy is considered.

Trade off is higher inflation

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C. Monitoring and Forecasting the Monetary Policy

1. Economic Indicators Monitored by the BNM

a. Indicators of Economic Growth

1.) GDP

2.) Industrial production index

3.) Unemployment rate

4.) Consumer confidence surveys

b. Index of Leading, Coincident, and Lagging Indicators

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C. Monitoring and Forecasting the Monetary Policy

2. Indicators of Inflation

a. Producer and Consumer Price Indices

b. Other Indicators wage rate price of oil price of gold

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D. Integrating Monetary and Fiscal Policies1. Framework

a. Monetary and Fiscal Policy Affect Interest Rates over Time

1.) Monetary policy has an indirect effect on the demand for

funds2.) Fiscal policy the demand for

funds through thea.) budgetb.) business tax rates

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Exhibit 5.10 Framework for Explaining How Monetary Policy and Fiscal Policy Affect Interest Rates over Time

Note: Diagram does not account for possible international effects

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Tutorial

1. Discuss the objectives of BNM as a central bank.2. Discuss the functions of BNM.3. Describe loose monetary policy – what is the mechanism, how

it works, and what is the expected outcome?4. Describe tight monetary policy – what is the mechanism, how

it works, and what is the expected outcome?5. Describe the following:

1. Open Market Operation (OMO)2. Adjusting the Overnight Policy Rate (OPR)3. Adjusting the Statutory Reserve Requirement (SRR) ratio

6. Questions and Applications (P109)1. Q6, Q9, Q11, Q12