Central banks

1.

BUS 362 Financial Institutions and
Markets
Week 5: Central Banks
Assoc. Prof. Hülya Hazar
Faculty of Economics and Administrative Sciences, Department of
Business Administration
[email protected]
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2.

Financial Institutions and Markets
1. What is meant by central banks?
2. Functions of the Central Banks
3. Monetary Policy
4. Inflation
5. Open Market Operations
6. Reserve Requirements
7. Independency of the Central Banks
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3.

Financial Institutions and Markets
Central banks are the government authorities in charge of
monetary policy.
“Monetary policy” refers to the management of the money
supply.
Although we typically hear about central banks in connection
with interest rates, their actions also affect credit, the money
supply, and inflation (just to name a few areas).
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4.

Financial Institutions and Markets
General functions:
• Issue new currency and remove damaged currency
• Conduct research related to monetary policy
• Lender of last resort
• Loans money to banks to prevent banking panics
• [ In Turkey: Banking Regulation and Supervision Agengy
• Evaluate bank mergers and expansions
• Perform bank examinations ]
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5.

Financial Institutions and Markets
Other Goals of Monetary Policy:
• Goals
• Employment
• Want demand = supply
• Economic growth
• Stability of financial markets
• Interest-rate stability
• Foreign exchange market stability
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6.

Financial Institutions and Markets
Expansionary monetary policy:
• Expansionary monetary policy leads to lower unemployment
and lower interest rates.
• This policy leads to higher inflation, and eventually, higher
interest rates.
• Hint: ir = i − e (see week 3)
ir : real interest rate
i : nominal interest rate
e: inflation rate
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7.

Financial Institutions and Markets
Price Stability:
• Price stability is not inconsistent with the other goals in the
long-run.
• However, there are short-run trade-offs.
• An increase in interest rates will help prevent inflation, but
increases unemployment in the short-run.
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8.

Financial Institutions and Markets
Inflation targeting:
• Announcing a medium-term inflation target
• Commitment to monetary policy to achieve the target
• Inclusion of many variables to make monetary policy
decisions
• Increasing transparency through public communication of
objectives
• Increasing accountability for missed target
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9.

Financial Institutions and Markets
The social and economic costs of inflation:
• Price stability has become a primary focus.
• High inflation seems to create uncertainty, hampering
economic growth.
• Indeed, hyperinflation has proven damaging to countries
experiencing it.
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10.

Financial Institutions and Markets
Policy tools of central banks:
• Open market operations
• Discount rate
• Reserve requirements
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11.

Financial Institutions and Markets
Open market operations:
• Open market operations are the most important tool that the
central bank has for controlling the money supply (along with
reserve requirements and the discount rate)
• Open market operations refer to the buying and selling of
government securities in the open market in order to expand
or contract the amount of money in the banking system.
• Securities' purchases inject money into the banking system
and stimulate growth, while sales of securities do the
opposite and contract the economy.
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12.

Financial Institutions and Markets
Open Market Operations:
1.
2.
Dynamic: Change reserves and monetary base
Defensive: Offset factors affecting reserves, typically uses
repos
Advantages of Open Market Operations
1.
2.
3.
4.
The central bank has complete control
Flexible and precise
Easily reversed
Implemented quickly
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13.

Financial Institutions and Markets
Reserves:
• All banks have an account at the central bank in which they
hold deposits.
• Reserves consist of deposits at the central bank plus
currency that is physically held by banks.
• Reserves are divided into two categories:
• Required reserves
• Excess reserves
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14.

Financial Institutions and Markets
Reserves:
• The central bank sets the required reserve ratio – the portion
of deposits banks must hold in cash.
• Reserve requirements are requirements put on financial institutions
to hold liquid (vault) cash again checkable deposits.
• Any reserves deposited with the central bank beyond this
amount are excess reserves.
• The central bank injects reserves into the banking system in
two ways:
• Open market operations
• Loans to banks, referred to as discount loans.
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15.

Financial Institutions and Markets
Trading:
• The trading desk typically uses two types of transactions to
implement their strategy:
1. Repurchase agreements: the central bank purchases
securities, but agrees to sell them back within about 15
days. So, the desired effect is reversed when the
central bank sells the securities back—good for taking
defense strategies that will reverse.
2. Matched sale-purchase transaction: essentially a
reverse repro, where the central bank sells securities,
but agrees to buy them back.
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Financial Institutions and Markets
Independency: How free is the Central Bank from political
pressures in pursuing its goals?
• Instrument Independence: the ability of the central bank to
set monetary policy instruments.
• Goal Independence: the ability of the central bank to set the
goals of monetary policy.
• In recent years, we have seen a remarkable trend toward
increasing independence.
• Arguments can be made both ways:
• Presidential appointment clearly sets the direction of the central
bank.
• Its independence allows the central bank to pursue policies that are
politically unpopular, yet in the best interest of the public.
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Subjects Covered
1. What is meant by central banks?
2. Functions of the Central Banks
3. Monetary Policy
4. Inflation
5. Open Market Operations
6. Reserve Requirements
7. Independency of the Central Banks
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18.

References
Readings:
Chapters 9 and 10
Reference Book:
Mishkin, Frederic S. Financial Markets and Institutions. Eighth Edition.
UK: Pearson, 2016.
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Financial Institutions and Markets
See you next week…
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