Ambo University

College Of Business and Economics Department Of Accounting

and Finance
MBA in Accounting and Finance

Term Paper

By Ketema Asefa Hora

ID No pge/57999/14

Instructor: Kokobe Seyoum (PHD)

1. Structure of Centeral banks

In keeping with the institutional role defined by articles of association, the organisational
structure of the Central Bank is based on a three-level hierarchical model: Department, Service
and Office.

The central bank's main functions are to set the base rate, control the money supply through
open market operations, set private banks reserve requirements, and control the nations foreign
exchange reserves.

2. Multiple deposit creation and the money supply

The deposit multiplie is the maximum amount of money that a bank can create for each unit of
money it holds in reserves. The deposit multiplie involves the percentage of the amount on
deposit at the bank that can be loaned. That percentage normally is determined by the reserve
requirement set by the Federal Reserve.

The deposit multiplie is key to maintaining an economy's basic money supply. It's a component
of the fractional reserve banking system, which is now common to banks in most nations
around the world.

Money Supply Process: So far, we have been vague about what determines money supply.
We just assumed that it is partly determined by the central bank and partly by non-policy shocks.
In this section, we take a closer look at the money supply process. It has important bearing on
the conduct of monetary policy. There are four important actors, whose actions determine the
money supply – (i) the central bank, (ii) banks, (iii) depositors, and (iv) borrowers. Of
the four players, the central bank is the most important. Its actions largely determine the money
supply. Let us first look at its balance sheet.

3. Determinants of Money Supply

There are two theories of the determination of the money supply. According to the first view, the
money supply is determined exogenously by the central bank. The second view holds that the
money supply is determined endogenously by changes in the economic activity which affects
people’s desire to hold currency relative to deposits, the rate of interest, etc.
Thus the determinants of money supply are both exogenous and endogenous which can be
described broadly as: the minimum cash reserve ratio, the level of bank reserves, and the desire
of the people to hold currency relative to deposits. The last two determinants together are called
the monetary base or the high powered money.

The supply of money is a stock at a particular point of time, though it conveys the idea of a flow
over time. The term ‘the supply of money’ is synonymous with such terms as ‘money stock’,
‘stock of money’, ‘money supply’ and ‘quantity of money’. The supply of money at any moment is
the total amount of money in the econom. There are three alternative views regarding the
definition or measures of money supply. The most common view is associated with the
traditional and Keynesian thinking which stresses the medium of exchange function of money.

According to this view, money supply is defined as currency with the public and demand
deposits with commercial banks. Demand deposits are sayings and current accounts of
depositors in a commercial bank. They are the liquid form of money because depositors can draw
cheques for any amount lying in their accounts and the bank has to make immediate payment on
demand. Demand deposits with commercial banks plus currency with the public are together
denoted as M1, the money supply. This is regarded as a narrower definition of the money supply.
The second definition is broader and is associated with the modern quantity theorists headed by
Friedman. Professor Friedman defines the money supply at any moment of time as “literally the
number of dollars people are carrying around in their pockets, the number of dollars they have to
their credit at banks or dollars they have to their credit at banks in the form of demand deposits,
and also commercial bank time deposits.”

4. Tools and conduct of Monetary Policy

Central banks use various tools to implement monetary policies. The widely utilized policy tools
include:

1. Interest rate adjustment

A central bank can influence interest rates by changing the discount rate. The discount rate (base
rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a
central bank increases the discount rate, the cost of borrowing for the banks increases.
Subsequently, the banks will increase the interest rate they charge their customers. Thus, the
cost of borrowing in the economy will increase, and the money supply will decrease.

2. Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be held by a
commercial bank. By changing the required amount, the central bank can influence the money
supply in the economy. If monetary authorities increase the required reserve amount,
commercial banks find less money available to lend to their clients, and thus, money supply
decreases.

Commercial banks can’t use the reserves to make loans or fund investments into new businesses.
Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest
on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on
required reserves).

3. Open market operations

The central bank can either purchase or sell securities issued by the government to affect the
money supply. For example, central banks can purchase government bonds. As a result, banks
will obtain more money to increase the lending and money supply in the economy.
Direct policy tools:-These tools are used to establish limits on interest rates, credit and
lending. These include direct credit control, direct interest rate control and direct lending to
banks as lender of last resort, but they are rarely used in the implementation of monetary policy
by the Bank.
 Interest rate controls:-The Bank has the power to announce the minimum and maximum
rates of interest and other charges that domestic banks may impose for specific types of loans,
advances or other credits and pay on deposits. Currently, the Bank does not set any interest
rate levied by domestic banks except for the minimum interest rate payable on savings
deposits. The Bank has opted not to use this as a tool of monetary policy but to let market
forces determine interest rate.
 Credit controls :-The Bank has the power to control the volume, terms and conditions
of domestic bank credit, including installment credit extended through loans, advances or
investments. The Bank has not exercised such controls in its implementation of monetary
policy.
 Lending to domestic banks :-The Bank may provide credit, backed by collateral,
to domestic banks to meet their short-term liquidity needs as lender of last resort. The interest
is set at a punitive rate to encourage banks to manage their liquidity efficiently.
Indirect policy tools:- Used more widely than direct tools, indirect policy tools seek to alter
liquidity conditions. While the use of reserve requirements has been the traditional monetary
tool of choice, more recently, the Bank shifted towards the use of open market operations to
manage liquidity in the financial system and to signal its policy stance.
 Reserve requirements – The Bank uses reserve requirements to limit the amount of funds
that domestic banks can use to make loans to its customers. Domestic banks are required to hold
a proportion of customers’ deposits in approved liquid assets. An increase in the reserve ratios
should reduce domestic banks’ lending and, therefore, the demand for hard currency, while a
decrease should yield the opposite effect.
 The secondary reserve requirement is a certain percentage of domestic banks’ deposit
liabilities that is to be held in approved liquid assets. It should be freely and readily convertible
into cash without significant loss, free from any charge, lien or encumbrance.
 The cash reserve requirement, also called primary reserve requirements, is a
percentage of domestic banks’ average deposit liabilities that must be held at the Bank in a non-
interest bearing account. Cash reserves are a component of the secondary reserve requirements.
 To encourage the development of the government securities market, a securities
requirement was instituted on 1 May 2010, requiring domestic banks to hold a proportion of
their average deposit liabilities in the form of Treasury bills. The securities requirement is also a
component of the secondary reserve requirements.
 Open market operations – The conduct of open market operations refers to the purchase
or sale of government securities by the Bank to the banking and non-banking public for liquidity
management purposes. When the Bank sells securities, it reduces domestic banks’ reserves
(monetary base), and when it buys securities, it increases banks’ reserves.
Fiduciary or paper money is issued by the Central Bank on the basis of computation of estimated
demand for cash. Monetary policy guides the Central Bank’s supply of money in order to achieve
the objectives of price stability (or low inflation rate), full employment, and growth in aggregate
income. This is necessary because money is a medium of exchange and changes in its demand
relative to supply, necessitate spending adjustments. To conduct monetary policy, some monetary
variables which the Central Bank controls are adjusted-a monetary aggregate, an interest rate or
the exchange rate-in order to affect the goals which it does not control. The instruments of
monetary policy used by the Central Bank depend on the level of development of the economy,
especially its financial sector. The commonly used instruments are discussed below.

Reserve Requirement: The Central Bank may require Deposit Money Banks to hold a fraction
(or a combination) of their deposit liabilities (reserves) as vault cash and or deposits with it.
Fractional reserve limits the amount of loans banks can make to the domestic economy and thus
limit the supply of money. The assumption is that Deposit Money Banks generally maintain a
stable relationship between their reserve holdings and the amount of credit they extend to the
public.
Lending by the Central Bank: The Central Bank sometimes provide credit to Deposit Money
Banks, thus affecting the level of reserves and hence the monetary base.
Interest Rate: The Central Bank lends to financially sound Deposit Money Banks at a most
favourable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor
for the interest rate regime in the money market (the nominal anchor rate) and thereby affects the
supply of credit, the supply of savings (which affects the supply of reserves and monetary
aggregate) and the supply of investment (which affects full employment and GDP).
Direct Credit Control: The Central Bank can direct Deposit Money Banks on the maximum
percentage or amount of loans (credit ceilings) to different economic sectors or activities,
interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the
available savings is allocated and investment directed in particular directions.
Moral Suasion: The Central Bank issues licenses or operating permit to Deposit Money Banks
and also regulates the operation of the banking system. It can, from this advantage, persuade
banks to follow certain paths such as credit restraint or expansion, increased savings
mobilization and promotion of exports through financial support, which otherwise they may not
do, on the basis of their risk/return assessment.
Exchange Rate: The balance of payments can be in deficit or in surplus and each of these affect
the monetary base, and hence the money supply in one direction or the other. By selling or
buying foreign exchange, the Central Bank ensures that the exchange rate is at levels that do not
affect domestic money supply in undesired direction, through the balance of payments and the
real 3 exchange rate.

5. Monetary Policy Goals and Targets

A key role of central banks is to conduct monetary policy to achieve price stability (low and stable
inflation) and to help manage economic fluctuations. The policy frame works with in which
central banks operate have been subject to major changes over recent decades.

Central banks in Canada, the euro area, the United Kingdom, New Zealand, and else where have
introduced an explicit inflation target. Many low-income countries are also making a transition
from targeting a monetary aggregate (a measure of the volume of money in circulation) to an
inflation targeting framework. Central banks conduct monetary policy by adjusting the supply of
money, generally through open market operations. For instance, a central bank may purchase
government debt from commercial banks and there by increase the money supply (a technique
called “monetary easing”). The purpose of open market operations is to steer short-term interest
rates, which in turn influence longer term rates and overall economic activity. In many countries,
especially low-income countries, the monetary transmission mechanism is not as effective as it is
in advanced economies. Before moving from monetary to inflation targeting, countries should
develop a framework to enable the central bank to target short-term interest rates. Following the
global financial crisis, central banks in advanced economies eased monetary policy by reducing
interest rates until short-term rates came close to zero, which limited the option to cut policy
rates further (i.e., conventional monetary options). With the danger of deflation rising, central
banks under took unconventional monetary policies, including buying bonds (especially in the
United States, the United Kingdom, the euro area, and Japan) with the aim of further lowering
long term rates and loosening monetary conditions. Some central banks even took short-term
rates below zero.

Monetary policy is an economic policy that manages the size and growth rate of the money
supply in an economy. It is a powerful tool to regulate macroeconomic variables such
as inflation and unemployment.
These policies are implemented through different tools, including the adjustment of the interest
rates, purchase or sale of government securities, and changing the amount of cash circulating in
the economy. The central bank or a similar regulatory organization is responsible for formulating
these policies.
Goals: The goal for high employment should therefore not seek an unemployment level of zero
but rather a level above zero consistent with full employment at which the demand for labor
equals the supply of labor. This level is called the natural rate of unemployment.
The goal of steady economic growth is closely related to the high-employment goal because
businesses are more likely to invest in capital equipment to increase productivity and economic
growth when unemployment is low. High employment, price stability, financial market stability.

Targets for monetary policy instruments which are readily controlled by monetary policy
tools, such as reserve aggregates (reserves, non borrowed reserves, monetary base, or non
borrowed base) or interest rates (federal funds rate or Treasury bill rate).