BRUNEL UNIVERSITY LONDON

Department of Economics and Finance

EC1030 LECTURE 7

Central Banks
Contents

1. Central Bank and Monetary Policy

2. Mechanics of Monetary Policy
3. Impact of Monetary Policy
4. Lecture 7 Summary
Central Bank and Monetary Policy
 Central Bank

• Central Bank is a financial institution owned by the government. It has the

responsibility for conducting national monetary policy to achieve (1) full employment
and (2) price stability (low or zero inflation)
• Central Bank’s monetary policy affects interest rates which has a strong influence on the
cost of borrowing for households and corporate businesses.
• UK: Governor performing in monetary policy, financial stability and prudential
regulation committees through the corresponding deputy governors.
• US: Member Banks
• Commercial banks can elect to become member banks if they meet specific
requirements of the Board of Governors.
• All national banks are required to be members of the Central Bank.
Central Bank (cont.)

• Central bank sets the interest rate for very short-term interbank loans
(overnight loans of reserves from one bank to another).
• UK: London Inter-bank Offered Rate (LIBOR)
• US: Federal Funds Rate.
• EU: Overnight Cash Rate.
Central Bank (cont.)

What do you think is the most important goal(s) for interest rate control
from monetary policy?

Price Stability? Economic Growth?

Monetary Policy

• The monetary policy of a central bank defines the strategy it follows in

adjusting interest rates. Monetary policy is generally set so as to limit price
inflation, while also maintaining conditions for economic growth.

• Monetary policy affects the economy via the “transmission mechanism”.

- For example, by increasing the interest rate, the central bank reduces the
volume of consumption and investment in the economy, which reduces
inflationary pressures by increasing unemployment.
Monetary Policy (cont.)

Open market Reserve Requirement:

operations the proportion of cash amount a
bank must hold in reserve against
deposits made by customers
→ To keep a certain amount of
deposits on hand to cover possible
withdrawals.

Central Bank

Reserve
Interest rate
Requirement
control
Ratio
 Monetary Policy (cont.)

Monetary policy tools

(1) Open market operations: The most common means whereby
central banks create shortages is by:
• Sell securities
• Buy securities
Monetary Policy (cont.)

(2) Interest rate control

• The basis of central bank control over interest rates is that it has a monopoly
over the creation of money (liquidity) in its own currency.
• A change in the short term money market rate controlled by the central bank
leads to a change in other “market determined” interest rates such as the loan
(mortgage) rate, and the bond yield as well. They will change to a degree that
depends on expectations of future central bank action, the state of the economy
etc.
• Even though most interest rates are market determined, the CB can have a
strong influence on these rates by controlling the supply of loanable funds.
Monetary Policy (cont.)

• Quantitative Easing vs Open Market Operations:

(1) Open Market Operations

(2) Quantitative Easing (conducted in US during Obama presidency)

Monetary Policy (cont.)

(3)Reserve Requirement Ratio

• The Reserve Requirement is the proportion of bank deposit accounts that must
be held as required reserves or funds held in reserve.
→ To keep a certain amount of deposits on hand to cover possible
withdrawals.
• This has historically been set between 8% and 12% of transaction accounts.
• By reducing the reserve requirement, the Board increases the proportion of a
bank’s deposits that can be lent out.

reserve requirement → bank’s lending capacity

Monetary Policy (cont.)

Adjusting the Reserve Requirement Ratio

• Changes in reserve ratios can also be used to influence interest rates/the
money supply.
• But in practice they are being abolished or at least changes in them are not
commonly used for monetary control.
• Note that it is not possible to control the money supply and its price (the
interest rate) separately – these must change together.
• Also it has proved very difficult to control the quantity of broad money due to
financial liberalization.
Mechanics of Monetary Policy
Mechanics of Monetary Policy

Central Bank
Home Sales
GDP
Index

Monitors the Economic Growth Indicators

National Retail Sales

Income Index

Industrial
Unemployment
Production
Rate
Index
 Mechanics of Monetary Policy (cont.)

Monitoring Indicators of Economic Growth:

The CB monitors indicators of economic growth:
• GDP - measures the total value of goods and services produced during a
specific period.
• National Income - the total income earned by firms and individual
employees during a specific period.
• Unemployment rate - the portion of unemployed people from the total
labour force in a country.
• Other indexes - Industrial production index, a retail sales index, and a
home sales index.
Mechanics of Monetary Policy (cont.)

Central Bank

Inflation Exchange
Monetary
Targeting Rate
Targeting
Targeting

Consumer Price Index

MV=PT Holding Exchange
Philips Curve Rate Constant
→ Price Stability
Inflation Targeting

(1)Inflation targeting
• A central bank such as the Bank of England has an objective for inflation set by
the government, but is then free to choose how to achieve the objective.
• In the UK the price stability objective is to achieve the inflation target as
measured by the 12-month increase in the Consumer Prices Index (CPI).
• The central bank then makes monthly forecasts of inflation looking future
years ahead to assess whether interest rates should be changed to avoid a
deviation from the target.
Inflation Targeting (cont.)

• The Bank will take into account influences from a wide range of economic
indicators, which will have a bearing on inflation over the future.
(a) Producer and consumer price indexes:
• Producer price index
• Consumer price index

(b) Other inflation indicators

• Wage rates
• Oil prices
• Gold prices
Inflation Targeting (cont.)

• In some cases, indicators of economic growth are also used to indicate

inflation.
• Although these reports are good news about the economic growth, their
information about inflation is unfavourable.
• Normally, unemployment rate and inflation rate have inverse relationship
(Phillips Curve)
• The financial market may be adversely affected by such reports since investors
anticipate the CB will increase interest rates to reduce the inflation rate effect
in the economy.
 Advantages of inflation targeting:

Inflation
Targeting (cont.)
Disadvantages of inflation targeting:
 Monetary Targeting

(2) Monetary targeting

• The background is the monetarist view that inflation is everywhere a monetary
phenomenon, and that without growth in the money supply, inflation must cease.
• Monetary targeting assumes a stable relationship between the price level (P) and money
supply (M), based on Irving Fisher’s Quantity Theory of Money:
MV=PT
where
• V is the money velocity (i.e. the amount of unit currency used per unit of time).
• T is the aggregate output (or quantity of goods and services), i.e. Real GDP.
→ If V is fixed and T is slow-moving then M largely determines P.
*Main Idea: there is a direct relationship between the quantity of money
(money supply) in an economy and the price levels of
goods and services sold
 Exchange Rate Targeting

(3)Exchange rate targeting

• In a small open economy, the best way to maintain price stability may be to hold the
exchange rate constant against the currency of a large country which itself
successfully pursues price stability.
• This is the approach of countries such as Denmark vis a vis the Euro and Hong Kong
vis a vis the Dollar.
Impact of Monetary Policy
 Impact on Financial Markets: Monetary policy
affects the valuation of securities:
• Bond values are inversely related to interest rates.
• Stock values are affected by interest rate movements.

Monitoring
Impact on Financial Institutions
the Impact of • When interest rates rise, the cost of funds (i.e. the

Monetary cost of borrowing money from the central bank) for

financial institutions rises faster than the return (i.e.
Policy the revenue the financial institutions receive by
lending money) they receive.
• Financial institutions such as commercial banks,
bond mutual funds, insurance companies, and
pension funds maintain large portfolios of bonds, so
their portfolios are adversely affected when the
Central Bank raises interest rates.
 • The Central Bank’s monetary policy is commonly
influenced by the administration’s fiscal policies.

• Fiscal policy refers to the use of (1) government

spending and (2) tax policies to influence
How Monetary macroeconomic conditions, including aggregate
demand, employment, inflation and economic growth.

Policy Responds • If fiscal pressures create large budget deficits, this may
place pressure to increase interest rates and the Centra

to Fiscal Policy Bank may feel pressured to use a stimulative monetary

policy to reduce interest rates.

• Fiscal policy shifts demand for loanable funds.

• However, monetary policy has a larger impact on

the supply of loanable funds.
Lecture 7 Summary
1. Central Bank
- A financial institution owned by the government.
- It has the responsibility for conducting national
monetary policy influencing interest rate and other
economic variables that determine the security prices.
- Member Banks: elected commercial banks meeting
specific requirements + all national banks
Lecture 7 Summary
(cont.)
2. Monetary policy is generally set by adjusting interest rates
to limit price inflation, while also maintaining conditions for
economic growth.
(a) Open market operations: Central bank sells or buys
securities that affects the interest rates
(b) Interest rate control
(c) Reserve requirement ratio
reserve requirement → bank’s lending capacity
Lecture 7 Summary
(cont.)
3. Mechanics of Monetary Policy
CB monitors indicators of economic growth:
- GDP, National Income, Unemployment rate, Industrial
production index, retail sales index, home sales index.
(1) Inflation targeting: CPI, Philips Curve
(2) Monetary targeting: MV=PT
(3) Exchange rate targeting: To hold exchange rate
constant for stability
Lecture 7 Summary
(cont.)
4. Impact of Monetary Policy
- Impact on Financial Markets: security valuation
- Impact on Financial Institutions: cost of funds
- Fiscal policy: (1) government spending and (2) tax
policies
→ However, monetary policy has a larger impact