Roles of central bank

- Control the availability of money supply and credit

- Provides loans to other banks
- Preserving the value of a nations’ currency
Objectives of Central Bank
- Low and stable inflation
- High and stable growth
- Financial system stability
- Stable interest rates
- Stable exchange rates

Interest rate adjusts to balance the demand and supply for money

Money Supply
- Does not depend on interest rate bc it is fixed by the CB => vertical curve
- The supply of real money is fixed by the Monetary policy

Money Demand
- determined by the interest rate and the level of income
 increase in income => increases demand for money
- Opportunity cost of holding money= interest rate
 Interest rate increase => opportunity cost of holding money increases =>
qt of money demanded falls

Excess supply of money : get rid of this money by buying bonds and increasing
up the price of bond => interest rate falls

Excess demand for money : sell bonds => price of bonds falls => interest rate
increase
Main tools of monetary policy
- Security (bond) sales and purchases
- Changes in the banking system’s borrowed reserves from the central
bank
- Changes in Reserve Requirements
- Quantitative Easing

CB Balance Sheet
- Assets: gov securities, loans to banking sector (providing liquidity to the
banking system + influencing interest rates + meet reserve requirements
of banks)
- Liabilities: currency in circulation, reserves

Buying/selling securities
- A security purchase leads to more reserves in the banking system and
causes the interest rate to fall => balance sheet expands
- A security sale leads to fewer reserves in the banking system and causes
the interest to rise

Lender of last resort: moral hazard (one party can take risks knowing the other
party will bear consequences)
 Risk that arise when banks and other financial institutions take on
excessive risk due to the belief that they will bailed out by gov
 CB must consider the trade-off between moral hazard cost and the
benefit of preventing financial panics.

Risk of interest rate= default risk = probability that the issuer of the bond is
unable of unwilling to make interest payments or pay off the face value.
 Risk premium = spread between the interest rate on bonds with default
risk and risk-free bonds with the same maturity.
 A high risk premium for a country typically reflects the increased risk
perceived by investors when investing in that country's assets, such as
government bonds or stocks.

Reserve requirements worldwide = minimum amount of reserves that

commercial banks must hold => impact the banks ability to lend => impact
money supply
Quantitative easing: CB purchases gov bonds and other securities.
 Stimulate economy when monetary policy is ineffective.
 Increase money supply and encourage lending and investment by
lowering interest rates