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Financial Institutions and Markets

Financial Institutions and Markets. Central banks and monetary policy. Outline of contents. A recap of topic 05 Central banks Central bank operations Central bank independence Case study: Bank of England (UK) Case study: European Central Bank (EMU) Case study: Federal Reserve Bank (US)

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Financial Institutions and Markets

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  1. Financial Institutions and Markets Central banks and monetary policy

  2. Outline of contents • A recap of topic 05 • Central banks • Central bank operations • Central bank independence • Case study: Bank of England (UK) • Case study: European Central Bank (EMU) • Case study: Federal Reserve Bank (US) • Learning outcomes • Further work • References

  3. Central banks and monetary policy A recap of topic 05

  4. Money • This is a • It has a number of functions • And properties • Demand for money consists of 3 motives • Supply of money has a number of measurements • Narrow (M0UK, M1ECB) • Broad (M4UK, M2ECB, M3ECB)

  5. The bank deposit multiplier • By operating with a fractional reserve, commercial banks can increase broad money • The reserve ratio determines the potential expansion of the money supply

  6. The process of credit creation Within the bank A deposit with the bank The remainder (e.g. 60%) 50% is deposited with the bank The bank lends out that 60% A reserve (e.g. 40%) Most of the money eventually returns to the banking system 50% A loan A firm The borrower may split the loan 50% 50% is spent

  7. Interest rate theories • Loanable funds = Classical economics (LR) • Demand for and supply of loanable funds are • Changes in the nominal rate of interest reflect only inflation; the real rate remains constant • Liquidity preference = Keynesian economics (SR) • Demand for money is • Changes in nominal rates of interest may reflect inflation or a number of other factors • Problems with each model

  8. Central banks and monetary policy Central banks

  9. What is a central bank? • What do you believe is meant by “central bank”? • We generally identify them by their functions • Not all central banks fulfil all functions and individual banks’ functions may change over time • The following list is also not exhaustive of all CB functions

  10. Functions of a central bank

  11. Central banks and monetary policy Central bank operations

  12. Focus of the section • Central banks may perform a huge variety of tasks • The focus in this topic will be monetary policy • Within that, the use of financial markets will be the emphasis for this module • This is to avoid too much overlap with your Macroeconomics course

  13. Monetary policy • This is • If there is too much money / the interest rate is too low, • is likely to be inhibited • If there is too little money / the interest rate is too high, • is likely to be inhibited

  14. Implementing monetary policy • Small changes in the monetary base (narrow money) can have a large impact on broad money • Narrow money may also therefore be called high powered money • Central banks manipulate high powered money in order to implement monetary policy

  15. Changing reserve requirements • A decrease in reserve ratios is a loosening of monetary policy • Commercial banks are permitted to make more loans • The money supply should increase and interest rates fall Interest rate Interest rate S0M SR D0R DM Quantity of reserves Quantity of money

  16. Changing the discount rate • The central bank may lend additional reserves to a commercial bank • This is discount window borrowing • The central bank charges interest on these loans, usually at a rate above money market rates • If the discount rate is increased, discount window borrowing will take place • If the discount rate is lowered, discount window borrowing will take place

  17. The discount rate Interest rate S0R S1R D1R D0R Quantity of reserves

  18. Changing the discount rate as a policy • Historically, a change in the discount rate was the main method of implementing monetary policy • It lacks effectiveness • It is difficult to predict how much borrowing will take place at the discount rate if it is increased or lowered • It is difficult to • Now, changing the discount rate acts as a • Indicates

  19. Open market operations • This refers to • It is the most crucial modern monetary policy tool • The central bank may buy or sell securities • Buy  the money supply • Sell  the money supply • Most OMOs are actually carried out using repos (or reverse repos)

  20. Dynamic versus defensive OMOs • Using OMOs to conduct monetary policy is termed dynamic OMOs • The central bank may also engage in defensive OMOs • Using the government securities markets to • Rather than actually intervening in the markets, the central bank may simply • The rational response for money market participants is to immediately adjust to the new rate

  21. Central banks and monetary policy Central bank independence

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