Fin 221 — Chapter 2 The Central Bank

Fin 221 - Chapter 2: The Central Bank (The Federal Reserve) and its powers Purposes and powers of a Central Bank: • Supervise nation’s money supply and payments system. • Regulate other financial institutions, especially depository institutions (Supervise banks more vigorously). • Serve as “Lender of last resort” when financial system has liquidity problems. • National government’s “fiscal agent” (i. e. depository bank) • Provide an “elastic” currency (currency notes - ability to adjust money supply to changes in economy) • Improve payments system (check clearing).

The balance sheet of the Central bank (B/S) • Changes in the CB’s B/S ultimately results in changes to the money supply in the economy. • The CB conducts monetary policy by changing the monetary base in the economy. • The monetary base = currency in circulation + the deposits of financial institutions at the CB. • An increase in the monetary base ( other things held unchanged ) will lead to an increase in the money supply.

Liabilities and Assets of the CB Liabilities include : 1. CB notes in circulation ( The largest single liability ). 2. Depository institution’s reserves : deposits held (by law) by the depository institutions at the central bank. Such deposits are called “Reserves” - CB deposits are useful in that they can be transferred from one institution to another through the clearing system. - Reserves are also useful to the CB for controlling the money supply.

Liabilities and Assets of……. . cont Total reserves = Required Reserves + Excess Reserves TR = RR + ER - RR is a specified percent ( fraction) of the total deposits. This fraction is called the required reserve ratio or reserve requirement ( %). For example : Let reserve ratio( requirement) = k= 10% Bank deposits = BD 1000 Therefore RR = 10% X 10000 = 100 Or ; k 100/ 10000 = 10% - The depository institution ( bank) could use the excess reserves to make commercial loans or lend them to other banks

Liabilities and Assets of……. . cont 3. Treasury deposits : these are govt. treasury deposits where the CB acts as the “fiscal agent” for the treasury department. i. e. the CB acts as a bank for the treasury which can pay its bills by writing ckeques from its account at the CB. 4. Deferred availability cash item (DACI): represent the value of cheques deposited at the central bank by depository institutions that have not yet been credited to the institutions account. 5. Capital ;

Liabilities and Assets of……. . cont CB Assets include : 1. The CB loan account : changes in the loan accounts lead to change in the reserve account and hence change in the money supply. The CB makes loans to banks and other depository institutions. The rate charged on these loans is the “ discount rate”. 2. Government securities: a portfolio of the treasury and government agency securities. The CB can sell and buy government securities through its open market operations. Selling securities in the market contracts money supply while buying securities increases the money supply. 3. Cash items in process of collection (CIPC): These are items the central bank is clearing but for which it has not yet obtained funds ( see DACI on the liab. Side) 4. Float: represents a net extension of credit from the CB to depository institutions ( the difference between CIPC and DACI).

The CB role in Cheque clearing • The CB plays a major role in cheque clearing, particularly in clearing cheques drawn on depository institutions which hold reserves or clearing deposit balances with the CB. • Bank deposits at the CB can be easily transferred between the accounts of the depository institutions by making appropriate entries on the CB books.

The tools of monetary policy The CB has three major tools to either increase or decrease the money supply: • Open –Market Operations. • Changing the Discount Rate. • Changing the Reserve requirement Ratio.

The tools of monetary policy………cont. 1. Open market operations : - Involves the buying and selling of government securities in the market. - The CB changes the amount of reserves in the banking system through the purchase or sale of government securities on the open market. - The purchase of government bonds by the CB will expand the money supply while the sale of bonds will result in contraction of the money supply.

The tools of monetary policy………cont Open market operations…. cont: Example 1: The CB decides to buy $1000 in govt. bonds from BNB. The T-accounts for the BNB and the CB after the transaction will be : BNB CB Example 2: The CB decides to sell $1000 bonds to the BNB. The T-accounts will show: BNB CB

The tools of monetary policy………cont 2. Changing the discount rate ( discount window borrowing): - The discount rate is the rate of interest that financial institutions must pay to borrow reserve deposits from the CB. - When the discount rate is low, borrowing becomes inexpensive and the financial institutions will prudently expand their assets and deposits more readily. - When the discount rate is high , the institutions are more reluctant to borrow reserves and become more careful about expanding asset and deposit holdings. - Example: when banks borrow from the discount window, the funds they borrow are paid in reserves by the CB. Suppose BNB borrows $1000 at the window. The T-account will look as follows: BNB CB

The tools of monetary policy………cont 3. Reserve Requirements : - The CB can establish reserve requirements within certain limits. Such requirements determine the amounts of funds financial institutions must hold at the CB to back their deposits. - Only the CB can change the reserve requirements for depository institutions. - Changing reserve requirements change the money supply. - Example: Assume BNB has: - Demand deposits = $ 5000 - Reserve requirement = 20% - The bank is fully loaned up and therefore has no excess reserves i. e. ER=0 - BNB’s T-account looks as follows:

The tools of monetary policy………cont BNB Now: The CB decides to reduce reserve requirement on demand deposits from 20% to 10%. What happens then? First step: The new requirement lowers the amount of reserves to $500 and increase the ER by $500. That is: RR = 10% X $5000 = $500 ER = $1000 -$500 = $500

The tools of monetary policy………cont The T-account of BNB will look as follows: BNB Second step: what BNB will do with the $500 ER? -could hold it at CB ( but this will generate no profits !!!) -make loans and expand deposits o the point where all of the excess reserves are again absorbed as RR. - The T-account of BNB will look as follows :

The tools of monetary policy………cont BNB - The CB expands the amount of bank deposits by lowering reserve requirements on deposits. - Similarly, when the CB increases the reserve requirements , the banking system will contract the amount of bank deposits and hence decrease the money supply.

Comparing the Monetary Tools • The CB does not use all three tools to conduct monetary policy on a regular basis • Each tool plays a different and important role In the CB monetary arsenal. Advantages of OMO : - Can be done easily almost instantaneously with no announcement effect. - Any changes in the money supply can be easily reversed without an announcement effect.

Comparing the Monetary Tools……cont Shortcomings of discount rate adjustment: • Changes in the Discount rate will affect the money supply only if banks are willing to respond. • Because the CB scrutinizes borrowing at the discount window, banks may be reluctant to overuse this privilege. • Borrowing under the discount window is short-term and it is difficult to gauge the impact on the money supply for a given change in the discount rate. • As a practical matter, changing the discount rate is not a viable tool for conducting monetary policy.

Comparing the Monetary Tools……. cont Changes to reserve requirements : • Changes in reserve requirements are not used as a tool of monetary policy. This is because it is difficult to make a number of small adjustments to reserve requirements and frequent changes are disruptive to the banking system. • Changing reserve requirements is typically done to deal with structural problems in the banking system.

Summary : How tools of monetary policy affect the money supply Monetary policy tool Increase in money supply Decrease in money supply OMO Purchasing Tsecurities in the market Selling T-securities in the market Adjusting the discount rate CB lowers the interest rate CB raises the interest rate Adjusting bank reserve requirement CB lowers the CB raises the reserve ratio to cause a lower a higher money multiplier