FMI_Lec5

1. GD20503
Financial Markets and Institutions
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2.  Central Banks (CBs)
i. Introduction
ii. Central Bank’s Balance Sheet
iii. How Central Bank Controls the Money Supply
 Mechanics of Monetary Policy
 Impact of Monetary Policy
 Global Monetary Policy
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3.  A central bank, reserve bank, or monetary
authority is a public institution that usually
issues the currency, regulates the money
supply, and controls the interest rates in a
country.
 The primary function of a central bank is to
provide the nation's money supply, but more
active duties include controlling interest rates
(via monetary policy), and acting as a lender of
last resort to the banking sector.
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4.  The conduct of monetary policy by central bank
(CB) involves actions that affect its balance
sheet. This is a simplified version of its balance
sheet, which we will use to illustrate the effects
of CB actions.
Assets Liabilities
Government securities Currency in circulation
Discount loans Reserves
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5.  The monetary liabilities of the CB include:
 Currency in circulation: the physical currency
in the hands of the public, which is accepted
as a medium of exchange worldwide.
 Reserves: All banks maintain deposits with the
central bank, known as reserves. The required
reserve ratio, set by the CB, determines the
required reserves that a bank must maintain
with the CB.
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6.  The monetary assets of the CB include:
 Government Securities: These are government
Treasury bills and bonds that the CB has
purchased in the open market. As we will
show, purchasing Treasury securities increases
the money supply.
 Discount Loans: These are loans made to
member banks at the current discount rate.
Again, an increase in discount loans will also
increase the money supply.
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7. 1. Open Market Operations
a. Purchase of securities
b. Sale of securities
2. Adjusting the Reserve Requirement Ratio
a. Reserve requirement adjustments affect
money growth because higher reserves lead
to less borrowing and lower reserves lead to
more borrowing
3. Adjusting the CB’s Loan Rate (discount rate)
a. An increase in discount loans will increase
the money supply and vice versa.
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8.  The monetary policy goals of most central banks are to
achieve a low level of inflation, a low level of
unemployment and economic growth.
 They assess indicators of the above mentioned economic
variables before they determine their monetary policy:
1. Indicators of Economic Growth
a. Central bank monitors
i. GDP
ii. Industrial production index
iii. Unemployment rate
iv. National Income
2. Indicators of Inflation
a. Producer and consumer price indexes
b. Other inflation indicators 8

9.  How Monetary Policy Corrects the Economy:
1. Correcting a Weak Economy: (see Exhibits 5.2
and 5.4)
a. CB can increase the level of spending to
stimulate the economy
b. Use open market operations to increase the
money supply
2. Correcting High Inflation (see Exhibits 5.3 and
5.4)
a. CB can institute a tight-money policy using
open market operations to reduce money
supply growth.
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10. Correcting a weak economy
Correcting high inflation
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13. Limitations of Monetary Policy:
1. Impact of a Credit Crunch: even if CB increases the
level of bank funds, banks may be unwilling to
extend credit.
2. Lagged Effects of Monetary Policy:
 a monetary policy may have an immediate impact on
the economy to some degree, but its full impact may not
occur until year or so after the implementation.
a. Recognition lag – the lag between the time a problem
arises and the time it is recognized
b. Implementation lag – the lag from the time a serious
problem is recognized until the time the CB
implements a policy
c. Impact lag – the lag from the time the policy is
implemented until the policy has its full impact on
the economy
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14. 3. Impact of a Stimulative Policy on Expected
Inflation (see Exhibit 5.5):
 Effect of increase in money supply growth may
be disrupted due to an increase in inflationary
expectations.
 Theory of Rational Expectations:
Business and households expect that an increase in
money growth will cause higher inflation
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16.  Tradeoff in Monetary Policy:
1. Inverse relationship between
inflation and unemployment.
a. Strong economic condition: high
inflation, low unemployment
b. Weak economic condition: low
inflation, high unemployment
 The CB may not be able to solve
both problems simultaneously.
Thus, the CB must determine
whether unemployment or inflation
is the more serious problem.
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17. 2. Impact of other forces on the
tradeoff
 Historical data on annual inflation
and unemployment rates show
that when one of these problems
worsens, the other does not
automatically improve.
 Both variables can rise or fall
simultaneously over time.
 For example, (i) a rise in oil prices
lead to higher inflation and (ii)
various training centers for
unskilled workers have been
closed. Assume that both (i) and
(ii) happen at the same time.
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18. 4. How Monetary
Policy
Responds to
Fiscal Policy
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19. 1. Impact on Financial Markets (see Exhibits 5.9
and 5.10)
2. Impact on Financial Institutions (see Exhibits
5.9 and 5.10)
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22. 1. Impact of domestic currency
a. If economic conditions are weak, a strong domestic
currency will not provide the stimulus needed to
improve conditions
b. CB may need to implement a stimulative monetary
policy.
2. Impact of global economic conditions
a. As economic conditions are strongly integrated across
countries, CB usually considers prevailing global
economic conditions when conducting monetary
policy.
b. For example, the Fed’s decision to lower U.S. interest
rates during the 2008 credit crisis and stimulate the
U.S. economy was partially driven by weak global
economic conditions.
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23. 3. Transmission of Interest Rates
a. Global interest rates will vary between
countries
b. Countries with higher interest rates will
attract investors from countries with lower
interest rates
c. If investors leave due to falling domestic
interest rates, the CB may believe it should
act to prevent rates from falling lower
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