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Chapter 15
Money, Banking, and
Financial Markets:
Central Banks in the
World Today
Tim Berry, Humber College
©2010 McGraw-Hill Ryerson Ltd.
Central Banks:
The Big Questions
1. What is the role of the central bank?
2. What are the central bank’s
objectives?
3. How are successful central bank’s
organized?
15-2
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Central Banks:
Roadmap
• The origins and roles of central banks
• Central bank objectives
• Designing a successful central bank
15-3
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Central Banks:
Origins and Roles
• There are about 170 central banks in the
world today. Nearly every country has
one.
• When the Soviet Union collapsed in 1990,
12 of the 15 republics had central banks
within a year
15-4
©2010 McGraw-Hill Ryerson Ltd.
Central Banks:
Origins and Roles
• Special type of financial intermediary
• Origin:
– To provide for government finance
– Originally private institutions
• Roles
– Government’s bank
– Banker’s bank
15-5
©2010 McGraw-Hill Ryerson Ltd.
Central Banks:
Origins and Roles
• Bank of Canada was created in 1934 –
during the Great Depression
• In the US there had been thousands of
bank failures and bank runs
• During this time no bank failures or
runs occurred in Canada
15-6
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Central Banks:
Functions of a Central Bank
• Determines and manages monetary policy
• Central banks create money
- they print currency
• Control availability of money and credit
15-7
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• Counterfeiting has been used as a
weapon in wartime
• Goal to destabilize enemy’s currency
• Without a stable currency it is difficult
for an economy to run efficiently
15-8
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Central Banks:
Functions of a Central Bank
• Operate interbank payments network
• Provide loans during periods of crisis
• Oversee financial intermediaries to
insure safety and soundness
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Functions of a
Modern Central Bank
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Central Bank Objectives:
Stability
•
•
•
•
•
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Low and stable inflation
High and stable growth
Stable financial markets
Interest-rate stability
Exchange-rate stability
©2010 McGraw-Hill Ryerson Ltd.
Central Bank Objectives:
Low and Stable Inflation
• Strives to eliminate inflation
A dollar should always be worth a dollar
– Prices are central to a market economy.
Allocating resources to their best uses
– Inflation makes it more difficult to tell
– High inflation is less predictable
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•
•
•
•
High inflation is volatile inflation
Volatile inflation means more risk
Risk requires compensation
High inflation means a higher risk
premium, so higher loan rates
• Volatile inflation makes long-term planning
difficult
15-13
©2010 McGraw-Hill Ryerson Ltd.
Central Bank Objectives:
High and Stable Real Growth
• Support maximum sustainable growth
• Stable countries grow faster
– Unstable growth creates risk
– Unstable growth drives up interest rates
– Higher interest rates me lower borrowing
– Less borrowing means less investment
– Less investment means less growth
15-14
©2010 McGraw-Hill Ryerson Ltd.
Central Bank Objectives:
Financial System Stability
• When the financial system collapses,
everything else goes with it.
• Can’t get car loans or mortgages
• Banks cease to operate properly
(Application of value-at-risk)
15-15
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Central Bank Objectives:
Interest-Rate Stability
• Stable interest rates make economic
decisions easier
• Stable short-term interest rates reduce
risk premium on long-term interest
rates
15-16
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Central Bank Objectives:
Exchange-Rate Stability
• The more open an economy, the more
important it is
• Makes cost of imports and revenue
from exports more predictable
15-17
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Central Bank Objectives:
Summary
15-18
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YOUR FINANCIAL WORLD
Does News about the Bank of Canada Affect Your Daily Life?
• Bank of Canada controls short-term interest
rates
• News about future short-term interest rate
affects long-term interest rates
• When long-term interest rates change, so do
car loan and mortgage rates
15-19
©2010 McGraw-Hill Ryerson Ltd.
Creating a
Successful Central Bank
• Independence
• Decision-making framework
• Accountability, transparency
and communication
15-20
©2010 McGraw-Hill Ryerson Ltd.
Central Bank Design:
Independence
• Central banks need to be independent
of political pressure
• Politicians have an incentive to create
short-term prosperity at the expense
of inflation tomorrow.
• Longer time horizon needed to avoid
“inflation bias”
15-21
©2010 McGraw-Hill Ryerson Ltd.
Independent Central Banks
Deliver Low Inflation
What drove
politicians to give up
control over
monetary policy?
Realization that
independent central
bankers would
deliver low inflation.
15-22
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Central Bank Design:
Decision-Making Framework
• Should policy be made by an
individual or by a committee?
- Committees provide safeguards
against putting the wrong person in
charge
15-23
©2010 McGraw-Hill Ryerson Ltd.
Central Bank Design: Accountability,
Transparency and Communication
• Central Bank independence is
inconsistent with representative
democracy
• Solution:
– Give central bankers clear objectives
– Public reporting of progress in achieving
objectives
15-24
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Central Bank Design:
Policy Tradeoffs
• Can’t always have everything at once
– Sometimes the economy is hit by a shock
that drives inflation and growth in opposite
directions
– Creates a tradeoff
– Central bankers must be honest about the
fact that goals are sometimes in conflict
15-25
©2010 McGraw-Hill Ryerson Ltd.
Central Bank Design:
Summary
15-26
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Central Banks
and Fiscal Policy
• In emerging market countries like
Brazil and Argentina, fiscal policy
problems can make it impossible for
central bankers to keep inflation low
15-27
©2010 McGraw-Hill Ryerson Ltd.
Central Banks
and Fiscal Policy
• Fiscal authorities have three sources of
funds:
– Taxes
– Borrowing
– Money printing
• The first two work only up to some limit
• If the budget is unsustainable, force
money printing
15-28
©2010 McGraw-Hill Ryerson Ltd.
Central Banks and Fiscal Policy:
Argentina in 2002
• Financial collapse tied to the regional
government’s issuance of their own
currency
• Made it so that the Central Bank of
Argentina was helpless
15-29
©2010 McGraw-Hill Ryerson Ltd.
Web Links
Bank of Canada
Federal Reserve System
Bank of England
European Central Bank
Bank of Japan (English)
Reserve Bank of Australia
Reserve Bank of New Zealand
Banco de Mexico (English)
15-30
©2010 McGraw-Hill Ryerson Ltd.
Chapter 15
Money, Banking, and
Financial Markets:
Central Banks in the World
Today
End of Chapter
Tim Berry, Humber College
©2010 McGraw-Hill Ryerson Ltd.