Download ch2note

1
CHAPTER TWO
THE CENTRAL BANK (FEDERAL RESERVE), MONETARY POLICY, AND INTEREST
RATE
TH CENTRAL BANK:
Monetary policy is the use of money supply and/or interest rates to affect and direct the
economy to achieve certain objectives (among which is economic stability and effective
payment system). It is implemented by the Central Bank. So what powers does the central bank
have to enable it conduct its monetary policy?
Powers of the Central Bank:
The central Bank regulates the money supply and financial institutions, because it works to:
1- provide elastic currency supply (currency notes).
2- serve as a lender of the last resort, during financial crises.
3- provides for sounder banking system (it can examine and check banks).
4- improve payment system (facilitates check clearing and settlement).
5- establish “reserve requirements” that requires banks to hold reserves at Central Bank.
6- control the interest rate and set a maximum interest rate that banks can pay on deposits,
or a deposit rate ceiling (to prevent competition between banks).
7- regulate the stock market “margin” and so affects the stock market (margin is the amount
of money (or %) which people can borrow to buy stocks).
8- regulate down payment percentage and maximum payment terms for many types of
consumer loans.
9- regulate foreign currency and foreign banks operating in the country.
10- regulate non-bank reserve requirements.
So, the Central Bank has power over banks, non-bank depositary institutions, consumer
lending, securities markets, foreign banks in the country, and many other institutions.
Moreover it can affect the whole economy thorough its monetary policy. But how does it
affect the economy? It simply makes changes in its balance sheet, and this is transmitted into
the economy.
The Balance Sheet of The Central Bank:
Changes in assets and liabilities of the Central Bank determine the monetary policy and
changes the monetary base in the country, which in turn affects the money supply and the
economy at large.
The monetary base is currency in circulation plus deposits of financial institutions with the
Central Bank. The balance sheet is made of assets and liabilities:
Assets of The Central Bank:
 Loans: It stands as lender of last resort for banks and other financial institutions.
 Government securities: Central bank buys and sells government securities through its
“open market operations”.
 Coins: It holds small amount of coinage to meet demand of banks that want to exchange
their deposits for coins.
 Cash Items in Process of Collection (CIPC), CIPC are items that central bank is clearing
but for which it has not yet obtained funds, i.e. checks in the process of clearing and
settlement.
2


Float: Represents net extension of credit from central bank to depositary institutions. It
represents a double counting of checks in the clearing system, which increases bank
reserves.
It is the difference between (CIPC) and Deferred Availability Cash Items (DACI). That
is Float = CIPC – DACI.
Other Assets:
- Foreign-denominated assets
- Gold certificates and Special Drawings Rights (SDRs)
- Buildings, computers vehicles, and other assets needed to house its operations
and conducts its business.
Liabilities of The Central Bank:
 Currency notes in circulation
 Deposits, which include: Deposit of financial institutions, Treasury deposit, as well as
foreign and other deposits
 Deferred Availability Cash Items (DACI). DACI represent the value of checks deposited
at the central bank by depositary institutions that have not yet been credited to the
institution’s accounts.
 Other liabilities, like outstanding checks and other miscellaneous items.
But how changes in the balance sheet affect the economy? The central bank uses some monetary
policy tools to do that.
MONETARY POLICY TOOLS:
The central bank uses three major tools to conduct its monetary policy and thus control supply
of money and affect the economy. These are:
1- Reserve Requirement
2- Open Market Operations (OMO)
3- The Discount Rate
1- RESERVE REQUIRMENT:
This is where central bank sets a minimum required reserves ratio or a minimum percentage of
deposits that has to be hold by banks in the form of reserve. If deposits of a bank are BD200
million and required reserve ratio is 10%, the bank should keep at least 10%*200=20 million in
the form of reserves with the central bank. In fact financial institutions keep reserves for two
reasons:
 To meet demand of people for cash (withdrawal)
 To meet central bank or government regulation requiring banks to keep certain
percentage as reserve.
2- OPEN MARKET OPERATIONS:
These are the purchase and sale of government securities by the central bank in the open market
operations.
3- THE DISCOUNT RATE:
This is the interest rate charged by the central bank. That is the rate banks have to pay for
borrowing from the central bank.
But how the use of these tools affect the supply of money and allow the central bank to
control the supply of money in the economy?