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Chapter 12

Roles and Services of the


Central Banks Around the
World

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Learning Objectives

To explore the many roles and functions of the


central banks around the world.

To discover how important central bank


independence from the dictates of governments is in
carrying out effective money and credit policy.

To understand the concept of legal reserves and


how the Central Banks influence the level and
growth of legal reserves and, ultimately, deposits
and loans.

12-3
Introduction Central Bank

A central bank is a government agency that


monitors the operation of its financial system and
controls the growth of the nations money supply.

Central banks are bankers banks. or the


lenders of last resort (institutions willing to
extend credit when no one else will) .They
communicate with commercial banks and
securities dealers in carrying out their essential
public policy functions.

12-4
The Roles of Central Banks
Control of the money supply
Linked to economic activity
Linked to price inflation
Stabilizing the money and capital markets
Fostering their development
Ensuring a stable flow of funds

Lender of last resort


Lend to financial institutions
Particularly those subject to liquidity pressure

Supervisor of the banking system 12-5


The Roles of Central Banks

Maintaining and improving the


payments mechanism - a smoothly
functioning and efficient payments
mechanism is vital for business and
commerce

12-6
The Worlds Leading
Central Banks

12-7
The Goals of Central Banking

Central banking in the U.S. and most other


nations is directed toward the goals of:
Achieving maximum sustainable output
and employment
Promoting stable prices
Recent emphasis has been on long-run price
stability
A growing list of nations have set inflation-
rate targets or target ranges

12-8
The Goals of Central Banking

The central bank is able to influence


the economys progress
Influence interest rates
Influence the growth of the money supply
However, the goals often conflict
Trade-offs have to be accepted

12-9
The Channels Through Which
Central Banks Work
Cost & availability of
credit

Market Size & growth Volume & growth


interest of the money supply of borrowing &
rates spending
Policy Market value by the public on
tools of the publics domestic & foreign
of the security holdings consumer & capital
central goods & services
Level &
bank growth Currency exchange
of rates Economic goals:
reserves A stable price level
in the Public expectations and low inflation
banking regarding security Sustainable
system prices, interest rates, economic growth
currency prices, Maximum
money supply & employment
credit availability
12-10
History of the
Federal Reserve System
The U.S. was one of the last major nations in
the Western hemisphere to permanently
charter a central bank

U.S. public officials were hesitant to do so


Feared that a strong central bank with would
restrict the availability of credit
A series of crises plagued the U.S. financial
system in the late 19th and early 20th centuries

12-11
Problems in the Early
U.S. Banking System
Prior to the Civil War, the states controlled the
banking system
Many did a poor job
The high failure rate among poorly capitalized and ill-
managed banks resulted in heavy losses

The 1863 National Banking Act


Created a dual banking system
State and federal governments charter banks
Competition between regulatory agencies sometimes
led to actions detrimental to public interest

12-12
Creation of the
Federal Reserve System
The Federal Reserve Act was signed in
1913
Twelve Federal Reserve banks were
chartered
They opened for business as World
War I began in Europe

12-13
How the Fed is Organized Today

Supervise Board of Governors Serve


(7 members appointed
by the president)

12 Federal Reserve banks


& 25 branch banks Federal Open Market
(reserve bank presidents Serve Committee
appointed by Board of (12 voting members)
Governors)
Supervise Supervise
2,700 member banks Manager of the System
of the system Open Market Account
12-14
Roles of the Central Banks
Today
Collecting and clearing checks and other
means of payment

Issuing currency and coin

Maintaining a sound banking and financial


system
Serving as a lender of last resort (through the
discount window of Reserve banks)
Supervising member banks

12-15
Roles of the Federal Reserve
System Today
Serving as the central governments fiscal
agent, by holding the Treasurys checking
account and by maintaining reasonable
stability in the government securities market

Providing information to the public, through


statistical releases and research reports

Carrying out monetary policy, through the


use of various tools

12-16
The Key Focus of
Central Bank Monetary Policy
Regulating money and credit conditions to
strengthen the economy

Most central banks target market interest


rates
To impact market rates, central banks usually
make use of their control over the volume of
reserves available to the banking system

These reserves are the raw material out of which


depository institutions create credit and cause the
money supply to grow

12-17
The Key Focus of
Central Bank Monetary Policy

The total supply of reserves can be


changed
Through open market operations
By making loans to depository institutions
through the central banks discount
window
By changing the legal reserve
requirements applicable to deposits held
by depository institutions

12-18
Reserve Composition

Legal reserves in the U.S. consist of the


Amount of deposits each institution keeps with
the Federal Reserve.
Plus the amount of currency and coin held in
its vault

Total legal reserves = Required reserves + Excess reserves

12-19
The Deposit Multiplier

The banking system can create more


deposit money by using its excess
reserves to make loans and purchase
securities

The deposit multiplier indicates the dollar


volume of deposits and loans that the
banking system can create for each new
dollar of excess legal reserves

12-20
The Deposit Multiplier

The central bank sets required reserves


A percentage of banks total transaction
deposits

Required Reserves = RRd x Transaction Deposits

RRd is the central banks reserve


requirement ratio

12-21
The Deposit Multiplier

Banks may also choose to hold some


excess reserves
Protective cushion
Meet unexpected withdrawals

Excess Reserves = EXR x Transaction Deposits

EXR is the excess reserve ratio


The amount of excess reserves that the bank
wants to hold for each one dollar of transaction
accounts
12-22
The Deposit Multiplier

Then total reserves in the banking system


are:

Total Reserves = RRd x Transaction Deposits +


EXR x Transaction Deposits

= (RRd + EXR) x Transaction Deposits

12-23
The Deposit Multiplier

So one dollar of reserves supports


_____1____
(RRd + EXR)

dollars in transaction deposits

12-24
Money Multiplier

Central bankers usually more interested in the


money multiplier

Defines the relationship between a measure of the


money supply that is closely related to spending
and income (M2) in the economy to the total
reserve base
Closely related to deposit multiplier
Currency and coin holdings impact reserves held
by depository institutions
If the public holds less currency, the excess is
typically redeposited
12-25
Money Multiplier

Develop idea of monetary base


Legal reserves plus currency and coin
held by the public

Monetary Base = Legal Bank Reserves + Currency


in the Hands of the Public

Monetary base is important


It is most of the liabilities of the central
bank
Can be closed controlled through the
use of open market operations
12-26
Money Multiplier

Monetary base
Also known as high-powered money
Linked to M2 through the money
multiplier

M2 = Money Multiplier x Monetary Base

Can derive an expression for the


money multiplier from the formula

12-27
Money Multiplier

Monetary base can be expressed as

CD is the currency-deposit ratio

12-28
Money Multiplier

So it is possible to estimate the


money supply from transaction
deposits

M2 = (1 + CD + LA) x Transaction Deposits

Where LA is the desired ratio of liquid


savings assets to transaction
deposits that households wish to
maintain
12-29
Money Multiplier

And the money multiplier is:

Money Multiplier = __1 + CD + LA .

RRd + EXR + CD

12-30
Markets on the Net

Answers.com at
www.answers.com/topic/lender-of-last-resort
and
www.answers.com/topic/high-powered-money
Bank of England at
www.bankofengland.co.uk
Bank of International Settlements at
www.bis.org
Bank of Japan at www.boj.or.jp
BanxCorp at banx.com
12-31
Markets on the Net

Board of Governors of the Federal Reserve


System at www.federalreserve.gov
Center for the Study of Central Banks at
www.law.nyu.edu/centralbankscenter
European Central Bank www.ecb.int
Fed 101 at
www.federalreserveeducation.org/Fed101
Federal Open Market Committee at
www.federalreserve.gov/fomc
12-32
Markets on the Net

Federal Reserve at
www.federalreserve.gov
Federal Reserve Bank of Kansas City at
www.kc.frb.org
Federal Reserve Bank of Minneapolis at
www.mpls.frb.org
Federal Reserve Bank of New York at
www.ny.frb.org
Federal Reserve Bank of St. Louis at
www.stls.frb.org/research
12-33
Markets on the Net

Federal Reserve Releases at


www.federalreserve.gov/releases
Federal Reserve Services at
www.frbservices.org
Investopedia.com at
www.investopedia.com/terms/l/lender
oflastresort.asp
Reserve Bank of New Zealand at
www.rbnz.govt.nz
12-34
Chapter Review

Introduction to central banking


The roles of central banks in the
economy and financial system
Control of the money supply to avoid
damaging Inflation
Stabilizing the money and capital markets
Lender of last resort
Supervisor of the banking system
Maintaining and improving the payments
mechanism
12-35
Chapter Review

Goals and channels of central banking


Central banks goals
Challenges in achieving central bank goals
The channels through which central banks
work
History of the Federal Reserve System
Problems in the early U.S. banking system
Creation of the Federal Reserve System
The early structure of the Fed
Goals and policy tools of the Fed
12-36
Chapter Review

Roles of the federal reserve system today


The clearing and collection of checks and
other payments media
Issuing currency & coin and related services
Maintaining a sound banking and financial
system
Serving as the federal governments fiscal
agent
Providing information to the public
Carrying out monetary policy
12-37
Chapter Review

The key focus of central bank monetary


policy: Interest rates, reserves and
money
Reserve composition and the deposit &
money multipliers
The deposit multiplier
The money multiplier

12-38