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Chapter 12

Roles and Services of the

Central Banks Around the

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.

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.

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

The Worlds Leading
Central Banks

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
A growing list of nations have set inflation-
rate targets or target ranges

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

The Channels Through Which
Central Banks Work
Cost & availability of

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
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

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

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

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)
Supervise Supervise
2,700 member banks Manager of the System
of the system Open Market Account
Roles of the Central Banks
Collecting and clearing checks and other
means of payment

Issuing currency and coin

Maintaining a sound banking and financial

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

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

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

Most central banks target market interest

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

The Key Focus of
Central Bank Monetary Policy

The total supply of reserves can be

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

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

The Deposit Multiplier

The banking system can create more

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

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

The Deposit Multiplier

The central bank sets required reserves

A percentage of banks total transaction

Required Reserves = RRd x Transaction Deposits

RRd is the central banks reserve

requirement ratio

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
The Deposit Multiplier

Then total reserves in the banking system


Total Reserves = RRd x Transaction Deposits +

EXR x Transaction Deposits

= (RRd + EXR) x Transaction Deposits

The Deposit Multiplier

So one dollar of reserves supports

(RRd + EXR)

dollars in transaction deposits

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
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
Can be closed controlled through the
use of open market operations
Money Multiplier

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

M2 = Money Multiplier x Monetary Base

Can derive an expression for the

money multiplier from the formula

Money Multiplier

Monetary base can be expressed as

CD is the currency-deposit ratio

Money Multiplier

So it is possible to estimate the

money supply from transaction

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

Where LA is the desired ratio of liquid

savings assets to transaction
deposits that households wish to
Money Multiplier

And the money multiplier is:

Money Multiplier = __1 + CD + LA .

RRd + EXR + CD

Markets on the Net

Answers.com at
Bank of England at
Bank of International Settlements at
Bank of Japan at www.boj.or.jp
BanxCorp at banx.com
Markets on the Net

Board of Governors of the Federal Reserve

System at www.federalreserve.gov
Center for the Study of Central Banks at
European Central Bank www.ecb.int
Fed 101 at
Federal Open Market Committee at
Markets on the Net

Federal Reserve at
Federal Reserve Bank of Kansas City at
Federal Reserve Bank of Minneapolis at
Federal Reserve Bank of New York at
Federal Reserve Bank of St. Louis at
Markets on the Net

Federal Reserve Releases at

Federal Reserve Services at
Investopedia.com at
Reserve Bank of New Zealand at
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
Chapter Review

Goals and channels of central banking

Central banks goals
Challenges in achieving central bank goals
The channels through which central banks
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
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
Serving as the federal governments fiscal
Providing information to the public
Carrying out monetary policy
Chapter Review

The key focus of central bank monetary

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