Chapter 24 Central banking and the monetary system

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Chapter 24Central banking and the monetary system

• David Begg, Stanley Fischer and Rudiger
  Dornbusch, Economics,
• 6th Edition, McGraw-Hill, 2000
• Power Point presentation by Peter Smith

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The central bank

• acts as banker to the commercial banks in a
  country
• and is responsible for setting interest rates or
  money supply.
• In Turkey,Central Bank of Republic of Turkey
  fulfils these roles.
• Two key tasks
• to issue coins and bank-notes
• to act as banker to the banking system and the
  government.

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Central Bank and the money supply

• Three ways in which the central bank MAY
  influence money supply
• Reserve requirements
• Discount rate
• Open market operations

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Structure of financial markets
Public
loans
Financial markets
A
Interbank money market repo market bond markt
deposits
B
Central Bank
C
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A digression

• M m?H
• H C R
• notice that money supply can be controlled by
  controlling H or m
• m 1cp
• cpcb
• m can be affected by
• cb R/D, cb?? m?

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Reserve requirements

• central bank sets a minimum ratio of cash
  reserves to deposits cb,m that commercial banks
  must meet
• For a given amount of deposits D
• cb,m?? R? or L? Lloans and hence M?

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Example24.1 Minimum reserve requirements

• R100, D1000, L900 when reserve requirements is
  cb 0.1
• ignoring cp that is cp 0
• m1/0.110, M10H101001000 or
• C0, MD1000
• then CB increased minimum reserve requirements to
  cb,m0.20
• m10.25, M5H5100500 or
• MCD but C0 so D500
• eventually deposits decline to 500
• C.B. decreases money supply from 1000 to 500 by
  controlling cb

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Example continued

• In the short run with some money in circulation
• i- banks decrease their loans to 800, reserves
  become R 200
• ii -if they preserve loans at 900,
• they demand extra deposits from public by
  offering higher interest rates
• cb,m0.2R/D or 0.8 L/D900/D,D 1125 they have
  to find 1125-1000 125 extra cash to preserve the
  same loans

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Discount rate

• the interest rate that the central bank charges
  when the commercial banks want to borrow
• setting this at a penalty rate may encourage
  commercial banks to hold more excess reserves

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Example 24.2

• Suppose minimum reserve ratio cb,m10
• at a point in time
• cb0.12 and D 1000 then R120
• 120 20 100
• excess required
• reserves reserves
• market interest rate r8
• banks desire to lend the excess 20m reserves to
  gain interest rates
• they take the risk that depositors demand their
  money so the reserve ratio falls bellow 10

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Example 24.2 continued

• Suppose 50m of the deposits are withdrawn D950
  R100-5050 so
• cb becomes cb 50/9500.052
• below the minimum 10
• then banks can borrow money from the C.B. to
  preserve the Cb to the minimum 0.10

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Example 24.2 continued

• But if the lending rate of C.B. is higher than
  the market rate of 8 say 10
• cost of borrowing from C.B. is high so
• banks do not want to lend the excess reserves the
  excess 20m as loans
• cb remain at 0.12 above the minimum 0.10 and
  money supply will be lower
• C.B. prevent M to increase without lowering cb,m
  but setting a higher lending rate to banks above
  the market rate

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Open market operations

• actions to alter the monetary base by buying or
  selling financial securities in the open market
• CB wishes to withdraw currency from circulation
  it sales bonds
• to increase H it purchases bonds from public
  handing them banknotes, thus increasing R or C
• the OMOs does its job
• repo and/or direct sales to decrease H
• reverse repo and/or direct purchases to increase
  H

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• Suppose CB wants to increase H by 100b TL
  bbillion and M by 1000 when m10
• CB can buy bonds or bills with a market value of
  100b and gives the money to the holders of these
  bonds
• no issue of new bonds but
• exchange of the existing bonds from banks or
  public to CB
• transfer of money notes from CB to banks or
  public

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• Conversely if CB wants to decrease H by 100b and
  hence M by 1000
• it sells bonds with a market value of 100 to
  public mostly from banks
• money is transferred from public to CB
• hence H and eventually M decreased
• 100m worth of bonds are in the hands of public

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A beginners guide to the financial markets

• Financial asset
• a piece of paper entitling the owner to a
  specified stream of interest payments over a
  specified period
• Cash
• Notes and coin, paying no interest
• the most liquid of all assets.
• Bills
• financial assets with less than one year until
  the known date at which they will be repurchased
  by the original owner
• highly liquid

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A beginners guide to the financial
markets(continued)

• Bonds
• longer term financial assets less liquid
  because there is more uncertainty about the
  future income stream
• Industrial shares (equities)
• entitlements to receive corporate dividends
• not very liquid

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Treasury bills T-bills or bonds

• To finance its deficits treasury sell bills or
  bonds to public including mostly to banks by
  auctions
• Each bill has a face value promising to pay that
  nominal value at the specified date to the holder
  of the bill
• during the auction a lower value is bided
  selling price

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Face value
Sale price
Issue date
Maturity date
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Example 24.3

• Suppose a T-bill will pay 100 on June 30
• on March 30 it is sold at 75 so the buyer pays 75
  to treasury hoping to get 100 in June 30 when
  returning the T-bill to the Treasury
• what is the interest rate?
• 100 (1r/4)75, r132 yearly nominal interest
  rate

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• The T-bill can be sold in the secondary market at
  its market price
• As the maturity date comes the market price
  approaches to the face value of 100
• the price depends on the market interest rate
• r??P?

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• For example on May 31
• one month to maturity
• if the annual nominal interest rate 96
• P(10.96/12)100, P 92.59
• if the annual nominal int. rate 60
• P(160/12)100, P 95.23
• note that as r?from 96 to 60
• P? from 82.89 to 96.23

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Treasury Auctions

• Suppose the borrowing requirement is 750b TL
• treasury gets offers from bank bid price offers
• offers bid price
• 2 77
• 3 76
• 3 75
• 2 71.5

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The secondary bond market

• The holder can sell the bond or bill at any time
  before its maturity in a market called the
  secondary bond market
• The nearer the maturity date of the bill The
  more liquid the bill it can be sold easily

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• Suppose market interest rate r96 per annum
• On April 30 what is the price of the bond two
  months to maturity
• 100(10.962/12)P so P86.28
• compare it with the May 31 price
• -one month to maturity
• P92.58
• P ? 100 as the maturity date comes at the same
  int rate of 96 per annum

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The repo market

• Involve sale of a security to someone with an
  agreement to repurchase it at a certain date, at
  an agreed-upon price
• The repurchase price is higher than the sale
  price, the difference being the interest earned
  on the loan extended through repo

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• When one party signs a repurchase agreement, the
  other party involved is entering a reverse repo
  agreement (buying with the understanding that he
  will sell it back)
• repo agreements may be drawn for a period as
  short as overnight or for 1 to 30 days most
  common 1 day and 7 day
• risk involvement in longer term repos are greater
  so interest expected is higher

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Example 24.4

• If the market value of a T-bill is 90 the annual
  nominal interest rate is 120
• n 1 day
• Pbuy 90 (market price)
• Psell after one day
• Psell (11.2(1/365))90 90.29
• you sell T-bill back to the bank at 90.29
• gain 0.29 in one day at a annual int rate of 90

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• Note that
• the bank is making repo
• selling the bond to you with the agreement to
  purchase it back in one day
• You make reverse repo
• buying the bond for a one day and supplying money
  to the bank

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The Interbank Money Market

• Regulate the liquidity of the economy and bring
  about a rational and effective allocation of
  domestic and foreign currency funds
• banks barrow or loan funds to each other
  anonymously with the intermediation of the C.B.
• Overnight transactions are the most important
  ones

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Other functions of the Central Bank

• Lender of last resort
• the Bank stands ready to lend to banks and other
  financial institutions when financial panic
  threatens
• Banker to the government
• the Bank ensures that the government can meet its
  payments when running a budget deficit
• Setting monetary policy to control inflation
• more of this later

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The demand for money

• The opportunity cost of holding money is the
  interest given up by holding money rather than
  bonds.
• People will only hold money if there is a benefit
  to offset that opportunity cost.

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Motives for holding money

• Transactions
• payments and receipts are not perfectly
  synchronized
• so money is held to finance known transactions
• depends upon income and payment arrangements

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Example 24.5

• Monthly income 150m TL at the beginning of month
• save 50m TL
• spend 100m TL
• two ways of spending
• i) all purchases at the first week
• total purchases 100
• 2) weekly purchasing
• each week 25m TL

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Example 24.5 (continued)

• What is transaction money demand in i and ii ?
• I) average money demand
• (100000)/425
• ii) average money demand
• (100755025)462.5
• holds more notes or chequing accounts in ii

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100
i
1 2 3 4
100
75
50
25
ii
1 2 3 4
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Motives for holding money

• Precautionary
• because of uncertainty
• people hold money to meet unforeseen
  contingencies
• depends upon the (nominal) interest rate

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Motives for holding money (2)

• Asset
• people dislike risk
• so may hold money as a low-risk component of a
  mixed portfolio
• depends upon opportunity cost (the nominal
  interest rate)
• Speculative
• people may hold money rather than bonds
• if bond prices are expected to fall
• i.e. the interest rate is expected to rise
• depends upon the rate of interest and on
  expectations about bond prices

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The demand for money summary

• The demand for money is a demand for real money
  balances
• It depends upon
• real income
• nominal interest rate (the opportunity cost of
  holding money)
• the price level (currently assumed fixed)
• expectations about future interest rates

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Money market equilibrium
Interest rate
r0
The position of this schedule depends upon
real income and the price level.
L0
Real money holdings
For every income level there is a different
money demand schedule LL is money demand at a
higher level of real income
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Money market equilibrium
Interest rate
The position of this schedule depends upon
real income and the price level.
Real money holdings
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Reaching money market equilibrium
This implies an excess supply of bonds which
reduces the price of bonds
and thus raises the rate of interest until
equilibrium is reached.
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Monetary control
Given the money demand schedule
The central bank can ...
EITHER set the interest rate at r0 and allow
money supply to adjust to L0
Interest rate
r0
OR set money supply at L0 and allow the market
rate of interest adjust to r0
LL
BUT cannot set both money supply and
interest rate independently.
L0
Real money holdings
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Monetary control some provisos

• Monetary control cannot be precise unless the
  authorities know the shape and position of money
  demand
• Controlling money supply is especially
  problematic
• and the Bank of England has preferred to work via
  interest rates
• The situation is further complicated by the
  relationship between the interest rate and the
  exchange rate

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Targets and instruments of monetary policy

• Monetary instrument
• the variable over which the central bank
  exercises day to day control
• e.g. interest rate
• Intermediate target
• the key indicator used as an input to frequent
  decisions about when to set interest rates
• The financial revolution has reduced the
  reliability of money supply as an indicator
• and central banks increasingly use inflation
  forecasts as the intermediate target