ACFI330 - Banking and the financial system - Central Banking

What are the three main roles central banks play as "the government's bank"?

1) Monopoly on currency issuance, 2) Control of money and credit availability through monetary policy, 3) Ability to stabilize economic growth and inflation

What is the relationship between money growth and inflation according to the document?

A high rate of money growth creates a high inflation rate

What is the primary cost of printing money, and why is it profitable?

A bill only costs a few cents to print but has face value, making it very profitable. However, losing control of the printing presses means losing control of inflation

What are the three key roles central banks play as "the banker's bank"?

1) Provide loans during times of financial stress, 2) Manage the payments system, 3) Oversee commercial banks and the financial system

What is the "lender of last resort" function?

The central bank's ability to create money means it can make loans even when no one else can, providing liquidity during financial crises

: Why is the central bank the natural place for interbank payments to be settled?

Because all banks have accounts at the central bank, making it efficient for transferring funds between institutions

What role do government examiners and supervisors play?

They monitor commercial banks and nonbank financial institutions to ensure soundness, handling sensitive information without conflict of interest

What does a central bank NOT control?

1) Securities markets (though it may monitor and participate), 2) Government's budget (determined by fiscal policy)

What are the five specific objectives central banks pursue to reduce economic and financial volatility?

1) Low and stable inflation, 2) High and stable real growth with high employment, 3) Stable financial markets and institutions, 4) Stable interest rates, 5) A stable exchange rate

What is the Bank of England's stated job (four objectives)?

1) Secure banknotes, 2) Stable prices, 3) Safe and sound banks, 4) A resilient financial system

What is the ECB's primary objective for monetary policy?

To maintain price stability, aiming for 2% inflation over the medium term

What is the Fed's "dual mandate"?

1) Price stability (core inflation around 2%), 2) Maximum employment (unemployment rate around 4%)

Why do most central banks consider price stability their primary job?

Because inflation that rises too high or falls too low for extended periods is generally the central bank's responsibility to control

How does price stability enhance money's usefulness?

It enhances money's usefulness as both a unit of account and a store of value by preserving the information content of prices

Why is zero inflation considered too low?

1) Risk of deflation (makes debts harder to repay, threatening banks), 2) Makes it difficult for employers to cut labor costs (they'd need to cut nominal wages, which is hard to do)

Why is a small amount of inflation beneficial for labor markets?

It allows employers to effectively cut real wages without cutting nominal wages, making labor markets work better from an employer's perspective

What are the three basic assets on a central bank's balance sheet?

1) Securities, 2) Foreign exchange reserves, 3) Loans

What are securities and why are they important?

Securities (traditionally Treasury securities free of default risk) are the primary asset of most central banks. The Fed controls their quantity through open market operations

What are foreign exchange reserves and their purpose?

The central bank's and government's balances of foreign currency (held as bonds issued by foreign governments), used in foreign exchange interventions to influence currency values

What are discount loans?

Loans the Fed makes when commercial banks need short-term cash (also extended to nonbanks during 2008-09 and 2020 crises)

What are the three major liabilities on a central bank's balance sheet?

1) Currency, 2) Government's deposit account, 3) Commercial banks' deposit accounts (reserves)

What is currency as a central bank liability?

Currency circulating in the hands of the nonbank public - the principal liability of most central banks due to their monopoly on currency issuance

What is the government's account at the central bank?

An account where the government deposits funds (mostly tax revenue) and makes payments, with the balance kept fairly constant through transfers between commercial banks and the Fed

What are reserves and their two components?

Commercial bank reserves = deposits at the central bank + vault cash. They consist of required reserves (mandated percentage) and excess reserves (held voluntarily)

What happened to reserve requirements in the US in March 2020?

The Federal Reserve set the reserve requirement to zero, so all US reserves are now excess reserves (called "reserve balances")

What happens to a bank's balance sheet immediately after the Fed purchases Treasury bonds?

Assets: Securities decrease, Reserves increase by the same amount (no change in total assets)

What happens after the bank extends a loan using the new reserves?

Assets: Reserves increase, Securities decrease, Loans increase. Liabilities: Demand deposits increase

What is the final impact after the borrower withdraws funds?

Assets: Reserves return to zero, Securities decrease, Loans increase. Liabilities: Demand deposits return to zero

What is the monetary base (high-powered money)?

Currency in the hands of the public plus reserves in the banking system - the privately held liabilities of the central bank

Why is it called "high-powered money"?

Because when the monetary base increases by a dollar, the quantity of money typically rises by several dollars (through the multiplier effect)

Who controls the monetary base?

The central bank

What is the simple deposit expansion multiplier formula (with assumptions)?

ΔD = (1/r_D) × ΔRR, where r_D is the required reserve ratio Example: With 10% reserve requirement, $100,000 in reserves creates $1,000,000 in deposits

What four assumptions underlie the simple deposit expansion multiplier?

1) Banks hold no excess reserves, 2) Reserve requirement ratio is constant, 3) Currency holdings don't change with deposits/loans, 4) When borrowers write checks, recipients don't deposit funds back in the originating bank

How does the deposit expansion process work through multiple banks?

First Bank loans $100,000 → Second Bank receives $100,000 deposit, holds $10,000 reserves, loans $90,000 → Third Bank receives $90,000, holds $9,000 reserves, loans $81,000, etc.

How do excess reserves and cash withdrawals affect deposit expansion?

They reduce the multiplier effect. Example: If depositors withdraw 5% as cash and banks hold 5% excess reserves, Second Bank can only loan $80,750 (not $90,000) from a $100,000 initial deposit

With 5% cash withdrawal and 5% excess reserves, what happens to Second Bank's balance sheet?

From $100,000 deposit: Required reserves +$9,500 (10% of $95,000), Excess reserves +$4,750 (5% of $95,000), Loan +$80,750, American Steel's deposit account +$95,000

What is the money multiplier formula?

M = [{C/D} + 1] / [{C/D} + r_D + {ER/D}] × MB

Where:

• M = Money supply

• MB = Monetary base

• C/D = Currency-to-deposit ratio

• r_D = Required reserve ratio

• ER/D = Excess reserve-to-deposit ratio

What four factors determine the quantity of money in the economy?

1) The monetary base (controlled by the Fed), 2) The reserve requirement, 3) Banks' desire to hold excess reserves, 4) The nonbank public's demand for currency

What factors affect banks' excess reserve holdings?

Higher interest rates on loans → lower excess reserves. Greater concern over deposit withdrawals → higher excess reserves

What determines the currency-to-deposit ratio {C/D}?

Cost of holding currency = interest foregone by not depositing. Benefit = lower risk and greater liquidity

How do interest rate changes affect the money multiplier?

As interest rates increase, both {ER/D} and {C/D} fall, increasing the money multiplier and the quantity of money

What is the impact of a cash withdrawal on the money supply?

Increases currency in public, decreases reserves, creates multiple deposit contraction, and reduces money supply

Why has the relationship between monetary base and money supply become unreliable for policy?

The money multiplier has become too variable and unpredictable, especially in developed economies like the US, Europe, and Japan

What has replaced money supply targeting as the primary monetary policy tool?

Interest rates have become the monetary policy tool of choice

What additional tools help during financial crises?

Other balance-sheet tools that address liquidity needs and market disruptions more directly than money supply manipulation

What happened to the M2 money multiplier from 1980-2023?

It varied significantly: peaked around 12 in mid-1980s, generally declined to about 8 by 2007, collapsed to 3-5 range after 2008 financial crisis, showing high volatility

Q: What is the relationship between money (M), deposits (D), and currency (C)?

A: M = C + D = ({C/D} + 1)D

What is the relationship between monetary base (MB), currency (C), and reserves (R)?

MB = C + R = ({C/D} + r_D + {ER/D})D

What formula shows deposits in terms of the monetary base?

D = [1 / ({C/D} + r_D + {ER/D})] × MB

What are the three uses of the monetary base?

1) Required reserves, 2) Excess reserves, 3) Cash in the hands of the nonbank public