Macroeconomics - Lecture 7

The Central Bank

• Central bank: functions as the banker to banks and the government.
• It is responsible for overseeing the banking system, implementing monetary policy, and issuing currency.
• Examples of central banks:
  • Bank of England (1694) - UK's central bank.
  • European Central Bank (1988) - central bank of countries using the euro.
  • Federal Reserve System (1913) - central bank of the United States.
• Central bank roles:
  • Oversee the monetary system, ensuring the stability and efficiency of Monetary Financial Institutions (MFIs).
  • Act as the government’s agent and banker, and carry out monetary policy.

Functions of the Bank of England

1. Issues notes
   • Sole issuer of banknotes in England and Wales.
2. Acts as a bank to:
   • Government (handling taxation, spending, borrowing, and lending).
   • Banks (mainly reserve balances).
   • Overseas central banks (currency deposits).
3. Operates monetary policy
   • Main goal: set monetary policy to achieve the Government’s target inflation of 2%.
   • The Bank of England’s Monetary Policy Committee (MPC) sets the Bank Rate.
     • The committee has 9 members: 4 external members, 4 BoE senior members, and the Governor.
   • Open-market operations: the sale (or purchase) by the authorities of government securities in the open market to reduce (or increase) money supply and affect interest rates.
4. Provides liquidity to banks
   • Supplies liquidity to meet the demands of depositors in banks.
   • Lender of last resort: role of the Bank of England as the guarantor of sufficient liquidity in the monetary system.
5. Oversees the activities of banks and other financial institutions
   • Prudential control: the BoE requires recognised banks to maintain adequate liquidity.
6. Operates exchange rate policy and manages reserves (on behalf of the Treasury)
   • Exchange equalisation account: BoE gold and foreign exchange reserves account.
   • The BoE can affect the exchange rate by buying and selling currencies.
   • If there were a sudden selling of sterling, the BoE could help to prevent the pound from depreciating by selling reserves (gold or foreign exchange) to buy up pounds.

Consolidated Balance Sheet of the Bank of England: 31 December 2022

Liabilities

• Notes in circulation: £77.7 billion, 13.0%
• Reserve balances: £473.2 billion, 79.1%
• Short-term open market operations: £0.0 billion, 0.0%
• Cash ratio deposits: £8.8 billion, 1.5%
• Other sterling liabilities: £15.2 billion, 2.5%
• Capital and reserves (equity): £4.4 billion, 0.7%
• Other foreign currency liabilities: £14.1 billion, 2.4%
• Term Funding Scheme Loan: £108.2 billion, 18.1%

Assets

• Ways and means advance to National Loans Fund: £0.4 billion, 0.1%
• Short-term open market operations: £0.0 billion, 0.0%
• Long-term open market operations: £8.5 billion, 1.4%
• Sterling denominated bond holdings: £14.1 billion, 2.4%
• Loans to Asset Purchase Facility: £445.0 billion, 74.4%
• Foreign currency public securities issued: £4.6 billion, 0.8%
• Other sterling assets: £1.0 billion, 0.2%
• Foreign currency reserve assets: £5.8 billion, 1.0%
• Other foreign currency assets: £15.0 billion, 2.5%

Total

• Total Liabilities: £597.9 billion, 100.0%
• Total Assets: £597.9 billion, 100.0%
  *Source: Bank of England Consolidated Balance Sheet, Bankstats, Table B1.1.3 (Bank of England, published 3 April 2024)

Money Markets

• Money market: the market for short-term debt instruments (e.g. government bills), in which financial institutions are active participants.
  • Discount markets (corporate bills and treasury bills).
  • Repo markets.
  • Parallel markets (certificates of deposit, foreign currencies, inter-bank loans).
• Capital market: a financial market where longer-term debt instruments (e.g. government bonds) can be bought and sold.

Money Supply

• There are two main measures of the money supply:
  • Monetary base (or ‘narrow money’): cash in circulation.
  • Broad money (‘the money supply’): cash in circulation + deposits.
• Definitions in the UK:
  • Monetary base: all cash held outside the Bank of England (that is cash held by individuals, firms, banks, and the public sector).
  • Broad money (M4): private-sector holdings of sterling, retail and wholesale deposits in banks (including CDs), commercial paper, and other short-term paper issued by MFIs.
• In 2021, UK monetary base was 4% of its GDP, money supply was 130% of GDP.

Determinants of Money Supply

• What causes money supply to increase?
  • Central bank action (e.g. buying government securities through open market operations).
  • Inflow of funds from abroad (e.g. financial and trade flows).
  • Public-sector deficit (e.g. funding deficit by selling treasury bills to commercial banks).
  • Banks choose to hold a lower liquidity ratio (e.g. expand advances).
  • Households and firms choose to hold less cash (e.g. deposit more with commercial banks).

The Creation of Credit

• Banks can expand the amount of bank deposits and hence the money supply.
  • Bank deposits multiplier: The number of times greater the expansion of bank deposits is than the additional liquidity in banks that causes it.
    • Depends on banks’ liquidity ratio and demand for bank credit (both vary with the business cycle).
  • Money multiplier: The number of times greater the expansion of money supply is than the expansion of the monetary base that caused it.