11 Central Banking

Question 1

money and their functions

Answer 1

Money = an asset generally accepted for business transactions
and used as a legal tender or for repaying debts.
three key functions of money:
1 a medium of exchange,
2 a unit of account,
3 a store of value

Question 2

wealth

Answer 2

the total collection of pieces of property that serve to store value.

Question 3

income

Answer 3

is a flow of earnings per unit of time (but money =
stock

Question 4

Monetary aggregates (3)

Answer 4

1. M1 (narrow money) = currency + deposits on current accounts at banks
2. M2 (intermidiate money) = M1 + term deposits at banks + other deposits at banks
3. M3 (broad money) = M2 + short-term securities of non-banks in domestic currency

the most stable - M3
the most liquid - M1

Question 5

Commercial bank´s balance sheet

Answer 5

• Assets: cash, claims on CB, securities, loans, other assets
• Liabilities: deposits, interbank market, capital

Question 6

main functions of central bank (3)

Answer 6

Three main functions:
1. granting credits to government institutions,
2. the management of government accounts
3. the issuance of banknotes and coins, arose later as the need for centralization of currency issuance occurred

Question 7

how CB have been founded? (3)

Answer 7

1. Their conversion from a commercial bank (e.g. Sveriges Riksbank in 1697),
2. The right to issue banknotes and coins (e.g. Banca D’Italia in 1926),
3. The foundation of a new institution (e.g. Bank of England in 1694).

Question 8

why CB play an important role on financial markets?

Answer 8

due to their close relationship with commercial banks, government institutions and other central banks

Question 9

macro and microeconomic functions of CB (7)

Answer 9

• Macroeconomic functions
  1. Issuance of banknotes & coins
  2. Monetary policy
  3. Foreign-exchange activities
• Microeconomic functions
  1. Regulation and supervision of banks
  2. The bank of banks
  3. The bank of the state
  4. Representation of the state

Question 10

Conventional instruments of CB (4)

Answer 10

1) open market operations (OMO)
2) mandatory minimum reserves
3) interest rates
4) other tools

Question 11

Nonconventional instruments of CB (4)

Answer 11

1) open liquidity facilities,
2) credit facilities,
3) large-scale asset purchases,
4) forward guidance

Question 12

(OMO)Classic Repo

Answer 12

a sale of securities followed by their future purchase

on balace sheets: claims on CNB (bank’s) to liabilities to banks (CNB’s)

Question 13

(OMO)Reverse Repo

Answer 13

a purchase of securities followed by their future sale

on balace sheets: other assets (CNB’s) to interbank market (bank’s)

Question 14

Mandatory minimum reserves

Answer 14

a part of a deposit that a commercial bank has to place in a central bank, are another tool of central banks.

In theory, central banks can influence banks through MMR, for example an increase in MMR may result in a lower multiplication of deposits.
However, in reality MMR plays an important role in an interbank payment system and liquidity management

Question 15

Other tools of CB

Answer 15

• Automatic facilities (used for providing and depositing liquidity overnight)
  ➢ The deposit facility
  ➢ The marginal lending facility
• Extraordinary facilities (introduced by the CNB in autumn 2008, extraordinary liquidity providing repo operations with two-week and three-month maturities aimed at fostering the functioning of the government bond market)
  ➢ Liquidity-providing repo operations (under special conditions)

Question 16

example of quantitative easing. why was it used?

Answer 16

The Federal Reserve announced that it would buy $600 billion in Treasuries over the next eight months in a second round of “quantitative easing”.

The decision to pump more liquidity into the American economy to bring down longterm interest rates and spur growth prompted modest rises in stockmarkets around the world.

QE was activated because conventional monetary policies (low i.r.) were not enough

Question 17

TARGET2

Answer 17

interbank payment system in the European Monetary Union (EMU)

Question 18

Primary tasks of the CNB

Answer 18

Since 1993, the Czech National Bank (ČNB) has operated as the Czech Republic’s central bank.
- Its primary goal, set by Czech law, is to take care of price stability

In addition, the ČNB has a broad economic responsibility because the law says:
“If its primary goal is not affected, the ČNB supports an economic policy of the Czech government that will result in long-term sustainable economic growth.”

Question 19

The mandate of the CNB (4)

Answer 19

1) to maintain price stability,
2) to maintain financial stability and see to the sound operation of the financial system in the Czech Republic,
3) to issue banknotes and coins, manage the circulation of currency and administer clearing between banks,
4) to supervise the entities operating on the financial market

Question 20

Instruments of the CNB

Answer 20

1) Open market operations
2) Mandatory minimum reserves
3) Interest rates
4) Other tools

o Central banks use open market operations for steering interest rates in the economy. A repurchase agreement (repo) ranks as the most important tool used by the CNB

Question 21

meaning of REPO under Czech laws

Answer 21

under Czech law a repo means a collateralized loan backed by securities (i.e. a repo is not a purchase and future sale of securities)

Question 22

CNB inflation targeting today

Answer 22

2%

o Targets originally set for “net inflation”, since 2002 for headline inflation.
o From January 2006 the target set at 3% with a tolerance band of ±1%, since January 2010 the point target of 2% established.
o Inflation targeting prevails around the world

Question 23

Exchange Rate Mechanism (ERM

Answer 23

System of fixed exchange rates.
ERM collapsed in early 1990s

Question 24

Basic tasks of the Eurosystem (4)

Answer 24

1. To conduct foreign exchange operations
2. To define and implement monetary policy
3. To promote the smooth operation of payment systems
4. To hold and manage the official foreign reservs of the participating EU member states

Question 25

Other tasks of the Eurosystem (6)

Answer 25

1. advisory functions
2. issuance of banknotes
3. collection and compilation of statistics
4. international cooperation
5. banking supervision as of November 2014
6. contribution to prudential supervision and financial stability

Question 26

Monetary policy (MP) diagram in theory

Answer 26

a)Transmission mechanism: central bank
instruments of MP -> monetary base -> monetary aggregates -> goals of MP
↓ 𝑖 →↑ 𝑀𝐵 →↑ 𝑀2 → ↑ 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

b)Transmission mechanism: economy
↓ 𝑖 →↑ 𝑐𝑟𝑒𝑑𝑖𝑡 →↑ 𝐶, ↑ 𝐼, ↑ 𝑁𝑋 → ↑ 𝐺𝐷𝑃

𝑩𝒂𝒏𝒌 𝒄𝒓𝒆𝒅𝒊𝒕: C, I, G, NX
𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋

Question 27

Low interest rates in the AS/AD model

Answer 27

↓ 𝑖 → ↑ 𝐺𝐷𝑃 𝑎𝑛𝑑 ↑ 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

Question 28

Transmission mechanism

Answer 28

monetary authority’s dream:
- monetary policy tools -> price stability
- macroprudential policy tools -> financial stability

the reality
- monetary policy tools and macroprudential policy tools -> transmission mechanism
- transmission mechanism -> price stability and financial stability

transmission mechanism is always complex - various stages and channels

Question 29

interest rate

Answer 29

• is the “rental” price of money;
• it is the price paid for the use of money for a period of time

 Real interest rate vs. nominal interest rate

Question 30

fisher equation

Answer 30

real IR = nominal IR - expected inflation

Question 31

Yield curve

Answer 31

shows the relationship between maturity and interest rates (yields on bonds against bond maturities);

it is constructed from the bonds of the same risk – usually from government (Treasury) bonds.

Question 32

types of YC

Answer 32

• normal,
• inverted,
• flat
• bulge.

Question 33

Theories explaining the shape of a yield curve

Answer 33

1. Expectations theories
   ◦ Pure expectations theory
   ◦ Liquidity-preference theory
   ◦ Preferred habitat theory
2. Market segmentation theory

Question 34

NIR?

Answer 34

Negative interest rates. Here now

Question 35

Reasons for NIRs

Answer 35

Inflation and Exchange Rate

1. 𝑛𝑒𝑔𝑎𝑡𝑖𝑣𝑒 𝑖 →↓ 𝑐𝑎𝑠ℎ 𝑖𝑛 𝑏𝑎𝑛𝑘𝑠 → ↑ 𝑐𝑟𝑒𝑑𝑖𝑡 → ↑ 𝐺𝐷𝑃 → ↑ inflation
    European Central Bank (ECB)
    Sveriges Riksbank (SR)
    Bank of Japan (BoJ)
2. 𝑛𝑒𝑔𝑎𝑡𝑖𝑣𝑒 𝑖 → ↓ 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐹𝑋 𝑟𝑎𝑡𝑒(𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛)
    Danmarks Nationalbank (DN)
    Swiss National Bank (SNB)