4.4 - Role of central banks

Question 1

Role of Central Banks

Answer 1

• implementation of monetary policy
• banker to the government
• banker to the banks – lender of last resort
• role in regulation of the banking industry

Question 2

Function of central bank:
Implementation of Monetary Policy

Answer 2

• Central banks have the primary responsibility for formulating and implementing monetary policy,
  > which involves managing the money supply and interest rates to achieve specific economic objectives, such as price stability and economic growth.
• Tools of monetary policy include:
  > open market operations (buying and selling government securities),
  > setting interest rates (e.g., the policy rate),
  > setting reserve requirements for banks.
• Central banks adjust these tools to influence borrowing costs, inflation rates, and overall economic activity.
  > low and stable inflation is a macroeconomic objective

Question 3

Function of central bank:
Banker to the Government

Answer 3

• Central banks act as the government’s banker by managing the government’s bank accounts, facilitating payments, and helping with debt issuance and management.
• They often oversee the issuance and redemption of government bonds and treasury bills, helping the government fund its operations and manage its debt.
• Central banks also provide advice on fiscal and monetary coordination to ensure overall economic stability.

Question 4

Function of central bank:
banker to the banks – lender of last resort

Answer 4

• Banks deposit their money within the
  central bank and this is often used to balance the accounts of banks at the end of each day, when banks owe each other money because cheques have been paid in
  by consumers etc.
• Central banks serve as a lender of last resort to financial institutions, especially during times of financial crises or bank runs.

> In this role, central banks provide emergency funding to banks facing liquidity problems
If banks experience liquidity problems, they can turn to the central bank to sell their illiquid assets or to take a loan in the short term.

> If the bank is on the brink of
collapse as its assets have fallen too far in value e.g. the financial crisis of 2007-8, then the bank can lend them money to prevent them from collapsing.
Banks tend to
lend to each other and so the collapse of one bank will lead to the collapse of other banks;
By offering short-term loans (often referred to as the discount window), central banks help maintain confidence in the banking system

• this means that this role is important since as it allows the bank to ensure
  financial stability.

Question 5

Function of central
banks
> Role in Regulation of the Banking Industry

Answer 5

• Central banks often play a critical role in supervising and regulating the banking sector to ensure its stability and soundness.
• They set and enforce prudential regulations, including capital adequacy requirements and risk management standards, to prevent excessive risk-taking by banks.
• Central banks may also conduct regular bank examinations to assess the financial health and compliance of financial institutions with regulatory standards.

> This is important to prevent financial institutions from undertaking activities which harm consumers or engage in risky activities which would lead to collapse and to prevent
systemic risk, the risk of the whole system collapsing.
The financial sector plays a
huge role in the economy because it impacts investment and can cause huge externalities if market failure occurs.

Question 6

Financial regulation

Answer 6

Regulation can include:
> banning market rigging
>preventing the sale of unsuitable products
> maximum interest rates to prevent consumer exploitation and prevent
excessively risky lending
> deposit insurance to protect consumer deposits and
increase stability
> liquidity ratios, when banks are forced to hold a certain percentage of liquid assets.

Question 7

3 bodies for financial regulation

Answer 7

• The FPC identifies and reduces system risk and supports government
  economic policy (macroprudential)
• The PRA ensures competition, ensures consumers have access to services, minimises risk should a bank fail and ensures banks take responsible action.
  (microprudential)
• The FCA protects consumers, promotes competition and enhances the integrity of the system by preventing market rigging.

Question 8

inflation target in UK

Answer 8

2% + or - 1%

Question 9

monetary policy tools

Answer 9

• interest rates
• quantitative easing/quantitative tightening
• forward guidance

Question 10

European central bank inflation target

Answer 10

under 2%
> more deflationary

Question 11

Federal reserve target

Answer 11

maximum employment and stable prices
> balanced objective

Question 12

The federal reserve is also essential in maintaining the …

Answer 12

Fed is also essential in maintaining the stability of the global financial system - the $ is the world’s reserve currency / cash.

Question 13

Money Supply / issuing notes and coin

Answer 13

• Central Bank has a monopoly on producing physical cash (UK - Royal Mint).
• Controlling money crucial for controlling inflation (the quantity theory).MV = PT
• Inflation is ultimately caused by ‘too much money chasing too few goods’

> But, in practice, commercial banks create money through credit all the time! Central Bank can influence this through regulation/capital requirements.

Question 14

Banker to the Government

Answer 14

• The Central Bank is effectively the Government’s Bank.
• The Bank of England used to manage the issuing of UK Government debt, in other words, it used to sell Government Bonds when the Government needed to borrow.
• This is now done by another agency, the Debt Management Office (DMO).
• Job is to manage the debt to get the best deal for the taxpayer - issue debt smoothly so the Government can also borrow as cheaply as possible.