Module 2

What is a Central Bank?

A central bank is a financial institution given privileged control over the production
and distribution of money and credit for a nation or a group of nations. In modern
economies, the central bank is usually responsible for the formulation of monetary
policy and the regulation of member banks.

Central banks are inherently non-market-based or even anti-competitive institutions.

Although some are nationalized, many central banks are not government agencies,
and so are often touted as being politically independent. However, even if a central
bank is not legally owned by the government, its privileges are established and
protected by law.

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The critical feature of a central bank—distinguishing it from other banks—is its legal
monopoly status, which gives it the privilege to issue banknotes and cash. Private
commercial banks are only permitted to issue demand liabilities, such as checking
deposits.
 • A central bank is a financial institution that is responsible for overseeing the
monetary system and policy of a nation or group of nations, regulating its
money supply, and setting interest rates.
• Central banks enact monetary policy, by easing or tightening the money
supply and availability of credit, central banks seek to keep a nation's
economy on an even keel.
• A central bank sets requirements for the banking industry, such as the amount
of cash reserves banks must maintain vis-à-vis their deposits.
• A central bank can be a lender of last resort to troubled financial institutions
and even governments.

Understanding Central Banks

Although their responsibilities range widely, depending on their country, central

banks' duties (and the justification for their existence) usually fall into three areas.
First, central banks control and manipulate the national money supply: issuing
currency and setting interest rates on loans and bonds. Typically, central banks raise
interest rates to slow growth and avoid inflation; they lower them to spur growth,
industrial activity, and consumer spending. In this way, they manage monetary
policy to guide the country's economy and achieve economic goals, such as full
employment.
Most central banks today set interest rates and conduct monetary policy using an
inflation target of 2-3% annual inflation.

Second, they regulate member banks through capital requirements, reserve

requirements (which dictate how much banks can lend to customers, and how much
cash they must keep on hand), and deposit guarantees, among other tools. They also
provide loans and services for a nation’s banks and its government and manage
foreign exchange reserves.

Finally, a central bank also acts as an emergency lender to distressed commercial

banks and other institutions, and sometimes even a government. By purchasing
government debt obligations, for example, the central bank provides a politically
attractive alternative to taxation when a government needs to increase revenue.

A Brief History of Central Banks

The first prototypes for modern central banks were the Bank of England and the
Swedish Riksbank, which date back to the 17 th century. The Bank of England was
the first to acknowledge the role of lender of last resort. Other early central banks,
notably Napoleon’s Bank of France and Germany's Reichsbank, were established to
finance expensive government military operations.

It was principally because European central banks made it easier for federal
governments to grow, wage war, and enrich special interests that many of United
States' founding fathers—most passionately Thomas Jefferson—opposed
establishing such an entity in their new country. Despite these objections, the young
country did have both official national banks and numerous state-chartered banks
for the first decades of its existence, until a “free-banking period” was established
between 1837 and 1863.

The National Banking Act of 1863 created a network of national banks and a single
U.S. currency, with New York as the central reserve city. The United States
subsequently experienced a series of bank panics in 1873, 1884, 1893, and 1907. In
response, in 1913 the U.S. Congress established the Federal Reserve System and 12
regional Federal Reserve Banks throughout the country to stabilize financial activity
and banking operations.
The new Fed helped finance World War I and World War II by issuing Treasury
bonds.

Between 1870 and 1914, when world currencies were pegged to the gold standard,
maintaining price stability was a lot easier because the amount of gold available was
limited. Consequently, monetary expansion could not occur simply from a political
decision to print more money, so inflation was easier to control. The central bank at
that time was primarily responsible for maintaining the convertibility of gold into
currency; it issued notes based on a country's reserves of gold.

At the outbreak of World War I, the gold standard was abandoned, and it became
apparent that, in times of crisis, governments facing budget deficits (because it costs
money to wage war) and needing greater resources would order the printing of more
money. As governments did so, they encountered inflation. After the war, many
governments opted to go back to the gold standard to try to stabilize their economies.
With this rose the awareness of the importance of the central bank's independence
from any political party or administration.

During the unsettling times of the Great Depression in the 1930s and the aftermath
of World War II, world governments predominantly favored a return to a central
bank dependent on the political decision-making process. This view emerged mostly
from the need to establish control over war-shattered economies; furthermore, newly
independent nations opted to keep control over all aspects of their countries—a
backlash against colonialism. The rise of managed economies in the Eastern Bloc
was also responsible for increased government interference in the macro-economy.
Eventually, however, the independence of the central bank from the government
came back into fashion in Western economies and has prevailed as the optimal way
to achieve a liberal and stable economic regime.

Central Banks and Deflation

Over the past quarter-century, concerns about deflation have spiked after big
financial crises. Japan has offered a sobering example. After its equities and real
estate bubbles burst in 1989-90, causing the Nikkei index to lose one-third of its
value within a year, deflation became entrenched. The Japanese economy, which
had been one of the fastest growing in the world from the 1960s to the 1980s, slowed
dramatically. The '90s became known as Japan's Lost Decade.

The Great Recession of 2008-09 sparked fears of a similar period of prolonged

deflation in the United States and elsewhere because of the catastrophic collapse in
prices of a wide range of assets. The global financial system was also thrown into
turmoil by the insolvency of several major banks and financial institutions
throughout the United States and Europe, exemplified by the collapse of Lehman
Brothers in September 2008.
Photo by CFI

Functions of a central bank usually include:

• Monetary policy: by setting the official interest rate and controlling the
money supply;
• Financial stability: acting as a government's banker and as the bankers'
bank ("lender of last resort");
• Reserve management: managing a country's foreign-exchange and gold
reserves and government bonds;
• Banking supervision: regulating and supervising the banking industry;
• Payments system: managing or supervising means of payments and inter-
banking clearing systems;
• Coins and notes issuance;
• Other functions of central banks may include economic research,
statistical collection, supervision of deposit guarantee schemes, advice to
government in financial policy.
Goals of central banks

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Price stability
The primary role of central banks is usually to maintain price stability, as defined as
a specific level of inflation. Inflation is defined either as the devaluation of a
currency or equivalently the rise of prices relative to a currency. Most central banks
currently have an inflation target close to 2%.

Since inflation lowers real wages, Keynesians view inflation as the solution to
involuntary unemployment. However, "unanticipated" inflation leads to lender
losses as the real interest rate will be lower than expected. Thus, Keynesian monetary
policy aims for a steady rate of inflation.

Central banks as monetary authorities in representative states are intertwined

through globalized financial markets. As a regulator of one of the most widespread
currencies in the global economy, Federal Reserve (FED) plays a huge role in the
international monetary market. Being the main supplier and rate adjusted for USD,
FED implements a certain set of requirements to regulate inflation and
unemployment in the US, willingly or unwillingly influencing the actions of Central
Bank of Armenia (CBA). Armenia is a small country with a relatively weak
economy and bears the consequences of FED policies the most.
High employment
Frictional unemployment is the time period between jobs when a worker is searching
for or transitioning from one job to another. Unemployment beyond frictional
unemployment is classified as unintended unemployment.

For example, structural unemployment is a form of unemployment resulting from a

mismatch between demand in the labour market and the skills and locations of the
workers seeking employment. Macroeconomic policy generally aims to reduce
unintended [Link] labeled any jobs that would be created by a rise
in wage-goods (i.e., a decrease in real-wages) as involuntary unemployment:

Men are involuntarily unemployed if, in the event of a small rise in the price of wage-
goods relatively to the money-wage, both the aggregate supply of labour willing to
work for the current money-wage and the aggregate demand for it at that wage would
be greater than the existing volume of employment.— John Maynard Keynes, The
General Theory of Employment, Interest and Money

Economic growth
Economic growth can be enhanced by investment in capital, such as more or better
machinery. A low interest rate implies that firms can borrow money to invest in their
capital stock and pay less interest for it. Lowering the interest is therefore considered
to encourage economic growth and is often used to alleviate times of low economic
growth. On the other hand, raising the interest rate is often used in times of high
economic growth as a contra-cyclical device to keep the economy from overheating
and avoid market bubbles.

Further goals of monetary policy are stability of interest rates, of the financial
market, and of the foreign exchange market. Goals frequently cannot be separated
from each other and often conflict. Costs must therefore be carefully weighed before
policy implementation.
Climate change
In the aftermath of the Paris agreement on climate change, a debate is now underway
on whether central banks should also pursue environmental goals as part of their
activities. In 2017, eight central banks formed the Network for Greening the
Financial System (NGFS) to evaluate the way in which central banks can use their
regulatory and monetary policy tools to support climate change mitigation.
The Federal Reserve System in the United States is generally regarded as one of the
more independent central banks

Numerous governments have opted to make central banks independent. The

economic logic behind central bank independence is that when governments
delegate monetary policy to an independent central bank (with an anti-inflationary
purpose) and away from elected politicians, monetary policy will not reflect the
interests of the politicians. When governments control monetary policy, politicians
may be tempted to boost economic activity in advance of an election to the detriment
of the long-term health of the economy and the country. As a consequence, financial
markets may not consider future commitments to low inflation to be credible when
monetary policy is in the hands of elected officials, which increases the risk of capital
flight. An alternative to central bank independence is to have fixed exchange rate
regimes.

Governments generally have some degree of influence over even "independent"

central banks; the aim of independence is primarily to prevent short-term
interference. In 1951, the Deutsche Bundesbank became the first central bank to be
given full independence, leading this form of central bank to be referred to as the
"Bundesbank model", as opposed, for instance, to the New Zealand model, which
has a goal (i.e. inflation target) set by the government.

Central bank independence is usually guaranteed by legislation and the institutional

framework governing the bank's relationship with elected officials, particularly the
minister of finance. Central bank legislation will enshrine specific procedures for
selecting and appointing the head of the central bank. Often the minister of finance
will appoint the governor in consultation with the central bank's board and its
incumbent governor. In addition, the legislation will specify banks governor's term
of appointment. The most independent central banks enjoy a fixed non-renewable
term for the governor in order to eliminate pressure on the governor to please the
government in the hope of being re-appointed for a second term. Generally,
independent central banks enjoy both goal and instrument independence.

Despite their independence, central banks are usually accountable at some level to
government officials, either to the finance ministry or to parliament. For example,
the Board of Governors of the U.S. Federal Reserve are nominated by the U.S.
President and confirmed by the Senate, publishes verbatim transcripts, and balance
sheets are audited by the Government Accountability Office.
In the 1990s there was a trend towards increasing the independence of central banks
as a way of improving long-term economic performance. While a large volume of
economic research has been done to define the relationship between central bank
independence and economic performance, the results are ambiguous.
The literature on central bank independence has defined a cumulative and
complementary number of aspects

• Institutional independence: The independence of the central bank is

enshrined in law and shields central banks from political interference. In
general terms, institutional independence means that politicians should
refrain from seeking to influence monetary policy decisions, while
symmetrically central banks should also avoid influencing government
politics.

• Goal independence: The central bank has the right to set its own policy
goals, whether inflation targeting, control of the money supply, or
maintaining a fixed exchange rate. While this type of independence is more
common, many central banks prefer to announce their policy goals in
partnership with the appropriate government departments. This increases
the transparency of the policy-setting process and thereby increases the
credibility of the goals chosen by providing assurance that they will not be
changed without notice. In addition, the setting of common goals by the
central bank and the government helps to avoid situations where monetary
and fiscal policy are in conflict; a policy combination that is clearly sub-
optimal.
 • Functional & operational independence: The central bank has the
independence to determine the best way of achieving its policy goals,
including the types of instruments used and the timing of their use. To
achieve its mandate, the central bank has the authority to run its own
operations (appointing staff, setting budgets, and so on.) and to organize
its internal structures without excessive involvement of the government.
This is the most common form of central bank independence. The granting
of independence to the Bank of England in 1997 was, in fact, the granting
of operational independence; the inflation target continued to be
announced in the Chancellor's annual budget speech to Parliament.
• Personal independence: The other forms of independence are not
possible unless central bank heads have a high security of tenure. In
practice, this means that governors should hold long mandates (at least
longer than the electoral cycle) and a certain degree of legal immunity. One
of the most common statistical indicators used in the literature as a proxy
for central bank independence is the "turn-over-rate" of central bank
governors. If a government is in the habit of appointing and replacing the
governor frequently, it clearly has the capacity to micro-manage the central
bank through its choice of governors.

• Financial independence: central banks have full autonomy on their

budget, and some are even prohibited from financing governments. This is
meant to remove incentives from politicians to influence central banks.

• Legal independence : some central banks have their own legal

personality, which allows them to ratify international agreements without
the government's approval (like the ECB), and to go to court.

There is very strong consensus among economists that an independent central bank
can run a more credible monetary policy, making market expectations more
responsive to signals from the central bank. Both the Bank of England (1997) and
the European Central Bank have been made independent and follow a set of
published inflation targets so that markets know what to expect. Even the People's
Bank of China has been accorded great latitude, though in China the official role of
the bank remains that of a national bank rather than a central bank, underlined by the
official refusal to "unpeg" the yuan or to revalue it "under pressure". The fact that
the Communist Party is not elected also relieves the pressure to please people,
increasing its independence.
International organizations such as the World Bank, the Bank for International
Settlements (BIS) and the International Monetary Fund (IMF) strongly support
central bank independence. This results, in part, from a belief in the intrinsic merits
of increased independence. The support for independence from the international
organizations also derives partly from the connection between increased
independence for the central bank and increased transparency in the policy-making
process.

Demand for and Supply of Money

It will be useful to have an idea of the demand for and the supply of money.
Let us analyze demand for and supply of money separately.

Demand for Money:

The old idea about the demand for money was that money was demanded for
completing the business transactions. In other words, the demand for money
depended on the volume of trade or transactions. As such the demand for money
increased during boom period or when the trade was brisk and it decreased during
depression or slackening of trade.

The modern idea about the demand for money was put forward by the late Lord
Keynes, the famous English economist, who gave birth to what has been called the
Keynesian Economics. According to Keynes, the demand for money, or liquidity
preference as he called it, means the demand for money to hold.

Broadly speaking, there are three main motives on account of which money is
wanted by the people by the people, viz:
(i) Transactions motive
(ii) Precautionary motive
(iii) Speculative motive
Now a word about each one of them.

(i) Transactions Motive:

This motive can be looked at:
(a) From the point of consumers who want income to meet the household
expenditure which may be termed the income motive, and
(b) From the point of view of the businessmen, who require money and want to hold
it in order to carry on their business, i.e., the business motive.

(a) Income Motive:

The transactions motive relates to the demand for money or the need for cash for the
current transactions of individual and business exchanges. Individuals hold cash in
order “to bridge the interval between the receipt of income and its expenditure.” This
is called the income Motive’.

Most of the people receive their incomes by the week or the month, while the
expenditure goes on day by day. A certain amount of ready money, therefore, is kept
in hand to make current payments. This amount will depend upon the size of the
individual’s income, the interval at which the income is received and the methods of
payments current in the locality.

(b) Business Motive:

The businessmen and the entrepreneurs also have to keep a proportion of their
resources in ready cash in order to meet current needs of various kinds. They need
money all the time in order to pay for raw materials and transport, to pay wages and
salaries and to meet all other current expenses incurred by any business of exchange.
Keynes calls it the ‘Business Motive’ for keeping money. It is clear that the amount
of money held, under this business motive, will depend to a very large extent on the
turnover (i.e., the volume of trade of the firm in question). The larger the turnover,
the larger in general, will be the amount of money needed to cover current expenses.

(ii) Precautionary Motive:

Precautionary motive for holding money refers to the desire of the people to hold
cash balances for unforeseen contingencies People hold a certain amount of money
to provide tor the risk of unemployment, sickness, accidents and other more
uncertain perils. The amount of money held under this motive will depend on the
nature of the individual and on the conditions in which he lives.
(iii) Speculative Motive:
The speculative motive relates to the desire to hold one’s resources in liquid form in
order to take advantage of market movements. The notion of holding money for
speculative motive is a new typically keynesian idea. Money held under the
speculative motive serves as a store of value as money held under the precautionary
motive does. But it is a store of money meant for a different purpose.

Conclusion:
Thus, the amount of money required to be held under the various motives constitutes
the demand for money. It may be borne in mind that, in economic analysis, demand
for money is the demand for the existing stock of money which is available to be
held. It is stock of money not a flow of it over time.

Supply of Money:

We have described the demand for money as the demand for the stock (not flow) of
money to be held. The flow is over a period of time and not at a given moment. In
the case of commodity, it is a flow. Goods are being continually produced and
disposed of. This is the essential difference between the demand for money and the
demand for a commodity.

Similarly, the supply of money conforms to the ‘stock’ concept and not the ‘flow’
concept. Just as the demand for money is the demand for money to hold, similarly,
the supply of money means the supply of money to hold. Money must always be
held by someone, otherwise it cannot exist. Hence, the supply of money means the
sum total of all the forms of money which are held by a community at any given
moment.

The stock of money, which constitutes the supply of it, consists of (a) metallic money
or coins, (b) currency notes issued by the currency authority of the country whether
the Central bank or the government, and (chequable bank deposits. In old times, the
coins formed the bulk of money supply of the country. Later, the currency notes
eclipsed the metallic currency and now the bank deposits in current account
withdraw-able by cheques have overwhelmed all other forms of money.

Besides currency, money supply with the public includes the deposit money, i.e., the
bank balances held in current accounts of the banks. In underdeveloped countries,
the currency, and not the bank deposits, occupies a dominant position, because in
such countries the bulk of commercial dealings are done through cash as a medium
of exchange and not through cheques as in advanced countries.

By adding total currency with the public and the total demand deposits, we get the
total money supply with the public. This shows that the banking habit has steadily
been growing in the country and the time will not be far off when deposit money
will far outstrip the currency money. The total amount of bank deposits in the
country is determined by the monetary policy of the central bank of the country.

Conclusion:
Thus, the supply of money in a country, by and large, depends on the credit control
policies pursued by the banking system of the country.

• Monetary policy has an effect on the money supply as well.

o Expansionary policy raises the total supply of money in the economy
faster than usual, while contractionary policy raises the total supply
of money more slowly than usual.
o Expansionary policies are used to combat unemployment, whereas
contractionary policies are used to slow inflation.
Conclusion
• The demand for money is the amount of money that is held under various
motives.
• It should be remembered that in economics, demand for money refers to the
demand for the existing stock of money that is available to be held. It is a
stock of money, not a flow of it over time.
• The supply of money in a country is largely determined by the credit control
policies pursued by the country's banking system

How Central Banks Control the Supply of Money

If a nation’s economy were a human body, then its heart would be the central bank.
And just as the heart works to pump life-giving blood throughout the body, the
central bank pumps money into the economy to keep it healthy and growing.
Sometimes economies need less money, and sometimes they need more.
The methods central banks use to control the quantity of money vary depending on
the economic situation and power of the central bank. In the United States, the
central bank is the Federal Reserve, often called the Fed. Other prominent central
banks include the European Central Bank, Swiss National Bank, Bank of England,
People’s Bank of China, and Bank of Japan.

Let's take a look at some of the common ways that central banks control the money
supply—the amount of money in circulation throughout a country.

• To ensure a nation's economy remains healthy, its central bank regulates the
amount of money in circulation.
• Influencing interest rates, printing money, and setting bank reserve
requirements are all tools central banks use to control the money supply.
 • Other tactics central banks use include open market operations and
quantitative easing, which involve selling or buying up government bonds and
securities.

Why the Quantity of Money Matters

The quantity of money circulating in an economy affects both micro- and

macroeconomic trends. At the micro-level, a large supply of free and easy money
means more spending by people and by businesses. Individuals have an easier time
getting personal loans, car loans, or home mortgages; companies find it easier to
secure financing, too.

At the macroeconomic level, the amount of money circulating in an economy affects

things like gross domestic product, overall growth, interest rates, and unemployment
rates. The central banks tend to control the quantity of money in circulation to
achieve economic objectives and affect monetary policy.

Set the Reserve Requirement

One of the basic methods used by all central banks to control the quantity of money
in an economy is the reserve requirement. As a rule, central banks mandate
depository institutions (that is, commercial banks) to keep a certain amount of funds
in reserve (stored in vaults or at the central bank) against the amount of deposits in
their clients' accounts.

Thus, a certain amount of money is always kept back and never circulates. Say the
central bank has set the reserve requirement at 9%. If a commercial bank has total
deposits of $100 million, it must then set aside $9 million to satisfy the reserve
requirement. It can put the remaining $91 million into circulation.

When the central bank wants more money circulating into the economy, it can reduce
the reserve requirement. This means the bank can lend out more money. If it wants
to reduce the amount of money in the economy, it can increase the reserve
requirement. This means that banks have less money to lend out and will thus be
pickier about issuing loans.

Central banks periodically adjust the reserve ratios they impose on banks. In the
United States (effective January 1, 2022), smaller depository institutions with net
transaction accounts up to $32.4 million are exempt from maintaining a reserve.
Mid-sized institutions with accounts ranging between $32.4 million and $640.6
million must set aside 3% of the liabilities as a reserve. Institutions with more than
$640.6 million have a 10% reserve requirement.

Influence Interest Rates

In most cases, a central bank cannot directly set interest rates for loans such as
mortgages, auto loans, or personal loans. However, the central bank does have
certain tools to push interest rates towards desired levels. For example, the central
bank holds the key to the policy rate—the rate at which commercial banks get to
borrow from the central bank (in the United States, this is called the federal discount
rate).

When banks get to borrow from the central bank at a lower rate, they pass these
savings on by reducing the cost of loans to their customers. Lower interest rates tend
to increase borrowing, and this means the quantity of money in circulation increases.

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