The Government's Bank
• The central bank started out as the
government’s bank, originally created by
rulers to finance wars
• However, the early examples are really
the exceptions, as central banking is
largely a 20th century phenomenon.
• The central bank occupies a privileged
position: it has a monopoly on the
issuance of currency
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McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Money and
Banking
Lecture 30
15-2
Review of the Previous Lecture
• Banking Crisis
• Sources of Runs, Panics and Crisis
• Government Safety Net
• Government as lender of last resort
15-3
Topics under Discussion
• Central Bank:
• The Government’s Bank
• The Bankers’ Bank
• Objectives
15-4
www.sbp.org.pk
15-5
The Government's Bank
• The central bank started out as the
government’s bank, originally created by
rulers to finance wars
• However, the early examples are really
the exceptions, as central banking is
largely a 20th century phenomenon.
• The central bank occupies a privileged
position: it has a monopoly on the
issuance of currency
15-6
• The central bank creates money and
thereby controls the availability of money
and credit in a country’s economy
• Most central banks go about this by
adjusting short-term interest rates, an
activity called monetary policy.
• In today’s world, central banks use
monetary policy to stabilize economic
growth and inflation.
15-7
• An expansionary or accommodative policy
(lower interest rates) raises growth and
inflation; tighter or restrictive policy
reduces them.
• Governments want to control the printing
of money because it is a very profitable
business; also, losing control of the
amount of currency means losing control
of inflation.
15-8
The Bankers' Bank
• The most important day-to-day jobs of
the central bank are to:
• provide loans during times of financial stress
(the lender of last resort).
• manage the payments system (settles
interbank payments).
• oversee commercial banks and the financial
system (handles the sensitive information
about institutions without conflicts of
interest).
15-9
• By ensuring that sound banks and
financial intermediaries can continue to
operate, the central bank makes the whole
financial system more stable.
• Central banks are the biggest and most
powerful players in a country’s financial
and economic system and are supposed
to use this power to stabilize the economy,
making us all better off.
15-10
• However, central banks that are under
extreme political pressure, or that are
simply incompetent, can wreak havoc on
the economic and financial systems.
• A central bank does not control :
• securities markets.
• the government’s budget.
15-11
• The common arrangement today is for
the central bank to serve the government
in the same way that a commercial bank
serves a business or an individual.
15-12
The Functions of a Modern Central Bank
The Government’s Bank
A: Manages the finances of the Govt.
B: Controls the availability of money and credit
through interest rates
The Bankers’ Bank
A: Guarantees that sound banks can do business by
lending to them even during crisis
B: Operates a payment system for interbank
payments
C: Oversees financial institutions to ensure
confidence in their soundness
15-13
Stability: The Primary Objective of All
Central Banks
• When economic and financial systems are left on
their own they are prone to episodes of extreme
volatility; central bankers work to reduce that
volatility
• Central bankers pursue five specific objectives:
• low and stable inflation
• high and stable real growth, together with high
employment
• stable financial markets
• stable interest rates
• a stable exchange rate
15-14
• Instability in any of those would pose an
economy-wide economic risk that
diversification could not mitigate.
• Thus the job of the central bank is to
improve general economic welfare by
managing and reducing systematic risk.
• It is probably impossible to achieve all five
of these objectives simultaneously, and so
tradeoffs must be made
15-15
Low, Stable Inflation
• Many central banks take as their primary
job the maintenance of price stability; they
strive to eliminate inflation.
• The rationale for keeping the economy
inflation-free is that money’s usefulness as
a unit of account and as a store of value is
enhanced when its purchasing power is
maintained.
15-16
• Inflation degrades the information
content of prices and impedes the
market’s function of allocating resources
to their best uses.
• The higher the inflation is, the less
predictable it is, and the more systematic
risk it creates.
• Also, high inflation is bad for growth.
15-17
• While there is agreement that low inflation
should be the primary objective of
monetary policy, there is no agreement on
how low inflation should be.
• Zero inflation is too low, because it brings
the risk of deflation (a drop in prices)
which in turn results in increased defaults
on loans and a threat to the health of
banks.
15-18
• Furthermore, if inflation were zero, an
employer wishing to cut labor costs would
need to cut nominal wages, which is
difficult to do.
• A small amount of inflation may actually
make labor markets work better, at least
from the employer’s point of view.