Central banks
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This presentation was delivered during a weekly tutorial for a Banking and Finance class at SOAS, university of London. It explains what the main functions of central banks are and what challenges they face in current times.
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Central banks
- 2. What are the main functions of a central bank? 2License: CC0 Public Domain Free for commercial use / No attribution required What are the current challenges for central banks?
- 4. monetary policy development issue notes lender of last resort 4 regulation
- 6. 6 lender of last resort banker to banks https://commons.wikimedia.org/wiki/File%3AShakespeare's_comedy_of_the_Merchant_of_Venice_(1914)_(14578617707).jpg
- 8. 8 discount rate License: CC0 Public Domain Free for commercial use / No attribution required
- 9. 9License: CC0 Public Domain Free for commercial use / No attribution required
- 10. 10License: CC0 Public Domain
- 11. 11License: CC0 Public Domain Free for commercial use / No attribution required
- 12. 12License: CC0 Public Domain Free for commercial use / No attribution required
- 13. 13License: CC0 Public Domain Free for commercial use / No attribution required limit credit expansion
- 14. 14License: CC0 Public Domain Free for commercial use / No attribution required credit growth deflation
- 15. 15Photo by samuiblue. Published on 23 February 2013 Stock photo - Image ID: 100141740
- 16. extra resources • http://www.preservearticles.com/201012281868/functions-of-central- bank.html • http://www.dineshbakshi.com/igcse-gcse-economics/individual-as- producer-consumer/revision-notes/1275-functions-of-central-bank (there is a nice video on money supply control and short videos about the ECB). • http://www.bis.org/publ/othp04_2.pdf • https://www.imf.org/external/np/speeches/2010/061810.htm • https://ideas.repec.org/b/sea/spaper/sp80.html • https://www.boj.or.jp/en/announcements/press/koen_2014/data/ko140109 a1.pdf 16
- 17. 17Photo by Stuart Miles. Published on 25 February 2013 Stock photo - Image ID: 100142338
Editor's Notes
- By the end of the presentation we will answer two questions: What are the functions of a central bank? I will list 9 of these. What are the current challenges for central banks? I will outline 5 of these.
- Today we associate central banks with different functions. We need to remember that these are the result of a historical evolution of the role central banks played in the economy. The majority of central banks is new.
- This is a timeline that shows how they have evolved. We go from the simple function of issuing notes, through monetary policy to end up with the latest ideas about supporting development. We will see them one by one and compare with what CBs do today.
- The progenitor of banks were initially issuers of banknotes and to this extent they were bankers to the government. These two functions are still part of what central banks do but in different ways. Today central banks are legal tenders (which means that they are given the authority to print money by law). Thanks to this, they can do three things control the money supply; make the system uniform and give credibility and prestige to the currency; avoid political interference and irregularities in the issuing of money. Moreover, CBs act as bankers to the government. They do what a commercial bank does for its customers: They receive deposits from the government and lend money to pay debt. They provide cash to pay government salaries. They also provide foreign exchange to purchase foreign goods or make payments. In addition, CBs have a third function: they are agents for the government: They act on behalf of the government when collecting taxes. They also represent the government in front of international institutions. Finally, they have a fourth function: they are advisors to the government. They advice the government on financial, fiscal, monetary and general economic matters.
- Over time, CBs started acting as lenders of last resort in case a customer bank had low liquidity. However, they were motivated by mere commercial self-interests. Today CBs act as lenders of last resort (5th function) for different reasons. They help banks in difficulty because of low liquidity in order to ensure the stability of the financial system. In particular they try to spread and maintain confidence about the working of the system, in order to avoid bank runs or bankruptcy. Moreover, they act as bankers of the commercial banks (6th function). They keep cash reserves of the banks and represent the clearing agent (they settle claims between banks).
- Let’s now jump at more recent times. With the collapse of the gold standard system, CBS became predominantly focused on ensuring internal and external stability of the currency. They managed monetary policy. Today this is a core function of CBs (and the 7th on our list). They control money supply with three tools.
- discount rate; open market operations; reserve requirements. The discount rate is the rate of interest at which the CB lends money to commercial banks. It represents the cost of borrowing for banks. In theory cheap credit for the banks should stimulate investment and hence promote growth. OMO consist of buying and selling government securities. Selling government bonds reduces the amount of money circulating in the economy. The central bank also sets reserve requirements, reserve ratios (i.e.: a. the % of total deposits that commercial banks must keep as reserves). The reserve requirements affects how much money can be created in the system. A higher ratio, implies that banks can lend less of what they have deposited, hence this reduces their power to create money through the multiplier.
- After the second WW many european central banks to the formal responsibility of regulation and overseeing the financial system.
- Changing attitudes towards the government led many central banks to take the role of promoters of economic development. Directly or via the banking system they finance sectors that were targeted by governments for rapid industrialisation.
- Now we get to the more interesting question. CBs perform all this functions we looked at in a very challenging climate. I will now outline 5 challenges.
- One challenge is that of predicting and forecasting the course of economic events. Globalisation of trade, output and finance make growth and inflation functions of global trends. hence, traditional model of economic relationships become weaker. Moreover, because economies and financial markets are now so interdependent there might be elements that are out of the direct control of a central bank in one specific country or region. This has led many to think that we need regional or international coordination.
- Challenge number 3. Because of the particular global financial environment, many CBs have important financial stability mandates. They have to use macro- prudential tools to face risks. These have three objectives: limit credit expansion (the tools here are reserve requirements and credit ceilings); maintain the quality of loans through regulations (the tools are debt to income ratios or improved credit information); strengthen the resilience of the system (the tools are make assets and liabilities stronger in front of balance sheet shocks asking for capital adequacy requirements and rules on the composition and types of foreign borrowings).
- A 4th challenge that CBs across the world had to face in recent times has been slow credit growth. It has been negative in the Euro area and the UK and slow in the US and Japan. The 5th challenge is the deflationary trends. This is particularly bad in the Euro area because of high unemployment and negative output gap. It is less of a concern for the US because of some economic growth in recent times.
- In conclusion, we have seen that CBs have 9 main functions (legal tenders, bankers to the government, agents to the government, advisors to the government, lenders of last resort, bankers to the banks, monetary policy, regulators and supervisors, development promoters. They operate in challenging times. Mainly because of unpredictability of new global trends and interdependence of financial markets. Moreover, they are in charge of implementing macro prudential tools. Finally, they deal with deflation and slow credit growth in times of slowdown.
- Here there are a few extra resources I used that you might find interesting to learn more on the topic and go over the things I did not have time to cover.