Chapter 15

Money, Banking, and Financial Markets:

Central Banks in the World Today

©2010 McGraw-Hill Ryerson Ltd.Tim Berry, Humber College

Central Banks:The Big Questions

1. What is the role of the central bank?2. What are the central bank’s

objectives?3. How are successful central bank’s

organized?

©2010 McGraw-Hill Ryerson Ltd.15-2

Central Banks:Roadmap

• The origins and roles of central banks• Central bank objectives• Designing a successful central bank

©2010 McGraw-Hill Ryerson Ltd.15-3

Central Banks:Origins and Roles

• There are about 170 central banks in the world today. Nearly every country has one.

• When the Soviet Union collapsed in 1990, 12 of the 15 republics had central banks within a year

©2010 McGraw-Hill Ryerson Ltd.15-4

Central Banks:Origins and Roles

• Special type of financial intermediary• Origin:–To provide for government finance–Originally private institutions

• Roles–Government’s bank–Banker’s bank

©2010 McGraw-Hill Ryerson Ltd.15-5

Central Banks:Origins and Roles

• Bank of Canada was created in 1934 – during the Great Depression• In the US there had been thousands of

bank failures and bank runs• During this time no bank failures or

runs occurred in Canada

©2010 McGraw-Hill Ryerson Ltd.15-6

Central Banks:Functions of a Central Bank

• Determines and manages monetary policy

• Central banks create money- they print currency

• Control availability of money and credit

©2010 McGraw-Hill Ryerson Ltd.15-7

• Counterfeiting has been used as a weapon in wartime

• Goal to destabilize enemy’s currency

• Without a stable currency it is difficult for an economy to run efficiently

©2010 McGraw-Hill Ryerson Ltd.15-8

Central Banks: Functions of a Central Bank

• Operate interbank payments network

• Provide loans during periods of crisis

• Oversee financial intermediaries to insure safety and soundness

©2010 McGraw-Hill Ryerson Ltd.15-9

Functions of a Modern Central Bank

©2010 McGraw-Hill Ryerson Ltd.15-10

©2010 McGraw-Hill Ryerson Ltd.15-11

Central Bank Objectives:Stability

• Low and stable inflation• High and stable growth• Stable financial markets• Interest-rate stability• Exchange-rate stability

Central Bank Objectives:Low and Stable Inflation

• Strives to eliminate inflationA dollar should always be worth a dollar– Prices are central to a market economy.

Allocating resources to their best uses– Inflation makes it more difficult to tell –High inflation is less predictable

©2010 McGraw-Hill Ryerson Ltd.15-12

• High inflation is volatile inflation• Volatile inflation means more risk• Risk requires compensation• High inflation means a higher risk

premium, so higher loan rates• Volatile inflation makes long-term planning

difficult

©2010 McGraw-Hill Ryerson Ltd.15-13

Central Bank Objectives:High and Stable Real Growth

• Support maximum sustainable growth• Stable countries grow faster–Unstable growth creates risk–Unstable growth drives up interest rates–Higher interest rates me lower borrowing– Less borrowing means less investment– Less investment means less growth

©2010 McGraw-Hill Ryerson Ltd.15-14

Central Bank Objectives:Financial System Stability

• When the financial system collapses, everything else goes with it.

• Can’t get car loans or mortgages

• Banks cease to operate properly

(Application of value-at-risk)

©2010 McGraw-Hill Ryerson Ltd.15-15

Central Bank Objectives: Interest-Rate Stability

• Stable interest rates make economic decisions easier

• Stable short-term interest rates reduce risk premium on long-term interest rates

©2010 McGraw-Hill Ryerson Ltd.15-16

Central Bank Objectives: Exchange-Rate Stability

• The more open an economy, the more important it is

• Makes cost of imports and revenue from exports more predictable

©2010 McGraw-Hill Ryerson Ltd.15-17

Central Bank Objectives:Summary

©2010 McGraw-Hill Ryerson Ltd.15-18

• Bank of Canada controls short-term interest rates

• News about future short-term interest rate affects long-term interest rates

• When long-term interest rates change, so do car loan and mortgage rates

YOUR FINANCIAL WORLDDoes News about the Bank of Canada Affect Your Daily Life?

©2010 McGraw-Hill Ryerson Ltd.15-19

Creating a Successful Central Bank

• Independence

• Decision-making framework

• Accountability, transparency and communication

©2010 McGraw-Hill Ryerson Ltd.15-20

Central Bank Design:Independence

• Central banks need to be independent of political pressure• Politicians have an incentive to create

short-term prosperity at the expense of inflation tomorrow.• Longer time horizon needed to avoid

“inflation bias”©2010 McGraw-Hill Ryerson Ltd.15-21

Independent Central Banks Deliver Low Inflation

What drove politicians to give up control over monetary policy?

Realization that independent central bankers would deliver low inflation.

©2010 McGraw-Hill Ryerson Ltd.15-22

Central Bank Design:Decision-Making Framework

• Should policy be made by an individual or by a committee? - Committees provide safeguards against putting the wrong person in charge

©2010 McGraw-Hill Ryerson Ltd.15-23

Central Bank Design: Accountability, Transparency and Communication

• Central Bank independence is inconsistent with representative democracy• Solution:–Give central bankers clear objectives–Public reporting of progress in achieving

objectives

©2010 McGraw-Hill Ryerson Ltd.15-24

Central Bank Design:Policy Tradeoffs

• Can’t always have everything at once– Sometimes the economy is hit by a shock

that drives inflation and growth in opposite directions– Creates a tradeoff– Central bankers must be honest about the

fact that goals are sometimes in conflict

©2010 McGraw-Hill Ryerson Ltd.15-25

Central Bank Design:Summary

©2010 McGraw-Hill Ryerson Ltd.15-26

Central Banksand Fiscal Policy

• In emerging market countries like Brazil and Argentina, fiscal policy problems can make it impossible for central bankers to keep inflation low

©2010 McGraw-Hill Ryerson Ltd.15-27

Central Banksand Fiscal Policy

• Fiscal authorities have three sources of funds:– Taxes–Borrowing–Money printing

• The first two work only up to some limit• If the budget is unsustainable, force

money printing©2010 McGraw-Hill Ryerson Ltd.15-28

Central Banks and Fiscal Policy:Argentina in 2002

• Financial collapse tied to the regional government’s issuance of their own currency

• Made it so that the Central Bank of Argentina was helpless

©2010 McGraw-Hill Ryerson Ltd.15-29

Web Links

Bank of CanadaBank of CanadaFederal Reserve SystemFederal Reserve SystemBank of EnglandBank of EnglandEuropean Central BankEuropean Central BankBank of Japan (English)Bank of Japan (English)Reserve Bank of AustraliaReserve Bank of AustraliaReserve Bank of New ZealandReserve Bank of New ZealandBanco de Mexico (English)Banco de Mexico (English)

©2010 McGraw-Hill Ryerson Ltd.15-30

Chapter 15Money, Banking, and

Financial Markets:Central Banks in the World

Today

End of Chapter

©2010 McGraw-Hill Ryerson Ltd.Tim Berry, Humber College