CHAPTER 8 – PART 1

CENTRAL BANK

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 CONTENT

DEFINITION

CENTRAL BANK INDEPENDENCE

FUNCTIONS OF CENTRAL BANK

 CENTRAL BANK
DEFINITION

Central bank is an authority in charge of issuing currency,

providing financial and banking services for government and
banking system, as well as implementing monetary policy.
 CENTRAL BANK
CENTRAL BANK DEPENDENT ON GOVERNMENT

GOVERNMENT

Monetary Policy Committee

CENTRAL BANK
CENTRAL BANK

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 CENTRAL BANK
CENTRAL BANK DEPENDENT ON GOVERNMENT

§ Central bank is a ministerial –level Advantages:

agency of the Government (i) Easy for Government to
§ Directly under control of centralize funds from Central
government in terms of: bank to upgrade infrastructure
appointing staffs, setting budget, and invest to the economy.
implementing monetary policy… (ii) Enhance effective coordination
§ Eg: NICs (Singapore, Korea, between monetary and fiscal
Taiwan…) policy.
Disadvantages:
Low independence of central bank;
monetary policy may become less
effective.
 CENTRAL BANK
CENTRAL BANK INDEPENDENT FROM GOVERNMENT

CONGRESS

CENTRAL BANK GOVERNMENT

Monetary policy tools: Law, administrative tools:

- Reserve Requirements - Budgeting
- Lending facilities - Public economics
- Open market operations - Transfer payment, insurance

Targets:
- Price stability
- High employment
- Economic growth
 CENTRAL BANK
CENTRAL BANK INDEPENDENT FROM GOVERNMENT
 CENTRAL BANK
CENTRAL BANK INDEPENDENT FROM GOVERNMENT
CENTRAL BANK

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 CENTRAL BANK
CENTRAL BANK INDEPENDENT FROM GOVERNMENT

§ Central bank has same level as Advantages: The more

Government, both agencies are independent Central bank is, the
under control of Congress more effective monetary policy
§ Central bank can implement is.
monetary policy without
influences of budget stance or
political decisions. Disadvantages: Difficult for
§ Eg: Fed, ECB, BOJ, Swiss National Government to centralize
Bank, Banque de France resources for economic and
infrastructural development
 CENTRAL BANK INDEPENDENCE
• Central bank independence refers to the freedom of monetary
policymakers from direct political or governmental influence in
the conduct of policy.
• The literature on central bank independence has defined a
number of types of independence. The most important ones are:
§Legal independence
§Policy independence
§Management independence
 CENTRAL BANK INDEPENDENCE
• Legal independence:
§The independence of the central bank is enshrined in law.
§Central bank may be accountable at some level to government, or
directly to a legislature.
§Legislation provides a framework within the government and the
central bank work out their relationship.
 CENTRAL BANK INDEPENDENCE
• Policy independence includes goal and instrument (operational)
independences.
§Goal independence: The central bank has the ability to set its
monetary policy goals. Normally, central banks prefer to announce
their policy goals in partnership with the appropriate government
authority. The setting of common goals by the central bank and the
government helps to avoid situations where monetary and fiscal
policy are in conflict.
 CENTRAL BANK INDEPENDENCE
§Instrument (Operational) independence: The central bank
has the ability to determine the best way of achieving its policy
goals, including the types of instruments used and the timing of
their use. This is the most common form central bank
independence.
 CENTRAL BANK INDEPENDENCE
• Management independence
§The central bank has the authority to run its own operations
(appointing staff, setting budgets, etc) without excessive
involvement of the government.
§The other form of independence are not possible unless the
central bank has a significant degree of management
independence.
CENTRAL BANK

Source: Alesina and Summers (1993)

FUNCTIONS OF CENTRAL BANK

A monopoly in issuing
monetary base

A bank of credit
institutions

A bank of government
 ISSUE OF MONETARY BASE

Rights:

• Possesses a monopoly in issuing monetary base

• All types of money (banknotes and coins) issued by
central bank are legal means of payment nationwide.

Responsibilities:

• Ensures adequate money supply and determine an

appropriate ratio between banknotes and coins for the
national economy.
 ISSUE OF MONETARY BASE

Why does Central bank have this function?

§Has policy tools to control the currencies in circulation.

§Ensures the coincidence of currencies
§Manages seigniorage profit
ISSUE OF MONETARY BASE

Loans to Government

Loans to commercial banks

Purchases in foreign exchange

market

Purchases in open market

operation
 BANK OF CREDIT INSTITUTIONS
www.themegallery.com

• Credit institutions are treated as central bank’s customers

• Central Bank provides banking services to credit institutions
oCB opens accounts and receives deposits from banks
oCB provides short-term loans to banks
oCB conducts payment transactions within banking system
 BANK OF CREDIT INSTITUTIONS
• Central bank opens a/c and receives deposits from banks
oReserve requirement deposit
oPayment deposit
→ Purpose: Central bank wants to manage reserves in banking
system in order to actively adjust monetary base
 BANK OF CREDIT INSTITUTIONS
• Central bank provides short-term loans to banks (refinancing
facilities)

oRefinancing facilities includes:

Discount financial instruments (discount lending)
Grant loans secured by financial instruments

oPurpose:
Issue monetary base
Supplement liquidity to banking system
Act as the last resort lender of banking system
 BANK OF CREDIT INSTITUTIONS
• Central bank conducts payment transactions within banking
system:
oTransactions among banks
oTransactions between banks and treasury
•Payment methods:
oSeparate payment
oClearing payment
•Purposes
oReduce cost of payment for banking system
oPerceive the change in reserves of banks
 BANK OF GOVERNMENT
• Government is treated as a customer of CB
• CB provides banking services to Government
oOpens account and receives deposits of Treasury. Also provides
Treasury services in terms of collection and payment of cash for
Treasury
oProvides advances for the central budget to deal with a temporary
deficit in the state budget. The amount of advances must be
refunded within fiscal year.
oConducts payment transactions between Treasury and banking
system.
 BANK OF GOVERNMENT
• CB provides other services:
oActs as an agent for Treasury in organizing Treasury bonds and
bills auction and in issuing. Distribute and make payment for
these instruments.
oConsults Government about money and banking operations
(policies, regulations..)
oManages foreign exchange reserves
oRepresents Government at world organizations
oInspects and supervises banking system
 A CENTRAL BANK BALANCE SHEET
ASSETS LIABILITIES
1. Claims on Government 1. Reserve money
2. Claims on commercial § Currency in circulation
banks § Reserve of commercial
3. Claims on foreign banks
institutions 2. Deposit of Treasury
4. Other items 3. Deposit of foreign
institutions
4. Central bank securities
5. Equity capital
 A CENTRAL BANK BALANCE SHEET

ASSETS LIABILITIES
1. Net domestic asset 1. Reserve money
2. Net foreign asset § Currency in circulation
§ Reserve of commercial
banks
2. Non-monetary liabilities
§ Central bank securities
§ Others
3. Equity capital
 FOREIGN EXCHANGE RESERVES
• Foreign exchange reserves include:
oForeign currencies in cash and foreign-currency deposits on
offshore accounts;
oSecurities and other financial instruments in foreign currencies
issued by foreign Governments, foreign organizations or
international organizations; Special drawing rights and reserves at
the International Monetary Fund;
oGold under the State Bank's management;
oOther types of foreign exchange owned by the State.
 (Cont)
• Central bank manages foreign exchange reserves under the law on
foreign exchange in order to:
oImplement the national monetary policy
oEnsure international solvency and the conservation of state
foreign exchange reserves.
CHAPTER 8 – PART 2

MONETARY POLICY

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 OUTLINES

DEFINITION

TARGETS OF MONETARY POLICY

TOOLS OF MONETARY POLICY

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 DEFINITION

Monetary policy is how a central bank control the supply of money

and interest rates in an economy in order to influence output,
employment, and price levels.

Expansionary Contractionary

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MONETARY POLICY FRAMEWORK

THE CASE OF FED

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 MONETARY POLICY FRAMEWORK
THE CASE OF VIETNAM

Tools of Central Policy Intermediate Final Goals

bank Instruments Targets

Open market operations

Refinancing policy Monetary Aggregate
Reserves Price
Reserve Requirement (M2)
Stability
Interest Rate and Bank Credit
Exchange Rate

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MONETARY POLICY FRAMEWORK

Operating Targets
(Policy Instruments)

Intermediate Targets

Final Goals

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 FINAL GOALS

Price Stability

Goals

Economic High
Growth Employment

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 FINAL GOALS
PRICE STABILITY

• Defining as low and stable inflation

• The most important goal of MP
• Indicators: CPI, Core CPI, GDP Deflator

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 FINAL GOALS
ECONOMIC GROWTH

• Increasing in real GDP and having appropriate structure

amongs sectors in economy
• Indicators: GDP growth, GNP growth, economic structure,
competitive capacity

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 FINAL GOALS
HIGH EMPLOYMENT

• Indicator: unemployment rate, the number of new employment

• High employment is a worthy goals since:
oHigh unemployment causes much human misery
oHigh unemployment leads to closed factories, unused
equipment and low GDP

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 FINAL GOALS
HIGH EMPLOYMENT
1. What is the relationship between economic growth and inflation?

2. What is the relationship between high employment and economic growth?

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 FINAL GOALS

The relationship between inflation and economic growth in Vietnam

Economic growth Inflation rate (RHS)

12 80.00

70.00
10
60.00

8 50.00

40.00
6
30.00

4 20.00

10.00
2
0.00

0 -10.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Source: IMF

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 INTERMEDIATE TARGETS

• Intermediate targets stand between the policy

instrument and the goals of MP. They are not as directly
affected by the tools of MP but might be more closely
linked to the goals of MP.

• Eg: Monetary aggregate (M2) or long term interest rate.

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 OPERATING TARGETS

• Operating targets (policy instruments) respond to central

bank’s tools and indicate the stance (easy or tight) of
monetary policy.

• Two basic types of policy instruments:

o Reserve aggregates: total reserves, MB, MBn and BR
o Interest rates: interbank rate (federal fund rate) and
other short term interest rates

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MONETARY POLICY TOOLS

Lending Facilities

Reserve Requirement

Open Market Operations

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 LENDING FACILITIES
DEFINITION
• The facility at which banks and other depository institutions can
borrow reserves from Central Bank.
• In this facility, Central Bank can adjust interest rate (discount rate,
refinancing rate…), financial instruments criteria, credit line, credit
maturity
• Purposes:
o Provide source of liquidity
o Act as Lender of Last Resort

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 LENDING FACILITIES
THE CASE OF FED
The Fed’s discount loans to banks are of three types: primary credit,
secondary credit, and seasonal credit

Source: www.federalreserve.gov
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LENDING FACILITIES
THE CASE OF ECB

Main Refinancing Operations

Marginal Lending Facility

Source: ECB
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LENDING FACILITIES
THE CASE OF VIETNAM

Discount loans

Refinancing loans

Others

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 LENDING FACILITIES
MECHANISMS

Effect on reserves of banking system

• Lower discount rate → ↑ Borrowing from Central Bank → ↑ R → ↑
Lending abilities → ↑ MS

Effect on interbank rate

• Lower discount rate → ↑ Supply for reserves → ↓ interbank rate → ↓
market rates

Change in discount rate brings policy signal to the

market
• Lower discount rate → ↓ market rates

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 LENDING FACILITIES

PROS CONS

§ Not fully
§ Flexible
controlled by CB
relatively
§ Difficult to
§ CB plays role
reverse
of lender of last
§ Misleading
resort
signal

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 RESERVE REQUIREMENT
DEFINITION
Reserve requirements are regulations that require depository
institutions to keep a certain fraction of their deposits in accounts
with the central bank. (Mishkin, 2016)

Tightening
Banking System (RR ratio = 5%)
Expansionary
Assets Liabilities
Cash
Required reserves Deposit
Deposit + $5 + $100

Loans
+ $95

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RESERVE REQUIREMENT

RESERVE REQUIREMENT IN US

Source: www.federalreserve.gov

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 RESERVE REQUIREMENT

RESERVE REQUIREMENT IN ECB

Overnight deposits, deposits with agreed Deposits with agreed maturity or

maturity or period of notice up to 2 years, period of notice over 2 years, repos,
debt securities issued with maturity up to debt securities issued with maturity
2 years, money market paper over 2 years

1% 0%

Source: ECB

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 RESERVE REQUIREMENT
RESERVE REQUIREMENT IN VIETNAM

Deposit in VND Deposit in foreign currency

Type of depository institutions
Below 12 Above 12 Below 12 Above 12
months months months months

- Credit unions
- Microfinance institutions 0% 0% 0% 0%

- Agribank
- Coopbank 3% 1% 7% 5%

- Others
3% 1% 8% 6%

Effective date: 01/06/2018

Source: SBV

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RESERVE REQUIREMENT
RESERVE REQUIREMENT IN VIETNAM

Reserve

Interbank Rate

Cost of Capital

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 RESERVE REQUIREMENT
MECHANISMS
Effect on Reserve
Reserve Excess Lending
MS↓
Ratio ↑ reserve ↓ abilities ↓

Banking System (RR ratio = 5%) Banking System (RR ratio = 10%)
Assets Liabilities Assets Liabilities

Required reserves Deposit Required reserves Deposit

+ $5 + $100 + $10 +$100

Loans Loans
+ $95 +$90

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 RESERVE REQUIREMENT
MECHANISMS
Effect on Reserve

Reserve Money Money

ratio ↑ Multiplier Supply ↓
↓

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 RESERVE REQUIREMENT
MECHANISMS
Effect on Interbank Rate
Reserve Demand for Interbank Market
ratio ↑ reserves ↑ rate ↑ rate ↑

Interbank rate

id RS1

i2
i1

Rd2
ior Rd1

NBR1 Reserves
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 RESERVE REQUIREMENT
MECHANISMS
Effect on Cost of Capital

Reserve Lending Market

Cost of
ratio↑ interest interest
Capital ↑ rate ↑
rate ↑

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RESERVE REQUIREMENT

What are pros and cons of

reserve requirement?

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RESERVE REQUIREMENT

Pros Cons
Very
powerful Inflexible

Same May cause

effects uncertainty

Tax on
banks

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 OPEN MARKET OPERATIONS
DEFINITION
Open market operations (OMO) is a central bank’s buying and
selling of securities in open market in order to provide or
withdraw reserves.

OMOs

Temporary Permanent
transactions transactions

Repurchase
Reverse
agreement
Repo
(Repo)

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OPEN MARKET OPERATIONS

Dynamic open market

operations are intended to
change the level of reserves
and the monetary base.

Defensive open market

operations are intended to
offset movements in other
factors that affect reserves
and the monetary base.

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 OPEN MARKET OPERATIONS
MECHANISMS

CB
purchases
government R↑ Lending
abilities ↑ MS↑
securities

Banking System Central Bank

Assets Liabilities Assets Liabilities

Government Government Reserves +$100

securities -$100 securities +$100
Reserves +$100

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 OPEN MARKET OPERATIONS
MECHANISMS

CB
purchases R↑ Interbank Market
securities rate ↓ rates ↓

Interbank rate

id
RS1
i1
RS2
i2
ier RD

NBR1 NBR2 Reserves

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 OPEN MARKET OPERATIONS
MECHANISMS
Conversely, CB sell goverments securities → R ↓ → Lending abilities ↓
→ MS ↓

Banking System Central Bank

Assets Liabilities Assets Liabilities

Government Government Reserves -$100

securities + $100 securities -$100
Reserves - $100

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 OPEN MARKET OPERATIONS
MECHANISMS

Interbank rate

id
RS2
i2 RS1
i1

RD

NBR2 NBR1 Reserves

CB purchases securities → supply for reserves ↓ → interbank rate

↓ → market rates ↑

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 OPEN MARKET OPERATIONS
PROS

Control ability
• CB can complete control over the volume

Flexible and Precise

• OMOs can be used to enact both small and large changes in
the monetary base
Easily reversed
• Mistakes can be quickly corrected in a way would not have
been possible with reserve requirements or discount lending.
Quickly implemented
• There is no administrative delay to conducting OMOs.

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