Introduction to Banking

Lecturer: Israfil Isgandarov

Department: Economics
Chapter 5.
Theory of central banking
Learning objectives
 To understand the crucial role of central banks in the
financial sector
 To describe the main functions of the central bank
 To understand the monetary policy functions of central
banks
 To understand the arguments put forward by the free
banking theorists
 To discuss the arguments for and against an
independent central bank
Introduction
 The core functions of central banks in
any countries are:
 to manage monetary policy with the aim of
achieving price stability;
 to prevent liquidity crises, situations of money
market disorders and financial crises;
 and to ensure the smooth functioning of the
payments system.
Introduction
 What are the monetary policy functions of a
central bank?
 Why do banks need a central bank? and
 Should central banks be independent from
government?
What are the main functions of a
central bank?
 A central bank can generally be defined as a financial
institution responsible for overseeing the monetary system
for a nation, or a group of nations, with the goal of fostering
economic growth without inflation.

1. The central bank controls the issue of notes and coins

(legal tender).

2. It has the power to control the amount of credit-money

created by banks

3. A central bank should also have some control over

non-bank financial intermediaries that provide credit
What are the main functions of a
central bank?
4. Encompassing both parts 2 and 3, the central bank should
effectively use the relevant tools and instruments of
monetary policy in order to control:
 a) credit expansion;
 b) liquidity; and
 c) the money supply of an economy.

5. The central bank should oversee the financial sector in

order to prevent crises and act as a lender-of-last-resort
in order to protect depositors, prevent widespread panic
withdrawal, and otherwise prevent the damage to the
economy caused by the collapse of financial institutions.
What are the main functions of a
central bank?
6. The central bank also acts as the official agent to the
government in dealing with all its gold and foreign
exchange matters.
How does monetary policy work?
 There are five major forms of economic policy (or, more
strictly macroeconomic policy) conducted by governments
that are of relevance

 Monetary policy is concerned with the actions taken by

central banks to influence the availability and cost of
money and credit by controlling some measure (or
measures) of the money supply and/or the level and
structure of interest rates.
How does monetary policy work?
 There are five major forms of economic policy (or, more
strictly macroeconomic policy) conducted by governments
that are of relevance
 Fiscal policy relates to changes in the level and
structure of government spending and taxation designed
to influence the economy.
 An expansionary fiscal policy
 A contractionary fiscal policy
 Exchange rate policy involves the targeting of a
particular value of a country’s currency exchange rate
thereby influencing the flows within the balance of
payments.
How does monetary policy work?
 A prices and incomes policy is intended to influence
the inflation rate by means of either statutory or
voluntary restrictions upon increases in wages,
dividends and/or prices.;
 National debt management policy is concerned with
the manipulation of the outstanding stock of government
debt instruments held by the domestic private sector
with the objective of influencing the level and structure of
interest rates and/or the availability of reserve assets to
the banking system.
Monetary policy functions of a central
bank
 The most important function of any central bank is to
undertake monetary control operations. Typically, these
operations aim to administer the amount of money (money
supply) in the economy and differ according to the monetary
policy objectives they intend to achieve.
 Typically, the most important long-term monetary target of a
central bank is price stability that implies low and stable
inflation levels.
Monetary policy functions of a
central bank
 Common for central banks to exercise direct controls on bank
operations by setting limits either to the quantity of deposits
and credits (e.g., ceilings on the growth of bank deposits and
loans), or to their prices (by setting maximum bank lending or
deposit rates).
 Indirect instruments influence the behaviour of financial
institutions by affecting initially the central banks’ own balance
sheet. In particular, the central bank will control the price or
volume of the supply of its own debt (reserve money), which in
turn will affect interest rates and the amount of money and
credit in the entire banking system.
Monetary policy functions of a
central bank
 The indirect instruments used by central banks in
monetary operations are generally classified into
the following:
 Open market operations (OMOs);
 Discount windows (also known as ‘standing
facilities’); and
 Reserve requirements.
Monetary policy functions of a
central bank
Debt securities and open market
operations
 Debt instruments are mainly represented by treasury securities (its
government debts) used by central banks in open market
transactions.
 Open market operations to influence short-term interest rates
are as follows
 they are initiated by the monetary authorities who have
complete control over
 the volume of transactions;
 open market operations are flexible and precise – they can be
used for major or
 minor changes to the amount of liquidity in the system;
 they can easily be reversed;
 open market operations can be undertaken quickly.
Debt securities and open market
operations
 The central bank operates in the market and buy or sells
state debt to the non-bank private sector.
 In general, if the central bank sells state debt, the money
supply falls (all other things are equal) because money is
removed from bank accounts and other sources to buy
other securities. This leads to an increase in short-term
interest rates.
 In case the state buys back the state debt, it results in the
injection of money into the system and short-term interest
rates decrease.
Loans to banks and the discount
window
 The second most important monetary policy tool of a central bank is
the so-called ‘discount window’
 This is a tool that allows appropriate bank institutions to borrow from
the central bank to meet their short-term liquidity needs.
 By changing the discount rate, the interest rate that monetary
authorities are ready to lend to the banking system, the central bank
can control the money supply in the system.
 For example, the central bank is increasing the discount rate, banks
will be more expensive to borrow from the central bank, so they will
be borrowed less and thus will cause the money supply to fall.
Debt securities and open market
operations
 For instance, the Eurozone’s discount rate is known as a ‘marginal
lending facility’, which offers overnight credit to banks from the Eurosystem
 In the United States, when the Federal Reserve System was established,
borrowing of reserve funds from the discount window aimed to be the most
important instrument of central banking transactions.
Reserve requirements
 If reserve level of one bank falls below minimum level, it is
required to obtain additional reserve assets to apply for loans or
extend credit opportunities.
 If authorities establish a reserve requirement that exceeds the
organization's required reserve levels, as a result, they will have to
diminish their lending and / or acquire additional reserve assets.
 This will lead to higher interest rates and reduced demand for loans,
which will hinder the growth in money supply.
 This fraction is often expressed in percentages and is therefore called
the required reserve ratio: The higher the required reserve rate, the
lower the amount of funds available to banks.
Debt securities and open market
operations
 If the authorities regularly make decisions about changing
reserve requirements it can cause problems for the liquidity
management of banks.
 Reserve requirements are often referred to as instruments of
portfolio constraint.
 Why do banks need a central
bank?
 The banking sectors of most countries have a pyramid structure where a central bank is at
the apex and the ordinary banking institutions are at the base of the pyramid. Responsible
for both ‘macro’ functions, such as monetary policy decisions; and ‘micro’ functions,
including the lender-of-last resort (LOLR) assistance of the banking sector
 The lender-of-last-resort (LOLR) function of the central bank
 LOLR function of a central bank that is often subject to controversial debates and criticisms because
it implies direct intervention of the monetary authorities in the banking markets
 The free-banking hypothesis
 Free banking theorists argue that regulation should be left to the market. Therefore, they object to a
single central bank being given the ‘privilege’ – or monopoly – in issuing banknotes.
 In Goodhart’s view central banks are needed for two main reasons. First, because banks provide
two essential functions: they operate the payment systems and undertake portfolio management
services.
Should central banks be
independent?
 Theoretical studies seem to suggest that central bank independence is
important because it can help produce a better monetary policy. For
example, an extensive body of literature predicts that the more independent
a central bank, the lower the inflation rate in an economy.
 Central bank independence can be defined as independence from political
influence and pressures in the conduct of its functions, in particular
monetary policy.
 It is possible to distinguish two types of independence: goal
independence, that is, the ability of the central bank to set its own goals for
monetary policy (e.g., low inflation, high production levels); and instrument
independence, that is, the ability of the central bank to independently set
the instruments of monetary policy to achieve these goals
Should central banks be
independent?