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MGT411 - Money & Banking - Lecture Handout 30

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  • 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
  • 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.
  • 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.

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).
  • 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.
  • 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
  • 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.

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
  • 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

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.
  • 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.
  • 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.
  • 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.

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