Role of Central Banks 4.4.3 Flashcards
Role of Central Banks
- Implementation of monetary policy
- Banker to the government
- Banker to the banks – lender of last resort (If banks experience liquidity problems, they can turn to the central bank to sell their illiquid assets or to take a loan in the short term)
- Role in regulation of the banking industry
Examples of central banks
- Bank of England (UK)
- European Central Bank (ECB) for all member nations of the Euro Area
- United States Federal Reserve (The Fed)
- Bank of Japan (BOJ)
- Reserve Bank of Australia (AUD)
- Reserve Bank of New Zealand (NZD)
What are the main functions of a central bank?
- monetary policy function
- financial stability and regulatory function
- policy operation functions
- debt management
Monetary policy function:
o Setting of the main monetary policy interest rate (base rate)
o Deciding on whether to use and the scale of quantitative easing (QE).
o Possible exchange rate intervention in a managed floating or fixed currency system.
Financial stability & regulatory function:
o Supervision of the stability of the wider financial system.
o Prudential policies designed to maintain financial stability during times of crisis and high volatility
Policy operation functions:
o Lender of last resort to the banking system when commercial banks face a liquidity crisis.
o Managing liquidity in the commercial banking system so that they continue to lend to each other.
o Overseeing the payments systems used by banks / retailers / credit card companies.
Debt management:
o Handling the issue and redemption of issues of government debt (bonds) of differing maturity.
Case for maintaining very low interest rates part 1
- Inflationary pressures in many advanced countries have remained weak giving little justification for raising interest rates to control inflationary pressures.
- Some economists argue that the Phillips Curve has flattened, i.e. the trade-off between unemployment and inflation has weakened, this implies that an economy can operate at a higher level of aggregate demand and employment without risking an acceleration of inflation.
- Maintaining low interest rates help to stimulate capital investment which increases a country’s long-run productive potential.
Case for maintaining very low interest rates part 2
- Low interest rates as part of an expansionary monetary policy have been helpful in supporting aggregate demand and output during an era of fiscal austerity in many developed countries.
- Keeping interest rates low may have helped to reduce the risks of price deflation and contributed to maintaining a competitive currency which has helped export industries.
drawbacks from very low interest rates part 2
- Higher interest rates will increase the return to saving – raising effective disposable incomes for retirees.
- Higher interest rates reduce the risk of malinvestment by business that only goes ahead because of the cheap cost of capital.
- Interest rates need to rise moderately now so that central banks can cut them in the event of a negative external shock. They need to give themselves some leeway when the economy next experiences a recession
Risks from raising interest rates part 1
High levels of unsecured debt – there is a risk of a significant slowdown in consumption if retail credit becomes more expensive to service e.g. expensive credit cards. In the UK consumer credit is well above £200 billion.
* Higher interest rates might choke off business investment e.g. in new house-building and renewable energy capacity.
Risks from raising interest rates part 2
- A rise in interest rates might cause the sterling exchange rate to appreciate
- Higher interest rates make government debt more expensive.
- Higher interest rates might lead to an economic slowdown, pension fund assets and dividend incomes.
A liquidity trap occurs when
the nominal (or money) interest rate is close or equal to zero, and central banks find that they have run out of room to stimulate aggregate demand during a slowdown or a recession.
Who are the main regulators of the UK financial system?
- Financial Policy Committee (FPC)
- Prudential Regulation Authority (PRA)
- Financial Conduct Authority (FCA)
- Competition and Markets Authority (CMA)
What are the main aims of financial market regulation
- protect against the consequences of market failure
- encourage confidence in the economy and government
- allow the central bank to perform its other roles such as lender of last resort
