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The influence of central banks varies according to

1. division of power between related government ministries,
central banks and
other regulatory bodies.

2. will also determine the bank’s importance. 


In the US, the central bank (the Federal Reserve) is

fully independent of the government.


In the UK, the central bank (the Bank of England) is

1. not fully independent
2. does however have power to set
--short-term interest rates,

--does in order to meet
--UK Government’s published inflation target
--of 2% pa
--based on the Consumer Price Index (CPI).


A central bank may be interested in:

1.   monetary, interest rate and inflation policy 

2  banking regulation 

3  implementation of government borrowing 

4  performance and integrity of financial markets 

5  intervention in currency markets 

6  printing and minting of notes and coins, and 

7  taxation.

8. which of these are set by central bank
--in a particular country
(and which truly determined by an independent central bank rather than implementing decisions made by political entities)
--will vary from country to country.


In many states, central banks are now primarily concerned with:

 monetary policy and control: 

1  adjustment of banking sector liquidity 

2  control of money supply growth
--and short-term interest rates. 


In UK, three new regulatory bodies were established:

1  the Financial Policy Committee (FPC) 

2  the Prudential Regulation Authority (PRA) 

3  the Financial Conduct Authority (FCA). 

The PRA and the FCA regulate the UK banking sector
--in a system referred to as “dual regulation”.
---The FPC focuses on
--higher-level systemic risks to the financial system. 


Adjustment of banking sector liquidity is achieved through:

Money Market intervention


Money market intervention is achieved through

1. buying and selling bills
--to influence the level of liquidity within the banking sector and
--short-term interest rates.

2 will include activity
--to stabilise rates
(when cash flows between the government and private sectors would otherwise impinge on bank liquidity).

3. buying and selling of bills is known as open market operations or OMOs.


If the central bank buys bills back from the banks in the money markets:

1. this increases the amount of money in the banking sector
2 allowing the banks to expand the money supply


Similarly, the central bank selling bills

will reduce the money supply.


Non-market controls:
As well as market intervention to control banking sector liquidity and hence money supply,central bank may also use non-market (direct) controls such as:

1  setting minimum liquid reserve ratios 

2  setting interest rate ceilings for bank deposits 

3  issuing directives regarding
--the types of lending to be undertaken. 


What is the main economic variable that the money supply is used to control?



Describe how each of these controls influences the money supply.



Quantitative easing usually means

Printing money


Quantitative Easing (QE) is

1. a monetary policy

2. used by some central banks
3. to increase the supply of money.

4. usually involves both
--a direct increase in the money supply
(ie electronically “printing” money) and
--a knock-on effect
-----from the fractional reserve system,
---increasing the money supply further,

5. although it can involve just making changes to the fractional reserve system.


The fractional reserve system refers to

1. funds received by banks
--- and loaned on to other customers.

2. means that bank reserves are
--only a fraction of the quantity of deposits in the banks.

3. the reserve ratio: is this fraction


QE is usually implemented by:

1. a central bank first crediting its own account
--with money it creates out of nothing
(“ex nihilo”).

2. then purchases financial assets,
--for example,
---government bonds,
---quasi-government debt,
---mortgage-backed securities and
--- corporate bonds,
from banks and other financial institutions

3. this process referred to as “open market operations”.

4. can also involve changing the reserve requirements for banks
--which, through the fractional reserve system,
--would increase the money supply.


How has The use of QE has evolved in recent years?

1. Now CBs typically give a degree of forward guidance
--to the market
--regarding the anticipated levels of QE that ---they intend to conduct
-- in the short to medium term.

2. part of a general evolution in the use of monetary policy,
--whereby communication by central bankers --is increasingly used
--as a monetary policy tool
--to influence the yield curve
--and consequently economic activity.


Forward Guidance is a

1. tool used by some central banks.

2. enables CB to indicate,
--in the absence of any unforeseen events,
--how the central bank believes monetary policy will change
--in the future –
----usually over following 18 to 24 months.

3. is designed to help people see
--- how the central bank sets interest rates
--and thus should reduce uncertainty
--about the future path of monetary policy.


The central bank controls short-term interest rates (here “short-term” means up to a month or so) through:

1. setting the base rate.

2. base rate in the UK is the overnight rate
--set by the central bank
--at which it will provide liquidity.

3. Forward Guidance allows central bank to
--influence long-term interest rates
--(here longer-term means up to, or slightly beyond, the period of the guidance – so up to perhaps 3 years)
--by indicating how it expects monetary policy to develop in the future.

4. also allows the central bank to influence inflation expectations
--which is also useful.


Forward Guidance is not a

guarantee and the central bank can depart from its guidance either as a consequence of some unforeseen economic event or if the economic outlook changes.


Investors may be classified into:

1  private individuals (“households”) 

2  managers of short-term and long-term mass savings products (“financial 

3  corporates (“businesses”) 

4  foreign investors.


The different categories, and investors within each category, will vary in their 

1  time horizons – eg whether they want investment returns over the short term or 
the long term 

2  appetite for risk – ie the extent to which they are averse to or tolerant of risk 

3  taxation position – reflecting both

---1 the tax rules that apply to the particular type of investor and
---2 the individual investor’s own particular set of circumstances,
eg how wealthy or otherwise.

investments which are risky for one investor may be less or more so for another investor depending on the different
1. liability profiles and
2 other features of the investors.


Example of differing appetites and perspectives

1. Consider fixed-interest government bonds in a developed country.
2. are risk-free for an investor with fixed monetary liabilities in that currency
3. but involve risk for an investor with liabilities linked to
--retail prices in another country.


What are the risks faced by the second investor in the above example?



Households are potentially interested in

1. a wide range of assets.

2 Diversification is often a key consideration,

particularly given that the typical householder will:

1  have only a relatively small amount of wealth to invest 

2  much of that wealth may be tied up in the house in which he or she lives.

Other considerations for households when making investment decisions include:

1.  liabilities (generally real in nature) 

2  liquidity 

3  uncertainty over future income and outgo 

4  tax 

5  level of investment expertise 

6  stability of asset values 

7  investment and risk characteristics of available assets 

8  attitude to risk. 


The importance of diversification leads to the need for

--financial intermediaries
--who form a link between households and
-- the businesses that need to
--finance investments in real assets. 


The alternative to investing in the products and services of a financial intermediary is to

invest directly in the underlying assets
(eg shares, bonds, properties) themselves.


A financial intermediary

1. channels resources between lenders
(ie investors) and borrowers.

2. is a wide range of financial intermediaries eg
insurance companies,
pension funds,
collective investment vehicles.


Financial intermediaries sell

1. their own liabilities
--to raise funds that are
--used to purchase
--the liabilities of other corporations.