centralbank

Unit 6 Central Banking

Objecties

After studying this unit, you will be able to:

Understand various roles of central banks in the economy. Describe the tools used by the Fed to influence monetary policy. Understand how Chinese central bank’s monetary policy works.

Text 1 The Role of Central Banks in the Economy How Central Banks Affect Economic Conditions

The most important players in financial markets throughout the world are central banks, the government authorities in charge of monetary policy. Central banks ordinarily do not deal directly with the public; rather, they are “bankers’ banks,” communicating with commercial banks and securities dealers in carrying out their essential policymaking functions. The central bank of the United States is the Federal Reserve System, a creation of Congress charged with issuing currency, regulating the banking system, and taking measures to protect the value of the dollar and promote full employment.

Central banks, including the Federal Reserve System, perform several important functions in a modern economy. The first and most important of their functions is . The Fed has become not only the principal source of currency and coin (pocket money) used by the U.S. public but also the principal government agency responsible for stabilizing the value of the dollar and protecting its integrity in international markets.

Why is so important? One reason is that changes in the money supply appear to be closely linked to changes in economic activity. A number of studies in recent years have found a statistically significant relationship between current and lagged changes in the money supply and changes in gross domestic product (GDP). The implication of these studies is that, if the central bank can control the growth rate of money, it can influence the growth rate of the economy as a whole.

Another important reason is that, in the absence of effective controls, money in the form of paper notes or bank deposits could expand virtually without limit. The marginal cost of creating additional units of money is nearly zero. Therefore, the banking system or the government or both are capable of increasing the money supply well beyond the economy’s capacity to produce goods and services. Because this action would result in severe inflation and eventually bring business activity to a halt, it is not surprising that modern governments have come to rely so heavily on central banks as guardians of the quantity and value of their currencies. For example, the Federal Reserve System enters the financial markets frequently in an attempt to control domestic price inflation in order to protect the purchasing power of the dollar.

A second vital function of central banking is . The financial system must transmit

savings to those who require funds for investment so the economy can grow. If the system of money and capital markets is to work efficiently, however, the public must have confidence in financial institutions and be willing to commit its savings to them. If the financial markets are unruly, with volatile fluctuations in interest rates and security prices, or if financial institutions are prone to frequent collapse, public confidence in the financial system might well be lost. The flow of capital funds would dry up, resulting in a drastic slowing in the rate of economic growth and a rise in unemployment. All central banks play a vital role in fostering the mature development of financial markets and in ensuring a stable flow of funds through those markets. Pursuing the objective, a central bank will, from time to time, provide funds to major securities dealers when they have difficulty financing their portfolios so that buyers and sellers may easily acquire or sell securities. When the money supply and interest rates rise or fall more rapidly than seems consistent with economic goals, a central bank may again intervene in the financial market place.

Another essential function of central banks is

. This means providing liquid funds to

those financial institutions in need, especially when alternative sources of funds have dried up. For example, through its discount window, the Federal Reserve will provide funds to selected deposit-type financial institutions to cover their short-term cash deficiencies. Before the Fed was created, one of the weaknesses in the financial system of the United States was the absence of a lender of last resort to aid financial institutions squeezed by severe liquidity pressures.

Finally, central banks have a role to play in

. This involves clearing checks, providing

an adequate supply of currency and coin, wiring funds, and preserving confidence in the value of the fundamental monetary unit. A smoothly functioning and efficient payments mechanism is vital for business and commerce. If checks or electronic payments cannot be cleared in a timely fashion or if the public cannot get the currency and coin it needs to carry out transactions, business activity will be severely curtailed. The result might well be large-scale unemployment and a decline in the rate of economic growth.

The Federal Reserve System (the Fed), as the central bank of the United States, has the responsibility for conducting national monetary policy. Financial market participants closely monitor the Fed’s actions so that they can anticipate how the monoey supply will be affected. They then use this information to forecast economic conditions and securities prices. The Fed can use three monetary policy tools to either increase or decrease the money supply.