Subject:
Investment Banking
Submitted to: Prof. Zafarullah
Submitted by: Sarmad Ellahi
Reg #:
236-SE/BsIBF/F11
ROLE OF
CENTRAL
BANK IN
THE
DEVELOPME
NT OF
Introduction:
Central bank of the country is responsible for controlling the monetary policy of the country. Essentially, this means that one of their key jobs is to manipulate the money supply in that country to meet its economic goals. Money supply is the total amount of monetary assets available in an economy at a specific time. It has also many other functions but money supply is one of the important function. Because central bank has the sole monopoly of note issue in almost every country. However, the monopoly of central bank to issue the currency notes may be partial in certain countries. For example, in India, one rupee notes are issued by the Ministry of Finance and all other notes are issued by the Reserve Bank of India. In Pakistan, State Bank of Pakistan (SBP) has the authority of note issue.
Since money used normally in all the economic transactions, it has powerful effect on economic activity. Thus increase in supply of
money will result in decrease in interest rates and increase in investment. In this way when extra money is spread in the society the consumers feel richer and will spend more. Industries acknowledge enhancing by ordering more raw materials and increase their production. When the business will flourish, the demand of labor and capital goods will be increased. Stock market prices increase and firms issue more equity and debt. In this perspective, money supply continuous to expand. Prices begin to rise, if output growth meets capacity limits. People began to expect inflation, lenders demand higher interest rates consumer purchasing power decreases over the life of their loans.
Expansionary Monetary Policy:
monetary policy (easy money policy). This policy will reduce the interest rate to boost up borrowing and spending, which will increase aggregate demand and output. The immediate step central bank will take will be to lower the federal funds rate. To achieve lower rate, central bank will use open-market operations to buy bonds from the bank and public.
Purchasing of bonds from the banks will increase the reserves in the
banking system. Or central bank could expand the reserve by lowering the reserve requirements, lowering the discount rate or some other way, but these tools are less frequently used than open-market operation.
The greater reserves in the banking system produce two critical results:
The supply of federal funds increase, lowering the federal funds rate to the new targeted rate.
A multiple expansion of nation’s money supply occurs.
Given the demand for money, the larger money supply places a downward pressure on other interest rate.
Effect of Expansionary Monetary Policy:
When the economy experience recession, a negative GDP gap, and unemployment. The central bank therefore institute an expansionary monetary policy. To increase the money supply, the central bank will take some actions: buy government securities from the banks, reduce the reserve ration or reduce the discount rate. The result will be an increase in excess reserve in the commercial banking system and decline in the
federal funds rate. Because excess reserve are the basic on which commercial banks can earn profit by lending and creating checkable-deposit money, the nation’s money supply will increase. An increase in money supply will lower the interest rate, increasing investment,
aggregate demand, and GDP.
Contractionary Monetary Policy:
Suppose that economy of the country is facing high rate of inflation. The central bank of the country will then use tight monetary policy. This policy will increase the interest rate in order to reduce the borrowing and spending, which will curtail the expansion of aggregate demand and hold down price-level increases. The central bank will announce a higher targeted for the federal funds rate. Through open-market operations, or by selling bonds to the public and commercial banks.
The supply of federal funds decreases, raising the Federal funds rate to the new targeted rate.
A multiple contraction of nation’s money supply occurs. Given the demand for money, smaller money supply places an upward pressure on interest rate.
Effect of Contractionary Monetary Policy:
If economy moves from a full-employment equilibrium to operating at more than full employment so that inflation is a problem and restrictive monetary policy would be appropriate. The central bank will undertake some following action: sell govt. securities to banks and the public in the open market, increase legal reserve ration or increase the discount rate. Then banks will discover that their reserves are below those required and federal funds rate has increased. So they will need to reduce their lending. This shrink the money supply and increase the interest rate. The higher interest rate will discourage investment, lowering the
aggregate demand and restraining the demand-pull inflation.
Monetary Policies in U.S.
In the early 1990s, the Fed’s expansionary monetary policy helped the economy recover from the 1990-1991 recession. The expansion of GDP that began in 1992 continued through the rest of the decade. By 2000 the U.S. unemployment rate had declined to 4 percent_ the lowest rate in 30 years. To counter potential inflation during the strong
expansion, in1994 and 1995, and then again early 1997, the fed reduced reserves in the banking system to raise interest rate. In 1998 the Fed reversed its course and moved to more expansionary monetary policy to make sure that U.S. banking system had plenty of liquidity in the face of a severe financial crisis in Southeast Asia.
In 2003 the Fed left the federal funds rate at historic lows. But as the economy began to expand in 2004, the Fed engineered a gradual series of rate hikes designed to boost the interest rate to make sure that aggregate demand continued to grow at a pace consistent with low
percentage point. Then, between September 2007 and 2008, it lowered the target for the federal funds rate from 5.25 per to 2 per.
“All these monetary actions helped to stabilize the banking sector and stimulate the economy”.
Printing of Money:
All governments spends money. Some of this spending is to buy goods and services such as roads and police. And some is to provide transfer payments for the poor and elderly. A government can finance its spending in three ways:
1. Raising revenue through taxes
2. Borrowing from the public by selling bonds 3. It can print money
When the government prints money to finance expenditure, it
increases the money supply. The increase in money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax. When the government prints new money for its use, it makes the old money in the hands of the public less valuable. Indeed, the printing of money to finance expenditure is primary cause of hyperinflation.
“Central bank has ultimate control over the rate of inflation. If central bank increase the money supply rapidly, the price level will rise rapidly”.
Recently Announced Monetary Policy of Pakistan:
The State Bank of Pakistan (SBP) raised its discount rate to 9.5 percent from 9.0 percent for September-October 2013. This was
544.5 million dollars from IMF. He said Pakistan’s balance of payment has been under pressure since FY08.
Impact on economy:
State bank of Pakistan is using tight monetary policy. Raising the discount and interest rates creates a tight economic environment where the supply of money decreases. Decreases in the supply of money
eventually result in a decrease in GDP, creating a more sustainable economic environment. Tightening of the economic market can result in deflation. Deflation occurs when consumers do not have enough money to purchase economic resources, which lowers prices.
References:
Macroeconomics (7th edition) by N. Gregory Mankiw
Principles of Economics (18th edition) by Campbell R, McConnell and
Stanley Brue
http://epaper.brecorder.com/2013/09/14/1-page/502945-news.html
http://en.wikipedia.org/wiki/Monetary_policy
