13. What are the functions of the Central Bank?

Central bank is a financial institution that manages a nation's currency, money supply, and interest rates.

The organization responsible for the conduct of a nation’s monetary policy is the central bank. In some countries the central bank is independent from the government (Fed), in others it is controlled by the government (Russia).

Central banks have a wide range of responsibilities, from overseeing monetary policy to implementing specific goals such as currency stability, low inflation and full employment. Central banks also usually oversee the commercial banking system.

Central bank has 4 functions:

The first one is actually to implement monetary policy. There are three ways to do it. First setting interest rate ceilings and floors, which means limiting the fluctuations of the interest rate. The second way to implement monetary policy is simply printing money, or destroying it – coins, banknotes. Central banks are commonly responsible for the issue of a country's notes and coin. The third one, which is a bit more modern, is open-market operations, which are simply buying and selling government bonds to and from commercial banks.  (A monetary policy is the means by which a central bank influences the demand, supply and, hence, price of money and credit in order to direct a nation's economic objectives. Central bank uses three tools: reserve requirements, the discount rate, and open market operations.)

The second one is exchange rate supervision. Mainly for floating exchange rates but one should not forget that even for a fixed exchange rate the central bank still has to make sure that it has enough reserves to counteract any upswing or downswing of this exchange rate.

Third main task is commercial banking supervision  -  make sure that the commercial banks have enough liquidities, for instance, to avoid any bank run.

Fourth main task of the central bank would be to act as a lender of last resort in case, actually, one of these commercial banks goes bankrupt and the investors, the people putting money in the bank, have to get back their money. The lender of last resort serves to protect depositors, prevent widespread panic withdrawal, and otherwise avoid damage to the economy caused by the collapse of an institution. it means that it will extend credit when no one else will.

13. What is the goal of monetary policy? Describe the tools of monetary policy. What are the drawbacks of monetary policy in comparison with fiscal policy?

monetary policy — the use of the govern­ment's power to control the money supply to regulate the level of economic activity. The conduct of the monetary policy is important because it affects the money supply and interest rates but also has a major influence on the level of economic activity and hence on our well-being. Monetary policy refers to regulating the supply of money as a way of stabilizing the economy. Monetary policy is the responsibility of the Federal Reserve System.

There is a direct relationship between the amount of money in circulation and the level of business activity. When the money supply is increased, consumer spending and business spend­ing tend to increase with it. It follows that in times of contraction and recession, an increase in the money supply will help bring about economic recovery.

When the opposite situation prevails and the booming econ­omy is pushing up prices in an inflationary spiral, a reduction in the money supply will serve to reduce demand and lower prices.

The money supply is partly a liability of the Bank (currency in private circulation) and partly a liability of commercial banks (chequing accounts of the general public).

A monetary policy is the means by which a central bank influences the demand, supply and, hence, price of money and credit in order to direct a nation's economic objectives. To do this, the Federal Reserve uses three tools: reserve requirements, the discount rate, and open market operations.

Reserve Requirements.

A required reserve ratio is a minimum ratio of cash reserves to deposits that the central bank requires commercial banks to hold. If a reserve requirement is in force, commercial banks can hold more than the required cash reserves but they cannot hold less. If their cash falls below the required amount, they must immediately borrow cash, usually from the central bank, to restore their required reserve ratio.

the effect is to reduce the creation of bank deposits, reduce the value of the money multiplier, and reduce the money supply for any given monetary base. Similarly, when a particular reserve requirement is already in force, any increase in the reserve requirement will reduce the money supply.

When the central bank imposes a reserve requirement in excess of the reserves that banks would otherwise have wished to hold, the banks are creating fewer deposits and undertaking less lending than they would really like. Thus a reserve requirement acts like a tax on banks by forcing them to hold a higher fraction of their total assets as bank reserves and a lower fraction as loans earning high interest rates.

The Discount Rate

The discount rate is the interest rate that the Bank charges when the commercial banks want to borrow money. By setting the discount rate at a penalty level in excess of the general level of interest rates, the Bank can induce commercial banks voluntarily to hold additional cash reserves. Since bank deposits now become a lower multiple of banks' cash reserves, the money multiplier is reduced and the money supply is lower for any given level of the monetary base.

Open Market Operations

An open market operation occurs when the central bank alters (изменять) the monetary base by buying or selling financial securities in the open market.

Whereas the previous two methods of monetary control operate by altering the value of the money multiplier, open market operations alter the monetary base. Since the money supply is the monetary base multiplied by the money multiplier, they alter the money supply.

DISADVANTAGES OF RESERVE REQUIREMENT CHANGES.

The fact that changing reserve requirements is a powerful tool, however, small changes in the money supply are hard to engineer by varying reserve requirements. It is true that small changes in the money supply could be obtained by extremely small changes in the reserve requirement (say by 0.001 percentage point) but because it is so expensive to administer changes in the reserve requirement, such a strategy is not practical.

Another disadvantage of using the reserve requirement to control the money supply is that raising the requirements can cause immediate liquidity problems for banks with low excess reserves. This policy tool is rarely used.