Central Banking and Monetary Policy – Week 2

International Monetary and Financial Systems Central Banking and Monetary Policy – Week 2 What is money? Money has three main functions: 1. It is a medium of exchange 2. It serves as a common unit of account 3. It acts as store of value over time How is money created? Most of the money in the UK economy is created, not by printing presses at the Bank of England, but by commercial banks when they make loans. “In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money” (McLeay et al. 2014: 14). Central Banks: Main Functions 1. Conducting monetary policy - Influencing the amount of money that is circulating in an economy and how much it costs to borrow. 2. Supervising the banking sector and acting as lender of last resort. 3. Acting as banker to, and raising money for, the government - Issues treasury bills and government bonds to help govt. raise capital. 4. Acting as banker to commercial banks. 5. Issuing currency and controlling foreign exchange reserves. Bank of England    Founded in 1694 Responsible for price and financial stability Key committees: Monetary policy committee, financial policy committee and prudential regulation committee. What is Monetary Policy? Monetary policy determines how much money is in the economy, and how much it costs to borrow (i.e., the quantity and price of money). Two major types: expansionary vs. contractionary monetary policy • Expansionary monetary policy involves cutting (short-term) interest rates and raising the money supply to stimulate the economy. It leads to an increase in consumption and investment and, ultimately, growth. • Contractionary monetary policy involves raising (short-term) interest rates and reducing the money supply to cool inflation. It leads to a reduction in consumption, investment, and economic activity. Monetary Policy Tools Central banks have traditionally used 3 tools to control the money supply:    Central bank interest rate Open market operations Banks’ reserve requirements at the central bank The Central Bank Rate Open Market Operations Unconventional Monetary Policy Tools: Quantitative Easing Quantitative easing involves the large-scale purchase of financial assets from banks and other financial institutions (e.g., pension funds, insurance companies, etc.) on the secondary market. Under quantitative easing, the Central Bank creates money (electronically) to buy financial assets such as government bonds from financial institutions (e.g., banks, pension funds, etc.). This injects money into the economy. On the one hand, it provides deposit institutions such as commercial banks with cash that they can lend to businesses and households. On the other, it provides non-deposit institutions/institutional investors, such as pension funds and insurance companies, with incentives to invest in financial assets other than government bonds such as corporate bonds or shares, whose prices will go up. This is expected to stimulate spending through a wealth effect and to stimulate investment by lowering the borrowing costs for corporations. Note: Quantitative easing in the UK now totals around 40% of GDP.