Central banks, the banking sector and the money supply

Overview

Main functions of a central bank, central bank normally given operational independence to set interest rates and lender of last resort function.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What are the main functions of a central bank?

   Model answer

   A central bank sets and operates monetary policy, usually by choosing a policy interest rate and by buying or selling assets. It issues the currency and is the ultimate source of settlement money in the economy. It acts as banker to the government, holding its account and managing the issue of its debt. It acts as banker to the commercial banks, holding their reserve balances and operating the payments system through which they settle with one another. It acts as lender of last resort to solvent but illiquid banks. It holds and manages the country's foreign exchange reserves. And it is generally responsible for the stability of the financial system as a whole, including supervision of banks and the setting of capital and liquidity requirements.

2. 2

   Why is a central bank normally given operational independence to set interest rates?

   Model answer

   A government that controls interest rates faces a temptation to keep them low, because the gain in output and employment comes quickly and the inflation arrives later, often after an election. Once the public expects that behaviour, it builds higher inflation into wage and price setting, so the government must deliver ever-looser policy simply to get the same output gain, and the economy ends up with higher inflation and no more output. Handing the instrument to an institution with a clear mandate for price stability and no electoral horizon removes the temptation. Because the commitment is credible, expected inflation falls, and the central bank can hit the target with less unemployment than a government could.

3. 3

   What does it mean to say that a central bank is banker to the commercial banks?

   Model answer

   Every commercial bank holds an account at the central bank, and the balances in those accounts are called reserves. When a customer of one bank pays a customer of another, the two banks settle by transferring reserves between their central bank accounts, so the central bank sits at the centre of the payments system. Because those reserves are the only asset with which banks can finally settle, the central bank controls the terms on which the ultimate settlement asset is supplied, and the rate it pays or charges on those balances sets the floor for interest rates across the whole banking system.

4. 4

   What is the lender of last resort function, and why does a banking system need one?

   Model answer

   Lender of last resort means that the central bank stands ready to lend to a bank that is solvent, in the sense that its assets exceed its liabilities, but illiquid, in the sense that it cannot turn those assets into cash quickly enough to meet withdrawals. Banks need such a backstop because their business is to hold long-term, illiquid loans while owing short-term, instantly withdrawable deposits, so no bank can ever repay all its depositors at once. Without a backstop, a solvent bank facing sudden withdrawals would have to sell assets at fire-sale prices and could be forced into failure by nothing more than a loss of confidence. Lending freely against good collateral at a penalty rate stops that happening while discouraging banks from relying on the facility.

5. 5

   Explain step by step how a run on a bank develops and how it can spread.

   Model answer

   First, a bank holds only a small fraction of its deposits in liquid form, because the rest is lent out long term. Second, news or rumour leads some depositors to doubt whether the bank can repay. Third, because those who withdraw first are paid in full while those who wait may not be, each depositor's best response is to withdraw immediately even if they believe the bank is basically sound. Fourth, the withdrawals exhaust the bank's liquid assets, forcing it to sell loans and securities quickly at depressed prices. Fifth, those forced sales push down the market value of the same assets held by other banks, weakening their balance sheets. Sixth, depositors at other banks observe this and begin to withdraw as well, so a problem at one institution becomes a system-wide panic. Deposit insurance and lender of last resort facilities exist to break the logic at the third step by removing the incentive to run.

6. 6

   Analyse how a change in a central bank's policy rate feeds through to the rates commercial banks charge borrowers and pay savers.

   Model answer

   The policy rate determines what banks earn on their reserves at the central bank and what they pay to borrow reserves overnight, so it fixes the marginal cost and marginal return of a bank's most liquid funds. A rise makes it more attractive to hold reserves and more expensive to fund lending, so banks raise the rate they charge on new loans and on variable-rate borrowing such as overdrafts and tracker mortgages, and they raise savings rates in order to attract deposits rather than borrow at the higher rate. The pass-through is rarely complete or immediate: banks pass rises to borrowers faster than to savers where competition for deposits is weak, and loans already fixed do not change at all until they are refinanced.

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