Central Bank Functions and Monetary Policy

Main Goals of Central Banks

Primary Objectives

• Promote steady growth in national output.
• Maintain low unemployment rates.
• Ensure stable and orderly financial markets.

Monetary Policy Actions

Inflation Rising

• Central Bank raises interest rates to reduce price pressures and slow down the economy.

Sluggish Economy

• Central Bank lowers interest rates to boost aggregate demand, output, and reduce unemployment.

Creation of the Federal Reserve System (1907)

• Comprises 12 regional Federal Reserve Banks.
• Key roles include:
  • Conducting monetary policy.
  • Supervising and regulating banks.
  • Ensuring financial stability.
  • Providing financial services to government and public.

Monetary Policy Instruments

Interest Rate

Primary tool for adjusting economic activity.

Open Market Operations

Buying/selling securities to influence liquidity and interest rates.

Required Reserve Ratio

Adjusting the proportion of deposits banks must hold as reserves.

Types of Monetary Policies

Easy/Expansionary Money Policy

Actions

• Buy securities.
• Decrease reserve ratio.
• Lower discount rate.

Objective

• Stimulate economic activity.

Tight/Contractionary Money Policy

Actions

• Sell securities.
• Increase reserve ratio.
• Raise discount rate.

Objective

• Control inflation and stabilize the economy.

Money and the Financial System

Functions of the Financial System

Key Functions

• Transfers resources across time, borders, and sectors.
• Manages risk.
• Pools and subdivides funds.
• Acts as a clearinghouse for financial transactions.

Major Financial Instruments

Categories

• Money (cash, demand deposits).
• Equities (stocks).
• Financial derivatives (options).
• Pension funds and national funds.

Money Supply

Components

• M1 (Narrow): Most liquid forms of money (currency, checks, demand deposits).
• M2: Includes M1 + less liquid assets (time deposits, bonds, shares).

Money Demand

• Transactions Demand: Driven by income and expenditure gaps.
• Asset Demand: Store of value; inversely related to interest rates.

Banking and Money Supply

• Banks create money by accepting deposits and providing loans.
• Reserve Ratio: Portion of deposits held by banks.
• Money Multiplier: Determines the extent of money creation from initial deposits.

Key Problem-Solving Scenarios

Traveler's Checks

Impact on M1 and M2 when cash is moved into different account types.

Banking Calculations

Calculating reserve ratios, money multipliers, and potential loan creation.

Economic Shifts

Impacts of financial innovations or policy changes on money supply components.