ROLE OF CENTRAL BANK IN THE DEVELOPMENT
Subject:
Investment Banking
Submitted to:
Prof. Zafarullah
Submitted by: Sarmad Ellahi
Reg #:
Class:
236-SE/BsIBF/F11
Bs (hons)
ROLE OF
CENTRAL
BANK IN
THE
DEVELOPME
NT OF
ECONOMY
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:
Suppose that economy of the country is facing recession and
unemployment. In this situation, central bank will use an expansionary
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 checkabledeposit 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 openmarket operations, or by selling bonds to the public and commercial
banks.
The smaller reserves in the banking system produce two results:
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
inflation. By the summer of 2006, the target for the federal funds rate had
risen to 5.25 percent and the prime rate was 8.25. With the economy
enjoying the robust, noninflationary growth, the Fed left the federal funds
rate at 5.25 percent for over a year until the mortgage debt crisis threaten
the economy during the last summer of 2007. In the response to the
crisis, the Fed took several actions. It lowered the discount rate by half
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
announced by the Governor, State Bank of Pakistan, Yaseen Anwar. He
said that SBP expects the inflation to be between 11 and 12 percent by
the end of financial year due to recent raising of prices. In Pakistan,
inflation has risen from 5.9 percent in January 2013 to 8.55 percent in
August 2013 and possibly be in the range of 11 to 12 percent by end-June
2014. He said SBP’s reserves had decreased from 10.8 billion dollars to 6
billion dollars on end-July and are now 5.2 billion dollars after receipt of
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
http://www.thestreet.com/story/10375486/1/how-do-central-bankswork.html
Investment Banking
Submitted to:
Prof. Zafarullah
Submitted by: Sarmad Ellahi
Reg #:
Class:
236-SE/BsIBF/F11
Bs (hons)
ROLE OF
CENTRAL
BANK IN
THE
DEVELOPME
NT OF
ECONOMY
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:
Suppose that economy of the country is facing recession and
unemployment. In this situation, central bank will use an expansionary
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 checkabledeposit 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 openmarket operations, or by selling bonds to the public and commercial
banks.
The smaller reserves in the banking system produce two results:
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
inflation. By the summer of 2006, the target for the federal funds rate had
risen to 5.25 percent and the prime rate was 8.25. With the economy
enjoying the robust, noninflationary growth, the Fed left the federal funds
rate at 5.25 percent for over a year until the mortgage debt crisis threaten
the economy during the last summer of 2007. In the response to the
crisis, the Fed took several actions. It lowered the discount rate by half
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
announced by the Governor, State Bank of Pakistan, Yaseen Anwar. He
said that SBP expects the inflation to be between 11 and 12 percent by
the end of financial year due to recent raising of prices. In Pakistan,
inflation has risen from 5.9 percent in January 2013 to 8.55 percent in
August 2013 and possibly be in the range of 11 to 12 percent by end-June
2014. He said SBP’s reserves had decreased from 10.8 billion dollars to 6
billion dollars on end-July and are now 5.2 billion dollars after receipt of
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
http://www.thestreet.com/story/10375486/1/how-do-central-bankswork.html