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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 31
LOW, STABLE INFLATION
Many central banks take as their primary job the maintenance of price stability; they strive to
eliminate inflation.
The rationale for keeping the economy inflation-free is that money's usefulness as a unit of
account and as a store of value is enhanced when its purchasing power is maintained.
Inflation degrades the information content of prices and impedes the market's function of
allocating resources to their best uses.
The higher the inflation is, the less predictable it is, and the more systematic risk it creates.
Also, high inflation is bad for growth.
While there is agreement that low inflation should be the primary objective of monetary policy,
there is no agreement on how low inflation should be.
Zero inflation is too low, because it brings the risk of deflation (a drop in prices) which in turn
results in increased defaults on loans and a threat to the health of banks.
Furthermore, if inflation were zero, an employer wishing to cut labor costs would need to cut
nominal wages, which is difficult to do.
A small amount of inflation may actually make labor markets work better, at least from the
employer's point of view.
High, Stable Real Growth
Central bankers work to dampen the fluctuations of the business cycle; booms are popular but
recessions are not.
Central bankers work to moderate these cycles and stabilize growth and employment by
adjusting interest rates.
Monetary policymakers can moderate recessions by lowering interest rates and can moderate
booms by raising them (to keep growth at a sustainable level).
Along with growth and employment, stability is also important, because fluctuations in general
business conditions are the primary source of systematic risk.
Financial System Stability
Financial system stability is an integral part of every modern central banker's job.
The possibility of a severe disruption in the financial markets is a type of systematic risk that
central banks must control.
Interest Rate and Exchange Rate Stability
Interest rate stability and exchange rate stability are a means for achieving the ultimate goal of
stabilizing the economy; they are not ends unto themselves.
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Money & Banking ­ MGT411
VU
Interest rate volatility is a problem because:
it makes output unstable as borrowing and expenditure fluctuate with changing rates.
it means higher risk and a higher risk premium and makes financial decisions more difficult.
Even though the exchange rate affects the prices of imports and exports, stabilizing exchange
rates is the last item on the list of central bank objectives.
Different countries have different priorities when it comes to the exchange rate;
Stable exchange rates are more important in developing countries because imports and exports
are central to their economies.
The objectives of a Modern Central Bank
Inflation creates confusion and makes planning difficult. When
Low Stable Inflation
inflation is high, growth is low
Stable predictable growth is higher than unstable, unpredictable
High Stable growth
growth
A stable financial system is necessity for an economy to operate
Financial System
efficiently
Stability
Interest rate volatility creates risk for both lenders and borrowers
Stable Interest Rates
Stable Exchange Rates Variable exchange rates make the revenues from foreign sales and the
cost of purchasing imported goods hard to predict
Meeting the Challenge: Creating a Successful Central Bank
The boom in the past decade with its associated decrease in volatility may have happened
because technology sparked a boom just as central banks became better at their jobs.
Policymakers realized that sustainable growth had gone up, so interest rates could be kept low
without worrying about inflation, and central banks were redesigned.
Today there is a clear consensus about the best way to design a central bank and what to tell
policymakers to do.
A central bank must be
Independent of political pressure,
Accountable to the public,
Transparent in its policy actions,
Clear in its communications with financial markets and the public
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY