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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 30
THE GOVERNMENT'S BANK
The central bank started out as the government's bank, originally created by rulers to finance
wars
However, the early examples are really the exceptions, as central banking is largely a 20th
century phenomenon.
The central bank occupies a privileged position: it has a monopoly on the issuance of currency
The central bank creates money and thereby controls the availability of money and credit in a
country's economy
Most central banks go about this by adjusting short-term interest rates, an activity called
monetary policy.
In today's world, central banks use monetary policy to stabilize economic growth and inflation.
An expansionary or accommodative policy (lower interest rates) raises growth and inflation;
tighter or restrictive policy reduces them.
Governments want to control the printing of money because it is a very profitable business;
also, losing control of the amount of currency means losing control of inflation.
The Bankers' Bank
The most important day-to-day jobs of the central bank are to:
Provide loans during times of financial stress (the lender of last resort).
Manage the payments system (settles interbank payments).
Oversee commercial banks and the financial system (handles the sensitive information about
institutions without conflicts of interest).
By ensuring that sound banks and financial intermediaries can continue to operate, the central
bank makes the whole financial system more stable.
Central banks are the biggest and most powerful players in a country's financial and economic
system and are supposed to use this power to stabilize the economy, making us all better off.
However, central banks that are under extreme political pressure, or that are simply
incompetent, can wreak havoc on the economic and financial systems.
A central bank does not control:
Securities markets
The government's budget
The common arrangement today is for the central bank to serve the government in the same way
that a commercial bank serves a business or an individual.
Stability: The Primary Objective of All Central Banks
When economic and financial systems are left on their own they are prone to episodes of
extreme volatility; central bankers work to reduce that volatility
Central bankers pursue five specific objectives:
Low and stable inflation
High and stable real growth, together with high employment
Stable financial markets
Stable interest rates
A stable exchange rate
Instability in any of those would pose an economy-wide economic risk that diversification could
Not mitigate
Thus the job of the central bank is to improve general economic welfare by managing and
reducing systematic risk.
It is probably impossible to achieve all five of these objectives simultaneously, and so tradeoffs
must be made
Low, Stable Inflation
Many central banks take as their primary job the maintenance of price stability; they strive to
eliminate inflation.
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Money & Banking ­ MGT411
VU
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.
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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