Chapter 5

5. Central Banking and Monetary Policy

Introduction

The most important players in financial markets throughout the world are central banks, the
government authorities in charge of monetary policy. Central banks' actions affect interest rates,
the amount of credit, and the money supply, all of which have direct impacts not only on
financial markets but also on aggregate output and inflation.
The central bank's monetary policy sets its goals first and draws strategies or instruments to
achieve these goals. It will have both operating and intermediate targets to reach its final goals.
The Central bank's name and independence varies from nation to nation and this has implications
on its operations.
5.1 Central Banking
Central banks are relatively new inventions. An American President (Andrew Jackson) even
cancelled his country's central bank in the nineteenth century because he did not think that it was
very important. But things have changed since. Central banks today are the most important
feature of the financial systems of most countries of the world.
Central banks are bizarre hybrids. Some of their functions are identical to the functions of
regular, commercial banks. Other functions are unique to the central bank. On certain functions it
has an absolute legal monopoly.
A nation's principal monetary authority, such as the Federal Reserve Bank (USA) and National
Bank of Ethiopia, which regulates the money supply and credit, issues currency, and manages
the rate of exchange. It is the entity responsible for overseeing the monetary system for a nation
(or group of nations). Central banks have a wide range of responsibilities - from overseeing
monetary policy to implementing specific goals such as currency stability, low inflation and full
employment. Central banks also generally issue currency, function as the bank of the
government, regulate the credit system, oversee commercial banks, manage exchange reserves
and act as a lender of last resort.
i. Activities and responsibilities of Central Banks
Functions of a central bank (not all functions carried out by all banks):
• monopoly on the issue of banknotes

1
 • the Government's banker
• the bankers' bank ("Lender of Last Resort")
• manages the country's foreign exchange and gold reserves and the Government's stock
register;
• regulation and supervision of the banking industry:
• Setting the official interest rate - used to manage both inflation and the country's
exchange rate - and ensuring that this rate takes effect via a variety of policy mechanisms.
ii. Policy instruments of the Central Bank
Monetary policy instruments may be divided in to two main types.
i. Direct controls
Direct controls are typically directives given by the central bank to control the quantity or price
(interest rate) of money deposited with commercial banks and credit provided by them. Ceilings
on the growth of bank lending or deposits are examples of quantity controls. Maximum bank
lending or deposit rates are examples of interest rate controls.
ii. Indirect instruments
An important reason for financial liberalization is to develop a system which promotes an
efficient allocation of savings and credit in the economy. In the monetary area, financial
liberalization involves a movement away from direct monetary controls towards indirect ones.
The latter operate by the central bank controlling the price or volume of the supply of its own
liabilities - reserve money - which in turn may affect interest rates more widely and the quantity
of money and credit in the whole banking system.
Indirect instruments used in monetary operations are often divided in to three:
1. Open Market Operations (OMO)
To enable open market operations, a central bank must hold foreign exchange reserves (usually
in the form of government bonds) and official gold reserves. It will often have some influence
over any official or mandated exchange rates: Some exchange rates are managed, some are
market based (free float) and many are somewhere in between "managed float" or "dirty float".
Through open market operations, a central bank influences the money supply in an economy
directly. Each time it buys securities, exchanging money for the security, it raises the money
supply. Conversely, selling of securities lowers the money supply. Buying of securities thus
amounts to printing new money while lowering supply of the specific security.

2
The main open market operations are:
• Temporary lending of money for collateral securities ("Reverse Operations"). These
operations are carried out on a regular basis, where fixed maturity loans are auctioned off.
• Buying or selling securities ("Direct Operations") on ad-hoc basis.
2. Reserve Requirements
Changes in reserve requirements affect the money supply by causing the money supply
multiplier to change. A rise in reserve requirements reduces the amount of deposits that can be
supported by a given level of the monetary base and will lead to a contraction of the money
supply. Conversely, a decline in reserve requirements leads to an expansion of the money supply
because more multiple deposit creation can take place.
3. Discount Policy
Discount policy, which primarily involves changes in the discount rate, affects the money by
affecting the volume of discount loans and the monetary base. A rise in discount loans adds to
the monetary base and expands the money supply; a fall in discount loans reduces the monetary
base and shrinks the money supply.
iii. CENTRAL BANK INDEPENDENCE
Why is central bank independence an important issue?
The brief answer to this question is that price stability is generally considered a good thing, and
that an independent central bank can help to achieve it. I do not need to dwell on the desirability
of price stability. Economies work better if investment and wage decisions are not confused and
thwarted by high inflation. Some people see price stability as an anchor not only for the
economy, but also for society at large. Price stability, however, is not the natural order of things
in a modern economy.
Apart from higher oil prices and other ‘shocks’, there are two particular threats which bear upon
the issue of central bank independence:
• the tendency for policy makers and politicians to push the economy to run faster and
further than its capacity limits allow; and
• The temptation that governments have to incur budget deficits and fund these by
borrowings from the central bank.
Let us examine these two sources of inflationary pressure more closely. It is understandable that
policy makers and politicians (in part in response to public pressure) should wish to squeeze as

3
much growth as possible out of the economy – to run it a bit faster and a bit further than its
capacity limits allow. In the jargon, there is a tendency to exploit the short-run trade-off between
output and inflation. Even economies which have few spare resources can grow at rates above
their long-term capacity limits for a time. Although it may take some time to show up, higher
inflation will be the inevitable result.
5.2 CONDUCT OF MONETARY POLICY: GOALS AND TARGETS
Now that we understand the tools central banks like the Federal Reserve (USA) and National
Bank (Ethiopia) use to conduct monetary policy, we can proceed to see how monetary policy is
actually conducted by central banks. Understanding the conduct of monetary policy is important
because it not only affects the money supply and interest rates but also has a major influence on
the level of economic activity and hence on our wellbeing.
To explore this subject, we look at the goals that the central banks establish for monetary policy
and their strategies for attaining them.
i. GOALS OF MONETAR POLICY
Six basic goals are continually mentioned by personnel at the Federal Reserve and other central
banks when they discuss the objectives of monetary policy: (1) high employment, (2) economic
growth, (3) price stability, (4) interest-rate stability, (5) stability of financial markets, and (6)
stability in foreign exchange markets.
High Employment
Promoting high employment that is consistent with a stable price level is the main
macroeconomic objective of Countries. High employment is a worthy goal for two main reasons:
(1) the alternative situation, high unemployment, causes much human misery, with families
suffering financial distress, loss of personal self-respect, and increase in crime (though this last
conclusion is highly controversial) and (2) when unemployment is high, the economy has not
only idle workers but also idle resource (closed factories and unused equipment), resulting in a
loss of output (lower GDP).
Although it is clear that high employment is desirable, how high should it be? At What point can
we say that the economy is at full employment? At first, it might seem that full employment is
the point at which no worker is out of a job, that is, when unemployment is zero. But this
definition ignores the fact that some unemployment, called frictional unemployment, which
involves searches by workers and firms to find suitable matchups, is beneficial to the economy.

4
For example, a worker who decides to look for a better job might be unemployed for a while
during the job search. Workers often decide to leave work temporarily to pursue other activities
(raising a family, travel, returning to school), and when they decide to reenter the job market, it
may take some time for them to find the right job. The benefit of having some unemployment is
similar to the benefit of having a nonzero vacancy rate in the market for rental apartments. As
many of you who have looked for an apartment have discovered, when the vacancy rate in the
rental market is too low, you wi11 have a difficult time finding the right apartment.
Another reason that unemployment is not zero when the economy is at full employment is due to
what is called structural unemployment, a mismatch between job requirements and the skills or
availability of local workers. Clearly, this kind of unemployment is undesirable. Nonetheless, it
is something that monetary policy can do little about.
The goal for high employment should therefore not seek an unemployment level of zero but
rather a level above zero consistent with full employment at which the demand for labor equals
the supply of labor. This level is called the natural rate of unemployment.
Economic Growth
The goal of steady economic growth is closely related to the high-employment goal because
businesses are more likely to invest in capital equipment to increase Productivity and economic
growth when unemployment is low. Conversely, if unemployment is high and factories are idle,
it does not pay for a firm to invest in additional plants and equipment. Although the two goals
are closely related, policies can be specifically aimed at promoting economic growth by directly
encouraging firms to invest or by encouraging people to save, which provides more funds for
firms to invest. In fact, this is the stated purpose of so-called supply side economics policies,
which are intended to spur economic growth by providing tax incentives for businesses to invest
in facilities and equipment and for taxpayers to save more.
Price Stability
Price stability is desirable because a rising price level (inflation) creates uncertainty in the
economy, and that may hamper economic growth. For example, the information conveyed by the
prices of goods and services is harder to interpret when the overall level of prices is changing,
which complicates decision making for consumers, businesses, and government. Not only do
public opinion surveys indicate that the public is very hostile to inflation, but also a growing
body of evidence suggests that inflation leads to lower economic growth! The most extreme

5
example of unstable prices is hyperinflation, such as Argentina and Brazil experienced until
recently. Many economists attribute the slower growth that these countries have experienced to
their problems with hyperinflation.
Inflation also makes it hard to plan for the future, For example, it is more difficult to decide how
much funds should be put aside to provide for a child's college education in an inflationary
environment. Further, inflation may strain a country's social fabric:
Conflict may result because each group in the society may compete with other groups to make
sure that its income keeps up with the rising level of prices.
Interest-Rate Stability
Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty in
the economy and make it harder to plan for the future. Fluctuations in interest rate that affect
consumers' willingness to buy house, for example, make it more difficult for consumers to
decide when to purchase a house and for construction firms to plan how many houses to build. A
central bank may also want to reduce upward movements in interest rates for the reasons we
discussed at the beginning of this chapter. Upward movements in interest rates generate hostility
toward central banks like the Fed and lead to demands that their power be curtailed.
Stability of Financial Markets
Financial crises can interfere with the ability of financial markets to channel funds to people with
productive investment opportunities, thereby leading to a sharp contraction in economic activity.
The promotion of a more stable financial system in which financial crises are avoided is thus an
important goal for a central bank. Indeed the Federal Reserve System of USA was created in
response to the bank panic of 1907 to promote financial stability.
The stability of financial markets is also fostered by interest-rate stability because fluctuations in
interest rates create great uncertainty for financial institutions. An increase in interest rates
produces large capital losses on long-term bonds and mortgages; losses that can cause the failure
of the financial institutions holding them. In recent years, more pronounced interest-rate
fluctuations have been a particularly severe problem for savings and loan associations and
mutual savings banks, many of which got into serious financial trouble in the 1980s and early
1990s.
Stability in Foreign Exchange Markets

6
With the increasing importance of international trade to a country's economy, the value of its
currency relative to other currencies (such as dollar) has become a major consideration for the
Central Banks. For example a rise in the value of the Birr makes Ethiopian industries less
competitive with those abroad, and declines in the value of the Birr stimulate inflation in
Ethiopia. In addition, preventing large changes in the value of the Birr makes it easier for firms
and individuals purchasing or selling goods abroad to plan ahead. Stabilizing extreme
movements in the value of the dollar in foreign exchange markets is thus viewed as a worthy
goal of monetary policy. In other countries, which are even more dependent on foreign trade,
stability in foreign exchange markets takes on even greater importance.
aceship reaches the moon)