Central Banking and the Effects of Monetary Policies in the Economy

A Central Bank is a monetary institution, which fully controls the production,

circulation, and the supply of money in the market, seeking to regulate the member
banks and stabilize a nation’s economy and national currency. A central bank is also
responsible for the monetary policy implemented in a country, including decisions about
interest rates, liquidity control, reserve requirements, and open market operations.
When a monetary policy is effective, the central bank keeps the unemployment rate at
low levels and stabilizes inflation and interest rates to stimulate economic growth.

What are the Functions of a Central Bank?

1. Bank of Issue

The central bank issues currency in order to secure control over the volume of
currency and credit. The currency notes printed and issued by the central bank are
declared legal tender throughout the country. The central bank has to keep gold, silver
or other securities against the notes issued. Printing money is an important
responsibility because printing too much can cause inflation.

The main objectives of the system of currency regulation in general are to see that:

I. People’s confidence in the currency is maintained.

II. Its supply is adjusted to the demand in the economy.

2. Banker, Agent and Adviser to the Government

The central bank operates as the government’s banker, not only because it is more
convenient and economical to the government, but also because of the intimate
connection between public finance monetary affairs.

• As banker to the government, the central bank makes and receives payments on
behalf of the government by keeping the banking account and balances of the
government after making disbursements and remittances.

• As an adviser to the government, the central bank advises the government on all
monetary and economic matters.

• As an agent to the government, the central bank acts as an agent where general
exchange control is in force.
3. Custodian of Cash Reserves

All commercial banks of a country keep part of their cash balances as deposits in
the central bank. Commercial banks draw during busy seasons and pay back during
slack seasons. The centralization of cash reserves in the central bank is a source of
great strength to the banking system of any country because it serves as a basis of
increased elasticity and liquidity of the banking system and credit structure as a whole.

4. Custodian of foreign Balances

After World War I, central banks have been keeping gold and foreign currencies as
reserve note-issue and also meet adverse balance of payment, if any, with other
countries. The central bank maintains the exchange rate fixed by the government and
manages exchange control and other restrictions imposed by the country. Thus, the
central bank becomes a custodian of nation’s reserves of international currency or
foreign balances.

5. Lender of Last Resort

Whenever member banks are short of funds, they can take loans from the central
bank and get their trade bills discounted in times of difficulties and strains. This facility of
turning assets into cash at such notice is of great use to the member banks and it
promotes elasticity and liquidity in the banking and credit system of a country.

6. Clearing House

The central bank acts as a clearing house for the settlement of accounts of
commercial banks. A clearing house is where mutual claims of banks on one another
are offset and a settlement is made by the payment of the payment of the difference.
Central bank is the banker of banks that keeps the cash balances of commercial banks
and makes it easier for member banks to adjust or settle their claims against one
another through the central bank.

7. Controller of Credit

The control and adjustment of credit is accepted by most economists and bankers
as the main function of a central bank. Commercial banks create a lot of credits which
sometimes result to inflation. The expansion and contraction of currency and credit are
the most important causes of business fluctuations which is why credit control is crucial
because money and credit play an important role in determining the levels of income,
output and employment.
8. Protection of Depositors’ Interests

The central bank supervises the commercial banks to protect the interest of the
depositors and ensure the development of banking. Legislation is enacted to enable the
central bank to inspect commercial banks in order to maintain a sound banking system,
comprised of individual units with adequate financial resources operating under proper
management in conformity with the banking laws and regulations and public and
national interests.

MONETARY POLICY

✓ measures or actions taken by the central bank to influence the general price level
and the level of liquidity in the economy
✓ To promote a low and stable inflation conducive to a balanced and sustainable
economic growth and low unemployment
✓ In cases of unemployment, recession and deflation, remedy is to increase money
in circulation and inducing spending
o Govt. actions: buying bonds in the open market and reducing interest
rates
✓ In times of inflation, remedy is to reduce money in circulation
o Govt. actions: selling bonds in the open market and increasing interest
rates

HOW DOES A MONETARY POLICY WORKS?

✓ The CB steers monetary policy through interest rates on deposits and loans,
and through the minimum required deposits of banks
✓ The interest rate is the so-called key lending rate. It is adjusted in regular
intervals taking the economic situation into account
✓ When CB wants to bring more money into circulation, it lends money to
commercial banks at especially low interest rates. This makes it possible for
these CBs to make the money available at less expensive terms to their
customers
✓ Whenever the money supply threatens to grow more rapidly than the real
economy, the CB has the possibility to raise the key lending rate and the min.
deposit required. This in turn reduces money supply
 Expansionary Monetary Policy vs. Contractionary Monetary Policy

EXPANSIONARY
• monetary policy setting that intends
to increase the level
liquidity/money supply in
economy -- could also result in a
relatively higher inflation path for the
economy.
• lowering of policy interest rates
• reduction in reserve requirements.
• It tends to encourage economic
activity as more funds are made
available for lending by banks.
• This, in turn, increases aggregate
demand which could eventually fuel
inflation pressures in the domestic
economy.
CONTRACTIONARY
• monetary policy setting that
of intends to decrease the level of
the liquidity/money supply in the
economy -- could also result in a
relatively lower inflation path for
the economy.
• increases in policy interest rates
• increase reserve requirements
• It tends to limit economic activity
as less funds are made available
for lending by banks
• This, in turn, lowers aggregate
demand which could eventually
temper inflation pressures in the
domestic economy.

Monetary Policy Tools

Here are the three main monetary policy tools that work together to sustain healthy
economic growth.

1. Open Market Operations

Open Market Operations are when central banks buy or sell securities. When the
central banks buy securities, it adds cash to the banks’ reserves. That gives them more
money to lend. When the central bank sells the securities, it places them on the banks’
balance sheets and reduces its cash holdings. The bank now has less to lend.

➢ Expansionary Monetary Policy – buys securities to increase money supply and

lower interest rates.
➢ Contactionary Monetary Policy- sells securities decrease money supply to
increase interest rates.
In conducting OMO, the BSP uses two instruments:

• Repurchase (repo) / reverse repurchase (reverse repo) agreements. The

BSP purchases government securities from a bank with a commitment to sell it
back at a specified future date at a predetermined rate. In effect, a repo
transaction expands the level of money supply as it increases the bank’s level of
reserves. Under a reverse repo, the BSP acts as the seller of government
securities, thus, the bank’s payment reduces its reserve account resulting in a
contraction in the system’s money supply. For both repos, the BSP can only
affect the level of money supply temporarily, given that the parties involved
commit to reverse the transaction at an agreed future date. At present, the BSP
enters into repo agreements for a minimum of one (1) day (overnight) for both
repos and a maximum of 91 days and 364 days for repo and reverse repo
agreements, respectively.

• Outright purchases and sales of securities. An outright contract involves

direct purchase/sale of government security by the BSP from/to the market for
the purpose of increasing/decreasing money supply on a more permanent basis.
In such a transaction, the parties do not commit to reverse the transaction in the
future, creating a more permanent effect on the banking system’s level of money
supply.

2. Reserve requirement

Reserve requirement is the amount of deposits that a bank must keep on hand at
all times. They can either keep the reserve in their vaults or at the central bank. Reserve
requirement is usually a specified percentage of banks’ demand deposits and time
deposits. The main purpose of a reserve requirement is to control growth in the money
supply.

When a central bank wants to restrict liquidity, it raises the reserve requirement.
That gives banks less money to lend. When it wants to expand liquidity, it lowers the
requirement. That gives member banks more money to lend. Central banks rarely
change the reserve requirement because it requires a lot of paperwork for the members.

➢ Expansionary Monetary Policy- lowers reserve requirement since it allows banks

to lend more of their deposits.
➢ Contractionary Monetary Policy- increases reserve requirement since it gives
banks less money to loan.
 3. Discount Rate

A central bank can influence the interest rates by changing the discount rate. The
discount rate (base rate) is an interest rate charged by a central bank to commercial
banks and other financial institutions for short-term loans. For example, if a central bank
increases the discount rate, the cost of borrowing for the banks increases.
Subsequently, the banks will increase the interest rate they charge their customers.
Thus, the cost of borrowing in the economy will increase, and the money supply will
decrease.

➢ Expansionary Monetary Policy- lowers the discount rate to stimulate economic

growth. When the central banks lower the discount rate, banks also have to lower
interest rates to compete. This increases the money supply, spurs lending, and
boosts economic growth.
➢ Contractionary Monetary Policy– increases the discount rate which makes
borrowing funds expensive and so they banks have less cash to lend out. This
reduces money supply, slows lending and therefore slows economic growth.
Central banks increase the discount rate to fight inflation.

Significant Economic Events and the Implementation of Monetary Policy

The Great Recession and the Expansionary Economic Policy

A good example of a country kick-starting an expansionary monetary policy is the

2008-2009 Great Recession, which impacted countries around the world, including the
U.S. and the U.K. In both of those countries, central banks cut interest rates to near 0%
levels after the recession hit, with the intent of expanding the pool of low-cost capital so
individuals and businesses had easier access to cheaper money. The idea was to lower
rates to the point where consumers would borrow more freely and inject more money
into declining country economies. In the case of the Bank of England, interest rates
were cut significantly from 5% to 0.5% within several months during 2008 and 2009.
Likewise, the U.S. Federal Reserve adopted the same tactic, as housing prices began
to drop and the economy slowed, the Federal Reserve began cutting its discount rate
from 5.25% in June 2007 all the way to 0% by the end of 2008.
 Both central banks also kept a sharp eye on inflation which tends to rise in a
low-interest rate environment. Yet economists adopted a low-interest rate policy just the
same, figuring it an acceptable risk at a period when economic growth trumped other
potential economic outcomes. One negative outcome from expansionary economic
policies during tough economic times is that the policy discourages savings. With
interest rates low on savings-oriented investment vehicles like bank savings and
checking accounts, money market accounts, certificates of deposit, and government
and corporate bonds, savers had to look elsewhere to generate wealth, and wound up
investing more money in capital appreciation vehicles, like stocks and commodities.

At the same time, the Bank of England and the U.S. Federal Reserve engaged in
quantitative easing - essentially creating money and steering that money toward the
acquisition of government bonds from private banks. With the economy still weak, it
embarked on purchases of government securities from January 2009 until August 2014,
for a total of $3.7 trillion.

That strategy was designed to boost national money supplies, which would result
in more bank lending to consumers and businesses. The strategy was also designed to
lower bank interest rates, resulting in more borrowing of capital among the populace
and stronger spending on capital and investments. There was no guarantee the policy
would work. Economic conditions back in 2008 and 2009 were so dire that consumers
weren't exactly gung-ho about spending money, even if credit was cheap and money (in
the form of lower-rate loans) widely available. Additionally, while banks were the primary
beneficiaries of quantitative easing policies, they weren't forced to pass on lower-
interest loans to the general population. Indeed, many didn't, causing economic growth
to slow down severely.

The result of expansionary economic policies during and after the Great
Recession

While economists differ, a general consensus developed that while expansionary

economic policies didn't trigger an outright economic boom, it did just enough to help
economies in the U.S. and the U.K. generate some much-needed traction and kept
economies in both countries on a path to recovery, albeit at a glacial pace.
Contractionary Economic Policy

Most economic environments aren't as dire as they were in the Great Recession,
but it's also safe to say that central banks are always looking for ways to either stimulate
economic growth or sustain it once an economy is rolling. Sometimes, that blueprint
works too well, as economies grow too hot and accelerate too fast, which may well
cause a central bank act to slow that growth down. Central banks can trigger too much
economic growth by injecting too much money into a nation's economy, which usually
results in inflation.

In a word, inflation means a rise in the price of goods and services, which leads
to a rising cost of living as prices climb throughout a nation's economy. Inflation is
measured by the national inflation rate, i.e., the regular percentage change in economic
prices as measured by economic benchmarks like the Consumer Price Index (CPI) in
the U.S. and the Retail Price Index (RPI) in the U.K. In general, a central bank like the
Federal Reserve aims for a "sweet spot" on inflation, usually at a rate of 2%. Anything
above that means the economy could be growing too fast, and that prices are growing
too high, leading a central bank to shift to a contractionary or restrictive economic
policy.

In that scenario, a central bank will usually opt to boost interest rates and sell
some of its government bond holdings to curb economic growth. It does by reducing a
nation's money supply, hardening lending and credit conditions, and keeping a nation's
inflation rate around that preferable 2% level.

That was the case in 2017 and 2018, when the U.S. Federal Reserve boosted
interest rates three times in the former year and four times in the latter one. The Fed
also sold a significant share of its government bond holdings to engineer what it hoped
would be a "soft landing" in getting inflation to 2%, while keeping the U.S. economy on a
steady growth path.

As for hitting that 2% inflation target through a decade of economic turmoil, the
data shows the Federal Reserve did its job. In the summer of 2008, right before the
economic downturn, the U.S. economy was still in white-hot growth mode, with inflation
at 5.6%. Over a decade later, in the first quarter of 2019, inflation, after numerous
gyrations, stood at 1.9% - a level that apparently allows a central banker to sleep well at
night.
 Banko Sentral ng Pilipinas (BSP)
Monetary Policy Framework and Primary Monetary Policy Instrument

The Bangko Sentral ng Pilipinas (BSP) is the central bank of the Republic of the
Philippines. The primary objective of its monetary policy is “to promote price stability
conducive to a balanced and sustainable growth of the economy” (Republic Act 7653).

The BSP adopts an inflation targeting framework of monetary policy in achieving

this objective. The National Government, through an inter-agency body, sets the
inflation target two years ahead in consultation with the BSP. The target is represented
by a point target with a tolerance interval of ±1 percentage point. The BSP announces
publicly the inflation target and strongly commits to achieving it over a policy horizon
using various monetary policy instruments.

The primary monetary policy instrument of the BSP is the overnight reverse
repurchase (RRP) rate. The RRP rate is the rate at which the BSP borrows money from
commercial banks within the country. The BSP uses a suite of quantitative
macroeconomic models to forecast inflation over a policy horizon of two years. The
bank considers the forecast when deciding on whether it should raise or reduce its
policy interest rate to attain the inflation target.

Adjustments in the interest rate for the BSP’s overnight reverse repurchase
(RRP) facility typically leads to corresponding movements in market interest rates, thus
affecting the demand by households and firms for goods and services. This, together
with the aggregate supply of goods and services, determines the level of prices.

Nevertheless, movements in inflation can be driven by factors beyond the

influence of the central bank, and this often poses challenges for the BSP’s conduct of
monetary policy. The inflation targeting framework of the BSP recognizes these factors,
which can include inflation pressures arising from (a) volatility in the prices of
agricultural products; (b) natural calamities or events that affect a major part of the
economy; (c) volatility in the prices of oil products; and (d) significant government policy
changes that directly affect prices such as changes in the tax structure, incentives, and
subsidies.

The Inflation Report is published quarterly as part of the BSP's transparency

mechanism under inflation targeting and to convey to the public the overall thinking and
analysis behind the BSP's decision on monetary policy. To ensure accountability in
cases where the BSP fails to achieve the inflation target, the BSP Governor issues an
Open Letter to the President outlining the reasons why actual inflation did not fall within
the target, along with the steps that will be taken to bring inflation towards the target.

Headline inflation in Q1 2019 slowed down further to 3.8 percent from 5.9
percent in Q4 2018, which is within the National Government’s announced
target range of 3.0 percent ± 1.0 percentage point (ppt) for the year.

On June 20, 2019, the Monetary Board decided to keep the interest rate
on the BSP’s overnight reverse repurchase (RRP) facility unchanged at
4.50 percent. The interest rates on the overnight lending and deposit
facilities were likewise held steady.