Level 1 CFA® Exam:
Central Bank
Central banks:
- are responsible for money supply and monetary policy,
- they are banks for the government and other banks,
- they regulate and supervise the national payment system,
- are the lender of last resort, and
- keep national reserves of gold and currencies.
The objectives of central banks are different in different countries. However, they usually include:
- controlling inflation. It is usually the main objective.
- maintaining the stability of the currency,
- maintaining full employment,
- maintaining positive economic growth, as well as
- maintaining a stable level of interest rates.
The central bank should have the following characteristics (qualities):
- should be independent of political influence,
- should be characterized by reliability and credibility. People’s trust in the central bank’s actions is key to the effectiveness of its actions.
- activities performed by central banks should be transparent and open to the public.
One of the roles of the central bank is to conduct the monetary policy.
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Through the monetary policy, the central bank affects the level of inflation, interest rates, and currency exchange rates and – consequently – also the economic growth.
Most central banks set inflation targets usually at the level ranging from 2 to 3%. If inflation is expected to rise above the set target, the money supply is reduced in order to reduce economic activity. Similarly, to stimulate economic activity, if inflation is below the target, the money supply is increased.
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Limitations of monetary policy:
- Monetary policy can affect inflation expectations so much that long-term interest rates may be changing in the opposite direction to short-term interest rates.
- The central bank may lack credibility.
- Banks are not willing to lend too much money, even if they have large excess reserves.
- Liquidity trap (consumers are willing to hold more cash, regardless of changes in short-term interest rates): liquidity trap goes hand in hand with a deflationary environment.
- Central banks are banks for the government and other banks.
- The objectives of central banks are different in different countries. However, they usually include: controlling inflation, maintaining the stability of the currency, maintaining full employment, maintaining positive economic growth, and maintaining a stable level of interest rates.
- Goals of the monetary policy can be achieved through: a policy rate, reserve requirement, and open market operations.
- Reserve requirement is a percentage of bank deposits that must be held as reserves.
- To stimulate the economy, the central bank, within open market operations, purchases securities from commercial banks.