role of a central bank

Money and Banking – The Role of the Central Bank (Cambridge IGCSE/A‑Level 9708)

1. Money – Definitions and Measures

• Money is any asset that is widely accepted as a medium of exchange, a store of value and a unit of account.
• In the syllabus money is measured at three levels. The table shows what each measure contains and why it matters to the central bank.

2. Commercial Banks – Functions and Money Creation

• Accept deposits, provide payment services and grant loans.
• Through the fractional‑reserve system they create money:
  1. A bank receives a deposit and must keep only a fraction (the reserve‑requirement ratio) as reserves.
  2. The remainder can be lent out, creating a new deposit in another bank.
  3. This process repeats, expanding the money supply by the money multiplier (see Section 6).
• The central bank influences this process by:
  • Setting the reserve‑requirement ratio,
  • Setting the policy (discount) rate, and
  • Providing liquidity through open‑market operations or emergency facilities.

3. The Central Bank – Definition and Core Objectives

A central bank is the principal monetary authority of a country. It is a public institution that operates independently of the commercial banking sector and day‑to‑day government finance, with the purpose of maintaining macro‑economic stability.

Core Objectives (linked to assessment objectives)

4. Main Functions of the Central Bank

1. Issuing Currency – Sole authority to produce banknotes and coins (M0).
2. Monetary‑Policy Implementation – Influences the quantity of money and the cost of borrowing.
3. Lender of Last Resort – Supplies emergency liquidity to solvent banks.
4. Regulation & Supervision – Sets prudential standards (e.g., capital adequacy, liquidity ratios under Basel III), monitors banks’ compliance and takes enforcement action. This role underpins financial‑system stability (AO 3).
5. Management of Foreign Reserves – Holds and, when necessary, sells foreign‑exchange assets to stabilise the national currency.
6. Financial‑Market Operations – Conducts open‑market operations and, where required, quantitative easing (see Section 5).

5. Monetary‑Policy Tools

The syllabus requires detailed knowledge of the three mandatory tools. Quantitative easing (QE) is an optional/advanced tool that may appear in higher‑order questions.

6. Money Multiplier and Reserve Requirement

The potential expansion of the money supply from a given level of base money is expressed by the money multiplier:

m = 1 ⁄ RRR

where RRR is the reserve‑requirement ratio (decimal form). Example:

• If RRR = 0.10, then m = 10. Each £1 of base money can support up to £10 of broad money (M2).

Limitations of the Multiplier

• Cash drain: Households may hold a larger share of cash, reducing the amount deposited in banks.
• Excess reserves: Banks may keep reserves above the statutory requirement, especially in uncertain periods.
• Changes in money demand: A fall in the velocity of money (V) weakens the link between M and economic activity.
• Regulatory constraints: Capital adequacy rules can limit the amount banks are willing to lend even if reserves are plentiful.

7. Quantity Theory of Money

The classic relationship linking money, price level and output is:

MV = PY

• M = money supply (usually M2).
• V = velocity of money (average number of times a unit of money is spent in a year).
• P = price level.
• Y = real output (real GDP).

Assuming V is relatively stable in the short‑run, an increase in M leads proportionally to a higher P if Y is at or near full capacity. This provides the theoretical basis for a central bank’s price‑stability objective and explains why many banks target a specific money‑growth rate (or, more commonly now, an inflation target).

8. Transmission Mechanism of Monetary Policy

Central‑bank actions affect the real economy through several inter‑related channels. For each channel the typical impact on aggregate demand (AD) is shown.

• Interest‑Rate Channel – Lower policy rates → lower market rates → ↑ investment & consumption → AD shifts right.
• Exchange‑Rate Channel – Lower rates → capital outflows → domestic currency depreciates → exports become cheaper, imports more expensive → AD shifts right.
• Asset‑Price (Wealth) Channel – Lower rates raise house and equity prices → households feel wealthier → ↑ consumption → AD shifts right.
• Credit Channel – Reduced reserve requirements or increased liquidity → banks extend more credit → ↑ investment & consumption → AD shifts right.
• Expectations Channel – Credible commitment to low inflation or to stimulus → firms and households adjust expectations → influences current spending and pricing decisions → can shift AD either way depending on the signal.

9. Independence vs. Accountability

• Independence – Operational freedom from short‑term political pressure enables the bank to pursue long‑run price stability. Most modern central banks have statutory guarantees of independence.
• Accountability – Democratic legitimacy is maintained through:
  • Regular policy statements and inflation‑target reports that set out the bank’s objectives and the rationale for its actions.
  • Publication of meeting minutes and forecasts.
  • Parliamentary or congressional hearings where the governor answers questions.
  • Clear, measurable targets (e.g., a 2 % inflation target) that allow performance to be assessed.
• Most central banks adopt a “dual‑mandate” (price stability + growth/employment) that balances independence with the need to be answerable to the public and elected officials.

10. Summary Checklist for Exams (AO1‑AO3)

• Define money and distinguish M0, M1 and M2; explain why the distinction matters to the central bank.
• Describe the role of commercial banks in the fractional‑reserve money‑creation process.
• State a concise definition of a central bank and list its six core functions, giving a short explanation of the supervisory role.
• List the three mandatory monetary‑policy tools (OMO, policy rate, reserve‑requirement ratio) and the optional QE; explain their impact on M and on the market interest rate i.
• Derive the money‑multiplier formula, calculate its value for a given RRR and mention the main limitations (cash drain, excess reserves, demand‑for‑money changes, regulatory constraints).
• Write the quantity‑theory equation MV = PY and discuss its implication for inflation targeting and for the choice of monetary‑policy stance.
• Outline the transmission mechanism, naming each channel and stating its usual effect on aggregate demand.
• Explain the trade‑off between the central bank’s objectives (price stability vs. growth/employment) and discuss independence versus accountability, citing policy statements and inflation‑target reporting as examples of transparency.
• Evaluate the likely effectiveness of a chosen tool (e.g., QE, OMO, reserve‑requirement change) in a specific macro‑economic context, weighing benefits against possible side‑effects (AO3).