International Finance 


and 

Financial Markets

Introduction to Central Banking

MBAIB 2020
University of Colombo

MBAIB5214 Lecture IV 26 Sept. 2020

 Recall of Lecture 3
Different Types of Financial Markets
• Different Dimensions of Financial Markets
• Distinction between Money Market and Capital Market
• Financial Products in Money and Capital Markets
• Interdependence between Money and Capital markets

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 Today’s Topic:
Central Banking

• Nature and Role of the Central Bank

• Operational Structure of the Central Bank
• Monetary Policy and Policy Tools
• Influence of the Operations of the Central Bank on the
Operations of the Financial System
• Factors affecting the Effectiveness of Monetary
Management
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 What is Central Banking?

• Central Bank is considered as the apex institution in the financial system of a

nation, as it is legally entrusted with the responsibility of maintaining secure and
efficient monetary, financial and payment and settlement systems to facilitate
economic agents to carry out their economic plans as per their expectations with
confidence
• Central Banks are empowered by the law as the sole authority to,
• Issue the currency notes and coins to facilitate smooth functioning economic activities
• Conduct the monetary policy to maintain the optimal volume of money to ensure price stability
• Issue licenses for commercial banks, special banks and finance companies to operate business
• Monitor, supervise and regulate the operations of banks and nonbank financial institutions
The Core areas of Central Bank’s Operations

• Secure Cash

• Stable Money

• Stable Monetary System and Financial System

• Stable Banking System

• Secure Payment System

 Nature and Role of the Central Bank
&
Operational Structure of the Central Bank

• Compulsory Reading : Available on LMS

Central Bank of Sri Lanka

Objectives, Functions
& Organization
Functions of the Central Bank of Sri Lanka

• Sole authority of issuing the legal tender

• Conduct the Monetary Policy

• Regulator of the Banking and Financial System

• Banker, Agent and Advisor to the Government

• Banker to Banks

• Custodian of the Cash Reserves

• Facilitator of Liquidity Management

• Lender at Last Resort

• Clearing Agent
Monetary Policy
• Definition :

The mission statement of the Central Bank of Sri Lanka (CBSL)

“Maintaining economic and price stability and financial system stability to
support sustainable growth through policy stimulus, advice, commitment, and
excellence”

• Final objective : Sustainable Growth

• Intermediate objective : Maintaining price stability

• Focus of the Monetary Policy : either on the volume of money, the liquidity,
or the interest rate (cost of funds)
>> Maintain price stability = Maintain a low and stable inflation rate. 8
Monetary Policy
• Monetary Targeting :
Influencing the overall price level by controlling the level of money supply
(Intermediate target).

P% = M% - Y%
where;
• P% = the rate of change the general price level, the inflation rate
• M% =the rate of change of money supply, monetary growth (AD)
• Y% = the rate of change of the real output level, real GDP growth (AS)

• Ex: It the economy experiences a real GDP growth of 5% and monetary growth 20%, that economy should
experience an inflation rate of 15%
• Monetary Policy has an immediate impact on the monetary Growth
Monetary Policy and Aggregate Demand
• Money represents the power of purchasing goods and services
• The act of purchasing represents the demand side of the market and not
the supply side
• If people have more money > higher purchasing power > demand for
more goods and services > push the prices up
• By reducing the availability of money or liquidity> lower the purchasing
power> less demand >push the prices down
• Monetary policy focuses on changes in prices driven by the aggregate
demand which is associated with money
• Therefore, it is directed to manage the aggregate demand to maintain
price stability
Monetary Policy
• Monetary Targeting :
• Since changes in money supply lead to changes in Aggregate Demand, the
monetary policy is considered as a Demand Management Policy
• How the monetary policy can influence the price level through change
in money supply?

Influence of Monetary Policy

Price level
rate (p) AS

Contractionary
P2 = 115
Monetary Policy
P3 = 105

P1 = 100
AD2 with M% =20%

AD3 with M% =10%

AD1 with M% =0%

0 AD1 AD2 AD3 Aggregate Demand (AD)

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Monetary Policy
Monetary Targeting :
•Assumption: all those factors remain constant and change in money supply
have immediate impact on inflation
•So many other factors affect the rate of inflation
✦ Demand for money
Ex: when demand for money goes down, when the Central Bank takes
contractionary measures to curtail aggregate demand, in could nullify the
effectiveness of monetary policy fully or partially, because it induces aggregate
demand
So, it is assumed that demand for money remains fairly constant, at least in
the short-term
•Monetary Policy does not deliver immediate results, but with time lags

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 Monetary Policy
• Inflation Targeting :
• Monetary Targeting : level of money supply as an intermediate target to achieve price
stability
• Inflation Targeting: A model base framework, which targets a specific rate of inflation
announced in advanced.
• Monetary policy stance is driven by the target inflation rate rather than the target rate of
monetary growth

• Flexible Inflation Targeting :

• The Flexible Inflation Targeting framework is concerned about both inflation and output
compared to strict inflation targeting framework.
• It focuses on minimizing deviations of projected inflation rate ( from a target inflation
rate) and aggregate output ( level from the potential (sustainable)) level of output
Monetary Policy Instruments
Conventionally, monetary policy instruments fall into two main categories,

Quantitative Instruments
• Monetary Base
✦
Open Market Operations (OMO)
✦
Policy Interest Rates
• Money Multiplier
✦ Statutory Reserve Ratio

Qualitative Instruments
• Overall Operations of the banking system
✦
Moral suasion
Open Market Operations (OMOs)
• The Central Bank (CB) conducts OMO either by buying or selling securities (Government
Debt securities :T Bills and T Bonds or Central Bank Securities) in the money market

• The time span for most of the OMOs is overnight. Transactions take place between the CB
and commercial banks and primary dealers.

• If the CB purchases securities, the domestic assets in the CB balance sheet increases with
corresponding increase in its liabilities in the form of currency in circulation. It adds to the
market liquidity.

• When the volume of liquidity in the market is increased >the interest rate decreases , unless
the demand for liquidity increases to match the increased supply.

• The reversal happens when the CB sells securities to absorb the market liquidity.
Impact of OMO on the Money Market

Market S1 (CB purchases Securities)

Interest Rate

S0
D1 (CB sells Securities)

i1

i0

i2

D0

0
Volume of Liquidity
 Policy Interest Rates
• Two types of interest rates;

✦ Policy Interest Rates

✦ Market Interest Rates

• OMO is used to influence the market interest rates by influencing the liquidity situation in the
market

• Policy interest rates are directly set by the CB to influence the market interest rates

• The CBSL sets three policy rates;

✦ Standing Deposit Facility Rate (SDFR)

✦ Standing Lending Facility Rate (SLFR)

✦ Bank Rate (BR)

Policy Interest Rates
Standing Deposit Facility (SDF) and Standing Lending Facility (SLF)

• The two facilities are maintained by the CBSL to facilitate short term liquidity management of commercial banks

• They provide alternative access for commercial banks to manage short term liquidity

• To borrow through SLF, deficit bank has to have short term securities acceptable to the CBSL at its disposal to use as
collateral to the funds

Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR)

• These two rates are associated with the two facilities discussed above

• SDFR: Policy interest rate the CBSL pays on deposits of commercial banks

• SLFR: Policy interest rate the CBSL charges from borrowing commercial banks

• These two rates form a corridor of interest rates that helps the CBSL to stabilise the fluctuations of the short-term
market interest rates and implement its monetary policy stance

• How these two rates can stabilise fluctuations of short term interest rates?

• How they can be used to influence aggregate demand to achieve and maintain price stability?
 Interest Rate Corridor and Interest Rate Stability
How SDFR and SLFR can stabilise fluctuations of short term interest rates?

DL1
SL0
Mkt. ii

i1 Out of the Corridor

SLFR = 5.5%

Within the
i0
SL11

SDFR = 4.5%
Out of the Corridor
i2
DL0

0 0
Volume of Liquidity Time

DL = Demand for Liquidity

SL = Supply of Liquidity

Mkt. i = Market Interest Rate

SLFR = Standing Lending Facility Rate

 The Bank Rate (BR)
• Central Bank functions as the “Lender at Last Resort”
“If a commercial bank faces a liquidity problem, but unable to raise funs from any source, Inter-bank money
market,SLF of the CB or mutual arrangement with any other institution, the only rescue available for them is to
turn to the CB”

• It is not rational for the Central Bank to lend money at the normal rate of SLFR, because it has to
lend without security against the money it lends
• The applicable lending rate is relatively higher than the SLFR. This rate is identified as the Bank
Rate/Penal Rate
• The difference between the SLFR and the Bank Rate represents a risk premium from the
borrowing bank (8.5% - 5.5% = 3%)

• It is an extra cost in the form of a penalty for losing financial discipline of commercial banks
Statutory Reserve Ratio (SRR)
• The SRR is the ratio of deposits that commercial banks are required by statute to maintain
with the CB
• This is a prudential requirement to preserve the solvency of a bank to face contingent
liquidity requirement
• The SRR is a cushion to absorb contingent liquidity shocks. Commercial banks can use the
balance of deposits after making reservations to meet reserve requirements
• The ability of commercial banks to offer checking accounts/demand deposits and extend
credit for borrowers with check writing facilities allow commercial banks to create credit/
liquidity
• The SRR allows the CB to influence the credit creation capacity of commercial banks, as it
reduces the money available for the bank to support its credit creation process
• The CB can raise the SRR to tighten the monetary policy and lower it for the policy to be
easing
Moral Suasion (MS)

• The Moral Suasion is a qualitative policy measure

• The CB tries to achieve its objectives through a dialogue and cordial relationship with
commercial banks rather than exercising its authoritative powers through the policy
instruments
• The CBSL conducts regular meetings with the officials of commercial banks to update about the
contemporary developments in the financial sector with special reference to the banking sector
and the economy as a whole
• These meetings help the CBSL to maintain a close dialog with the banking community and
convince them about benefits of designing their operations by taking overall macro picture into
account rather than being too biased towards only micro approach taking only institutional
interests
Monetary Transmission Mechanism
“The process of transmitting the impact of the monetary policy actions to influence the real sector of
the economy thorough aggregate demand”

• The time period taken for this process is identified as “Lags in the Monetary Transmission Mechanism”

• That transmission takes place through multiple channels;

✦ Interest rate channel

✦ Wealth channel

✦ Exchange rate channel

✦ Bank lending channel

• The degree of effectiveness depends on the degree of development of the banking and financial systems and their
sophistication

• The degree of sensitivity of economic agents to changes in policy environment also affect the efficacy of the
monetary policy to tame inflation to maintain price stability
Interest Rate Channel
• This channel is considered as the traditional channel, which focuses on the cost of funds, the
interest rate
• Market interest (i) falls > Increase the expenditure (sensitive to changes in i), investment (I)
(fixed and inventory investment, residential housing and consumer durables)
• As I is a component of Aggregate Expenditure, “AE” associated with Aggregate Demand
(AD)> AD increases

i I AD
Expansionary Monetary Policy :

• The monetary policy can influence the interest rate directly by adjusting the policy rate
based on the recommendations of the monetary policy committee
• Alternatively, it can conduct open market operations which impact the interest rate
indirectly

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Wealth Channel
• One of the main functions of money is store of value

• Expansionary monetary policy > Expansion of money supply> Demand for assets > Asset
prices tend to rise > Increase the wealth of asset holders > Spend more on Consumption (C)

• As C, is a part of Aggregate Demand (AD), both output and prices tend to rise

Expansionary Monetary Policy M Ps W C AD

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Exchange Rate Channel
• In a freely floating exchange rate regime exchange rate responds to differences in interest
rates

• Expansionary monetary policy> When the interest rate ( i) goes down > returns from assets
denominated in domestic currency tend to fall and foreign assets become relatively
attractive > FX outflow >(EUSD/LKR) rises /LKR tends to depreciate

• Shift in demand for domestic goods and services by way of discouraging imports (M) and
encouraging exports (X) > BothAggregate Demand (AD) and prices to rise

X
Expansionary Monetary Policy i FX Out EUSD/LKR AD
M

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Bank Lending or Credit Channel

• Expansionary monetary policy> Expands money supply (M) > Banks receive more deposits
(D) > Increase lending/Credit expansion (L) > Expand both consumption (C) and
Investment (I) > Push the Aggregate Demand (AD) to rise

Expansionary Monetary Policy M D L C/I AD

Impact of the Monetary Policy

• The impact of monetary policy on the real sector varies from economy to economy depending on the
structure of the economy and the level of sophistication of the financial sector

• The degree of sensitivity of economic agents to changes in policy environment also affect the
efficiency of the monetary policy to tame inflation to maintain price stability
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Lecture 5 - Outline
• Interest Rate
• Definition of Interest Rate
• Distinction between Policy Interest Rates and Market Interest Rates
• Term Structure of Term Interest Rates/ Yield Curve
• Channels of Policy interest rates influencing Market of interest rates

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