MONEY TREE

MONEY TREE

Wednesday, July 21, 2010

IMPORTANCE OF PUBLIC EXPENDITURE

I n today dynamic world, the importantance of public expenditure increasing not only to maintain law and order but also for the growth, stability of the economy and weal fear of the state. The importance of the public expenditure is explained below.

1. DEFENSE
Due to the increasing cost of new weapons, sophisticated tanks and guns, modernization of defense forces a large part of the total expenditure is needed.

2. WELFARE SCHEMES
Since wage is under developed countries are low, a number of welfare schemes are under take by the government, such as free or subsidized health services, child welfare, welfare of the handicapped, subsidies on food and housing, special schemes for the unemployed, for scheduled castes and tribes as in Nepal etc.

3. POPULATION GROWTH
Population has been expanding fast in developing countries. The population theory of Malthus has been operating in such countries. A large amount has to be spent on child welfare, nutrition, social security measures, public health service, family planning programmers such as free supplies of contraceptives etc.

4. INDUSTRIAL DEVELOPMENT
A developing country need industrial development both in the private and public sectors cheeps credit to small-scale industries, supply of raw materials at concessional rates, expert subsidies, tax concessionals for industries in the backward regions, setting up of strategic industries in the public sector, etc has increased the importance of public expenditure.

5. EDUCATION
Illiteracy is rampant in developing countries so public expenditure an account of education, art, culture, scientific service and research has increased considerably.

CONCEPT OF INFLATION & DIFLATION

Inflation Purchasing power of people expands with increase in money income supply of goods and services doesnot increase to the same extend. This brings about the economic disequilibrium, which is known as inflation.There are various reason of inflation. Inflation occurs due to the following reasons:1. Demand- pull inflationIf the aggregate demand for goods and services exceed the supply of these goods and services, it is called damand-pull inflation. It occurs due to the following reasons which are given below:a) Reduction of taxation: If the government reduces the rates, it will increase purchasing power of people due to increase in disposable income of people. Consequently, the consumption expenditure and inflation occurs.b) Miscellaneous: There are other of demand-pull inflation, such as increase in private expenditure, shortage of goods and services in the market, increasing the volume of exports, repayment of debts etc. all above mentioned factors creates the problem of excess of demand over supply of goods and services and finally inflation occurs.2. Cost-push inflation: If the price of commodities rises due to the rise in cost of factors and raw materials, the inflation is called cost-push inflation. In cost push inflation, general price will be high and aggregate supply will be low as compared to aggregate demand for goods and services. Following are the causesof inflation;a) Increase in wages: Sometimes price of goods and services increase rapidly due to rise in wage rate of labor. If the trade unions are strong in the country, they demand more wages to maintain real wages which increases the cost of production and inflation occurs, which is also known as wages push inflation.b) International reasons: In the context of international trade, most of developing countries like Nepal are dependent on for raw materials, fuel energy, consumer goods etc. If the price of such goods increases in foreign country, obviously the price of such products increases in the country.DeflationPrice decline adversely affects employment condition. It creates unemployment which brings deflation. It is also known as disinflation.Following arethe causes of deflation:1. Decrease in money supply: Deflation occurs due to the low supply of money in the economy. When the central bank or other financial institutions does not issue sufficient amount of money in comparison to goods and services produced in the economy, then there will be less velocity of money or circulation of money and finally deflation occurs.2. Control of credit: One of the major functions of central bank is to control on credit creation to the commercial banks. The notice may circulate by central bank to commercial banks for increasing the ratio of cash reserved fund. It creates the deflation in the economy.3. Increase in Tax Rate: Sometimes government may impose high direct tax rate to the people due to various reasons such as control on inflation, increase in public expenditure, fulfilling war and emergency expenses etc. The high burden of tax on people lacks the circulation of money in the economy, which creates deflation and as a result deflationary situation appears in the economy.

INDEX NUMBER OF MONEY

Value of money changes from time to time according to variation in prices of different commodities. All prices do not change in the same extend. Some may rise or fall of remain constant. The degree of changes in price may differ from commodity to commodity.Index number is an instrument to measure change in value of money according to change in prices. Generally index number takes the from of table.Types of Index Number:In general there are two types of index number:i) Simple Index NumberThe index number is constructed by giving equal importance or weighted to all commodities is called simple index number. In the simple index number, we assume base year equal to 100. According to this method, price index number is the outcome of the sum of prices for the current year divided by the sum of actual prices for the base year.ii) Weighted Index NumberThe index number constructing by giving weighted to various items as per their importance is called as weighted index number. Simple index number just gives equal importance to all commodities. Since, weighted index number are constructed on the basis of importance of commodities to the people, it measures accurate change in the value of money. In this method, different weights are assigned to different items according to their relative economic importance. There are different formulae to calculate index number by assigning different weights to different commodities.Importance of Index Numberi) Measurement of changes in cost of livingWhen a price of commodity goes up, cost of living rises. If prices fall cost of living also fall.ii) Study of fluctuationBy index number we can measured the rate of inflation and deflation.iii) Wage policy formulationGovernment changes wage policy on the basis of index number. If price level rises then government increases the wage level.iv) Government policy formulationGovernment has to formulate monetary and fiscal from time to time on the basis of price level.v) Business forecastBusiness is a matter of forecast. Prices may rise or fall in future. On the basis of past and present facts the future expectation can be made on the basis of index number.Difficulties in constructing Index Numberi) Selection base yearOne should be serious while selecting base year for index number. It should be normal year. It should not be fluctuated by any abnormal factors such as war, flood, earthquake etc. It is difficult task to select such.ii) Problem of weightTaking appropriate weight from the selected commodities is another difficulty of constructing index number. There should be accuracy and reliability in measuring the standard of weight commodities.iii) Collection of dataAnother difficulty of constructing index number is collection of data from the representative commodities. It is also difficult to find the reliable and authentic source of data.

ATM

ATM stands for Automated Teller Machine. It is a latest technology in world providing by the banks to their customer to withdraw cash immediately at any place. Now a day's in Nepal also it is most familiar to all the people. It is electrical use switching technology that organies digital data into 53-byte cell units and transmits them over a physical medium using digital signal technology. Individually, a cell is processed a synchronously relative to other related cells and is queued before being multiplexed over the transmission path.It is designed to be easily implemented by hardware rather than software, faster processing and switch speeds are possible. The prespecified bit rates are either 155.520Mbps or 622.080Mbps. Speeds on ATM networks can reach 10 Gbps. Along with synchronous optical networks and several other technologies; ATM is a key component of broadband ISDN.It is also known as a machine that bank customers use to make transactions without a human teller.There are a growing number of banks that are providing free ATM cards to their customer. The customer who withdraw amount from the customer who have the account in that bank ATM can't cut the amount if customer are taking from other banking at that time bank are take some amount from customer account. From this kind of facility customer feel easy and they don't have to carry many amounts if they are going from one place to another place. Customers feel easy from robbing. Such facilities are providing their customer 24hr's they can take their money. In Nepal this facility was started from 1999. In this ATM machine people can take money by inserting card and and they should follow the rules and they can enter their pin number and they can withdraw their needed money easily. In Nepal at one time only Fifty Thousand amounts can draw by one person.Historically, most banks have allowed their own customers to access their accounts with the bank for free while changing non-customers for use of their ATM. This gave banks with a large branch network a competitive advantage as banking with that bank offered the convenience of a greater number of free ATMs around the town. However branches are expensive to build and maintain and banks with few or no branches soon found that by reimbursing the fees charged to their customers when the customers use ATMs belonging to other banks, they could again the same.Competitive advantage at a much lower cost. Further, this cost could be contained by capping the amount of the fee reimbursed per transaction and or the number of transaction per month.According to the banking with USAA Federal savings Bank which from it's beginnings a few decades ago has had customers world-wide but only one office at the USAA headquarters in San Antonio, Texas. Originally, deposits were made via mail or wire transfer and cash with draw as through other bank ATMs with USAA reimbursing the ATMs. Other banks, especially internet banks, have since followed suit and many now offer reimbursement of ATM fees.

MEANING OF CAPITAL MARKET

Capital Market:-The capital market incorporates the financial instruments with more than one year. It deals with the long term financial instruments like corporate equities, government bonds, and debentures. The long and medium-term investment funds are raised through the capital market instruments for meeting the fixed and working capital requirements of the industry or government. Main difference between the money and capital market is the maturity of the credit instruments used in the market. The former relates to the market instruments with less than one year whereas the4 later deals with the instruments used for raising medium and long-term credit from the market. Capital market plays vital role for meeting external finance need of the corporations. The corporations, instead of borrowing from the banks, can directly raise the external funds from the public and, in turn, give them share certificates which they can trade in the capital market and convert into cash. The capital market serves as a bridge to establish a link between savers and investors or surplus or deficit units of the economy. Moreover, capital market provides incentives to the savers in the form of dividends or interest which induce them to save more. In the context of Nepal, the development of modern capital market is relatively a new phenomenon. It is a small and underdeveloped by any standard. The shares of few listed companies are traded in the stock exchange, Nepal Stock Exchange Limited (NEPSE) which was established in 1993.

MEANING OF MONEY MARKET

Money Market:- The financial system is the mechanism funds from surplus to deficit units through the various financial instruments include: treasury bills, corporate equities, debentures, certificate of deposits, government securities etc. The main purpose of these instruments is to collect scattered money and make funds available for investment or for payments. Some instruments are issued and traded for short-term in order to raise funds for the short period of time, usually less than one year. The market where the short term instruments such as treasury bills, certificate of deposits, money at call, inter bank transactions, commercial paper etc. are traded is known as money market. In other words money market refers to the totality of financial institutions which deal with the supply of and demand for short-term funds in the economy. The money market instruments are close substitute for money as they are highly liquid and easily marketable. The money is bought and sold in the money market. The main functions of money market are to provide short-term loans to government and the businessmen to meet their day to day requirements of the working capital, temporary funds to the speculators, and provide better opportunity for the commercial banks to utilize their funds for the short period of time. The money market provides opportunity for the banks and businessmen to utilize their extra funds which can be quickly converted into cash whenever necessary. It also enables banks to make up their unexpected needs for funds that they can obtain cheaply from the money market. London Money Market and Wall Street Money market in the USA are the two largest money markets with daily transactions of hundreds of billions of dollar every day.

Tuesday, July 20, 2010

IMPORTANCE OF PUBLIC FINANCE

There is great socio-economic significance of public finance, both in developed and developing countries. In developed country countries, price-stability and full employment are the main economic goals of public finance. In developing countries, rapid economic development through capital formulation and creation of infrastructure art the important goals of public finance operations. Socially equitable distributions of income, reduction of inequalities in income are some important functions of public finance operations. The importance of public finance can be clarified from the following functions.

1. TO INCREASE THE RATE OF SAVING AND INVESTMENT
Most of the people spend their income on consumption. Saving is very low so the investment is also low. The government can encourage the saving and investment.

2. TO SECURE EQUAL DISTRIBUTION OF INCOME AND WEALTH
Unequal distribution of income and wealth is the basic problem of the under developed countries. The rich are getting richer and richer while the poor are becoming poorer and poorer. So for the equal distribution of income and wealth there is need of government.

3. OPTIMUM ALLOCATION OF RESOURCES
Fiscal measures like taxation and public expenditure programmers can greatly affect the allocation of resources in various occupation and sectors.

4. CAPITAL FORMULATION AND GROWTH
Fiscal policy will be designed in a manner to perform two functions as of expanding investment in public and private enterprises and by diverting resources from socially less desirable to more desirable investment channels.

5. PROMOTING ECONOMIC DEVELOPMENT
The state can play a prominent role in promoting economic development especially through control and regulation of economic activities. It is fiscal policy which can promote economic development.

6. IMPLEMENTATION OF PLANNING
Under democratic planning fiscal policy plays crucial role as financial plan is as much important as physical plan and the implementation of the financial will obviously depend upon the uses of fiscal measures.

7. INFRASTRUCTURE BUILDING
Public finance helps to build up well-development physical and institutional infrastructure.

8. TO CONTROL INFLATION
The imbalance between demand for and supply of real resources may lead to inflations to under-development countries inflation ruins the entire economic structure of the national and the process of economic development in these countries comes to stand still. So to check inflation, budgetary policies can be used by the government.

MEANING OF PUBLIC FINANCE

Public finance is a study of income and expenditure or receipt and payment of government. It deals the income raised through revenue and expenditure spend on the activities of the community and the terms ‘finance’ is money resource i.e. coins. But public is collected name for individual within an administrative territory and finance. On the other hand, it refers to income and expenditure. Thus public finance in this manner can be said the science of the income and expenditure of the government.

Different economists have defined public finance differently. Some of the definitions are given below.

According to prof. Dalton “public finance is one of those subjects that lie on the border lie between economics and politics. It is concerned with income and expenditure of public authorities and with the mutual adjustment of one another. The principal of public finance are the general principles, which may be laid down with regard to these matters.

According to Adam Smith “public finance is an investigation into the nature and principles of the state revenue and expenditure”

To sum up, public finance is the subject, which studies the income and expenditure of the government. In simpler manner, public finance embodies the study of collection of revenue and expenditure in the public interest for the welfare of the country.

KINDS OF MONEY

Kinds of money are also known as forms of money. Money can be classified into various parts. On the basis of its evolution, there are following kinds of money.


COMMODITY MONEY

In the days of human civilization, human society had used each and every commodity like, cattle and their bones and leathers, food grains etc as money. The commodity which used as money is called commodity money. The commodity money lakes the basic feature of good money such as uniformity, stability durability, and transportability.


2. METALIC MONEY

Money made from metal like gold, silver, copper, brass is called metallic money. This money possesses quality of good money. The metallic money is of following types.


a. STANDARD OF FULL-BODIES COINS

The money made up of superior metals gold, silver etc with definite weight, value and purity is called standard or full body’s coins. The face value of such money is supposed to be equal to its intrinsic value. Its value does not fall when it is sold after melting.


b. TOKEN OR SUBSIDITY COIN

The money made of inferior metals like iron, copper, brass etc is called token or subsidiary money. The face value of token money is higher then the intrinsic value. Its real value disappears if it is melted. It holds nature of limited legal tender.

3. PEPER MONEY

The money issued by the central bank or monetary authority of the country in the form of paper notes is called paper money. The paper money was first invented in china in 18th century. Such money possesses higher face value than its intrinsic value. The paper money is widely used through the world.


a. REPRESENTATIVE OR CONVERTIBLE PAPER MONEY

Paper money that represents precious metals is known as representative paper money. They serve as a substitute of gold and silver to user. They hold cent percent reserve in the central bank or monetary authority of the country. It is difficult to issue money because all money should keep gold and silver reserve. It is also known as convertible paper money because; they can be converted into gold and silver easily in cash of need.


b. FIAT OR INCONVERTIABLE MONEY

The money issue by the central bank without cent percent gold and silver reserve is called flat money. Its face value is many time higher than the intrinsic value. It is issued by the state, so it has unlimited legal tender, but there is no legal provision to convert fiat money into gold and silver. Hence it is called non convertible paper money.


4. BANK OR CREDIT MONEY

The credit institution issued by the banks and finance companies, whose acceptance not obligatory, are known as credit or bank money. Credit instrument such as cheque, credit cards, debit cards, promissory notes, bills of exchange, draft, latter of credit etc are the example of credit money. It is also known as optional or non legal tender money.


VALUE OF MONEY

The value of money indicates purchasing power of money. It refers to the quality of goods and services that a unit of money can purchase unit of time. The purchasing power of money depends on the level of price of goods and services. Thus, it refers the buying and purchasing power of money. There is inverse relationship between the value of money and the price level. If price is high purchasing power of money is low. Similarly if price is low the purchasing power is high. There is positive relationship between value of money and its purchasing power. Higher the value of money, lower will be the purchasing power. Similarly, lower the value of money, lower will be the purchasing power. The relationship between the value of money and its purchasing power is exactly proportional. Thus, in consumption, the value of money refers to the money to command or buy the goods and services.


According to Benham, “The value of money means the purchasing power of a unit of currency in general.”


In the word of Crowther, “The value of money is that what it mill buy”

Fisher define the value of money a “The purchasing power of money is the reciprocal of the level of prices”

DEFECT/EVILS OF MONEY

Modern world is moving with the wheel of money. Money is not only important in every aspect of human life; it is also evil. Money is a good servant but bad master. Hence it is referred as necessary evil. The main defects are as follows.


1. ECONOMICS INSTABILITY

The value or purchasing power of money doesn’t remain same. This fluctuation in value of money causes economic instability. Increasing in quantity of money reduce value of money and invite inflation which makes the reach richer and the poor poorer. On the other hands decrease in the quantity of money increase value of money and causes deflection which increase unemployment and hardship.


2. TRADE CYCLE

Money can cause Boom and Slump. During boom employment expand beyond full employment level and price goes very high. During slump unemployment increase and productivity capacity and investment deceases. This trade cycle is monetary phenomena i.e. causes by money.


3. INEQUALITY OF INCOME AND WEALTH

Money cause inequality in the distribution of income and wealth which divide the society into richer and poor and causes class conflict. It disturbed the social harmony.



4. DISCOURAGE CAPITAL FORMULATION

Money discourages the capital formulation because if there is inflection, money gives rich to speculative activity and attracts resources away from productivity channels. On the other hand, if there is deflection, the whole economy machine goes out of gear and spreads missing all rounds.


5. SOCIAL DISADVANTAGE


Money brings about social disadvantage. It has been responsible for decline of spiritualism, increasing greed, encouraging theft, robbery, prostitution etc. it also increases exploitation and large scale corruption in the modern society.

ROLE/ IMPORTANT OF MONEY

Money is the lubricant of an economy. Without money economic activities such as production, consumption, capita formation etc can not be performed. This shows that money is the life blood of an economy. Due to its quality of portability, divisibility, stability, acceptability and durability, it is regarded as the wheel of the economics’ system. Following are the role of money:


1. ON CONSUMPTION

The satisfactions can be obtained by consumption of various goods and services, which is measured by the help of money. Due to its purchasing power, people can satisfy their wants by purchasing different commodities with money.


2. ON DISTRIBUTION

Money is used in factors pricing. It is the phenomena of determining the price of factors of production, such as wage, salary, for labor, interest for capital, profit for origination and rent for land. Any producer can maximize the profit by using money.


3. ON PRODUCTION

In production entrepreneur has to compensate all factors of production for their contribution. Rent to land, wage to laborers, interest to capital, profit to enterprises has to pay and without money we can’t assess the exact compensation of factors of production.


4. CREDIT FACILITY

Money facilitates the environment of credit business in modern economy. It has made easier both lending and borrowing. Money is also used in standard of different payment.


5. MEASURING NATIONAL INCOME

National income of the country is calculated in terms of money which shows the standard of living of people. Without money measurement of national income can not be done because national income is money value of total outlay of a country within a year.


6. MONEY IN CAPITAL FORMULATION

Capital is scare and important factors of production. Money provides mobility to capital. Capital formulation is possible when there is an exact unit to measure the amount of the capita in the country. The process of the capital formulation in the modern economy is almost impossible without money.


7. SOCIAL ECONOMIC DEVELOPMENT

Money plays a signification role in social economic development. It is an effective means of mobilizing factors of production. Money facilities the development of social and physical infrastructure such as road, electricity, communication, school, hospital etc.

FUNCTIONS OF MONEY

* PRIMARY FUNCTIONS

Primary functions are the major function of the money which can be explained the following headings.


1. MEDIUM OF EXCHANGE

The primary and unique function of the money is to serves as the medium of exchange. It provides the economic freedom to the people. With the money people can sell or bye the product in the market. It also insures the purchasing power of the consumers.


2. MEASURE OF THE VALUE

Money serves as a common measure of value and standard unit of account. After the invention of the money, value of goods and services can be expressed in terms of currency of money. It has made the transaction easy and simplified the problem of measuring and compeering the price of the goods and services in the market. It also helps to calculate the macroeconomic indicators like NI, per capita income, GDP, GNP and Human Development indicators.


* SECONDARY FUNCTIONS

Secondary functions of money is less important then that of primary functions. This function are originated and derived from primary functions of money. Following are the secondary functions of the money.


1. STORE OF VALUE

Money serves as store of value of any goods and services in both short run and long run. In modern world people want to have some currency or coins in their pocket, home ,bank account etc to use anytime for the purchase of anything. The value of goods and services can be store in terms of money for many y due to quality of stability and durability. Money as the liquid store of value facilitates its owners to purchase any other assets in any times.


2. STANDERD OF DIFFERENT PAYEMENT


Lending and borrowing was the very difficult before the invention of the money, so that it was difficult to settle of lone. But due to different payment credit system become easy. With the help of money people can buy or sell goods and services only on commitment and payment can be made in the future in the form of installment. Money is regarded as the best transaction due to its quality of stability, accepting and durability. The future payment also possible through the help of money.


3. TRANSFER OF VALUE

Money also serves as the common tool to transfer the value of assets and income. Sale, purchase, mobilization and transfer if movable and immoveable property can also made with the help of the money. One can sell at one place and can buy them elsewhere. Value shift from one place to another because it transferred in terms of money.

Wednesday, July 14, 2010

DEFINITION OF MONEY

Money is anything, which is generally accepted as a means of payment and it possess liquidity. It is the king of means, which is printed and acceptable to all for buying and selling goods and services. In other words, it refers to that commodity which performs as the medium of exchange goods and services, measuring the value of factors of productions, goods / services, common and useful means of credit transaction in business society and having quality of store of value of goods / services in the form of cash.
In other words, it is anything which possesses hand to hand easily as mediums of exchange among people. Money has become so much a part of our day to day activities that we have started to talk it for garneted. The complex economy system stands on the base of money because money is something which generally acceptable as a medium of exchange.


Wednesday, June 30, 2010


A central bank, reserve bank, or monetary authority is a banking institution granted the exclusive privilege to lend a government its currency. Like a normal commercial bank, a central bank charges interest on the loans made to borrowers, primarily the government of whichever country the bank exists for, and to other commercial banks, typically as a 'lender of last resort'. However, a central bank is distinguished from a normal commercial bank because it has a monopoly on creating the currency of that nation, which is loaned to the government in the form of legal tender. It is a bank that can lend money to other banks in times of need.[1] Its primary function is to provide the nation's money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system). It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.

Most of the rich countries today have an "independent" central bank, that is, one which operates under rules designed to prevent political interference. Examples include the European Central Bank (ECB) and the Federal Reserve System in the United States. Some central banks are publicly owned, and others are privately owned. For example, the United States Federal Reserve is a quasi-public corporation.[2]

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History

In Europe prior to the 17th century most money was commodity money, typically gold or silver. However, promises to pay were widely circulated and accepted as value at least five hundred years earlier in both Europe and Asia. The medieval European Knights Templar ran probably the best known early prototype of a central banking system, as their promises to pay were widely regarded, and many regard their activities as having laid the basis for the modern banking system.

As the first public bank to "offer accounts not directly convertible to coin", the Bank of Amsterdam established in 1609 is considered to be a precursor to a central bank.[3]. In 1664, the central bank of Sweden—"Sveriges Riksbank" or simply "Riksbanken"—was founded in Stockholm and is by that the world's oldest central bank (still operating today)[4]. This was followed in 1694 by the Bank of England, created by Scottish businessman William Paterson in the City of London at the request of the English government to help pay for a war.

Although central banks today are generally associated with fiat money, the nineteenth and early twentieth centuries central banks in most of Europe and Japan developed under the international gold standard, elsewhere free banking or currency boards were more usual at this time. Problems with collapses of banks during downturns, however, was leading to wider support for central banks in those nations which did not as yet possess them, most notably in Australia.

With the collapse of the gold standard after World War I, central banks became much more widespread. The US Federal Reserve was created by the U.S. Congress through the passing of the Glass-Owen Bill, signed by President Woodrow Wilson on December 23, 1913, whilst Australia established its first central bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New Zealand in the aftermath of the Great Depression in 1934. By 1935, the only significant independent nation that did not possess a central bank was Brazil, which developed a precursor thereto in 1945 and created its present central bank twenty years later. When African and Asian countries gained independence, all of them rapidly established central banks or monetary unions.

The People's Bank of China evolved its role as a central bank starting in about 1979 with the introduction of market reforms in that country, and this accelerated in 1989 when the country took a generally capitalist approach to developing at least its export economy. By 2000 the People's Bank of China was in all senses a modern central bank, and emerged as such partly in response to the European Central Bank. This is the most modern bank model and was introduced with the euro to coordinate the European national banks, which continue to separately manage their respective economies other than currency exchange and base interest rates.

Activities and responsibilities

Functions of a central bank (not all functions are carried out by all banks):

  • implementing monetary policy
  • determining Interest rates
  • controlling the nation's entire money supply
  • the Government's banker and the bankers' bank ("lender of last resort")
  • managing the country's foreign exchange and gold reserves and the Government's stock register
  • regulating and supervising 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

Monetary policy

The Bank of England, central bank of the United Kingdom

Central banks implement a country's chosen monetary policy. At the most basic level, this involves establishing what form of currency the country may have, whether a fiat currency, gold-backed currency (disallowed for countries with membership of the IMF), currency board or a currency union. When a country has its own national currency, this involves the issue of some form of standardized currency, which is essentially a form of promissory note: a promise to exchange the note for "money" under certain circumstances. Historically, this was often a promise to exchange the money for precious metals in some fixed amount. Now, when many currencies are fiat money, the "promise to pay" consists of nothing more than a promise to pay the same sum in the same currency.

In many countries, the central bank may use another country's currency either directly (in a currency union), or indirectly, by using a currency board. In the latter case, local currency is directly backed by the central bank's holdings of a foreign currency in a fixed-ratio; this mechanism is used, notably, in Bulgaria, Hong Kong and Estonia.

In countries with fiat money, monetary policy may be used as a shorthand form for the interest rate targets and other active measures undertaken by the monetary authority.

Goals of monetary policy

Price Stability
Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for inflation. Effort successful if monetary policy able to maintain steady rate of inflation.
High Employment
The movement of workers between jobs is referred to as frictional unemployment. All unemployment beyond frictional unemployment is classified as unintended unemployment. Reduction in this area is the target of macroeconomic policy.
Economic Growth
Economic growth is enhanced by investment in technological advances in production. Encouragement of savings supplies funds that can be drawn upon for investment.
Interest Rate Stability
Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected changes that cause damage, making policy formulation difficult.
Financial Market Stability
Foreign Exchange Market Stability
Conflicts Among Goals
Goals frequently cannot be separated from each other and often conflict. Costs must therefore be carefully weighed before policy implementation. To make conflict productive, to turn it into an opportunity for change and progress, Follett advises against domination, manipulation, or compromise. "Just so far as people think that the basis of working together is compromise or concession, just so far they do not understand the first principles of working together. Such people think that when they have reached an appreciation of the necessity of compromise they have reached a high plane of social development . . . But compromise is still on the same plane as fighting. War will continue - between capital and labour, between nation and nation - until we reliquich the ideas of compromise and concession."

Currency issuance

Many central banks are "banks" in the sense that they hold assets (foreign exchange, gold, and other financial assets) and liabilities. A central bank's primary liabilities are the currency outstanding, and these liabilities are backed by the assets the bank owns.

Central banks generally earn money by issuing currency notes and "selling" them to the public for interest-bearing assets, such as government bonds. Since currency usually pays no interest, the difference in interest generates income, called seigniorage. In most central banking systems, this income is remitted to the government. The European Central Bank remits its interest income to its owners, the central banks of the member countries of the European Union.

Although central banks generally hold government debt, in some countries the outstanding amount of government debt is smaller than the amount the central bank may wish to hold. In many countries, central banks may hold significant amounts of foreign currency assets, rather than assets in their own national currency, particularly when the national currency is fixed to other currencies.

Naming of central banks

There is no standard terminology for the name of a central bank, but many countries use the "Bank of Country" form (e.g., Bank of England, Bank of Canada, Bank of Russia). Some are styled "national" banks, such as the National Bank of Ukraine; but the term "national bank" is more often used by privately-owned commercial banks, especially in the United States. In other cases, central banks may incorporate the word "Central" (e.g. European Central Bank, Central Bank of Ireland). The word "Reserve" is also often included, such as the Reserve Bank of India, Reserve Bank of Australia, Reserve Bank of New Zealand, the South African Reserve Bank, and U.S. Federal Reserve System. Many countries have state-owned banks or other quasi-government entities that have entirely separate functions, such as financing imports and exports.

In some countries, particularly in some Communist countries, the term national bank may be used to indicate both the monetary authority and the leading banking entity, such as the USSR's Gosbank (state bank). In other countries, the term national bank may be used to indicate that the central bank's goals are broader than monetary stability, such as full employment, industrial development, or other goals.

Interest rate interventions

Typically a central bank controls certain types of short-term interest rates. These influence the stock- and bond markets as well as mortgage and other interest rates. The European Central Bank for example announces its interest rate at the meeting of its Governing Council; in the case of the Federal Reserve, the Board of Governors.

Both the Federal Reserve and the ECB are composed of one or more central bodies that are responsible for the main decisions about interest rates and the size and type of open market operations, and several branches to execute its policies. In the case of the Fed, they are the local Federal Reserve Banks; for the ECB they are the national central banks.

Limits of enforcement power

Contrary to popular perception, central banks are not all-powerful and have limited powers to put their policies into effect. Most importantly, although the perception by the public may be that the "central bank" controls some or all interest rates and currency rates, economic theory (and substantial empirical evidence) shows that it is impossible to do both at once in an open economy. Robert Mundell's "impossible trinity" is the most famous formulation of these limited powers, and postulates that it is impossible to target monetary policy (broadly, interest rates), the exchange rate (through a fixed rate) and maintain free capital movement. Since most Western economies are now considered "open" with free capital movement, this essentially means that central banks may target interest rates or exchange rates with credibility, but not both at once.

Even when targeting interest rates, most central banks have limited ability to influence the rates actually paid by private individuals and companies. In the most famous case of policy failure, George Soros arbitraged the pound sterling's relationship to the ECU and (after making $2 billion himself and forcing the UK to spend over $8bn defending the pound) forced it to abandon its policy. Since then he has been a harsh critic of clumsy bank policies and argued that no one should be able to do what he did.

The most complex relationships are those between the yuan and the US dollar, and between the euro and its neighbours. The situation in Cuba is so exceptional as to require the Cuban peso to be dealt with simply as an exception, since the United States forbids direct trade with Cuba. US dollars were ubiquitous in Cuba's economy after its legalization in 1991, but were officially removed from circulation in 2004 and replaced by the convertible peso.

Policy instruments

Bank of Israel

The main monetary policy instruments available to central banks are open market operation, bank reserve requirement, interest rate policy, re-lending and re-discount (including using the term repurchase market), and credit policy (often coordinated with trade policy). While capital adequacy is important, it is defined and regulated by the Bank for International Settlements, and central banks in practice generally do not apply stricter rules.

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").

Interest rates

By far the most visible and obvious power of many modern central banks is to influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. Although the mechanism differs from country to country, most use a similar mechanism based on a central bank's ability to create as much fiat money as required.

The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from (taking deposits from) a limited number of qualified banks, or by purchasing and selling bonds. As an example of how this functions, the Bank of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited.[5] Other central banks use similar mechanisms.

It is also notable that the target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity and other factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, even below the short-term rate. Many central banks have one primary "headline" rate that is quoted as the "central bank rate." In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced.

"The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines." - Henry C.K. Liu.[6] Liu explains further that "the U.S. central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed funds rate, which its Open Market Committee tries to match by lending or borrowing in the money market ... a fiat money system set by command of the central bank. The Fed is the head of the central-bank because the U.S. dollar is the key reserve currency for international trade. The global money market is a USA dollar market. All other currencies markets revolve around the U.S. dollar market." Accordingly the U.S. situation is not typical of central banks in general.

A typical central bank has several interest rates or monetary policy tools it can set to influence markets.

  • Marginal lending rate (currently 1.75% in the Eurozone) – a fixed rate for institutions to borrow money from the central bank. (In the USA this is called the discount rate).
  • Main refinancing rate (1.00% in the Eurozone) – the publicly visible interest rate the central bank announces. It is also known as minimum bid rate and serves as a bidding floor for refinancing loans. (In the USA this is called the federal funds rate).
  • Deposit rate (0.25% in the Eurozone) – the rate parties receive for deposits at the central bank.

These rates directly affect the rates in the money market, the market for short term loans.

Open market operations

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.

The main open market operations are:

All of these interventions can also influence the foreign exchange market and thus the exchange rate. For example the People's Bank of China and the Bank of Japan have on occasion bought several hundred billions of U.S. Treasuries, presumably in order to stop the decline of the U.S. dollar versus the renminbi and the yen.

Capital requirements

All banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the central bank or the banking supervisor. For international banks, including the 55 member central banks of the Bank for International Settlements, the threshold is 8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain assets (such as government bonds) are considered to have lower risk and are either partially or fully excluded from total assets for the purposes of calculating capital adequacy. Partly due to concerns about asset inflation and repurchase agreements, capital requirements may be considered more effective than deposit/reserve requirements in preventing indefinite lending: when at the threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet.

Reserve requirements

In practice, many banks are required to hold a percentage of their deposits as reserves. Such legal reserve requirements were introduced in the nineteenth century to reduce the risk of banks overextending themselves and suffering from bank runs, as this could lead to knock-on effects on other banks. See also money multiplier. As the early 20th century gold standard and late 20th century dollar hegemony evolved, and as banks proliferated and engaged in more complex transactions and were able to profit from dealings globally on a moment's notice, these practices became mandatory, if only to ensure that there was some limit on the ballooning of money supply. Such limits have become harder to enforce. The People's Bank of China retains (and uses) more powers over reserves because the yuan that it manages is a non-convertible currency.

Even if reserves were not a legal requirement, prudence would ensure that banks would hold a certain percentage of their assets in the form of cash reserves. It is common to think of commercial banks as passive receivers of deposits from their customers and, for many purposes, this is still an accurate view.

This passive view of bank activity is misleading when it comes to considering what determines the nation's money supply and credit. Loan activity by banks plays a fundamental role in determining the money supply. The central-bank money after aggregate settlement - final money - can take only one of two forms:

  • physical cash, which is rarely used in wholesale financial markets,
  • central-bank money.

The currency component of the money supply is far smaller than the deposit component. Currency and bank reserves together make up the monetary base, called M1 and M2.

Exchange requirements

To influence the money supply, some central banks may require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally used in countries with non-convertible currencies or partially-convertible currencies. The recipient of the local currency may be allowed to freely dispose of the funds, required to hold the funds with the central bank for some period of time, or allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be otherwise limited.

In this method, money supply is increased by the central bank when it purchases the foreign currency by issuing (selling) the local currency. The central bank may subsequently reduce the money supply by various means, including selling bonds or foreign exchange interventions.

Margin requirements and other tools

In some countries, central banks may have other tools that work indirectly to limit lending practices and otherwise restrict or regulate capital markets. For example, a central bank may regulate margin lending, whereby individuals or companies may borrow against pledged securities. The margin requirement establishes a minimum ratio of the value of the securities to the amount borrowed.

Central banks often have requirements for the quality of assets that may be held by financial institutions; these requirements may act as a limit on the amount of risk and leverage created by the financial system. These requirements may be direct, such as requiring certain assets to bear certain minimum credit ratings, or indirect, by the central bank lending to counterparties only when security of a certain quality is pledged as collateral.

Examples of use

The People's Bank of China has been forced into particularly aggressive and differentiating tactics by the extreme complexity and rapid expansion of the economy it manages. It imposed some absolute restrictions on lending to specific industries in 2003, and continues to require 1% more (7%) reserves from urban banks (typically focusing on export) than rural ones. This is not by any means an unusual situation. The USA historically had very wide ranges of reserve requirements between its dozen branches. Domestic development is thought to be optimized mostly by reserve requirements rather than by capital adequacy methods, since they can be more finely tuned and regionally varied.

Banking supervision and other activities

In some countries a central bank through its subsidiaries controls and monitors the banking sector. In other countries banking supervision is carried out by a government department such as the UK Treasury, or an independent government agency (e.g. UK's Financial Services Authority). It examines the banks' balance sheets and behaviour and policies toward consumers. Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes and coins or foreign currency. Thus it is often described as the "bank of banks".

Many countries such as the United States will monitor and control the banking sector through different agencies and for different purposes, although there is usually significant cooperation between the agencies. For example, money center banks, deposit-taking institutions, and other types of financial institutions may be subject to different (and occasionally overlapping) regulation. Some types of banking regulation may be delegated to other levels of government, such as state or provincial governments.

Any cartel of banks is particularly closely watched and controlled. Most countries control bank mergers and are wary of concentration in this industry due to the danger of groupthink and runaway lending bubbles based on a single point of failure, the credit culture of the few large banks.

Independence

Over the past decade, there has been a trend towards increasing the independence of central banks as a way of improving long-term economic performance. However, while a large volume of economic research has been done to define the relationship between central bank independence and economic performance, the results are ambiguous.

Advocates of central bank independence argue that a central bank which is too susceptible to political direction or pressure may encourage economic cycles ("boom and bust"), as politicians may be tempted to boost economic activity in advance of an election, to the detriment of the long-term health of the economy and the country. In this context, independence is usually defined as the central bank's operational and management independence from the government.

The literature on central bank independence has defined a number of types of independence.

Legal independence
The independence of the central bank is enshrined in law. This type of independence is limited in a democratic state; in almost all cases the central bank is accountable at some level to government officials, either through a government minister or directly to a legislature. Even defining degrees of legal independence has proven to be a challenge since legislation typically provides only a framework within which the government and the central bank work out their relationship.
Goal independence
The central bank has the right to set its own policy goals, whether inflation targeting, control of the money supply, or maintaining a fixed exchange rate. While this type of independence is more common, many central banks prefer to announce their policy goals in partnership with the appropriate government departments. This increases the transparency of the policy setting process and thereby increases the credibility of the goals chosen by providing assurance that they will not be changed without notice. In addition, the setting of common goals by the central bank and the government helps to avoid situations where monetary and fiscal policy are in conflict; a policy combination that is clearly sub-optimal.
Operational independence
The central bank has the independence to determine the best way of achieving its policy goals, including the types of instruments used and the timing of their use. This is the most common form of central bank independence. The granting of independence to the Bank of England in 1997 was, in fact, the granting of operational independence; the inflation target continued to be announced in the Chancellor's annual budget speech to Parliament.
Management independence
The central bank has the authority to run its own operations (appointing staff, setting budgets, etc.) without excessive involvement of the government. The other forms of independence are not possible unless the central bank has a significant degree of management independence. One of the most common statistical indicators used in the literature as a proxy for central bank independence is the "turn-over-rate" of central bank governors. If a government is in the habit of appointing and replacing the governor frequently, it clearly has the capacity to micro-manage the central bank through its choice of governors.

It is argued that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. Recently, both the Bank of England (1997) and the European Central Bank have been made independent and follow a set of published inflation targets so that markets know what to expect. Even the People's Bank of China has been accorded great latitude due to the difficulty of problems it faces, though in the People's Republic of China the official role of the bank remains that of a national bank rather than a central bank, underlined by the official refusal to "unpeg" the yuan or to revalue it "under pressure". The People's Bank of China's independence can thus be read more as independence from the USA which rules the financial markets, than from the Communist Party of China which rules the country. The fact that the Communist Party is not elected also relieves the pressure to please people, increasing its independence.

Governments generally have some degree of influence over even "independent" central banks; the aim of independence is primarily to prevent short-term interference. For example, the chairman of the U.S. Federal Reserve Bank is appointed by the President of the U.S. (all nominees for this post are recommended by the owners of the Federal Reserve, as are all the board members), and his choice must be confirmed by the Congress.

International organizations such as the World Bank, the BIS and the IMF are strong supporters of central bank independence. This results, in part, from a belief in the intrinsic merits of increased independence. The support for independence from the international organizations also derives partly from the connection between increased independence for the central bank and increased transparency in the policy-making process. The IMF's FSAP review self-assessment, for example, includes a number of questions about central bank independence in the transparency section. An independent central bank will score higher in the review than one that is not independent.

Criticism

According to the Austrian School of Economics, central banking plays an important role in business cycles, according to the Austrian Business Cycle Theory. Hayek and Mises both were able to predict The Great Depression.[7] The main proponents of the Austrian business cycle theory are Ludwig von Mises, Friedrich Hayek and Murray Rothbard.[8] F.A. Hayek shared a Nobel Prize in economics (with Stockholm school economist, Gunnar Myrdal) in 1974 based on "their pioneering work in the theory of money" among other contributions. Hayek discusses central banking in his book, The Use of Knowledge in Society.

Demurrage currencies provide an alternative and perhaps complementary means towards central banking's goal of sustaining economic growth with different specific characteristics and a mechanism that follows naturally from the use of commodity currencies, is more uniform in operation, does not devalue the currency unit, and is more predictable and potentially more decentralized in its operation. Historically, the idea of demurrage influenced Keynes' prescription for net-inflationary central bank policy.