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b. What are the objectives of financial stability? How is financial stability achieved
domestically?
Objective of financial stability:
a. Price stability: Price stability is low and stable (non-volatile) changes in the general price
level.
b. Stable conditions in the financial system: Stable conditions in the financial system are
accomplished when there is a high degree of confidence that the financial intermediaries and
markets are stable, i.e. are able to meet obligations without disruption.
How is financial stability achieved domestically? - There are two elements to financial
stability, i.e. stable conditions in the financial sector and price stability. The former is
achieved by the CB putting in place measures and facilities that allows it to:
Ensure the availability of notes and coin in circulation in convenient denominations to
serve as a means to effect financial transactions.
Create an efficient national payments and interbank settlement system.
Support the development of efficient money, bond and foreign exchange markets.
Supervise the financial risks of banks.
Support the development of an efficient banking system.
The other leg of financial stability, price stability, is achieved through the implementation of
sound monetary policies in order to protect the value of the currency.
Answer: The interbank markets are where the settlements of interbank claims take place and
where monetary policy begins. There are following three types of interbank markets:
1. The bank-to-central bank interbank market: It is an administrative market in which
the flow is one-way: from the banks to the central bank in the form of the cash reserve
requirement. In the vast majority of countries the cash reserve requirement balances earn
no interest, which is an essential element in monetary policy. Another important element
of monetary policy in most countries is that banks are kept chronically short of reserves
by the central bank, such that Excess reserves (ER) for the banking system does not exist.
2. The central bank-to-bank interbank market: It is also an administrative market, and
it is at the centre of the vast majority of countries monetary policy. It represents loans
from the central bank to the banks (borrowed reserves). The central bank provides these
reserves at its Key Interest Rate (KIR).
In most countries monetary policy is aimed at ensuring that the banks are indebted
to the central bank at all times so that the KIR is applied and therefore is made effective
on part of the liabilities of the banks. The KIR has a major influence on the banks
deposit rates and, via the more or less static bank margin, on the banks prime rate.
3. The bank-to-bank interbank market: This market operates during the banking day but
particularly at the close of business each day. In the b2b IBM, no new funds are created;
existing funds are merely shifted around and banks place funds with or receive funds
from other banks depending on the outcome of the clearing.
The main advantages of the central bank's functioning as the lender of the last resort are:
a. It increases the elasticity and liquidity of the whole credit structure of the economy.
b. It enables the commercial banks to carry on their activities even with their limited cash
reserves.
Thus, the Central Bank is able to control credit while discharging the function of lender of
last resort. The Central Bank is also regarded as performing the function of last resort when it
grants accommodation to the government in times of monetary stringency.
b) Why does central bank keep and manage gold and foreign exchange
reserve?
The central bank keeps and manages gold and foreign exchange reserve for the following
reasons
Central banks are the custodians of the foreign asset reserves of the country. Essentially,
they hold a stock of reserves on behalf of government and the public. In other words they
are required by government to hold sufficient reserves
To intervene, i.e. to sell or buy foreign exchange, in the foreign exchange market in order
to influence the value of the currency.
For transactions purposes. An example is to supply government with forex to enable it to
repay a maturing foreign loan. Another is to be able to supply forex to the market if there
is an unusually large demand for forex in order to prevent a sudden fall in the exchange
rate.
Foreign (inward) investments tend to take place in countries that have large and stable
forex reserves.
primary dealership system is in place, the CB organises it, appoints the dealers and conducts the
tenders as well. Usually the primary dealers are obliged to tender for a certain minimum amount.
The bonds on offer are allocated in ascending order of yields bid.
The CB participates in Treasurys debt management meetings, and acts an advisor in decisions
on the timing, size, type of security, and the maturity structure of bond issues. It also advises
Treasury in respect of foreign issues of bonds.
3. a) How did Japan develop their economy with the help of their central bank
after the Second World War?
Answer: After Second World War, the Central bank of Japan (Bank of Japan) played a vital role
in the economic development of Japan. In this regard, the bank of Japan adopted the following
policies
1. Financial institutions were classified into the following different categories, with
each category specializing in a specific function.
a. Government financial institutions were founded, including the Japan Development
Bank (in 1951) and the Export-Import Bank of Japan (in 1951). The Long-Term
Credit Bank Law took effect in 1952; it strengthened the function of long-term credit
banks such as the Industrial Bank of Japan.
b. For international businesses, a Foreign Exchange Bank Law became effective in
1954; it categorized the Bank of Tokyo and other authorized foreign exchange banks
as financial institutions specializing in foreign exchange business.
c. Working funds were to be supplied by financial institutions other than those
mentioned above, with major commercial banks (city banks) being the key players.
d. Four key industries (electric power, coal mining, iron and steel, and shipbuilding) and
export-related enterprises were prioritized in money allocations.
2. The Overlending Policy: The demand for funds for key industries or exporting
enterprises centered on city banks. They did not have sufficient deposits or capital of their
own to meet the demand, so the deficit was financed first by borrowing surplus funds
from other financial institutions like regional banks, and ultimately by borrowing from
the Bank of Japan (the overlending phenomenon). For funds for foreign trade, various
types of trade financing backed by the government were available, as for example, the
Bank of Japans rediscounting of trade bills.
3. The Low interest Policy: Financial institutions were in a managerial environment such
that a profit was guaranteed even if they loaned to others at low interest. Specifically:
First, The system was devised to restrict competition among financial institutions. The
domestic and international financial markets were separated from each other.
Second, The Ministry of Finance and the Bank of Japan assigned a credit limit to each
bank through their window guidance and thus cont rolled the total amount of credit
given by all the banks.
Third. There was a ceiling on interest rates. Banks lending rates were linked to and
moved together with the Bank of Japans official discount rate.
Fourth, each financial institution was under the strict control of the Ministry of Finance
concerning financial reports.
4. Finally, the convoy system was adopted. This system aimed at preventing banks from
collapsing and also at preventing the occurrence of credit uncertainty.
In Japans postwar economy, where capital or wealth was in short supply, such a financial system
was an effective tool for economic reconstruction and the high economic growth that followed.
b) Describe the Objectives for the Establishment of Reserve Bank of India (R.B.I).
The main objectives for establishment of RBI as the Central Bank of India are as follows:
To manage the monetary and credit system of the country
To stabilizes internal and external value of rupee.
For balanced and systematic development of banking in the country.
For the development of organized money market in the country.
For proper arrangement of agriculture finance.
For proper arrangement of industrial finance
For proper management of public debts. To establish monetary relations with other
countries of the world and international financial institutions.
For centralization of cash reserves of commercial banks.
To maintain balance between the demand and supply of currency.
Rural Development Board financed by SONALI BANK. Banks are advised to extend credit
considering banker-customer relationship.
4. Statutory reserve requirement: Cash reserve requirement (CRR) of the deposit money
banks has a significant potential to regulate money supply through affecting money
multiplier, while statutory liquidity requirement (SLR) is generally used to affect the
lending capability of the bank. Bangladesh Bank used these two instruments very
infrequently before 1990 and very often after 1990.
Operations of monetary policy of Reserve bank of India: The important function of RBI is to
control money and credit in the country. The instruments of monetary policy operated by the RBI
may be classified into two categories
A. Quantitative credit control
1) Bank rate: - The RBI provides credit to banks by rediscounting eligible bills of exchange
and by making advances against eligible securities such as government securities. The
lending rate for these advances by the RBI is called the BANK RATE which is a traditional
weapon to control money supply.
2) Reserve requirements: - Reserve requirements are used by RBI to control the credit creation
capacity of banks. Every commercial bank needs to maintain a certain proportion of its assets
in the form of reserve. Cash reserve ratio (CRR) and statutory liquidity ratio (SLR) are the
two reserve requirements imposed by the RBI.
3) Open Market Operations: - The RBI can enter the money market for the purpose of
purchase or sale of government securities on its own account. Open market operations are
highly flexible. Easily reversible in time, their effect on money supply is immediate, and they
do not carry announcement effect as in the case of changes in the bank rate.
4) Repo And Reverse Repo Rates - At present, the repo and the reverse repo rates are
becoming important in determining interest rate trends. Repo (sale and repurchase
agreement) is a swap deal involving the immediate sale of securities and simultaneous
purchase of those securities at a future date, at a predetermined price. Such swap deals take
place between the RBI on one hand, and banks and other financial institutions, on the other.
The repo rate helps commercial banks, to acquire funds from the RBI by selling securities
and at the same time agreeing to repurchase them at a later date. Reverse repo rate is just the
opposite of repo rate.
B. Selective or qualitative methods: The RBI has the power to direct banks to meet their
obligation through selective methods of credit control. The following are some of the
selective methods followed by RBI:1) Margin requirements
2) Discriminatory rates of interest
3) Ceiling on credit
4) Direct action
5) Moral Suasion
Like the U.S. Constitution, the Federal Reserve System, originally established by the Federal
Reserve Act, has many checks and balances and is a peculiarly American institution. The ability
of the 12 regional banks to affect discount policy was viewed as a check on the centralized power
of the Board of Governors, just as states rights are a check on the centralized power of the
federal government. The provision that there be three types of directors (A, B, and C)
representing different groups (professional bankers, businesspeople, and the public) was again
intended to prevent any group from dominating the Fed. The Feds independence of the federal
government and the setting up of the Federal Reserve banks as incorporated institutions were
further intended to restrict government power over the banking industry.
c) The independence of the Fed has meant that it takes the long view and not the
short view. Is this statement true, false or uncertain? Explain your answer.
Uncertain. Although independence may help the Fed take the long view, because its personnel
are not directly affected by the outcome of the next election, the Fed can still be influenced by
political pressure. In addition, the lack of Fed accountability because of its independence may
make the Fed more irresponsible. Thus it is not absolutely clear that the Fed is more far sighted
as a result of its independence.
d. Price stability: Price stability is low and stable (non-volatile) changes in the general
price level. Inflation distorts economic calculations and expectations while deflation
creates depression in the economy. Thus price stability should be the main aim of
monetary policy. Price stability promotes business confidence, makes economic
calculation possible, controls business cycle and introduces certainty in economic life.
e. Exchange Stability: Maintenance of stable exchange rates is an essential condition for
the creation of international confidence and promotion of smooth international trade on
the largest scale possible. A restrictive monetary policy trends to reduce a countrys
balance of payment defect in various ways.
f. Full Employment: In under developed countries, the full employment objective is more
crucial, because such economies have both unemployment and under employment open
and disguised. In less developed countries, though full employment cannot be achieved
within a short period, the monetary policy should try to achieve at least a near full
employment situation.
g. Economic Growth: This comparatively a recent object of monetary policy. If refers to
the growth of real income or output per capita. Monetary policy can contribute to
economic growth in the following ways:
b) Define bank rate & State the effects and limitation of variation of the bank rate
Answer: Bank rate is the rate at which the Central Bank is prepared to rediscount the approved
bills or to lend on eligible paper. By changing this rate the Central Bank control the volume of
credit. The effects of variation of bank rate are given below:
a. Effects on price level: If bank rate increases, cost of credit will increase and the
businessmen will reduce their borrowings from commercial banks. This will reduce
production and increase unemployment in the economy. As a result, income and price
level will go down and depression in business and trade will be the outcome. If there is a
decrease in the bank rate the opposite results of above will be experienced in the economy.
b. Effects on foreign trades: An increase in bank rate wills increases other interest rates in
the country. So, investment will be profitable. It will ensure the insertion of foreign capital
into the economy and leakage of domestic capital will be stopped. Moreover, increased
bank rate will decrease the piece level because amount of credit will be reduced into
country. This decreased price level will again encourage expert and discourage import,
which will make balance of payment favorable. Opposite effects of above will be
experienced if the central bank decreases the bank rate in the economy.
Limitations: The Bank Rate Policy suffers from the following limitations:
a. The rate of interest in money market may not change according to the changes in the
bank rate.
b. In rigid economic system, i.e., planned and regulated economies, the prices and costs may
not change as a result of changes in the rate of interest.
c. The bank rate cannot be the sole regulator of the economic system, and the volume of
savings and investments cannot be controlled through the rate of interest alone.
d. The effect of rise in the bank rate in controlling credit for industrial and commercial
purpose is limited.
e. The change in the methods of financing by the business firms reduces the importance of
bank rate policy.
f. The bank rate policy does not discriminate the activities into productive and unproductive
activities.
Once the banks have no excess reserves, they cannot make new loans. Therefore in the case of an
upward shift in the demand for loans (from D1 to D2), interest rates will rise.
Answer: The differences between cambridge cash balance approach and fisher's transaction approach
to the quantity theory of money are given below:
1. Functions of Money:
The two versions emphasize on different functions of money. The Fisherian approach lays
emphasis on the medium of exchange function while the Cambridge approach emphasises the
store of value of function of money.
2. Flow and Stock:
In Fishers approach money is a flow concept while in the Cambridge approach it is a stock
concept. The former relates to a period of time and the latter to a point of time.
3. V and k Different:
The meaning given to the two symbols V and in the two versions is different. In Fishers
equation V refers to the rate of spending and in Robertsons equation refers to the cash
balances which people wish to hold. The former emphasises the transactions velocity of
circulation and the latter the income velocity.
4. Nature of Price Level:
In Fishers equation, P refers to the average price level of all goods and services. But in the
Cambridge equation P refers to the prices of final or consumer goods.
5. Nature of T:
In Fishers version, T refers to the total amount of goods and services exchanged for money,
whereas in the Cambridge version, it refers to the final or consumer goods exchanged for money.
6. Emphasis on Supply and Demand for Money:
Fishers approach emphasises the supply of money, whereas the Cambridge approach emphasises
both the demand for money and the supply of money.
7. Different in Nature:
The two approaches are different in nature. The Fisherian version is mechanistic because it does
not explain how changes in V bring about changes in P. On the other hand, the Cambridge
version is realistic because it studies the psychological factors which influence.
2. Collection and transfer of money: Bangladesh bank collects govt. revenues from different
sectors and deposit it the account of govt. Besides it transfers money from one place to
another according to directions of govt.
3. Handling of government monetary transaction: Bangladesh bank performs all monetary
transaction of home and abroad on behalf of govt.
4. Supervision of loan: Bangladesh bank not only performs monetary transaction on behalf of
govt. but also sanctions supervising of loans of different ministry, department and institution
of govt.
5. Maintaining relation with foreign bank: As an agent of govt. central banks maintain
relationship with central banks of different countries, World Bank (WB), International
Monetary Fund (IMF), Regional Development bank (i.e. ADB), different development
agencies etc.
6. Implementation of government monetary policy: Central bank influences the economy
through monetary policy.
C. Other Functions:
1. Economic research:
2. Development of banking system
3. Development of foreign trade.
4. Improving the quality of economic plan.
5. Development of natural resources.
standard measure of core inflation in the Bangladesh context at this time, the construction
methodology is made complex by two facts.
First is that food items constitute nearly 60 percent of the CPI index.
Secondly, in the Bangladesh context, the volatility of the international energy prices
appear not to filter down to the CPI since the relevant domestic prices are subsidized by
the state.
3. Growth target: GDP growth projections of the Medium Term Macroeconomic
Framework (MTMF) in the government's National Strategy for Accelerated Poverty
Reduction (NSAPR), modified appropriately in the light of unfolding actual
developments, are used as output growth targets for the purpose of monetary policies.
5.
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government with a financial deficit which need to borrow. Ultimate lenders and
borrowers usually do not participate directly in the markets. As a rule they deal through
an intermediary, who performs functions of broker, dealer or investment banker.
Businesses: Businesses raise funds in the money market primarily by issuing commercial
paper, which is a short-term unsecured promissory note. In recent years an increasing
number of firms have gained access to this market, and commercial paper has grown at a
rapid pace. Business enterprisesgenerally those involved in international tradealso
raise funds in the money market through bankers acceptances (A time draft drawn on
and accepted by a bank).
Money Market Mutual Funds: A Money Market Mutual Fund includes short-term, lowrisk securities and generally allows small investors to participate in the money market by
aggregating their funds to invest in large-denomination money market securities.
Formally, money market mutual funds are investment funds that are pooled and managed
by firms that specialize in investing money for others for the purpose of investing in
short-term financial assets.
Pension funds: Pension funds are retirement plans funded by corporations or
government agencies for their workers and administered primarily by the trust
departments of commercial banks or by life insurance companies. It maintains funds in
money market instruments in readiness for investment in bonds, stocks, mortgages, and
real estate.
Insurance Companies: The largest type of financial intermediary handling individual
savings. Receives premium payments and places these funds in loans or investments to
cover future benefit payments. Lends funds to individuals, businesses, and governments
or channels them through the financial markets. It maintains liquidity needed to meet
unexpected demands.