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Central banks Introduction

A central bank is a public authority that is responsible for monetary policy for a country or a group of countries. Two important central banks are the European Central Bank (for countries that are members in the European Monetary Union) and the Federal Reserve of the United States.

Central banks have a monopoly on issuing the national currency, and the primary responsibility of a central bank is to maintain a stable national currency for a country (or a stable common currency for a currency union). Stability is sometimes specified in terms of inflation and / or growth rate in the money supply.

Other important responsibilities include providing banking services to commercial banks and the government and regulating financial markets and institutions. In this sense, a central bank is the "bankers' bank" - other banks can borrow from or lend money to the central bank. Therefore, all banks in a country have an account in the central bank. When a commercial bank orders currency from the central bank, the corresponding amount is withdrawn from this account. This account is also used for transfers between commercial banks. Central banks also manage the country's foreign exchange and gold reserves.

Monetary Base

The monetary base is defined as the total value of all currency (banknotes and coins) outside the central bank and commercial banks' (net) reserves with the central bank. The monetary base is a debt in the balance sheet of the central bank. Its assets are mostly comprised of the foreign exchange and gold reserves and bonds issued by the national government. Currency inside the central bank has no value - it is comparable to an "I owe you" written by yourself and held by yourself.

Since the central bank has a monopoly on issuing currency, it is in complete control of the monetary base. In section 7.4.2 we will describe exactly how they change the monetary base. However, the central bank does not completely control the money supply. This is due to the second component of the money supply - bank deposits - which it cannot control. Fortunately, it has methods of influencing the total money supply and these methods will be discussed in chapter 7.

In many countries, the central bank imposes reserve requirements. This means that commercial banks are obliged to hold a certain percentage of deposits as reserves either as currency in their vaults or as a deposit at the central bank. Reserve requirements are usually rather small (typically between 0% and 10%) which means that the monetary base is quite close to the value of all currency outside the central bank.

Market Interest Rates

The most important interest rates from a macroeconomic perspective are interest rates that the government pays on the loans they use to finance the national debt. The government borrows money by issuing government bonds. All such bonds have a fixed nominal amount and a given maturity date. The government promises to pay exactly the nominal amount (also called the principal or the face amount) to the holder at the maturity date. Some bonds also promise regular payments, so-called coupon payments, at regular intervals, the coupon dates.

In most countries you will find many types of government bonds. An important distinction is the duration of the bond, that is, the difference between the maturity date and the date when the bond was issued. For example, in the United States, government bonds maturing in one year or less are called Treasury bills.

Typically, bonds with a maturity of a year or shorter have no coupons. Instead, they are sold below the nominal amount at what is called the issue price. The issue price for a bond without coupons must be below the nominal amount. For example, if you pay 23,500 for a bond with a nominal amount of 25,000 maturing in one year, your interest rate is (25 000 - 23500)/23500 = 6.38%.

In most countries, you also find government bonds with longer maturity. For example, in the United States you have Treasury notes (two to ten years) and Treasury bonds (10 years or longer). Government bonds with longer maturity typically make coupon payments. You will also find other types of bonds

Relationship between the interest rate and the bond price

Note that the higher the issue price, the lower the interest rate. In the same way, when the price of a government bond increases, the interest rate falls and vice versa. The price of a government bond is normally determined by supply and demand which means that you can understand movements in these interest rates by analyzing the market. For example, if the government needs to borrow more money, supply increases, bond prices fall and interest rates increase.

Calculating interest rates on a yearly basis

If the maturity is different from one year, the interest rate is usually recalculated to a corresponding one year rate. For example, consider a bond which matures in six months, has a nominal amount of 25,000 and a current price of 24,200 (no coupons). The six month interest rate is then 800/24,200 = 3.3%. If we want to express this rate as a yearly rate we imagine that we make this investment twice. Our return would then be 1.033.1.033 = 1.067 or 6.7%. Note that if the interest rate is fairly low, then the yearly interest rate is approximately two times the six month interest rate. In the same way, the monthly interest rate is approximately one twelfth of the yearly interest rate.

Keep in mind that the six month interest rate, recalculated to a yearly rate, will typically not be equal to the one year interest rate. For example, suppose that we expect interest rates to increase. In such a case, the yearly interest rate would be an average of the current six month rate and the six month rate six months from now, which is expected to be higher. Hence, the one year rate would be higher than the current six month rate. In the same way, if we expect interest rates to fall, then shorter interest rates will be higher than longer interest rates.

This means that we have many different market rates in a country - rates depending on maturity. Even though rates with different maturity (all recalculated to a yearly rate) need not be exactly equal, they cannot be too different either. This is particularly true for rates with similar maturity. The seven month rate cannot deviate far from the six month rate since they are fairly close substitutes.

The Yield Curve

The yield curve is a graph of interest rates of different maturity (recalculated to yearly rates) at a particular point in time. It is common for the yield curve to slope upwards (interest rates with longer maturity are generally higher than those with a shorter maturity). The reason for this is that there is a higher demand for loans with longer maturity due to the reduced uncertainty. Many borrowers are prepared to pay a premium to avoid fluctuations in the interest rates.

As discussed above, if the market expects higher interest rates, then the slope of the yield curve will increase. Although not very common, the slope may be negative if the market expects the interest rates to fall more than the premium on longer rates.

Other Interest Rates

There are many other interest rates in a society. For example, you will earn interest when you deposit money in a bank account and you will pay interest when you borrow money. These interest rates will depend on the specifics of the deposit and the perceived risk when you borrow money. However, all interest rates are correlated with the market interest rates. When you borrow money, you typically pay a higher interest rate compared to government bonds, and when you lend money, you will receive a lower rate.

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