Sample Economic Project on The Instruments of Central Banking

One of the main responsibilities of the Central Bank is to issue money based on computation of estimated cash demands. It is therefore important for the financial institutions to initiate monetary policy that will provide some guidance on the best approach to use in the supply of money to ensure that it achieves the objectives of financial stability. This is considered a necessity because money is a medium of exchange, and any alterations in its demand are relative to the supply. This necessitates the introduction of adjustments in spending. To ensure that it engages in an effective approach of conducting monetary policy, it is the responsibility of the central bank to introduce monetary variables that can adjust a monetary aggregate, the exchange rate, or the interest rate that can have an effect on the goals that it does not fully control. The instruments used in the development and implementation of monetary policy, form the instruments of central banking. The use of these instruments is highly dependent on the level of economic development with regard to the financial sector. This paper will discuss the commonly used instruments of central banking and the effect of these instruments on the performance of the financial sector.


Reserve requirements

These make reference to the amount of financial resources that banking institutions must hold as part of their reserve against the deposits that the customers make in these banks. According to the Central Bank, it is important for these financial resources to be in the vaults of commercial banks or at the closest Federal Reserve Bank. Reserve requirement is therefore a regulation tool employed by most of the Central Banks in different countries around the world as a way of ensuring that banks do not lend out or engage all their finances in external operations. In certain situations, central banks use reserve requirement as a tool of monetary policy. This influences the ability of a country to borrow and the interest rates that banks charge on their loans. This is often accomplished when these banks change the required reserve ratio that is available for commercial banks to make loan with. There are central banks that rarely alter the ratio to minimize the possibility of immediate liquidity problems especially among banks with low levels of excess reserves.

In different countries, the percentage of required reserves varies in relation to the type of account. In demand deposit account, for instance the required reserve ration can be in the range of 8% to 14%. In such cases, 3% of the initial $42 million of the demand deposits is often included. In business owned time and savings deposit accounts, the required reserve ratio can be in the range of zero to 9%. There are however, effects that arise from lowering the required reserve ratio. These include the automatic increase of excess reserves in all banks. This increases demand deposits as it allows banks to engage in multiple lending. The ultimate impact however is highly dependent on the desire of the commercial banks to engage in loan making activities. The decision by commercial banks to lower the required reserve ratio also increases the possibility that the money supply in any economy will be relatively higher.

In situations where the central bank decides to raise the required reserve ratio, there will be a decrease in the amount of excess reserves in Comerica banks. This may compel such banks to take the initial step of rectifying any deficit reserve position. In addition, such an increase will also affect the banks as they will be compelled to restrain from lending and deposit creation. The money supply in such an economy will be contracted.

The use of required reserve ratio as a necessity for banks must always be maintained even in the absence of legal reserve requirements. This is because by holding cash reserves as deposits with the Federal Reserve as vault cash, banks will have the ability to meet the needs of their customers. Without the legal required reserve ratio, it is also possible for the multiplier relationship between reserve and the supply of money to fluctuate significantly.

Discounting and Discount rate

Discounting rate makes reference to the interest rates that banking institutions must submit in the form of payment to Federal Reserves to allow borrowing from the reserves. It is through the discounting rate that financial institutions have the ability to acquire temporary loans in ways that will ensure that they cover a deficiency. The ability of commercial banks to borrow does not need to sell their securities or call in for loans. This is because such activities will reduce money supply to ensure that the banks deal with any form of deficit in their reserves. The process of borrowing from the reserves is often possible through the discount window. The discount window acts as a facility that allows commercial banks to borrow reserves from Federal Reserves.  Central Banks use the discounting rate as instruments that influence the desire and the ability of commercial banks to borrow. Lowering the discount rate allows commercial banks to engage in more borrowing while at the same time increasing the supply of money in the economy. Any raise of the discounting rate discourages borrowing and this decreases the supply of money in the market. Actual borrowing, which is defined by an acceptable discounting rate also, has the ability of changing money supply. However, the desire and the ability to engage in this approach to borrowing are dependent on the willingness of the banks to use the discounting window to acquire reserves.

Quantity of discount borrowing

Central Banks are the ultimate sources of liquidity in any economy. This means that they are the lenders of last resort. The existence and the operationalization of Central Banks permits commercial banks to borrow from Federal Reserve whenever they are threatened with cash drains. However, according to Central Bank regulations, it is improper for commercial banks to engage in repeated or frequent use of this discount facility especially when they are threatened with temporary cash drain. It is a requirement by the Central Banks in different countries for banks to ensure proper management of their affairs to minimize the possibility of using the discounting facility. This is because the facility is considered as a privilege and cannot be exercised as a right by the banks. This means that the use of this facility should be founded in the desire to realize a financial need and should never be used with the intention of making profits.

To ensure that there is effective regulation in terms of the ability of banks to access the discount facility, the Central Bank in the United States for instance has introduced new lending procedure. This procedure is characterized by the introduction of penalties for Federal Reserve charges that are deemed to be above the short-term market rates. Deposit the charges the central bank has been able to justify the introduction of these penalties by eliminating conditions and restrictions for commercial banks that qualify to access primary credit. The main intention of the new policy governing the discounting facility is to ensure an improvement in access to discount window borrowing. This has been facilitated through the elimination of negative connotations of borrowing from the Central Bank.

Discounting rate and market interest rates

Central Banks discourage discount borrowing especially in situations where the discounting rate is higher than other short-term rates, and encourage when the rate is below. There are countries in which the discounting rate is maintained at a level above the short-term rates. In such countries the central banks ensure the institutionalization of a penalty rate as a technique of restraining excessive borrowing. In the United States, the discounting rate is often lower than the Treasury bill rate. This requires the Central Bank to depend on surveillance as a way of minimizing abuse of the borrowing through the discounting window.

Relationship between other market interest rates and the discounting rate

The discounting rate is defined as the administered rate of borrowing as defined by the central bank. There is however a weak association between the discounts rate money supply and reserve. All the alterations in the discount rate often occur after changes in federal funds rate and the Treasury bill rate.

When an unexpected change in discount rate occurs, it signals that the bank has the desire to institute changes in the monetary policy. The reaction of the public to this expectation takes action that results in the desires of the central bank to occur. Any changes in the discount rate are a confirmation of the prevailing financial conditions but do not initiate any of the happenings.


Open market operations

Open market operations are considered as the most important tool that central banks can use in altering reserves. Open market operation involves the process of purchasing and selling securities by the central banks as an instrument of controlling bank reserves. Banking institutions that are geared towards defending a target level of reserves from the external influences are often perceived to be defensive of the open market operations. Such institutions and entities in the financial sector encourage the central bank to operate in ways that allow for effective and relatively open way of regulating the flow of money in the market. There are those institutions and entities that have the objective of altering the levels of reserves and this makes them relevant in advocating for the existence of a dynamic market operations. For central banks to ensure successful implementation of the open market operations, its responsibility is to engaging in buying and selling of securities to the non-banking and the bunking public on behalf of the Treasury in the open market. Examples of a security that can be sold or bought are Treasury Bills. When the central bank engages in the sale of securities, there is a significant reduction in the quantity of reserves hence a decrease in the amount of money that is available for circulation. In other situations, when the central bank is engaged in the purchase of securities, through a process of redeeming them from the open market, there is an upsurge in reserves to the Deposit Money Banks hence increasing the supply of financial resources in the market. The central bank through the Federal Reserve allows the market to set the price for purchasing and selling prices of Treasury securities. This allows for the alterations of the interest rates that are charged during the process of buying or selling securities to different stakeholders in the open market.


Conducting open market operations

A committee in charge of operationalizing this instrument such as the Federal Open Market Committee (FOMC) has the responsibility of deciding on the general goals and objectives of monetary policies and setting of monetary targets. These include the required reserve ratios for banks, interest rates and money supply or circulation in any market economy. Through these processes it is possible to develop the best strategy that is essential in facilitating the process of purchase and sale government securities.

The process of conducting this operation is also possible from the perspective of monetary policy operations balance sheet. These are facilities that permit commercial banks to engaging in borrowing reserves from central banks. Alternatively it is also possible to use these facilities in placing excess reserves on deposit at the central banks.  Open market operations constitute reserve purchase with the participants in the money market.  In addition, a purchase agreement, which involves agreement of purchasing risk free and long term securities such as government bonds is included as part of open market operations.  The difference between the sale and purchase price is in effect the interest rate in the temporary addition to the reserves the commercial banks are able to obtain.

Open market operations involve the sale and purchase of government securities in the secondary market by the central banks. When the central bank purchases securities from a dealer, it does its payments by acknowledging the reserve account of the dealer’s account. The bank conducts this payment by writing a check to itself. Since the transaction involves the existence of offsetting charges in reserves available at other depository institutions, an increase in the reserves of the dealers account necessitates a rise in the aggregate volume of reserves in the monetary system. When the central bank sells securities to any dealer the consequences of the reserve involves payments of the dealer and this necessitates a reduction of reserves of the bank account of the dealer and those of the monetary system.  An additional way by which the central bank ensures effective functioning of the open market is by engaging in matched sale-purchase agreement in which the central bank sells security to the open market and agrees to purchase them in the near future.

Lender of last resort

One of the responsibilities of the central bank is to lend financial assistance to commercial banks and other fiscal institutions when the do not have an alternative means of raising finances. In the 2007, there was a global banking financial in which banking institutions faced financial difficulties. UK’s Northern Rock, one of the largest banking institutions in the UK was the first major bank to seek financial assistance from the central bank. The difficulties arose from an increase in the run on the bank where customers queue to acquire their deposits. With difficulty in providing their customers with their deposits, the government through the central Bank in the UK was compelled to step in by proclaiming that all deposits will be under the protection of the state. In this situation the government was acting in the position of the lender in case of no other option. The central bank as the lender of the last resort at times leads to moral hazard problem. This is in relation to the rise in the concern that there are commercial banks and other monetary institutions that operate on the knowledge that they will be bailed out. This makes them take on huge risks with the understanding that it is the obligation of the central government to protect them in times of financial crisis. Inasmuch as it is the obligation of central banks to protect commercial banks from possibility of succumbing to financial crisis.

The use of this instrument of central banking is often used to protect the customers who deposit their funds in banks from any loss of finances. At the same time this instrument of central banking also plays the role of minimizing the possibility of panic in withdrawing funds from banks that operate on the basis of temporary limited liquidity. There is a rise in the tendency of commercial banks to minimize borrowing from the lender of last resort since these actions can be used as indications of financial crisis. Central banks also have a responsibility of discouraging commercial banks from seeking moneylender of last resort as this will be an indication of the weakness of the financial institution hence limiting its possibility to attract more deposits.

Those criticizing this instrument of central banking argue that the lender of last resort is irrational in terms of its safety. This is because it inadvertently qualifies institutions into acquiring more risks than necessary. This is because of a high likelihood that the banking institutions have a likelihood of recognizing the probable consequences of risky actions to be less severe.


The instruments used in the development and implementation of monetary policy, form the instruments of central banking. Reserve requirement is a regulation tool employed by most of the Central Banks as a way of ensuring that banks do not lend out or engage all their finances in external operations. In certain situations, central banks use reserve requirement as a tool of monetary policy. Open Market Operation involves the process of purchasing and selling securities by the central banks as an instrument of controlling bank reserves. The use of the financier of last resort as an instrument of central banking is often used to protect the customers who deposit their funds in banks from any loss of finances. Central Banks use the discounting rate as instruments that influence the desire and the ability of commercial banks to borrow. Lowering the discount rate allows commercial banks to engage in more borrowing while increasing the supply of money in the economy. It is through these instruments that central banks have the ability to ensure effective control of money circulation in the market. In addition, it is also the role of central banking systems to ensure that the available structures.