7 central banks

Money, Banking and Financial MarketsCentral Banks

Chahir Zaki

Cairo University

July, 2011

Chahir Zaki (Cairo University) Money, Banking and Financial Markets July, 2011 1 / 28

1 The Task of the Central Bank

2 The Aim of Central Bank Policy

3 Central Bank Independence

4 Instruments of Monetary Policy

5 The Egyptian Case


Outline





5 The Egyptian Case


What is a Central Bank

The central bank is an organization of the state. According to textbooksthe central bank is

the monopoly of supplying the national currency;

the lender of last resort;

the bank of the state;

the operator of the payments system of the country.


Tasks of the Central Bank

to issue currency;

to supervise banks;

to define and implement monetary policy;

to conduct foreign exchange operations;

to hold and manage official gold and foreign exchange reserves;

to promote the smooth operation of the payments system;

to compile and publish monetary statistics of the economy.


Outline





5 The Egyptian Case


Objectives of Monetary Policy

The main objective of monetary policy is to keep the price levelstable. Why?

In an economy where money is used as a medium of exchange, thefollowing identity holds. M × vM = P × T where M money supply,vM velocity of money, P average price of a transaction, T number oftransactions (per year).



The quantity theory of money can be developed from the previous identityadding some assumptions:

The number of transactions is determined by the level of income andproduction in the economy. Thus, T can be replaced by Yr which isthe real GDP. The velocity of money, vM , then becomes the incomevelocity of money, v

The income velocity of money is constant (v = v).

Real GDP is determined by real variables only (e.g. availability ofproduction factors, production technology). These determinants arerather stable in the short run. Yr is also constant in the short run(Yr = Yr ).

M × v = P × Yr



The central bank and monetary policy An important finding from thequantity theory of money is that a change in money supply leads to acorresponding percentage change in the price level. Thus theorganization that can control money supply should be in charge forkeeping the price level stable. This is the central bank.

Accordingly any change in money supply will lead in the long run onlyto a corresponding change in the price level. No other variable will beaffected.

This relation between money supply and the price level is why manycentral banks in charge for price stability carefully observe changes inmoney supply.


Outline





5 The Egyptian Case


Why Central Bank Independence?

The central bank is in charge for monetary policy. The aim ofmonetary policy is to keep inflation low.

Keeping actual inflation low can be successful only when the centralbank manages to keep the expected rate of inflation low.

People expect the rate of inflation to be low only, when decisionmakers about monetary policy cannot gain from setting monetarypolicy so that inflation will be high.

Borrowers gain from high inflation as inflation reduces the real burdenof servicing debt.

The government is the biggest debtor in the country. Thus thegovernment gains from inflation.

A central bank which is not independent from the government willfind it hard to keep inflation low.


Why Central Bank Independence?

Politicians lack expertise about the complex relation betweenmonetary policy, inflation and financial stability. Both a stable pricelevel and financial stability are too important to leave it to peoplelacking expertise.

Political business cycles may emerge when politicians in power(ab)use monetary policy before an election to make people reelectthem.

Counterargument to central bank independence: In a democracy,a powerful organization such as the central bank, should be underdemocratic control. An independent central bank may conductmonetary policy too ignorant to other aims of public policy.


Elements of the Central Bank Independence

Institutional independence: the central bank is an organization byitself (not a department of another institution).

Personal independence: members of the monetary council must notbe affiliated to any other institution.

Goal independence: Ability of the central bank to set the goals ofmonetary policy.

Instrumental independence: Ability of the central bank to setmonetary policy instruments.

Financial independence: the budget of the central bank is not to beapproved by any other authority.


Outline





5 The Egyptian Case


Instruments of Monetary Policy

The instruments of monetary policy used by the Central Bank depend onthe level of development of the economy, especially its financial sector.They are classified as follows:

Reserve Requirement: The Central Bank may require DepositMoney Banks to hold a fraction (or a combination) of their depositliabilities (reserves) as vault cash and or deposits with it. Fractionalreserve limits the amount of loans banks can make to the domesticeconomy and thus limit the supply of money.

Open Market Operations: The Central Bank buys or sells ((onbehalf of the Fiscal Authorities (the Treasury)) securities to thebanking and non-banking public (that is in the open market). Onesuch security is Treasury Bills. When the Central Bank sells securities,it reduces the supply of reserves and when it buys (back) securities-byredeeming them-it increases the supply of reserves to the DepositMoney Banks, thus affecting the supply of money.


Instruments of Monetary Policy

Lending by the Central Bank: The Central Bank sometimesprovide credit to Deposit Money Banks, thus affecting the level ofreserves and hence the monetary base.

Exchange Rate: The balance of payments can be in deficit or insurplus and each of these affect the monetary base, and hence themoney supply in one direction or the other. By selling or buyingforeign exchange, the Central Bank ensures that the exchange rate isat levels that do not affect domestic money supply in undesireddirection, through the balance of payments and the real exchangerate. The real exchange rate when misaligned affects the currentaccount balance because of its impact on external competitiveness.

Discount Rate:


Outline





5 The Egyptian Case


The Egyptian Case: Objectives

Egypt’s Monetary Policy Objective Law No. 88 of 2003 of the “CentralBank, Banking Sector and Monetary System”: entrusts the Central Bankof Egypt (CBE) with the formulation and implementation of monetarypolicy, with price stability being the primary and overriding objective. TheCBE is committed to achieving, over the medium term, low rates ofinflation which it believes are essential for maintaining confidence and forsustaining high rates of investment and economic growth. TheGovernment’s commitment to fiscal discipline is important to achieve thisobjective.


The Egyptian Case: Interest Rates

What is the Interest Rate Corridor? On June 2, 2005 the CBEintroduced an interest rate corridor, two standing facilities, theovernight lending and the overnight deposit facility. The interest rateson the two standing facilities, the overnight lending and the overnightdeposit rates, define the ceiling and floor of the corridor, respectively.By setting the rates on the standing facilities, the MPC determinesthe corridor within which the overnight rate can fluctuate. Effectively,steering the overnight inter-bank rate within this corridor is theoperational target of the CBE.

What are the merits of the Corridor? Since the corridor wasintroduced in June 2005, volatility in the overnight inter-bank ratedeclined significantly.

Who decides on the Corridor? The Monetary Policy Committee(MPC) decides on the corridor rates.


The Egyptian Case: MPC

What is the Monetary Policy Committee (MPC)? Monetarypolicy decisions are taken by the CBE’s Monetary Policy Committee(MPC), which consists of nine members comprising of the Governorof the CBE, the two Deputy Governors, and six members of the Boardof Directors.

How often does the MPC meet? The MPC convenes on Thursdayevery six weeks. The annual schedule of the MPC meetings is postedon the CBE’s web-page at “Monetary Policy¿Monetary PolicyDecisions¿MPC Meeting Schedule”


The Egyptian Case: MPC

How does the MPC decide on the interest rate? The MonetaryPolicy Department prepares briefing material for the MPC ahead ofeach meeting. This material is analytical in content and focuses onboth domestic and international developments.

On the domestic front, the following variables are monitored: inflation,interest rates, monetary and credit developments, asset prices, and thereal sector variables. Moreover, inflation forecasts based on the CBE’sforecasting models are presented every quarter.On the external side, several variables are examined closely, includingglobal growth, global interest rates, international commodity prices,global inflation, in addition to many other variables.

Does the MPC justify its policy actions? Yes, the CBE publishesa press release after each MPC. It is accessible at “Monetarypolicy¿Monetary Policy Decisions¿MPC Press Releases”


The Egyptian Case: Inflation

What is meant by the consumer price index (CPI)? It is a priceindex, published by the Central Agency for Public Mobilization andStatistics (CAPMAS) every month on www.capmas.gov.eg, capturingweighted price movements of consumer goods and services whichconstitute a representative “consumption basket” purchased byhouseholds. The weights in the basket reflect the relative importanceof the goods and services in the household consumption basket basedon the Household Expenditure Survey, which is carried out byCAPMAS every five years. This index is commonly referred to as theheadline CPI.



What is meant by headline CPI inflation? It is a general increasein the price level of consumer goods and services contained in thehousehold consumption basket over time. While the annual inflationrate captures the inflation story over the whole year, the monthlyinflation rate contains the most recent developments.

What is meant by core CPI inflation? And how is it different fromthe headline CPI inflation? Core CPI is a variant of the headline CPIthat excludes the impact of temporary price shocks on inflation thatcould result for various reasons, including weather conditions, supplydisruptions or infrequent resetting of prices by the government.

Does the core inflation measure replace the headline measure?No, the core measure is derived from the headline and is used as acomplementary indictor, mainly to distinguish the underlying trend ofthe inflation rate from its transitory movements.



Why use core inflation measure? Temporary and suddenmovements in the prices of some CPI components cause the headlineinflation rate to experience sharp fluctuations. The volatility causedby temporary price shocks can make it difficult for policymakers toaccurately distinguish between price changes that are likely to bepersistent which, in turn, have implications for future inflation trends,and those which are temporary. The core measure provides a mean bywhich the monetary authority can separate the noise and short-runfluctuations in the incoming data from the more persistent trendwhich provides signals about current and future inflation. By timelycommunicating the core inflation measure, the CBE aims to improvethe public’s understanding of the inflation dynamics. This is expectedto reduce the pass-through of temporary price shocks to inflationexpectations and, in turn, minimize the variability in inflation.



Central Bank of Egypt Monthly Inflation Developments

1

Headline and Core Inflation – June 2011

Headline CPI published by the Central Agency for Public Mobilization and Statistics on July 10, 2011, inched up by 0.42 percent (m/m) in June following 0.20 percent (m/m) in May. The annual rate remained almost unchanged at 11.79 percent in June compared to 11.80 percent in the previous month. More than half of the increase in monthly headline inflation came on the back of an increase in regulated prices, driven by higher tobacco prices. The remaining portion is explained by sporadic increases in the prices of some food items including milk, rice and red meat, which were largely offset by the decline in the prices of fruits and vegeta‐bles as well as poultry and eggs. In the meantime, core CPI computed by the Central Bank of Egypt increased by 0.45 percent (m/m) in June following 0.54 percent (m/m) in May. The annual rate inched up to 8.94 per‐cent in June compared to 8.81 percent in May. Meanwhile, retail prices witnessed a marginal increase while paid services remained broadly unchanged. 1

Monthly Headline and Core CPI Inflation(in percent )

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

Jun-

09Ju

l-09

Aug

-09

Sep-

09O

ct-0

9N

ov-0

9D

ec-0

9Ja

n-10

Feb-

10M

ar-1

0A

pr-1

0M

ay-1

0Ju

n-10

Jul-1

0A

ug-1

0Se

p-10

Oct

-10

Nov

-10

Dec

-10

Jan-

11Fe

b-11

Mar

-11

Apr

-11

May

-11

Jun-

11

Headline CPI

Core CPI

Source: CAPMAS and the CBE

Headline and Core CPI Inflation 1/ (year-on-year percentage change )

0.0

5.0

10.0

15.0

20.0

25.0Ju

n-07

Aug

-07

Oct

-07

Dec

-07

Feb-

08A

pr-0

8Ju

n-08

Aug

-08

Oct

-08

Dec

-08

Feb-

09A

pr-0

9Ju

n-09

Aug

-09

Oct

-09

Dec

-09

Feb-

10A

pr-1

0Ju

n-10

Aug

-10

Oct

-10

Dec

-10

Feb-

11A

pr-1

1Ju

n-11

0.0

5.0

10.0

15.0

20.0

25.0

CPI - All Items (100%)

CPI excl. regulated items, fruits & vegetables (74.43%)Core

Headline

Source: CAPMAS and the CBE

1. Headline CPI2

Headline CPI inched up by 0.42 percent (m/m) in June following the 0.20 percent (m/m) increase in May, which is well below the average monthly pace of 0.79 percent recorded in the first five months of 2011. The annual rate remained almost unchanged at 11.79 percent in June compared to 11.80 percent in the previous month.

Key Highlights Regulated prices rose by 1.66 percent (m/m) in

June on the back of a 10.17 percent (m/m) in‐crease in tobacco prices, contributing by 0.30 percentage points to monthly headline infla‐tion. This represents the second consecutive monthly increase in tobacco prices, which rose by 4.98 percent (m/m) in May.

Contributions to Monthly Headline CPI Inflation(in percent)

0.20.8

0.4 0.60.2

0.5 0.20.5 0.5 0.4 0.3

1.1

2.1

0.20.5 0.5

0.10.5 0.6 0.4 0.3

1.5

1.11.1 0.5

0.2

0.40.8

1.50.3

-1.3-0.9

0.5 1.50.6

-0.4 -0.2-0.3

0.611

-0.4

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Jun-

09Ju

l-09

Aug

-09

Sep-

09O

ct-0

9N

ov-0

9D

ec-0

9Ja

n-10

Feb-

10M

ar-1

0A

pr-1

0M

ay-1

0Ju

n-10

Jul-1

0A

ug-1

0Se

p-10

Oct

-10

Nov

-10

Dec

-10

Jan-

11Fe

b-11

Mar

-11

Apr

-11

May

-11

Jun-

11

Fruits & Vegetables

Regulated Items

Core CPI

Source: CBE

Contributions to Annual Headline CPI Inflation (in percent)

5.6 5.03.9 4.3 4.6 4.7 4.9 5.2 4.9 4.9 4.6 4.6 4.6 4.8

6.2 5.7 6.0 6.6 7.2 7.3 7.1 6.4 6.5 6.6 6.7

1.20.8

0.8 0.61.3 1.3 1.3 1.4

1.2 1.1 1.1 1.1 1.11.7

1.81.8 1.8

1.71.8 1.6 1.8

1.8 1.8 2.1 2.33.1

4.14.3

5.9

7.4 7.4 7.1 7.06.8 6.2

5.7 4.9 5.0 4.22.9 3.5 3.2 1.8 1.3 1.9 1.8 3.4 3.7 3.2 2.8

0.0

4.0

8.0

12.0

16.0

Jun-

09Ju

l-09

Aug

-09

Sep-

09O

ct-0

9N

ov-0

9D

ec-0

9Ja

n-10

Feb-

10M

ar-1

0A

pr-1

0M

ay-1

0Ju

n-10

Jul-1

0A

ug-1

0Se

p-10

Oct

-10

Nov

-10

Dec

-10

Jan-

11Fe

b-11

Mar

-11

Apr

-11

May

-11

Jun-

11

Fruits & VegetablesRegulated Items Core CPI

Source: CBE


The Egyptian Case: Inflation Central Bank of Egypt Monthly Inflation Developments

4

(in percent)

Headline - All items 100.00 102.44 114.51 0.42 11.79

Food and beverages 39.92 105.86 126.01 0.13 19.03

Tobacco and related products 2.19 100.00 169.86 10.16 69.86

Clothing and footwear 5.41 100.00 102.23 0.42 2.23Housing, water, electricity, gas and other fuels 18.37 99.30 100.42 0.00 1.12

Furnishings, household equipment and routine maintenance of the dwelling 3.77 102.60 105.16 0.25 2.50

Medical care 6.33 100.00 101.93 0.00 1.93

Transportation 5.68 100.65 101.66 0.00 1.00

Communications 3.12 99.87 99.99 -0.04 0.12

Recreation and Culture 2.43 102.38 108.42 0.56 5.90

Education 4.63 100.00 124.31 0.00 24.31

Hotels, cafes and restaurants 4.43 100.23 112.37 0.00 12.11

Miscellaneous goods and services 3.73 100.70 103.15 0.55 2.44

Selective aggregates

Fruits & vegetables 3/ 6.90 108.91 150.20 -2.30 37.92

Regulated items 18.66 99.59 112.49 1.66 12.95

Food excl. fruits & vegetables 31.08 105.55 122.07 0.82 15.65

Retail items 14.48 101.05 103.76 0.35 2.68

Paid services 5.87 100.00 109.55 0.00 9.55

Other services 23.00 100.09 103.28 0.06 3.19

Core CPI 74.43 102.55 111.71 0.45 8.941/ Source: CAPMAS and CBE calculations 2/ Based on 2008/2009 Household Expenditure Survey3/ Excluding pulses, processed vegetables and dried fruits

Weight in basket 2/ June 2010 June 2011 June 2011 to May

2011

(January 2010 = 100)(percentage change)(index)

June 2011 to June 2010

Table 2. Consumer Price Index and Major Components 1/



Central Bank of Egypt Monthly Inflation Developments

4

(in percent)

Headline - All items 100.00 102.44 114.51 0.42 11.79

Food and beverages 39.92 105.86 126.01 0.13 19.03

Tobacco and related products 2.19 100.00 169.86 10.16 69.86

Clothing and footwear 5.41 100.00 102.23 0.42 2.23Housing, water, electricity, gas and other fuels 18.37 99.30 100.42 0.00 1.12

Furnishings, household equipment and routine maintenance of the dwelling 3.77 102.60 105.16 0.25 2.50

Medical care 6.33 100.00 101.93 0.00 1.93

Transportation 5.68 100.65 101.66 0.00 1.00

Communications 3.12 99.87 99.99 -0.04 0.12

Recreation and Culture 2.43 102.38 108.42 0.56 5.90

Education 4.63 100.00 124.31 0.00 24.31

Hotels, cafes and restaurants 4.43 100.23 112.37 0.00 12.11

Miscellaneous goods and services 3.73 100.70 103.15 0.55 2.44

Selective aggregates

Fruits & vegetables 3/ 6.90 108.91 150.20 -2.30 37.92

Regulated items 18.66 99.59 112.49 1.66 12.95

Food excl. fruits & vegetables 31.08 105.55 122.07 0.82 15.65

Retail items 14.48 101.05 103.76 0.35 2.68

Paid services 5.87 100.00 109.55 0.00 9.55

Other services 23.00 100.09 103.28 0.06 3.19

Core CPI 74.43 102.55 111.71 0.45 8.941/ Source: CAPMAS and CBE calculations 2/ Based on 2008/2009 Household Expenditure Survey3/ Excluding pulses, processed vegetables and dried fruits

Weight in basket 2/ June 2010 June 2011 June 2011 to May

2011

(January 2010 = 100)(percentage change)(index)

June 2011 to June 2010

Table 2. Consumer Price Index and Major Components 1/


References

Mishkin, chapter 4.

The Central Bank of Egypt website.


7 central banks

Economy & Finance

central bankthe central

independent central

textbooksthe central

central bank2the

aim of monetary policy

money supply leads

vm velocity of money

income velocity of money