7 central banks

Money, Banking and Financial Markets
Central 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 textbooks
the 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 level
stable. Why?
In an economy where money is used as a medium of exchange, the
following identity holds. M × vM = P × T where M money supply,
vM velocity of money, P average price of a transaction, T number of
transactions (per year).



The quantity theory of money can be developed from the previous identity
adding some assumptions:
The number of transactions is determined by the level of income and
production in the economy. Thus, T can be replaced by Yr which is
the real GDP. The velocity of money, vM , then becomes the income
velocity of money, v
The income velocity of money is constant (v = v ).
¯
Real GDP is determined by real variables only (e.g. availability of
production factors, production technology). These determinants are
rather 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 the
quantity theory of money is that a change in money supply leads to a
corresponding percentage change in the price level. Thus the
organization that can control money supply should be in charge for
keeping the price level stable. This is the central bank.
Accordingly any change in money supply will lead in the long run only
to a corresponding change in the price level. No other variable will be
aﬀected.
This relation between money supply and the price level is why many
central banks in charge for price stability carefully observe changes in
money supply.


Outline





5 The Egyptian Case


Why Central Bank Independence?

The central bank is in charge for monetary policy. The aim of
monetary policy is to keep inflation low.
Keeping actual inflation low can be successful only when the central
bank manages to keep the expected rate of inflation low.
People expect the rate of inflation to be low only, when decision
makers about monetary policy cannot gain from setting monetary
policy so that inflation will be high.
Borrowers gain from high inflation as inflation reduces the real burden
of servicing debt.
The government is the biggest debtor in the country. Thus the
government gains from inflation.
A central bank which is not independent from the government will
find it hard to keep inflation low.


Why Central Bank Independence?

Politicians lack expertise about the complex relation between
monetary policy, inflation and financial stability. Both a stable price
level and financial stability are too important to leave it to people
lacking expertise.
Political business cycles may emerge when politicians in power
(ab)use monetary policy before an election to make people reelect
them.
Counterargument to central bank independence: In a democracy,
a powerful organization such as the central bank, should be under
democratic control. An independent central bank may conduct
monetary policy too ignorant to other aims of public policy.


Elements of the Central Bank Independence

Institutional independence: the central bank is an organization by
itself (not a department of another institution).
Personal independence: members of the monetary council must not
be aﬃliated to any other institution.
Goal independence: Ability of the central bank to set the goals of
monetary policy.
Instrumental independence: Ability of the central bank to set
monetary policy instruments.
Financial independence: the budget of the central bank is not to be
approved by any other authority.


Outline





5 The Egyptian Case


Instruments of Monetary Policy

The instruments of monetary policy used by the Central Bank depend on
the level of development of the economy, especially its financial sector.
They are classified as follows:
Reserve Requirement: The Central Bank may require Deposit
Money Banks to hold a fraction (or a combination) of their deposit
liabilities (reserves) as vault cash and or deposits with it. Fractional
reserve limits the amount of loans banks can make to the domestic
economy and thus limit the supply of money.
Open Market Operations: The Central Bank buys or sells ((on
behalf of the Fiscal Authorities (the Treasury)) securities to the
banking and non-banking public (that is in the open market). One
such security is Treasury Bills. When the Central Bank sells securities,
it reduces the supply of reserves and when it buys (back) securities-by
redeeming them-it increases the supply of reserves to the Deposit
Money Banks, thus affecting the supply of money.


Instruments of Monetary Policy

Lending by the Central Bank: The Central Bank sometimes
provide credit to Deposit Money Banks, thus affecting the level of
reserves and hence the monetary base.
Exchange Rate: The balance of payments can be in deficit or in
surplus and each of these affect the monetary base, and hence the
money supply in one direction or the other. By selling or buying
foreign exchange, the Central Bank ensures that the exchange rate is
at levels that do not affect domestic money supply in undesired
direction, through the balance of payments and the real exchange
rate. The real exchange rate when misaligned affects the current
account 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 “Central
Bank, Banking Sector and Monetary System”: entrusts the Central Bank
of Egypt (CBE) with the formulation and implementation of monetary
policy, with price stability being the primary and overriding objective. The
CBE is committed to achieving, over the medium term, low rates of
inflation which it believes are essential for maintaining confidence and for
sustaining high rates of investment and economic growth. The
Government’s commitment to fiscal discipline is important to achieve this
objective.


The Egyptian Case: Interest Rates

What is the Interest Rate Corridor? On June 2, 2005 the CBE
introduced an interest rate corridor, two standing facilities, the
overnight lending and the overnight deposit facility. The interest rates
on the two standing facilities, the overnight lending and the overnight
deposit rates, define the ceiling and floor of the corridor, respectively.
By setting the rates on the standing facilities, the MPC determines
the corridor within which the overnight rate can fluctuate. Effectively,
steering the overnight inter-bank rate within this corridor is the
operational target of the CBE.
What are the merits of the Corridor? Since the corridor was
introduced in June 2005, volatility in the overnight inter-bank rate
declined 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)? Monetary
policy decisions are taken by the CBE’s Monetary Policy Committee
(MPC), which consists of nine members comprising of the Governor
of the CBE, the two Deputy Governors, and six members of the Board
of Directors.
How often does the MPC meet? The MPC convenes on Thursday
every six weeks. The annual schedule of the MPC meetings is posted
on the CBE’s web-page at “Monetary Policy¿Monetary Policy
Decisions¿MPC Meeting Schedule”


The Egyptian Case: MPC

How does the MPC decide on the interest rate? The Monetary
Policy Department prepares briefing material for the MPC ahead of
each meeting. This material is analytical in content and focuses on
both domestic and international developments.
On the domestic front, the following variables are monitored: inflation,
interest rates, monetary and credit developments, asset prices, and the
real sector variables. Moreover, inflation forecasts based on the CBE’s
forecasting models are presented every quarter.
On the external side, several variables are examined closely, including
global 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 publishes
a press release after each MPC. It is accessible at “Monetary
policy¿Monetary Policy Decisions¿MPC Press Releases”


The Egyptian Case: Inflation

What is meant by the consumer price index (CPI)? It is a price
index, published by the Central Agency for Public Mobilization and
Statistics (CAPMAS) every month on www.capmas.gov.eg, capturing
weighted price movements of consumer goods and services which
constitute a representative “consumption basket” purchased by
households. The weights in the basket reflect the relative importance
of the goods and services in the household consumption basket based
on the Household Expenditure Survey, which is carried out by
CAPMAS every five years. This index is commonly referred to as the
headline CPI.



What is meant by headline CPI inflation? It is a general increase
in the price level of consumer goods and services contained in the
household consumption basket over time. While the annual inflation
rate captures the inflation story over the whole year, the monthly
inflation rate contains the most recent developments.
What is meant by core CPI inflation? And how is it different from
the headline CPI inflation? Core CPI is a variant of the headline CPI
that excludes the impact of temporary price shocks on inflation that
could result for various reasons, including weather conditions, supply
disruptions 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 a
complementary indictor, mainly to distinguish the underlying trend of
the inflation rate from its transitory movements.



Why use core inflation measure? Temporary and sudden
movements in the prices of some CPI components cause the headline
inflation rate to experience sharp fluctuations. The volatility caused
by temporary price shocks can make it difficult for policymakers to
accurately distinguish between price changes that are likely to be
persistent which, in turn, have implications for future inflation trends,
and those which are temporary. The core measure provides a mean by
which the monetary authority can separate the noise and short-run
fluctuations in the incoming data from the more persistent trend
which provides signals about current and future inflation. By timely
communicating the core inflation measure, the CBE aims to improve
the public’s understanding of the inflation dynamics. This is expected
to reduce the pass-through of temporary price shocks to inflation
expectations and, in turn, minimize the variability in inflation.


ercent (m/m) in May. The annual rate inched up to 8.94 per‐
Meanwhile, retail prices witnessed a marginal increase while

Headline and Core CPI Inflation 1/
25.0 (year-on-year percentage change ) 25.0

20.0 20.0

15.0 15.0

10.0 10.0

5.0 5.0
Headline CPI - All Items (100%)
Core CPI excl. regulated items, fruits & vegetables (74.43%)
0.0 0.0
Jun-07
Aug-07
Oct-07
Dec-07
Feb-08
Apr-08
Jun-08
Aug-08
Oct-08
Dec-08
Feb-09
Apr-09
Jun-09
Aug-09
Oct-09
Dec-09
Feb-10
Apr-10
Jun-10
Aug-10
Oct-10
Dec-10
Feb-11
Apr-11
Jun-11
Jun-11

Source: CAPMAS and the CBE

Contributions to Monthly Headline CPI Inflation
(in percent)
Chahir Zaki (Cairo University)
3.0 Money, Banking and Financial Markets July, 2011 25 / 28

Central Bank of Egypt
          Monthly Inflation Developments

Table 2.
Consumer Price Index and Major Components 1/

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

(in percent) (index) (percentage change)
(January 2010 = 100)
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 2.23
Housing, 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
Chahir Zaki (Cairo items
Retail University) Money, Banking and Financial Markets
14.48 101.05 103.76 0.35 July, 2011
2.68 26 / 28

Furnishings, household equipment and
routine maintenance of the dwelling
Medical care
3.77
6.33
102.60
100.00
105.16
101.93
0.25
0.00
2.50
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 8.94
1/ Source: CAPMAS and CBE calculations
2/ Based on 2008/2009 Household Expenditure Survey
3/ Excluding pulses, processed vegetables and dried fruits


References

Mishkin, chapter 4.
The Central Bank of Egypt website.


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