Central Banks and interest rates- why bother

TheInquisitor

One thing that has being annoying me recently is the question

Central banks set interest rates ( their own profits) , they literally say an amount and that is how much profit they make. What happens this interest? Does it go to the government or stay with the central bank?

Central banks don't seem to do anything really. they were meant to stablise the banking system but recent times have shown that the government still need to step in because central banks are useless. Should they be gotten rid of? Let banks themselves set interest rates and compete with eachother. Cut out the central bank and inflation will immediately fall 2%. It is another line of costly bureaucratic red tape.

turgon

You just became donegalfellas favourite person

One of the arguments against a Euro Central Bank is that it has the same interest rates for the whole Eurozone, even though the economic conditions will be different in different countries.

I havent read any economics books, but one alternative to a Central Bank appears to be basing a currencies value on gold.

andrew

They don't just set interest rates. They're a lender of last resort for banks. They act as a 'bankers bank' from which banks can gain financing. They provide financing for the government through the sale of government bonds (AFAIK), and they act to control inflation.

You'd probably get a better answer on the Economics forum.

Daftendirekt

This is probably a stupid question, but what the hell .


Would it be possible to allow banks to set their own interest rates, even with a central bank, or would that just make the central bank completely redundant?

andrew

Daftendirekt wrote: »

This is probably a stupid question, but what the hell .


Would it be possible to allow banks to set their own interest rates, even with a central bank, or would that just make the central bank completely redundant?

Again, this comes with a 'I don't know that much about economics but I do know a bit' disclaimer. AFAIK, what the Central Bank does is set a target rate. Then, through several mechanisms, the Banks themselves come to adopt that rate. I don't think there's anything stopping them from setting whatever rate they want, it's just setting a rate which deviates from the target rate by too large an amount wouldn't make economic sense. I think that the reason that the CB sets a target rate is to give it a degree of control over the economy.

By controlling the interest rate, the CB can control the amount of money in the economy and therefore has a degree of control over economic growth and can stabilize the economy and prevent booms and busts. Well, thats the aim in theory. In reality the CB can mess up, as happened in America, interest rates were set too low, which stimulated the housing bubble. So I think that yes, the CB could relinquish control over interest rates, but that it doesn't so as to maintain control over monetary policy. I don't know enough about economics to be able to fully explain the consequences of it relinquishing control. I think it would just mean less of an ability to alter the economy, which some would perceive as a bad thing. For example, currently interest rates have been set very low so as to stimulate lending and stop the credit crunch. But if the CB couldn't do that, then interest rates would be (some feel) too high, making the credit crunch a much bigger problem.

Daftendirekt

andrew wrote: »

Again, this comes with a 'I don't know that much about economics but I do know a bit' disclaimer. AFAIK, what the Central Bank does is set a target rate. Then, through several mechanisms, the Banks themselves come to adopt that rate. I don't think there's anything stopping them from setting whatever rate they want, it's just setting a rate which deviates from the target rate by too large an amount wouldn't make economic sense. I think that the reason that the CB sets a target rate is to give it a degree of control over the economy.

By controlling the interest rate, the CB can control the amount of money in the economy and therefore has a degree of control over economic growth and can stabilize the economy and prevent booms and busts. Well, thats the aim in theory. In reality the CB can mess up, as happened in America, interest rates were set too low, which stimulated the housing bubble. So I think that yes, the CB could relinquish control over interest rates, but that it doesn't so as to maintain control over monetary policy. I don't know enough about economics to be able to fully explain the consequences of it relinquishing control. I think it would just mean less of an ability to alter the economy, which some would perceive as a bad thing. For example, currently interest rates have been set very low so as to stimulate lending and stop the credit crunch. But if the CB couldn't do that, then interest rates would be (some feel) too high, making the credit crunch a much bigger problem.

I see. Cheers for the explanation.

One other question: is there any real advantage to the CB even having any control over the interest rates? Would simply exposing the banks to competition from each other keep interest rates relatively stable?

Or would this result in much the same situation (interest rates stay low, people borrow too much, increased inflation)?

Joey the lips

This thread is interesting... Its like that time when your a boy and you ask your father why doesnt the banks produce loads of money so we are all rich...( Dad stairs :eek: wtf) The answer is the same!

You dont need to know much about Economics or the central banking system to understand why they set the rates as they do you just need to apply a certain logic.

If the central bank set rates to high it discourages borrowing due the high cost of loans, causes people to save more as there is a better return. This results in a slow down in the Economy as there is no money circulating. Prices fall. Unemployment increases. This causes interest rates to fall.

If the central bank sets interest rates to low this encourages borrowing, causes people to spend more the result is the economy speeds up. Money looses its value as such employment increases. Prices go up umemployment increases. Interest rates rise to encourage saving


Its like steering a boat

The Bank sets us off in a direction

You asses the journey as you cruise along

You notice you are going off course

You take action to correct it.

Its in the central banks interest to keep the economy moving but just incase my arguement is crap i will leave it to the bank to explain it another way


The Bank's Role

The Bank’s mandate for financial stability is derived from that of the Eurosystem, which has a clear mandate to contribute to financial stability in the euro area. This provides the basis for the Bank’s responsibility for financial stability in Ireland and in the Eurosystem. According to the Statutes of the European System of Central Banks (ESCB) and the ECB.... “the ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system” (Article 3.3).
Financial stability is an abstract concept that defies measurement and is often defined by its absence – the occurrence of a financial crisis. The Bank’s role involves monitoring both domestic and international financial developments and highlighting potential areas of concern relevant to the Irish financial system. There are two broad yet complementary approaches to analysing issues pertaining to financial stability, and these are the macro-prudential and micro-prudential perspectives.
The macro-prudential approach is the assessment and surveillance of the strengths and vulnerabilities of financial systems. In contrast, the micro-prudential approach examines the financial soundness of individual institutions. Both approaches are necessary for a full assessment of financial stability. The results are published at regular intervals in the Bank's Financial Stability Report. Our work, with respect to its concern with the health of the domestic financial system, complements that of IFSRA's supervisory departments. A memorandum of understanding between the Central Bank and IFSRA can be downloaded here.
The Central Bank and Financial Services Authority of Ireland is also a signatory to the Memorandum of Understanding on cooperation between financial supervisory authorities, central banks, and finance ministries of the European Union on cross-border financial stability. A copy of the memorandum of understanding can be downloaded here.
The Bank's Responsibilities for Financial Stability

The Bank's responsibility to contribute to the overall stability of the financial system also involves:

1. stability of the monetary system. The Bank will monitor this as part of its Eurosystem monetary policy function. It will act daily in the markets and deal with day-to-day fluctuations in liquidity;
2. financial system infrastructure, in particular the payments system. The Bank must ensure the smooth operation of the payments system;
3. overview of the financial system as a whole. The Bank is uniquely placed to do this. Through its involvement in the payments system it may be the first to spot potential problems. The Bank will be able to advise on the implications for financial stability of developments in the domestic and international markets and payments systems and can assess the impact on monetary conditions of events in the financial sector;
4. undertaking official financial operations in exceptional circumstances in order to limit the risk of problems affecting particular institutions spreading to other parts of the financial system; and
5. increasing the efficiency and effectiveness of the financial sector by promoting improvements in its infrastructure.

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Yeap I see your point we are as wise as ever!

TheInquisitor

My main question still stands, what happens the money the ECB takes in from the base rate? As in the ECB charges normal banks 2% interest and that is the base rate. What happens this money? Does it go to Europe?

Économiste Monétaire

33.1. The net profit of the ECB shall be transferred in the following order:

(a) an amount to be determined by the Governing Council, which may not exceed 20% of the net profit, shall be transferred to the general reserve fund subject to a limit equal to 100% of the capital;
(b) the remaining net profit shall be distributed to the shareholders of the ECB in proportion to their paid-up shares.

33.2. In the event of a loss incurred by the ECB, the shortfall may be offset against the general reserve fund of the ECB and, if necessary, following a decision by the Governing Council, against the monetary income of the relevant financial year in proportion and up to the amounts allocated to the national central banks in accordance with Article 32.5.

The 'shareholders' are, of course, your national central banks:
NCB|Capital Key %|Paid-up capital €
Nationale Bank van België / Banque Nationale de Belgique|2.4256 |139,730,384.68
Deutsche Bundesbank|18.9373|1,090,912,027.43
Central Bank and Financial Services Authority of Ireland|1.1107|63,983,566.24
Bank of Greece|1.9649|113,191,059.06
Banco de España|8.3040|478,364,575.51
Banque de France|14.2212|819,233,899.48
Banca d'Italia|12.4966|719,885,688.14
Central Bank of Cyprus|0.1369|7,886,333.14
Banque centrale du Luxembourg|0.1747|10,063,859.75
Central Bank of Malta|0.0632|3,640,732.32
De Nederlandsche Bank|3.9882|229,746,339.12
Oesterreichische Nationalbank|1.9417|111,854,587.70
Banco de Portugal|1.7504|100,834,459.65
Banka Slovenije|0.3288|18,941,025.10
Národná banka Slovenska|0.6934|39,944,363.76
Suomen Pankki - Finlands Bank|1.2539|72,232,820.48
Total|69.7915|4,020,445,721.56

Surplus income is divided amongst these based on the capital key. You'll notice a €38m surplus income payment from the CBFSAI to the Irish Exchequer in the last Exchequer release for May 2009. The NCBs of the other 11 members of the EU also pay the remaining capital subscription, 30.2085%, but they're not eligible to receive any surplus income.

Permabear

This post has been deleted.

lmtduffy

donegalfella wrote: »

This post has been deleted.

No we'd be in much the same mess we are in now, as these economic cycles of up and down are natural and increase with magnitude.

The aspirations of the central banking idea is to as another poster said is to steer us back into a moderate level of growth or at least stability.

Senna

My question is, had Ireland control over its rates during the last 8 years, would the Irish central bank have kept rates higher? The UK and US had control, but did they set them correctly?

The ECB rates were all wrong (for Ireland) during the bubble, i suspect they will be just as damaging over the next 5 years (high rates when we need low rates).

Colonel Sanders

This book isn't a bad read for what you're talking about

The author examines most schools of thought re. central banks and gives his own insights into central banks (and also how to avoid boom bust cycles)

SeanW

I'm not a total Austrian when it comes to economics and finance, but on the question of monetary policy I'm totally in Ron Paul's camp - sound money backed by hard assets FTW.

Crushing people's savings between triple millstones of monetary inflation, artificially low interest, and taxes on said interest, seems to only discourage wealth building and encourage irresponsible borrowing and spending on the part of average/working person and business.

I no longer think the economy is a simple matter of people spend = more circulation = more wealth for people.

With the world economy in the toilet, the people of the world have had to economise, prioritise, and get back to basics. To learn to "cut your cloth according to your measure" as my mother used to say. i.e. live frugally and within your means. To put their financial ship right, back on balance, to have a sound future.

But what are the governments doing? Imposing more onerous regulations on the remaining productive businesses and people, borrowing more, spending more, taxing more and printing more money to pay for all the spending and lower interest rates ... yet further. I've been following the mess that the Fed etc caused in the U.S. and of course the dodgy deals with Anglo and the Bank Guarantee here, and I don't think anything positive will come from any of it. In fact some of it is downright scary.

nesf

andrew wrote: »

Again, this comes with a 'I don't know that much about economics but I do know a bit' disclaimer. AFAIK, what the Central Bank does is set a target rate. Then, through several mechanisms, the Banks themselves come to adopt that rate.

Not really, it depends on the central bank. The Bank of Canada is the simplest example. It sets an overnight rate* of X% and there's a band of +/- .25% around this. So say X is 1%. This means you can lend money to the central bank at 0.75% or borrow money from the central bank at 1.25% (and for all intents and purposes you can assume that the central bank can lend or borrow an infinite amount of money). This puts a hard ceiling and floor on the interest rates banks will charge each other for lending money to each other. So a bank might offer 500 million Canadian dollars overnight for 1.20% and so on. The actual rate banks charge each other (i.e. the weighted average of all the loans back and forth) will fluctuate between 0.75% and 1.25% over time, there is nothing forcing the banks to loan to each other at 1% per se.

Other central banks do things a bit differently but for the most part in essence they control short term interest rates on loans (i.e. overnight loans etc) by offering a ceiling and/or a floor on what banks can charge each other. They don't actually force the banks to adopt a particular rate. It's more complicated if you look at the actual mechanics of how things are done in the ECB and the Fed etc but that's the simple version.



*The overnight rate is the interest rate charged on loans, or received on deposits on funds lent or borrowed overnight. Banks lend money back and forth to each under (in normal business times) for various reasons that I won't get into.