CHAPTER TWO: CENTRAL BANKING

2.1. Introduction
A central bank functions as the apex controlling institution in the banking and financial system
of the country. The core functions of central banks in any countries are: to manage monetary
policy with the aim of achieving price stability; to prevent liquidity crises, situations of money
market disorders and financial crises; and to ensure the smooth functioning of the payments
system. This chapter explores these issues and focuses specially on the functions of central bank,
monetary policy objectives and instrument as well as independence of central bank.

2.2. Functions of Central Bank

A central bank can generally be defined as a financial institution responsible for
overseeing the monetary system for a nation, or a group of nations, with the goal of
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fostering economic growth without inflation. In the monetary and banking setup of a
country, central bank occupies central position and perhaps, it is because of this fact that this
called as the central bank. In this way, this bank works as an institution whose main objective is
to control and regulate money supply keeping in view the welfare of the people. Central bank is
an institution that fulfills the credit needs of banks and other credit institution, which woks as
banker to the banks and the government and which work for the economic interest of the
country.
The main functions of a central bank are discussed in the following section.

2.2.1. Monopoly of note issue

The central bank has the sole monopoly of note issue in almost every country. The currency
notes printed and issued by the central bank become unlimited legal tender throughout the
country.

In the words of De Kock, "The privilege of note-issue was almost everywhere associated with
the origin and development of central banks."

However, the monopoly of central bank to issue the currency notes may be partial in certain
countries. For example, in India, one rupee notes are issued by the Ministry of Finance and all
other notes are issued by the Reserve Bank of India.

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The main advantages of the note issue by central bank are:
1. People have more confidence in the currency issued by the control bank because it has
the protection and recognition of the government.
2. It brings uniformity in the currency system in the country
3. Monetary management of the paper currency becomes easier. Being the supreme bank of
the country, the central bank has full information about the monetary requirements of the
economy and, therefore, can change the quantity of currency accordingly.

2.2.2. Banker, Agent and Adviser to the Government

The central bank functions as a banker, agent and financial adviser to the government:
(a) As a banker to government, the central bank performs the same functions for the government
as a commercial bank performs for its customers. It maintains the accounts of the central as well
as state government; it receives deposits from government; it makes short-term advances to the
government; it collects cheques and drafts deposited in the government account; it provides
foreign exchange resources to the government for repaying external debt or purchasing foreign
goods or making other payments,

(b) As an Agent to the government, the central bank collects taxes and other payments on behalf
of the government. It raises loans from the public and thus manages public debt. It also
represents the government in the international financial institutions and conferences,

(c) As a financial adviser to the lent, the central bank gives advice to the government on
economic, monetary, financial and fiscal ^natters such as deficit financing, devaluation, trade
policy, foreign exchange policy, etc.

2.2.3. Bankers’ bank

As a custodian of the cash reserves of the commercial banks the central bank maintains the cash
reserves of the commercial banks. Every commercial bank has to keep a certain percentage of its
cash balances as deposits with the central banks. These cash reserves can be utilised by the
commercial banks in times of emergency. Such cash reserves with the Central Bank have the
following advantages:

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 (i) Centralised cash reserves inspire confidence of the public in the banking system of
the country.
(ii) Centralised reserves can be used to the fullest possible extent and in the most
effective manner during the periods of seasonal strains and financial emergencies.
(iii) Centralised reserves enable the central bank to provide financial accommodation to
the commercial banks which are in temporary difficulties. In fact the central bank
functions as the lender of the last resort on the basis of the centralised cash reserves.
2.2.4. Lender of Last Resort
As the supreme bank of the country and the bankers' bank, the central bank acts as the lender of
the last resort. In other words, in case the commercial banks are not able to meet their financial
requirements from other sources, they can, as a last resort, approach the central bank for financial
accommodation. The central bank provides financial accommodation to the commercial banks by
rediscounting their eligible securities and exchange bills.

The main advantages of the central bank's functioning as the lender of the last resort are:
(i) It increases the elasticity and liquidity of the whole credit structure of the economy.
(ii) It enables the commercial banks to carry on their activities even with their limited cash
reserves.
(iii) It provides financial help to the commercial banks in times of emergency.
(iv) It enables the central bank to exercise its control over banking system of the country.

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2.2.5. Act as custodian of National reserves
Central Bank is the custodian of nation's gold and foreign exchange reserves. Previously, to
some extent, the value of a currency depends upon the gold reserves or foreign exchange
reserves held as the backing for the currency. As such, it is the responsibility of the Central Bank
to maintain sufficient reserves and to prevent their depletion.

The Central Bank manipulates the bank rates and takes other steps to conserve the reserves of
gold and foreign exchange. Some Central Banks have absolute powers to control the foreign
exchange reserves and to license the various uses to which the foreign exchange is put to use. In
modern times, the foreign exchange control has become the essential function of the Central
Bank.

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2.2.6. Clearing House

Central bank acts as a Clearing house and facilitates banking transactions and their internal
exchanges. All commercial bank have their accounts with the central bank. They have to send
their weekly reports. The internal adjustment of dealing of banks is made without transfer of
money by the central bank. This system saves time and expenditure of the bank. Therefore,
central bank settles the mutual transactions of banks and thus saves all banks controlling each
other individually for setting their individual transaction. Clearing house keeps the central bank
fully informed about the liquidity position of the commercial banks.

2.2.7. Collection of Data

Central banks in almost all the countries collects statistical data regularly relating to economic
aspects of money, credit, foreign exchange, banking etc. from time to time, committees and
commission are appointed for studying various aspects relating to the aforesaid problem.

2.2.8. Monetary policy

Monetary policy is the process of controlling the supply of money, often targeting a rate of
interest , by the central bank in order to promote economic growth and stability.

The most important function of any central bank is to undertake monetary control
operations. Typically, these operations aim to administer the amount of money
(money supply) in the economy and differ according to the monetary policy objectives
they intend to achieve. These latter are determined by the government’s overall
macroeconomic policies.

Monetary policy is one of the main policy tools used to influence interest rates,
inflation and credit availability through changes in the supply of money (or
liquidity) available in the economy. It is important to recognize that monetary
policy constitutes only one element of an economic policy package and can be
combined with a variety of other types of policy (e.g., fiscal policy) to achieve
stated economic objectives.

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 2.2 .8 .1. Mon e ta ry p ol i cy ob je c ti ve s
Historically, monetary policy has, to a certain extent, been subservient to fiscal
and other policies involved in managing the macro economy, but now a days it can
be regarded as the main policy tool used to achieve various stated economic policy
objectives (or goals).

The main objectives of monetary policy include:

A. Economic growth: Economic growth can be enhanced by investment in capital, such as
more or better machinery. A low interest rate implies that firms can loan money to invest in
their capital stock and pay less interest for it. Lowering the interest is therefore considered to
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encourage economic growth and is often used to alleviate times of low economic growth.
B. High employment – Monetary policy affects the national money supply and the
availability of credit for business and consumers. This leads to the demand for the
employees who produce those goods and services hence leads to a decrease in
unemployment rate
C. Price stability- Price stability means that one year from now a birr/dollar will buy
roughly the same as it buys today. Strong rising (inflation) or falling (deflation)
prices leads to insecurity and will harm the economy. Hence price stability is a
necessary precondition for a healthy economy. Rapidly rising prices erode purchasing
power. People will start demanding higher wages. Companies will, in turn, factor the
higher wages into the prices of their products. In such an environment, where all
goods and services keep growing more and more expensive, consumers and business
are left without solid ground to base sound economic decisions on. Price stability
offers them security and confidence, which contribute to sustainable economic
growth. This is why the central bank is directed at maintaining price stability.
2.2.8.2. Monetary policy instruments
Let us now focus on the tools or instruments of monetary policy. In the past, it was
common for central banks to exercise direct controls on bank operations by setting
limits either to the quantity of deposits and credits (e.g., ceilings on the growth of
bank deposits and loans), or to their prices (by setting maximum bank lending or
deposit rates).

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 The monetary policy instruments used by central banks in monetary operations are
generally classified into the following:
● Open market operations (OMOs)
● Discount windows
● Reserve requirements
I. Open market operations
These operations are the most important tools by which central banks can
influence the amount of money in the economy.

Although the practical features of open market operations may vary from country to
country, the principles are the same: the central bank operates in the market and
purchases or sells government debt to the non-bank private sector. In general, if the
central bank sells government debt the money supply falls (all other things being
equal) because money is taken out of bank accounts and other sources to purchase
government securities. This leads to an increase in short-term interest rates. If the
government purchases (buys-back) government debt this results in an injection of
money into the s ys t e m and short-term interest rates fall. As a result, the central
bank can influence the p o r t f o l i o of assets h e l d by the p r i v a t e sector. This will
influence the level of liquidity within the financial system and will also affect the
level and structure of interest rates.

The main attractions of using open market operations to influence short-term

interest rates are as follows:
● They are initiated by the monet ar y authorities who have complete control over the
volume of transactions;
● Open market operations are flexible and precise – they can be used for major or
minor changes to the amount of liquidity in the system;
● They can easily be reversed;
● Open market operations can be undertaken quickly.

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Open market operations are the most commonly used instruments of monetary
policy in developed economies. One of the main reasons for the wide- spread use of
open market operations relates to their flexibility in terms of both the frequency of
use and scale (i.e.,quantity) of activity. These factors are viewed as essential if the
c e n t r a l bank wishes to fine-tune its monetary policy. In addition, OMOs have the
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advantage of not imposing a tax on the banking system.
II. The discount window
The second most important monetary policy tool of a central bank is the so-called
‘discount window’ (in the United Kingdom this tool is often referred to as ‘standing
facilities’). It i s an instrument that allows eligible banking institutions to borrow
money from the c en t r al bank, usually to meet short-term liquidity needs.

By changing the discount rate, that is, the interest rate that monetary authorities
are prepared to lend to the banking system, the central bank can control the
supply of money in the system. If, for example the central bank is increasing the
discount rate, it will be more expensive for banks to borrow from the central bank so
they will borrow less thereby causing the m on e y supply to decline. Vice versa if the
central bank is decreasing the discount rate, i t will be cheaper for banks to borrow
from it so they will borrow more money.
III. Reserve requirements
Banks need to hold a quantity of reserve assets for prudential purposes. If a
bank falls to its minimum desired level of reserve assets it will have to turn
away requests for loans or else seek to acquire additional reserve assets from
which to expand its lending. The result in either case will generally be a rise
in interest rates that will serve to reduce the demand for loans.

The purpose of any officially imposed reserve requirements is effectively to

duplicate this process. If the authorities impose a reserve requirement in
excess of the institutions’ own desired level of reserves (or else reduce the
availability of reserve assets) the consequence will be that the institutions
involved will have to curtail their lending and/or acquire additional

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reserve assets. This will result in higher interest rates and a reduced
demand for loans that, in turn, will curb the rate of growth of the money
supply.

By changing the fraction of deposits that banks are obliged to keep as

reserves, the central bank can control the money supply. This fraction is
generally expressed in percentage terms and thus is called the required
reserve ratio: the higher the required reserve ratio, the lower the amount of
funds available to the banks. Vice versa, the lower the reserve ratio required by
the monetary authorities, the higher the amount of funds available to the
banks for alternative investments
The advantage of reserve requirements as a monetary policy tool is that they affect all
banks equally and can have a strong influence on the money supply. However, the
latter can also be a disadvantage, as it is difficult for the authorities to make small
changes in money supply using this tool. Another drawback is that a call for greater
reserves can cause liquidity problems for banks that do not have excess reserves. If
the authorities regularly make decisions about changing reserve requirements it can
cause problems for the liquidity management of banks. In general, an increase in
reserve requirements affects banks’ ability to make loans and reduces potential bank
profits because the central bank pays no interest on reserves.
2.3. Central bank independence
In recent years there has been a significant trend towards central bank
independence in many countries and the issue has generated substantial
debate all over the world. Theoretical studies seem to suggest that central
bank independence i s important because it can help produce a better
monetary policy.

Central bank independence can be defined as independence from political influence

and pressures in the conduct of its functions, in particular monetary policy. In this
context, independence is usually defined as the central bank's operational and management
independence from the government.

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While central bank independence indicates autonomy from political influence and
pressures in the conduct of its functions (in particular monetary policy),
dependence implies subordination to the government. In this latter case, there is a
risk that the government may ‘manipulate’ monetary policy for economic and
political reasons. It should be noted, however, that all independent central banks
have their governors chosen by the government; this suggests that to some extent
central banks can never be entirely independent.
Only an independent central bank operating outside the day-to-day
business of politics can be considered a guarantor of long-term economic
stability.
2.3.1. Types of central bank independence
Over the past decade, there has been a trend towards increasing the independence of central
banks as a way of improving long-term economic performance. However, while a large volume
of economic research has been done to define the relationship between central bank
independence and economic performance, the results are ambiguous.

Advocates of central bank independence argue that a central bank which is too susceptible to
political direction or pressure may encourage economic cycles ("boom and bust"), as politicians
may be tempted to boost economic activity in advance of an election, to the detriment of the
long-term health of the economy and the country. In this context, independence is usually
defined as the central bank's operational and management independence from the government.

A. Goal independence - That is, the ability of the central bank to set its own
goals for monetary policy (e.g., low inflation, high production levels);

The central bank has the right to set its own policy goals, whether inflation
targeting, control of the money supply, or maintaining a fixed exchange rate. While
this type of independence is more common, many central banks prefer to announce
their policy goals in partnership with the appropriate government departments. This
increases the transparency of the policy setting process and thereby increases the
credibility of the goals chosen by providing assurance that they will not be changed
without notice. In addition, the setting of common goals by the central bank and the

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 government helps to avoid situations where monetary and fiscal policy are in
conflict; a policy combination that is clearly sub-optimal.
B. Instrument independence - that is, the ability of the central bank to
independently set the instruments of monetary policy to achieve these
goals. The central bank has the independence to determine the best way of
achieving its policy goals, including the types of instruments used and the timing of
their use. This is the most common form of central bank independence.

Generally, Instrument independence refers the central bank’s ability to freely adjust
its policy tools in pursuit of the goals of monetary policy.
C. Management independence: The central bank has the authority to run its own operations
(appointing staff, setting budgets, and so on.) without excessive involvement of the
government. The other forms of independence are not possible unless the central bank has a
significant degree of management independence. One of the most common statistical
indicators used in the literature as a proxy for central bank independence is the "turn-over-
rate" of central bank governors. If a government is in the habit of appointing and replacing
the governor frequently, it clearly has the capacity to micro-manage the central bank through
its choice of governors.

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