Chapter 5

CENTRAL BANKING
AND THE
MONETARY POLICY
Chapter five
1-INTRODUCTION:
●A central bank is an independent national authority that conducts

monetary policy, regulates banks, and provides financial services
including economic research. Its goals are to stabilize the nation's
currency, keep unemployment low, and prevent inflation.
●In contrast to a commercial bank, a central bank possesses a
monopoly on increasing the monetary base in the state, and usually
also prints the national currency, which usually serves as the state's
legal tender. Central banks also act as a "lender of last resort" to the
banking sector during times of financial crisis. Most central banks
usually also have supervisory and regulatory powers to ensure the
solvency of member institutions.
2-FUNCTIONS OF CENTRAL BANKS:
A- Issue of Currency:
The central bank is given the sole monopoly of issuing currency in
order to secure control over volume of currency and credit. These
notes circulate throughout the country as legal tender money. It has to
keep a reserve in the form of gold and foreign securities.
:B- BANKER TO GOVERNMENT
Central bank functions as a banker to the government—both central

and state governments. It carries out all banking business of the
government. Government keeps their cash balances in the current
account with the central bank. Similarly, central bank accepts receipts
and makes payment on behalf of the governments. Also, central bank
carries out exchange, remittance and other banking operations on
behalf of the government. The government can also borrow any
amount of money from the central bank by selling its securities to the
latter.
C- BANKER’S BANK AND SUPERVISOR:
●There are usually hundreds of banks in a country. There should be

some agency to regulate and supervise their proper functioning. This
duty is discharged by the central bank.
CENTRAL BANK ACTS AS BANKER’S
:BANK IN THREE CAPACITIES
(i) It is the custodian of their cash reserves. Banks of the country

are required to keep a certain percentage of their deposits with the
central bank; and in this way the central bank is the ultimate holder
of the cash reserves of commercial banks.
(ii) Central bank is lender of last resort. Whenever banks are short
of funds, they can take loans from the central bank and get their
trade bills discounted. The central bank is a source of great
strength to the banking system.
(iii) It acts as a bank of central clearance, settlements and transfers.
D- CONTROLLER OF CREDIT AND MONEY
SUPPLY:
●Central bank controls credit and money supply through its monetary
policy which consists of two parts—currency and credit. Central bank
has monopoly of issuing notes and thereby can control the volume of
currency.
3-MONETARY POLICY:
The main objective of credit control function of central bank is price
stability along with full employment.
WHAT ARE THE INSTRUMENTS OF MONETARY POLICY?
To conduct monetary policy, some monetary variables which the
Central Bank controls are adjusted-a monetary aggregate, an interest
rate or the exchange rate-in order to affect the goals which it does not
control.
THE COMMONLY USED INSTRUMENTS
ARE DISCUSSED BELOW:
-1Reserve 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. The assumption is that
Deposit Money Banks generally maintain a stable relationship between
their reserve holdings and the amount of credit they extend to the
public.
2-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 buy/sells securities, it affects the supply of reserves, thus
affecting the supply of money.
3 -INTEREST RATE:
The Central Bank lends to financially sound Deposit Money Banks at a

most favorable rate of interest, called the minimum rediscount rate
(MRR). The MRR sets the floor for the interest rate regime in the
money market and thereby affects the supply of credit, the supply of
savings (which affects the supply of reserves and monetary aggregate)
and the supply of investment (which affects full employment and GDP).

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CENTRAL BANKING

●A central bank is an independent national authority that conducts

Central bank functions as a banker to the government—both central

●There are usually hundreds of banks in a country. There should be

(i) It is the custodian of their cash reserves. Banks of the country

-1Reserve Requirement: The Central Bank may require Deposit

The Central Bank lends to financially sound Deposit Money Banks at a

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