CHAPTER 2: CENTRAL BANKING

2.1. Introduction

Among the most important players in financial markets throughout the world are central banks,
the government authorities in charge of monetary policy. Central banks’ actions affect interest
rates, the amount of credit, and the money supply, all of which have direct impacts not only on
financial markets, but also on aggregate output and inflation.

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 fostering economic growth
without inflation.

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.

2.2. Functions of a central bank

The main functions of a central bank can be listed as follows:

1) The central bank controls the issue of notes and coins (legal tender). Usually, the central
bank will have a monopoly of the issue, although this is not essential as long as the
central bank has power to restrict the amount of private issues of notes and coins.
2) It has the power to control the amount of credit-money created by banks. In other words,
it has the power to control, by either direct or indirect means, the money supply.
3) A central bank should also have some control over non-bank financial intermediaries
that provide credit.
4) The central bank should effectively use the relevant tools and instruments of monetary
policy in order to control:
a) Credit expansion;
b) Liquidity; and
c) The money supply of an economy.
5) The central bank should oversee the financial sector in order to prevent crises and act as a
lender-of-last-resort in order to protect depositors, prevent wide-spread panic withdrawal,

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 and otherwise prevent the damage to the economy caused by the collapse of financial
institutions.
6) A central bank acts as the government’s banker. It holds the government’s bank account
and performs certain traditional banking operations for the government, such as deposits
and lending. In its capacity as banker to the government it can manage and administer the
country’s national debt.
7) The central bank also acts as the official agent to the government in dealing with all its
gold and foreign exchange matters. The government’s reserves of gold and foreign
exchange are held at the central bank. A central bank, at times, intervenes in the foreign
exchange markets at the behest of the government in order to influence the exchange
value of the domestic currency.

2.3. How does monetary policy work?

There are five major forms of economic policy (or, more strictly macroeconomic policy)
conducted by governments that are of relevance. These are: monetary policy; fiscal policy;
exchange rate policy; prices and incomes policy; and national debt management policy.

 Monetary policy is concerned with the actions taken by central banks to influence the
availability and cost of money and credit by controlling some measure (or measures) of
the money supply and/or the level and structure of interest rates.
 Fiscal policy relates to changes in the level and structure of government spending and
taxation designed to influence the economy. As all government expenditure must be
financed, these decisions also, by definition, determine the extent of public sector
borrowing or debt repayment. An expansionary fiscal policy means higher government
spending relative to taxation. The effect of these policies would be to encourage more
spending and boost the economy. Conversely, a contractionary fiscal policy means
raising taxes and cutting spending.
 Exchange rate policy involves the targeting of a particular value of a country’s currency
exchange rate thereby influencing the flows within the balance of payments. In some
countries it may be used in conjunction with other measures such as exchange controls,
import tariffs and quotas.

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  A prices and incomes policy is intended to influence the inflation rate by means of
either statutory or voluntary restrictions upon increases in wages, dividends and/or prices.
 National debt management policy is concerned with the manipulation of the
outstanding stock of government debt instruments held by the domestic private sector
with the objective of influencing the level and structure of interest rates and/or the
availability of reserve assets to the banking system.

Price stability, therefore, has become a key element of economic strategy, and monetary policy is
widely accepted as the most appropriate type of policy to influence prices and price expectations.

The preference for using monetary policy over other types of policy relates to two main factors –
the role of the monetary authorities (central banks) as sole issuers of banknotes and bank
reserves (known as the monetary base) and the long-run neutrality of money.
As a consequence in the long run:
 A central bank can only contribute to raising the growth potential of the economy by
Maintaining an environment of stable prices.
 Economic growth cannot be increased through monetary expansion (increased money
supply) or by keeping short-term interest rates at levels inconsistent with price stability.

2.4 Monetary policy objectives

Monetary policy is one of the main policy tools used to influence interest rates, inflation and
credit avail-ability through changes in the supply of money (or liquidity) available in the
economy.

The main objectives of economic (and monetary) policy include:

 High employment  Financial market stability

 Price stability –  Stability in foreign exchange
 Stable economic growth – markets –
 Interest rate stability –

2.5. Monetary policy functions of a central bank

The most important function of any central bank is to undertake monetary control operations.
Typically, the most important long-term monetary target of a central bank is price stability that
implies low and stable inflation levels.
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Figure 2.1 Monetary policy instruments, targets and goals

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.
Reserve requirements are often referred to as instruments of portfolio constraint. It means that
they may be imposed by the authorities on the portfolio structure of financial institutions, with
the purpose of influencing credit creation and, possibly, the type of lending taking place.

Figure 2.4 Reserve requirements

2.6. The lender-of-last-resort (LOLR) function of the central bank
In its role as a LOLR, the central bank will provide reserves to a bank (or banks) experiencing
serious financial problems due to either a sudden withdrawal of funds by depositors or to a
situation where the bank has embarked on highly risky operations and thus cannot find liquidity
anywhere else (i.e., no other institutions will lend to a bank considered near collapse).

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Technically, this important function of central banks derives from the discount window tool that
is one of the instruments used to influence reserves and money supply in the banking sector.
However, central banks operate under different frameworks in conducting the LOLR activities.
These differences can reflect various country-specific factors such as public policy objectives,
historical experience or other elements.
2.7. Should central banks be independent?
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 is important because it can help produce a better
monetary policy. For example, an extensive body of literature predicts that the more independent
a central bank, the lower the inflation rate in an economy.
Central bank independence can be defined as independence from political influence and
pressures in the conduct of its functions, in particular monetary policy.
It is possible to distinguish two types of independence: 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); and instrument independence, that is, the ability of the central bank to independently set
the instruments of monetary policy to achieve these goals.