TOPIC 4: CENTRAL BANKING

At the end of this chapter, the student should be able to:-

✓ Define what is meant by central bank
✓ Explain the main functions of central bank
✓ Explain major macro-economic policies
✓ Discuss clearly about monetary policy
✓ Explain the monetary policy objectives and instruments which central bank can use
toachieve its objectives
✓ Give reason why banks need central bank
1) INTRODUCTION
The Central Bank of Kenya (CBK), like most other central banks/ Federal Reserve Banks around
the world, is entrusted with the responsibility of formulating and implementing monetary policy
directed to achieving and maintaining low inflation as one of its two principal objectives; the
other being to maintain a sound market-based financial system. Since its establishment in 1966,
the CBK has essentially used a monetary –targeting framework to pursue the inflation objective.
The use of this monetarypolicy strategy has been and continues to be based on the presumption
that money matters, that the behavior of monetary aggregates has major bearing on the
performance of the economy, particularly on inflation.
2) WHAT ARE THE MAIN FUNCTIONS OF A 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 fostering economic growth
without inflation. Like a Federal Reserve Bank in other countries, this is a bank established by
the government through the Act of Parliament to manage and control the monetary matters in
the country.
The main functions of a central bank can be listed as follows:
i. The central bank controls the issue of currencies in form 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.
ii. Controller of the commercial banks on how they carry out their functions in the
economy to ensure that their clients are served well. 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. A central bank should also have some
control over non-bank financial intermediaries that provide credit.
iii. Encompassing both parts 2 and 3, the central bank should effectively use the relevant
tools and instruments of monetary policy in order to control the monetary system in
the country to regulate the economy. In doing this they put in place various monetary
policies that can either expand or depress the economic activities in the country:
• Credit expansion;
• Liquidity; and
• The money supply of an economy.
iv. Banker to the commercial banks, by ensuring that all the commercial banks in the
country operate an account with them
v. 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 widespread panic
withdrawal, and otherwise prevent the damage to the economy caused by the collapse of

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 financial institutions.
vi. 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 a banker to the government, it can manage and
administer the country’s national debt.
vii. Advisor to the government on financial issues in the economy
viii. The central bank also acts as the official agent to the government in dealing with all
its gold and foreign exchange matters and maintain stability in the exchange rates
between the local currencies and the foreign ones. The government’s reserves of gold
and foreignexchange 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.
ix. Provide links with other central banks in other countries, facilitating financial
relationships. It also provides a link between the country and other financial institutions
such as IMF.
x. Facilitates the clearing of cheques between different commercial banks through its
clearing house (a department in the central bank).
xi. Administering of the public debt by facilitating the receipt and providing a means
through which the government pays back the borrowed money.

3) Major Macro-Economy Policies

There are five major forms of economic policy (or, more strictly macroeconomic policies)
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.
xii. 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.
xiii. 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 or else a Contractionary Policy is a tool used to reduce
government spending or the rate of monetary expansion by a central bank to combat rising
inflation. The main contractionary policies employed by any country include raising interest
rates, increasing bank reserve requirements, and selling government securities.
xiv. 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.
xv. Prices and incomes policy is intended to influence the inflation rate by means of either
statutory or voluntary restrictions upon increases in wages, dividend and/or prices.
xvi. 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.

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 4) MONETARY POLICY
Monetary policy relates to the control of some measure/measures of the money supply and/or
the level and structure of interest rates. In recent years, much greater emphasis has been placed
on monetary policy within a government’s policy package.
This is because broad consensus has emerged that suggest that price stability is an essential pre-
condition for achieving the central economic objective of high and stable levels of growth and
employment. Monetary policy is viewed as the preferred policy choice for influencing prices.

Although, traditionally the choice of monetary policy over fiscal policy as the main policy tool
was viewed as a matter of ideological choice, nowadays it is seen more as a pragmatic solution.
As it is widely recognized that high and variable inflation harms long-term growth and
employment, policymakers have tended to focus on those policies that appear to be most
successful in dampening inflationary pressures.

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.

The central bank is the monopoly supplier of the monetary base and as a consequence can
determine the conditions at which banks borrow from the central bank. The central bank can
influence liquidity in the short-term money markets and so can determine the conditions at which
banks buy and sell short-term wholesale funds. By influencing short-term money market rates,
the central bank influences the price of liquidity in the financial system and this ultimately can
impact on various economic variables such as output or prices.
In the long run, a change in the quantity of money in the economy will be reflected in a change
in the general level of prices but it will have no permanent influence on real variables such as
the level of (real) output or unemployment. This is known as the long-run neutrality of money.
The argument goes that real income or the level of unemployment rates are, in the long term,
determined solely by real factors, such as technology, population growth or the preferences of
economic agents. Inflation is therefore solely a monetary phenomenon.
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 though monetary expansion (increased money
supply) or by keeping short-term interest rates at levels inconsistent with price
stability.
In the past, it has been noted that long periods of high inflation are usually related to high
monetary growth. While various other factors (such as variations in aggregate demand,
technological changes or commodity price shocks) can influence price developments over the
short period, over time these influences can be offset by a change in monetary policy.

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 5) Monetary Policy Functions of a Central Bank
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 &
Demand) in the economy and differ according to the monetary policy objectives they intend to
achieve.

DEMAND FOR MONEY

This is the tendency or desire by an individual or general public to hold onto money instead of
spending it. It also refers to as liquidity preference. Money is held by people in various forms:
* Notes and coins
* Securities and bonds
* Demand deposits such bank current account balances.
* Time deposits such as fixed account balances
REASONS (MOTIVES) FOR HOLDING MONEY
1. Transaction Motive: Money is held with a motive of meeting daily expenses for both the firms
and individuals. The demand for money for transaction purpose by individuals depends on the
following factors:
* Size/level of individual’s income: The higher the income of and individual, the more the
number of transactions thus high demand for transactions.
* Interval between pay days/ receipt of money: if the interval is long, then high amount of
money will be held for transaction reasons.
* Price of commodities: if the prices are high, the value of transactions will also increase thus
more money balances required.
* Individuals spending habits-people who spend a lot of money on luxuries will hold more
money than those who only spend money on basics.
* Availability of credit-people who have easy access to credit facilities hold little amount of
money for daily transactions than those who do not have easy access to credit.
The transaction motive can further be divided to;
* Income motive i.e., holding money to spend on personal/ family needs.
* Business motive i.e., holding money to meet business recurring needs such as paying wages,
postage, raw materials etc.
2. Precautionary Motive: Money is held in order to be used during emergencies such as
sicknesses.
The amount of money held for this motive will depend on the factors such as:
* Level of income- the higher the income the higher the amount of money held for precautionary
motive.
* Family status- high class families tend to hold more money for precautionary motive than low
class families.
* Age of the individual- the aged tend to hold more money for precautionary motive than the
young since they have more uncertainties than the young.
* Number of dependants- the more the dependants one has, the more the money they are likely
to hold for precautionary motive.
* Individual’s temperament- pessimists tend to hold more money for precautionary motives
than the optimists because they normally think things will go wrong.
* Duration between incomes- those who earn money after a short time are likely to keep less
money than those who earn money after a long time.

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3. Speculative Motive: Money is held to be used in acquiring those assets whose values are prone
to fluctuations such as shares/ money is held anticipating fall in prices of goods and services. This
depends on the following:
* The wealth of an individual
* The rate of interest on government debt instruments
* Interest on money balances held in the bank.
* How optimistic or pessimistic a person is.

SUPPLY OF MONEY
This is the amount of money/ monetary items that are in circulation in the economy at a particular
period of time. They include the following;
* Total currency i.e., the coins and notes issued by the central bank.
* Total demand deposits: money held in current accounts in banks and are therefore
withdrawable on demand.
Factors influencing supply of money
* Government policies: If there is more money in the economy, the government will put in place
measures to reduce the supply such as increasing interest rates.
* Policies of commercial banks: The more the loans offered by commercial banks, the more the
amount of money in circulation.
* Increase in national income: increase in national income means that more people will be
liquid due to increase in economic activities.
* Increase in foreign exchange: The foreign exchange reserves will increase thus supply
increases.

Monetary policy objectives

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.
Historically, monetary policy has, to a certain extent, been subservient to fiscal and other
policies involved in managing the macro-economy, but nowadays it can be regarded as the main
policy tool used to achieve various stated economic policy objectives (or goals).
The main objectives of economic (and monetary) policy include:
i. High employment – often cited as a major goal of economic policy. Having a high level
of unemployment results in the economy having idle resources that result in lower levels
of production and income, lower growth and possible social unrest. However, this does
not necessarily mean that zero unemployment is a preferred policy goal. A certain level
of unemployment is often felt to be necessary for the efficient operation of a dynamic
economy. It will take people a period of time to switch between jobs, or to retrain for
newjobs, and so on – so even near full employment there maybe people switching jobs
who are temporarily out of work. This is known as frictional unemployment.
In addition, unemployment may be a consequence of mismatch in skills between workers
and what employers want – known as structural unemployment. (Typically, although
structural unemployment is undesirable monetary policy cannot alleviate this type of
unemployment). The goal of high employment, therefore, does not aim to achieve zero

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 unemployment but seeks to obtain a level above zero that is consistent with matching the
demand and supply of labour. This level is known as the natural rate of unemployment.
(Note, however, that there is much debate as to what is the appropriate natural level of
unemployment – usually a figure of around 4% is cited as the appropriate level)
ii. Price stability – considered an essential objective of economic policy, given the general
wish to avoid the costs associated with inflation. Price stability is viewed as desirable
because a rising price level creates uncertainty in the economy and this can adversely
affect economic growth. Many economists (but by no means all) argue that low inflation
is a necessary prerequisite for achieving sustainable economic growth.
iii. Stable economic growth – provides for the increases over time in the living standards
of the population. The goal of steady economic growth is closely related to that of high
employment because firms are more likely to invest when unemployment is high and
firms have idle production, they are unlikely to want to invest in building more plants
and factories. The rate of economic growth should be at least comparable to the rates
experienced by similar nations.
iv. Interest rate stability – a desirable economic objective because volatility in interest
ratescreates uncertainty about the future and this can adversely impact on business and
consumer investment decisions (such as the purchase of a house). Expected higher
interest levels deter investment because they reduce the present value of future cash
flowsto investors and increase the cost of finance for borrowers.
v. Financial market stability – also an important objective of the monetary authorities. A
collapse of financial markets can have major adverse effects on an economy. The US
Wall Street Crash in 1929 resulted in a fall of manufacturing output by 50 percent and
an increase in unemployment to 25 to 30 percent of the US work force by 1932. (Over
11,000 banks closed over this period). Note that financial market stability is influenced
by stability of interest rates because increases in interest rates can lead to a decrease in
the value of bonds and other investments resulting in losses in the holders of such
securities.
vi. Stability in foreign exchange markets – has become a policy goal of increasing
importance especially in the light of greater international trade in goods, services and
capital. A rise in the value of a currency makes exports more expensive, whereas a
decline in the value of a currency leads to domestic inflation. Extreme adverse
movements in a currency can therefore have a severe impact on exporting industries and
can also have serious inflationary consequences if the economy is open and relatively
dependent on imported goods. Ensuring the stability of foreign exchange markets is
therefore seen as an appropriate goal of economic policy.
At first glance it may appear that all these policy objectives are consistent with one another,
however conflicts do arise. The objective of price stability can conflict with the objectives of
interest rate stability and full employment (at least in the short-run) because as an economy
grows and unemployment declines, this may result in inflationary pressures forcing up interest
rates. If the monetary authorities do not let interest rates increase this could fuel inflationary
pressures, yet if they do increase rates then unemployment may occur. These sorts of conflicts
create difficulties for the authorities in conducting monetary and other macroeconomic policy.

Typically, the most important long-term monetary target of a central bank is price stability that
implies low and stable inflation levels. Such a long-term goal can only be attained by setting

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short-term operational targets. Operational targets are usually necessary to achieve a particular
level of interest rates, commercial banks reserves or exchange rates. Often, they are
complemented by intermediate targets such as a certain level of long-term interest rates or broad
money growth (monetary aggregates). In choosing the intermediate targets, policymakers should
take into account the stability of money demand and the controllability of the money aggregate.
The chosen target should also be a good indicator of the effect of the monetary policy decision
on the price stability target.
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). As a
result of the significant financial liberalization process aimed at achieving an efficient allocation
of financial resources in the economy, there has been a movement away from direct monetary
controls towards indirect ones.
Indirect instruments influence the behaviour of financial institutions by affecting initially the
central banks‟ own balance sheet. In particular the central bank will control the price or volume
of the supply of its own liabilities (reserve money) that in turn may affect interest rates more
widely and the quantity of money and credit in the whole banking system.
The two most significant assets of the Central Bank are debt securities followed by loans and
advances. On the liability side, debt securities are again the largest proportion, followed by
deposits by central banks and deposits by banks and building societies.

The indirect instruments used by central banks in monetary operations are generally classified
into the following:
• Open Market Operations (OMOs);
• Discount windows
• Reserve requirements.

(a) Debt Securities and Open Market Operations

Debt securities are mainly represented by Treasury securities (i.e., government debt) that central
banks use in Open Market 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 held constant/being equal) because money is taken
out of bank accounts and other sources to purchase government securities-mopping up excess
liquidity in the economy. 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 system and
short-term interest rates fall. As a result, the central bank can influence the portfolio of assets
held by the private 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 advantages of using open market authorities to influence short-term interest rates
are as follows:
i. They are initiated by the monetary authorities who have complete control over
thevolume of transactions;

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 ii. Open market operations are flexible and precise – they can be used for major or minor
changes to the amount of liquidity in the system;
iii. They can easily be reversed;
iv. Open market operations can be undertaken quickly.

Open market operations are the most commonly used indirect instruments of monetary policy in
developed economies. One of the main reasons for the widespread use of 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 central bank wishes to fine-tune its monetary
policy. In addition, OMOs have the advantage of not imposing a tax on the banking system.
(b) Loans to banks and the discount window
The second most important monetary policy tool of central bank is the so-called “discount
window” (in the United Kingdom this tool is often referred to as “standing facilities”). It is an
instrument that allows eligible banking institutions to borrow money from the central bank,
usually to meet short-term liquidity needs. Discount loans to banks account for a relatively large
proportion of a central bank’s total assets.
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
banksto borrow from the central bank so they will borrow less thereby causing the money supply
to decline. Vice versa, if the central bank is decreasing the discount rate, it will be cheaper
for banks to borrow from it so they will borrow more money. Manipulation of the discount rate
can therefore influence short-term rates in the market.
Direct lending to banks can also occur through the central bank’s lender-of-last-resort (LOLR)
function. By acting as a lender-of-last-resort the central bank provides liquidity support directly
to individual financial institution if they cannot obtain finance from other sources. Therefore, it
can help to prevent financial panics.
(c) 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 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

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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.
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.
Other instruments
1) Moral Suasion
Moral suasion refers to the range of informal requests and pressure that the authorities may exert
over banking institutions. The extent to which this is a real power of the authorities relative to
direct controls is open to question, since much of the pressure that the authorities would exert,
involves the institutions having to take actions that might not be in the bank’s commercial
interests. However, the position and potential power of the authorities probably provides them
with some scope to use moral suasion, which may perhaps be utilized most effectively in the
context of establishing lending priorities rather than absolute limits to credit creation.
2) Direct Controls
Direct controls involve the authorities’ issuing directives in order to attain particular
intermediate targets. For example, the monetary authorities might impose controls on interest
rates payable ondeposits, may limit the volume of credit creation or direct banks to prioritize
lending according tovarious types of customers.
Although these direct controls have the benefits of speed of implementation and precision, they
are discriminating towards the institutions involved and are likely to lead to disintermediation
as both potential borrowers and potential lenders seek to pursue their own commercial interests.
Their use, therefore, is perhaps best reserved for short-term requirements not least since their
effectiveness will tend to decline the longer, they are applied. Such controls, however, are widely
used in many developing countries where the authorities may force banks to (say) lend a certain
percentage of loan-book to “priority sectors”.
3) Gentlemen’s Agreements
These are voluntary agreements between the central bank and banks, aimed at improving
monetary conditions in the economy. In Tanzania, such agreements have been used between the
central bank and the largest commercial bank in an effort to lower the spread on interest rates.
6) Why do banks need a central bank?
The banking sectors of most countries have pyramid structure where a central bank is at the apex
and the ordinary banking institutions are at the base of the pyramid. Central banks can also be
thought of as “super-banks”, at the centre of the financial system, responsible for both “macro”
functions, such as monetary policy decisions; and “micro” functions, including the Lender-Of-
Last Resort (LOLR) assistance of the banking sector. Over time the role and functions of central
banks have developed and evolved, as has the environment in which banks operate.
Liberalization, financial innovation and technology have contributed to major changes in the
operating environment.

The Lender-Of-Last-Resort (LOLR) function of the central bank

In its role as the Lender-Of-Last-Resort (LOLR), the central bank will provide reserves to a bank

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(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).
It is clear that the central bank will extend credit to an illiquid bank to prevent its failure only in
exceptional situations and in doing so it also carries out a “macro” function by preventing
potential financial panics. However, the central bank cannot guarantee the solvency of every
banking institution in a country. This is because it would encourage bankers to undertake undue
risk and operate imprudently, especially if banks knew that they would always be bailed out (by
taxpayer’s money) were they to become insolvent. In other words, the security of the LOLR
function could induce or increase moral hazard in banks’ behaviour.

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.

It is common for a central bank/ Federal Reserve Systems to have instrument independence
without goal independence; however, it is rare to find a central bank that has goal independence
without having instrument independence. In the United Kingdom, for example, the Bank of
England is currently granted instrument independence and practices what is known as inflation
targeting. This means that it is the government that decides to target the inflation rate and the
Bank is allowed to independently choose the policies that will help to achieve that goal. Such a
situation is only acceptable in a democracy because the Bank is not elected and thus goals should
only be set by an elected government.
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 the 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.

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