Unit - 3

The Central Banking System and Monetary

Policy
 The Central Banking System and Monetary Policy
• The roles of central banks in the economy and financial system;
• Major central banking systems: the European Central Bank, the
Federal Reserve System and the Bank of England;
• Structure and functions of Nepal Rastra Bank – the central bank of
Nepal;
• Formulation and conduction of monetary: goals of monetary policy,
monetary policy tools- open market operations, the discount rate,
reserve requirements (reserve ratios) and interest on reserves;
• Selective credit controls, major provisions of recent monetary
policy of Nepal Rastra Bank.
 Concept of central bank
• A central bank is a financial institution given privileged control over the
production and distribution of money and credit for a nation or a group
of nations.
• In modern economies, the central bank is usually responsible for the
formulation of monetary policy and the regulation of member banks.
• Central banks are inherently non-market-based or even anti-
competitive institutions.
• Although some are nationalized, many central banks are not
government agencies, and so are often touted as being politically
independent.
• However, even if a central bank is not legally owned by the
government, its privileges are established and protected by law.
 Features of Central Bank

The basic nature of Central banks is that they are non-market-

based and also anti-competitive institutions. The key features of a
central bank are:
• Most central banks are centralized though there could be central
banks that are not government agencies.
• Even if the central government does not own a central bank, the
law establishes and protects the privileges of a central bank.
• It has a legal monopoly status that enables it to issue cash and
banknotes as opposed to private commercial banks that can issue
only demand liabilities, for example, checking deposits.
 Functions of central bank
• A central bank is deemed as the lender of the last resort, as per
Hawtrey ( a British economist). The central bank is the organ of
the government which controls major financial operations of the
government. Through its various operations, the objectives of the
central bank are to support the economic policy of a country by
influencing the way financial institutions behave.
• The central bank of Nepal is NRB or Nepal Rastra Bank and it is a
statutory bank. The primary role of NRB in Nepal is to print
currency notes and manage the money supply in the economy of
Nepal. Let us now delve into the central bank and its functions
where we will discuss the role of the central bank in the money
market:
 Functions of central bank contd………
• Regulator of Currency
• Banker and Advisor to the Government
• Custodian of Commercial Banks
• Custodian and Manager of Foreign Exchange Reserves
• Lender of the Last Resort
• Controller of Credit
• Transfer and Settlements
 The roles of central banks in the economy and financial system
What is Central Bank?
• The central bank definition refers to an entity that supervises a
nation's money system.
• Examples of some of the most famous central banks are the Federal
Reserve of the United States, the European Central Bank, the Bank
of England, and the Bank of Japan.
• These banks have significant control over their respective regions'
monetary policies. Though many people have the misconception
that central banks are government agencies, these banks are more
often private institutes. The central banks of communistic and
socialistic countries are more likely to be nationalized.
 What is Central Banking System?
• The most famous central bank out of the above mentioned is the Federal Reserve
of the U.S. In banking terms, a reserve is defined as an amount of money that a
bank must keep to ensure that it can adequately pay its customers.
• The Federal Reserve System was created in 1913 under President Woodrow
Wilson.
• The system was essentially created to balance out the financial sector around a
central entity.
• The Fed temporarily adjusted its policies when America got involved in the two
World Wars, but otherwise, the system functioned efficiently.
• The Great Depression of the early 1930s was the first catastrophe that the Fed had
to handle. Similar to ensuing economic crashes like that of 1987, the Tech Bubble
(the stock market collapse of 2000), and the 2008 Financial Crisis, the central bank
used monetary policies to maintain and stimulate the economy. There are 12
regional reserve banks in the U.S. that all form part of the central bank.
 What Does a Central Bank Do?

The role of central bank extends to a lot of different functions and

purposes. This role is captured in a set of obligations such as
supervising banks and financial institutions, maintaining inflation
and employment rates, monitoring currency, controlling the money
supply, and ensuring economic stability:
Supervision
 Inflation
 Employment
 Interest rate
The roles of central banks in the economy and financial
system
• The central bank in a developing country aims at the promotion and
maintenance of a rising level of production, employment and real income in
the country. The central banks in the majority of underdeveloped countries
have been given wide powers to promote the growth of such economies. They,
therefore, perform the following functions towards this end.
• Creation and Expansion of Financial Institutions
• Proper Adjustment between Demand for and Supply of Money
• A Suitable Interest Rate Policy
• Debt Management
• Credit Control
• Solving the Balance of Payments Problem
 Creation and Expansion of Financial Institutions

• One of the aims of a central bank in an underdeveloped country is

to improve its currency and credit system.
• More banks and financial institutions are required to be set up to
provide larger credit facilities and to divert voluntary savings into
productive channels.
• Financial institutions are localized in big cities in underdeveloped
countries and provide credit facilities to estates, plantations, big
industrial and commercial houses.
 Contd…………
• In order to remedy this, the central bank should extend
branch banking to rural areas to make credit available to
peasants, small businessmen and traders.
• In underdeveloped countries, the commercial banks provide
only short-term loans. Credit facilities in rural areas are
mostly non-existent. The only source is the village
moneylender who charges exorbitant interest rates.
 Contd…………..
• The hold of the village moneylender in rural areas can be slackened
if new institutional arrangements are made by the central bank in
providing short-term, medium term and long-term credit at lower
interest rates to the cultivators.
• A network of co-operative credit societies with apex banks financed
by the central bank can help solve the problem.
• Similarly, it can help the establishment of lead banks and through
them regional rural banks for providing credit facilities to marginal
farmers, landless agricultural workers and other weaker sections.
• With the vast resources at its command, the central bank can also
help in establishing industrial banks and financial corporations in
order to finance large and small industries.
 Proper Adjustment between Demand for and Supply of
Money
• The central bank plays an important role in bringing about a
proper adjustment between demand for and supply of money.
• An imbalance between the two is reflected in the price level.
• A shortage of money supply will inhibit/slow down growth while
an excess of it will lead to inflation.
• As the economy develops, the demand for money is likely to go
up due to gradual monetization of the non-monetized sector and
the increase in agricultural and industrial production and prices.
 Contd…………
• The demand for money for transactions and speculative motives will
also rise. So the increase in money supply will have to be more than
proportionate to the increase in the demand for money in order to
avoid inflation.
• There is, however, the likelihood of increased money supply being
used for speculative purposes, thereby inhibiting growth and causing
inflation.
• The central bank controls the uses of money and credit by an
appropriate monetary policy.
• Thus in an underdeveloped economy, the central bank should control
the supply of money in such a way that the price level is prevented
from rising without affecting investment and production adversely.
 A Suitable Interest Rate Policy

• In an underdeveloped country the interest rate

structure stands at a very high level.
• There are also vast disparities/inequality between
long-term and short-term interest rates and between
interest rates in different sectors of the economy.
• The existence of high interest rates acts as an
obstacle to the growth of both private and public
investment, in an underdeveloped economy.
 Contd…………..
• A low interest rate is, therefore, essential for encouraging private
investment in agriculture and industry.
• Since in underdeveloped country businessmen have little savings
out of undistributed profits, they have to borrow from the banks
or from the capital market for purposes of investment and they
would borrow only if the interest rate is low.
• A low interest rate policy is also essential for encouraging public
investment.
• A low interest rate policy is a cheap money policy. It makes public
borrowing cheap, keeps the cost of servicing public debt low and
thus helps in financing economic development.
 Contd…………
• In order to discourage the flow of resources into speculative
borrowing and investment, the central bank should follow a policy
of discriminatory/biased interest rates, charging high rates for
non-essential and unproductive loans and low rates for
productive loans.
• But this does not imply that savings are interest-elastic in an
underdeveloped economy.
• Since the level of income is low in such economies, a high rate of
interest is not likely to raise the propensity to save. In the context
of economic growth, as the economy develops, a progressive rise
in the price level is inevitable/expected.
 Contd…………..
• The value of money falls and the propensity/partiality to save
declines further.
• Money conditions become tight and there is a tendency for the
rate of interest to rise automatically.
• This would result in inflation.
• In such a situation any effort to control inflation by raising the rate
of interest would be disastrous.
• A stable price level is, therefore, essential for the success of a low
interest rate policy which can be maintained by following a
judicious monetary policy by the central bank.
 Debt Management

• Debt management is one of the important functions of the

central bank in an underdeveloped country.
• It should aim at proper timing and issuing of government
bonds, stabilizing their prices and minimizing the cost of
servicing public debt.
• It is the central bank which undertakes the selling and
buying of government bonds and making timely changes in
the structure and composition of public debt.
 contd…………..
• In order to strengthen and stabilize the market for government
bonds, the policy of low interest rates is essential.\
• For, a low rate of interest raises the price of government bonds,
thereby making them more attractive to the public and giving an
impetus/force to the public borrowing programs of the government.
• The maintenance of structure of low interest rates is also called for
minimizing the cost of servicing the national debt.
• Further, it encourages funding of debt by private firms. However, the
success of debt management would depend upon the existence of
well-developed money and capital markets in which wide range of
securities exist both for short and long periods. It is the central bank
which can help in the development of these markets.
 Credit Control

• Central Bank should also aim at controlling credit in order to influence

the patterns of investment and production in a developing economy.
• Its main objective is to control inflationary pressures arising in the
process of development. This requires the use of both quantitative
and qualitative methods of credit control.
• Open market operations are not successful in controlling inflation in
underdeveloped countries because the bill market is small and
undeveloped.
• Commercial banks keep an elastic cash-deposit ratio because the
central bank’s control over them is not complete. They are also
reluctant to invest in government securities due to their relatively low
interest rates.
 Contd………..
• Moreover, instead of investing in government securities, they prefer to
keep their reserves in liquid form such as gold, foreign exchange and cash.
• Commercial banks are also not in the habit of rediscounting or borrowing
from the central bank.
• The bank rate policy is also not so effective in controlling credit in LDCs
due to:
– (a) the lack of bills of discount
– (b) the narrow size of the bill market
– (c) a large non-monetized sector where barter transactions take place
– (d) the existence of a large unorganized money market
– (e) the existence of indigenous banks which do not discount bills with the
central banks; and
– (f) the habit of commercial banks to keep large cash reserves.
 Contd…………….
• The use of variable reserve ratio as method of credit control is more
effective than open market operations and bank rate policy in LDCs.
• Since the market for securities is very small, open market operations are
not successful.
• But a rise or fall in the reserve ratio by the central bank reduces or
increases the cash available with the commercial banks without affecting
adversely the prices of securities.
• Again, the commercial banks keep large cash reserves which cannot be
reduced by a raise in the bank rate or sale of securities by the central
bank.
• But raising the cash-reserve ratio reduces liquidity with the banks.
However, the use of variable reserve ratio has certain limitations in LDCs.
 Contd…………….

• First, the non-banking financial intermediaries do not keep

deposits with the central bank so they are not affected by it.
• Second, banks which do not maintain excess liquidity are not
affected than those who maintain it.
• The qualitative credit control measures are, however, more
effective than the quantitative measures in influencing the
allocation of credit, and thereby the pattern of investment.
• In underdeveloped countries, there is a strong tendency to invest
in gold, jewellery, inventories, real estate, etc., instead of in
alternative productive channels available in agriculture, mining,
plantations and industry.
 Contd……………
• The selective credit controls are more appropriate for controlling
and limiting credit facilitates for such unproductive purposes.
• They are beneficial in controlling speculative activities in food-
grains and raw materials.
• They prove more useful in controlling ‘sectional inflations’ in the
economy.
 Solving the Balance of Payments Problem

• The central bank should also aim at preventing and

solving the balance of payments problem in a
developing economy.
• Such economies face serious balance of payments
difficulties to fulfill the targets of development plans.
• An imbalance is created between imports and exports
which continue to widen with development.
 Contd……….
• The central bank manages and controls the foreign exchange of the
country and also acts as the technical adviser to the government
on foreign exchange policy.
• It is the function of the central bank to avoid fluctuations in the
foreign exchange rates and to maintain stability.
• It does so through exchange controls and variations in the bank
rate.
• For instance, if the value of the national currency continues to fall,
it may raise the bank rate and thus encourage the inflow of foreign
currencies.
 Conclusion:
Thus the central bank plays an important role in
achieving economic growth of a developing
country through the various measures
discussed above. It should promote economic
growth with stability, help in attaining full
employment of resources, in overcoming
balance of payments disequilibrium, and in
stabilizing exchange rates.
 Major central banking systems
• The European Central Bank
• The Federal Reserve System and
• The Bank of England
 The European Central Bank
Overview
• Role: To manage the euro, keep prices stable and conduct EU economic
& monetary policy
• President: Christine Lagarde
• Members: ECB President and Vice-President and governors of national
central banks from all EU countries
• Established in: 1998
• Location: Frankfurt (Germany)
• Website: European Central Bank
• The European Central Bank (ECB) manages the euro and frames and
implements EU economic & monetary policy. Its main aim is to keep
prices stable, thereby supporting economic growth and job creation.