Chapter Two

Central Banking
2.1. Introduction
National bank is a recent phenomenon. Before 20th century, there was no clearly defined concept
of national banking system. In many countries like, England, France, Sweden, etc, some banks
were assuming more power, were enjoying the right of note issue and were acting as a
government banker and agent. They were not originally called the national or central of bank.
The oldest central bank was Ritz bank of Sweden, which was established in 1556.
The variation in circumstances surrounding the origins of central banks means that their roles
and functions have not all evolved in the same way. Some started life as special purpose
government banks constructed to bring some order to the issuance of banknotes. Some were
established to act as funding conduits for the government. Some were large commercial banks,
whose dominance was subsequently boosted by the granting of monopoly rights to issue
banknotes. The majority were, however, created in the 20th century specifically as central banks
– public policy agencies for central banking functions.
Typically, an economy will have a central bank, like National Bank of Ethiopia, Federal Reserve
in the US or the Bundes bank in Germany. Central banks are responding to the financial crisis by
setting in place more healthy policy frameworks.
2.2. Definition of Central Bank
It is very difficult to suggest a precise definition of a central bank. However, a central bank can
best be defined with reference to its functions.
It can be defined as the bank which stands as the leader of the money market-also called the
financial market-issues notes and coins, supervises, controls and regulates the activities of the
banking system and acts as the banker of the government. In our pyramidal financial structure,
the central bank sits at the top.
A central bank is a bank which constitutes the apex of the monetary and banking structure. It
manages the economy in the interest of general public welfare, but not maximization of profit. In
addition, the central bank is the bank which controls credit.

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The central bank duty is to control the monetary base and through control of this ‘high-powered
money’ to control the community’s supply of money.” But as a private citizen, no one-even the
Head of the country-either can open a bank account or borrow money from the central bank.
The establishment of a central bank in a modern economy is essential as it is the apex institution
of a country’s financial as well as monetary system. Its action affects money supply, the volume
of credit, interest rates, etc. All these have direct impacts not only on financial markets but also
on national output and inflation (deflation). Thus the central bank plays an important role in any
economy.
In fact, every independent country must have a central bank for organizing, running, supervising,
regulating and developing the monetary- financial system of the country.
Implementation of the government’s economic policy requires the presence of the central bank
which stands as the undisputed leader of the money market. In view of this, some people feel that
the central bank is one of the great inventions of modern civilization.
In most countries, the central bank is a nationalized institution. It is the main agent of the
government for the purpose of administering its monetary and banking policies. Unlike
commercial banks, its aim is not to make profit for its shareholders. So, it does not compete with
the commercial banks for ordinary banking business.
The first central bank was established in the 18th century. Though the Riks Bank of Sweden was
set up in 1656 and the Bank of England in 1694, the Bank of England started functioning as the
central bank of England in 1844. It is said that the Bank of England is the oldest central bank of
the world.
2.3. Objectives of Central Bank
The objectives of the central bank include economic growth in line with the economy’s potential
to expand; a high level of employment; stable prices (that is, stability in the purchasing power of
money); and moderate long-term interest rates.
The central bank is ultimately concerned with preserving the integrity of a country’s financial
institutions, combating inflation, defending the exchange rate of the country’s currency and
preventing excessive unemployment.

2.4. Functions of Central Bank:

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One can find some differences in the style of functioning of a central bank. Its functions in an
underdeveloped country differ from those in a developed country. But the central bank performs
the following common but vital functions in every country.
(a) Monopoly Power of Note Issue:
The central bank has been given the monopoly power of note issue. It has been empowered to do
so in the interest of uniformity and to bring a balance between demand for money and supply of
money (i.e., prevention of over-issue or under-issue of notes).
The notes issued by the central bank are considered as legal tender money of the country and
form the cash basis of the credit of commercial banks. Being the sole supplier of money in the
economy, the central bank regulates the volume of currency of the country. It has also the power
to withdraw worn and torn notes from circulation in exchange for new ones, so that good quality
notes and coins circulate in the economy.
(b) Bankers’ Bank
Commercial banks are required, by law or convention, to keep a certain percentage of their
deposits are serves with the central bank. In this way, it acts as a custodian of cash reserves.
Banks draw cash balances from the central bank as and when the situation demands.
As a bankers’ bank, it acts as a lender of the last resort. If commercial banks face serious
liquidity crisis they approach the central bank and it stretches its lending hand to them—either by
discounting bills or buying securities from them. This sort of accommodation makes the central
bank a lender of the last resort. This is essential to prevent bank failure.
It gives advice to banks on good/sound banking practice. A central bank usually discusses
government policy with them and reports back to the government. Thus, a central bank closely
monitors the activity of commercial banks.
(c) Banker, Agent and Adviser to the Government:
The central bank acts as a banker, agent and adviser to any government. As a banker of the
government, it has to maintain banking accounts of both central and state governments. It makes
and receives payments on behalf of the government as it acts as the agent of the government.
Truly speaking, government (central, state, and union territories) expenditure (say, on road
building, hospital construction, etc.,) and revenue (say from income tax, excise duty, etc.,) pass
through the central bank. In brief, it performs merchant banking functions for the government.

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It also provides short-term loans and advances (known as ways and means advances) to the
government to enable the latter to tide over its financial difficulties. It also advises the
government on necessary monetary and financial matters such as market borrowing, loan
repayment, deficit financing, and control of inflation.
(d) Controller of Credit:
The central bank of a country prescribes broad parameters of banking operations within which
the country’s banking and finance system operates. In a modern credit-oriented economy, credit
is an important component of money supply. Being profit-making institutions, commercial banks
may adopt the policy of undue expansion or contraction of credit to suit their needs.
This may lead to inflation or deflation. Neither of the two is desirable. To ensure price stability,
credit supply is to be regulated. And, this task has been entrusted with the central bank. The
central bank, through its credit control policy, intends to curb the lending potential of
commercial banks.
Actually, it keeps the creation of credit within limits. It is accepted that this is its most important
function. However, for controlling credit, it uses several official instruments like the bank rate,
open market operations, and so on.
(e) Custodian of Foreign Exchange Reserves:
With the aim of facilitating foreign trade and payment and promoting orderly development and
maintenance of foreign exchange market, a central bank acts as the manager of foreign exchange.
The central bank acts as the sole custodian of gold and foreign currencies for the purpose of
issuing notes and for correcting an adverse balance of payments situation.
In this connection, one may note that, by holding gold and foreign currencies, the central bank
intends to stabilize foreign exchange rate. Like internal price stability, stability in foreign
exchange rate is equally vital. A central bank aims at affecting the foreign exchange rate (i.e., the
rate at which one currency is converted into another currency) by buying and selling foreign
currencies in the foreign exchange market.
(f). Monetary Policy Function
Monetary policy is an economic policy that manages the size and growth rate of the money
supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation
is an economic concept that refers to increases in the price level of goods over a set period of

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time. The rise in the price level signifies that the currency in a given economy loses purchasing
power (i.e., less can be bought with the same amount of money) and unemployment.
These policies are implemented through different tools, including the adjustment of the Interest
Rate. An interest rate refers to the amount charged by a lender to a borrower for any form of debt
given, generally expressed as a percentage of the principal, purchase or sale of government
securities, and changing the amount of cash circulating in the economy. 
Objectives of Monetary Policy
The primary objectives of monetary policies are the management of inflation or unemployment,
and maintenance of currency exchange rates, Fixed vs. Pegged Exchange Rates, Foreign
currency exchange rates measure one currency's strength relative to another. The strength of a
currency depends on a number of factors such as its inflation rate, prevailing interest rates in its
home country, or the stability of the government, to name a few..
1. Inflation
Monetary policies can target inflation levels. A low level of inflation is considered to be healthy
for the economy. If inflation is high, a contractionary policy can address this issue.
2. Unemployment
Monetary policies can influence the level of unemployment in the economy. For example, an
expansionary monetary policy generally decreases unemployment because the higher money
supply stimulates business activities that lead to the expansion of the job market.
3. Currency exchange rates
Using its fiscal authority, a central bank can regulate the exchange rates between domestic and
foreign currencies. For example, the central bank may increase the money supply by issuing
more currency. In such a case, the domestic currency becomes cheaper relative to its foreign
counterparts.
Tools of Monetary Policy
Central banks use various tools to implement monetary policies. The widely utilized policy tools
include:
1. Interest rate adjustment
A central bank can influence interest rates by changing the discount rate. The discount rate (base
rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a
central bank increases the discount rate, the cost of borrowing for the banks increases.

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Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost
of borrowing in the economy will increase, and the money supply will decrease.
2. Change reserve requirements
Central banks usually set up the minimum amount of reserves that must be held by a commercial
bank. By changing the required amount, the central bank can influence the money supply in the
economy. If monetary authorities increase the required reserve amount, commercial banks find
less money available to lend to their clients and thus, money supply decreases.
Commercial banks can’t use the reserves to make loans or fund investments into new businesses.
Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest
on the reserves. 
3. Open market operations
The central bank can either purchase or sell securities issued by the government to affect the
money supply. For example, central banks can purchase government bonds. As a result, banks
will obtain more money to increase the lending and money supply in the economy.
Monetary policy approaches
Depending on its objectives, monetary policies can be expansionary or contractionary.
i. Expansionary Monetary Policy
This is a monetary policy that aims to increase the money supply in the economy by decreasing
interest rates, purchasing government securities by central banks, and lowering the reserve
requirements for banks. An expansionary policy lowers unemployment and stimulates business
activities and consumer spending. The overall goal of the expansionary monetary policy is to
fuel economic growth. However, it can also possibly lead to higher inflation.
ii. Contractionary Monetary Policy
The goal of a contractionary monetary policy is to decrease the money supply in the economy. It
can be achieved by raising interest rates, selling government bonds, and increasing the reserve
requirements for banks. The contractionary policy is utilized when the government wants to
control inflation levels.