Central Banking

Lecture 2 :Introduction to Central Banking

Google Classroom S D Nilanka Chamindani

Institute of Bankers of Sri Lanka Google Classroom

 Introduction
What is Central Banking?

It is the apex institution in the financial system of a nation. Because it performs a unique
function of maintaining a monetary and financial system to support real sector performance.

In overall, it facilitates economic activities and efficient allocation of resources in the

economy and foster sustainable growth.

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 Introduction
Why Central Bank is important?

The importance of a central bank can be assessed by examining its responsibilities. They have
evolved as specific to central banks, as no any other institution to discharge such
responsibilities better.

The history of the evolution of Central Banks is the history of the evolution of their
responsibilities, which were added from time to time to address the issues related to money
and finance.

Producing and distributing money became the main responsibility of central banks.
Accordingly, core responsibilities of central banks are also associated with those main areas of
using money.


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 Responsibilities of Central Banks
Responsibilities of the Central Bank of Sri Lanka (CBSL) are two Types;

a. Core Responsibilities
• Maintaining Stable Money
• Maintaining Stable Monetary System and Stable Financial System
• Maintaining a Stable Banking System
• Maintaining a Secure Payment System
• Ensuring Secure Cash
b. Other Responsibilities
All other responsibilities other than core responsibilities, are basically the
agency functions on behalf of the Government

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 Core Responsibilities : Maintaining Stable Money
• The Stability of Money is measured in terms of its purchasing power, which has two sides,

Internal Value: is measured in terms of the capacity of a given volume of currency to purchase a given
units of goods and services. Maintaining internal value of money is maintaining a low and stable rate
of inflation and it is knows as maintaining price stability (Related economic terms : Price Indices,

Inflation and Deflation )

• Why it is important to maintain Price Stability?

Economic agents plan for their future consumption, production and investment and take decisions to
manage their cash flow in an unforeseen future. Prices that matter for such decisions in one of the
most important factors. Hence, only if the price changes are low and behave in a predictable manner,
they can take rational decisions and implement them with confidence. Then only the economic activity
becomes dynamic and support sustainable grow

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 Core Responsibilities : Maintaining Stable Money
External Value: is measured in terms of the number of units of a given foreign currency that one unit of
domestic currency can purchase. It capacity of the domestic currency a given volume of money to purchase a
given units of goods and services (Related economic terms : Exchange Rate

Depreciation and Devaluation Appreciation and Revaluation)

Maintaining external value of money is maintaining a realistic and stable exchange rate

• Why it is important to maintain Exchange Rate Stability?

An open economy experiences continuous inflows and outflows of foreign exchange. Such flows are
associated with the various economic activities and are reflected in the Balance of Payments (BOP)
Account. Exchange rate matters for every transaction involving a foreign currency and domestic currency .
A highly volatile exchange rate can harm business activities and affect the position of the BOP. Hence the
CBSL can help the external sector economic activities by maintaining a stable exchange rate.

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 Core Responsibilities : Maintaining Stable Monetary System and
Stable Financial Systems

Monetary System: It is a set of institutions and relationships associated with the production,
distribution and management of money (Liquidity)

Stability in the monetary system is an environment that facilitates efficient management to ensure optimal
level of the money supply

Financial System: It is a set of institutions and relationships associated with mobilization of financial
resources among different sectors of the economy

Stability in the financial system is an environment where users of the services of financial institutions do not
lose the confidence they have in the institutions and the system as a whole

With stable and smooth functioning of monetary and financial system, economic agents can focus
on their economic activities without any doubts and make the economy more dynamic

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 Core Responsibilities : Maintaining Stable Banking System
• Stable Banking System is an environment where all banks (Commercial and Specialized) are
resilient individually and as a system to shocks emanating from both within the domestic
economy and from rest of the world

• Banking system is the dominant sub sector in the entire financial system. It is the strongest pillar.
Hence, stability of the banks, specially commercial banks, is vital for the stability of the entire
financial system

• If banking system is stronger, it can act as a shield for non bank financial institutions as well
when they are under financial stress

• Accordingly, the Central Bank gives special emphasize to the banking system in its efforts to
maintain financial system stability to facilitate economic activities move smoothly

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 Core Responsibilities : Maintaining Secure Payment System
• When legal tender is used as the intermediary tool for the payment, the settlements also take
place at the same time or in real time

• However, this can be different when modes of payments, such as cheques, credit and debit cards
and electronic fund transfers are used. In such as environment, a third party, a payment and
settlement system is involved. Compared to a cash payment where paying and receiving parties
are visible, part of the payments and settlements through a system is invisible. This where the
trust in the system matters

• Rational and risk averse economic agents tend to avoid inviable systems, if they are doubtful
about the security they have for their hard-earned money when they use a payment and
settlement system. If a payment and settlement system fails to build confidence among users, it
collapse and the economic activities fail to function smoothly

• Hence, the Central Bank has the responsibility of ensuring a secure payment and settlement
system for the financial sector and economic activities to function smoothly

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 Core Responsibilities : Ensuring Secure Cash

• The important characteristic of cash, either in the form of coins or notes, is the general
acceptance in exchange of goods, services and assets. It depends on the trust the users have on
the genuineness of cash

If counterfeit coins and notes are in circulation, it affect the trust and general acceptance of cash
resulting in people abandoning them and moving an inefficient mode of barter in their exchange

• Therefore, the Central Bank as the sole legal authority of producing and distributing legal tender
or fiat money has the responsibility of ensuring a security of cash in circulation to facilitate
exchange of goods and service for the economy to function smoothly

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 Other Responsibilities
• All Non-Core responsibilities of the CBSL fall under other responsibilities. There are generally
referred to as Agency Functions as most of them are entrusted on the CBSL to perform on behalf
of the Government. Following are such responsibilities of the CBSL

a. Management of Public Debt

b. Management of Foreign Exchange
c. Management of the Employees’ Provident Fund
d. Promoting Financial Inclusion
e. Proving Financial Intelligent Services
• Central Bank responsible in the above are they are entrusted by the government to facilitate a
better economic management.

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 Lecture 2 : Functions of the Central Bank

• Core Functions of the Central Bank

• Agency Functions of the Central Bank

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