Central Banking - English

Central Banking

S D Nilanka Chamindani
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LESSION 2 : Introduction to Central Banking

1. Introduction

What is Central Banking?

It is about functions and operations of a central Bank.

What is a Central Bank?

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

1
The monetary authority or the central bank is the most important institution in the
financial system. It facilitates economic activities and efficient allocation of resources in the
overall economy and foster sustainable growth.

Its primary function is to provide the legal tender/money to facilitate payments and
settlements, so the economic agents of the economy can engage in their activities
efficiently and effectively as per their expectations with confidence.

The provisioning of legal tender per se does not create a conducive environment to
generate economic activities effectively, as too much of money or inadequate supply of
money could harm smooth functioning of the economy due to high volatility moments of
prices in general. Hence the Central Bank/Monetary Authority is entrusted with the
responsibility of managing the Price stability. It is a situation of low and stable inflation
rate that does not interfere with decisions of economic agents. They need such a stable
situation to form expectations with respect to their consumption, production and
investment and execute their plan with confidence. The central bank enjoys the legal

1 Some countries have the monetary authority in place of the central bank, ex: Singapore has
Singapore Monetary Authority (SMA). There are specific differences between a monetary authority
and a central bank in term of the authority and functions. However, their core functions are similar.

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authority to conduct monetary policy to manage level of money supply/liquidity to

maintain price stability.

Financial system with an efficient and effective payment and settlement system is the
platform that money can perform its functions efficiently. The rust people have on these
systems is crucial for its efficient performance and sustainability. Therefore, the central
bank is also entrusted with the responsibility of maintaining financial system stability and
secure an efficient system for payment and settlement. Central Bank executes the authority
it has from the law to supervise and regulate bank and other financial institutions to
maintain financial system stability.


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 other institution is likely to discharge such
responsibilities better.

As we discussed in Lesson 1 under evolution of the central banks, we saw that the primary
objective of establishing them was to lend to the government to meet government financial
requirements. The money required for such lending either in the form of coins or notes
were produced by central banks. That is how producing and distributing money became
the main responsibility of central banks. Overtime the banking sector was the main
channel of distribution. Money, as you may have already studied, facilitates payments and
settlements. A secure payment system is essential for smooth a functioning of the
economy. Accordingly, core responsibilities of central banks are also associated with those
main areas of using money as well.

2. The core responsibilities

(I) Maintaining Stable of Money

What does it mean by stable money? What does money issued by the central bank give
you? It gives the confidence that you can use that money to buy goods and services, to
satisfy your needs and wants. You can understand that we cannot consume money as they

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are and have to be exchanged with goods and services of our choice. Accordingly, the
basket of goods and services is our concern when we keep money. It is called the real
value of money or its purchasing power.

Stability of Internal Value of Money

If prices of goods and services rise continuously, the phenomenon known as inflation,
while the nominal amount of money does not increase at the same rate of price increase,
the real value of money drops. If prices increase faster, higher inflation, real value of
money drops significantly. If this situation continues unabated, continuous drop in real
value of money makes people stop using legal tender. They can even shift to a barter
system where goods and services are exchanged directly rather than using money as the
medium of exchange. The central bank as the monetary authority is responsible to
preserve the real value of money or internal value of money to ensure continuation of the
monetary system on the nations.

Stability of External Value of Money

Another aspect of the functions of central bank is preserving external value of money.
What is distinction between the internal value and external value of money? Internal value
is the ability of money to purchase goods and services at domestic prices. The external
value, in contrast, is its ability to purchase foreign currencies, which depends on the
exchange rate of domestic currency vis a vis foreign currency. The exchange rate is directly
associated with the economic transactions economic agents have with the rest of the
world. They can be associated with the main economic activities of consumption,
production, distribution, and investments. All legal transactions related to such economic
activities are recorded in the Balance of Payments (BOP).

If exchange rate is volatile, economic agents find it difficult to plan their economic
activities and execute them with confidence. Therefore, the central bank is responsible to
main stability of the exchange rate so that stability of the external value of the domestic
currency is preserved.

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(II) Maintaining a Stable Monetary System and Financial System

The monetary system is mainly the institutions and activities associated with the
production, distribution and management of money supply to ensure the optimum level
of money supply or liquidity in the economy, whereas the financial system is mainly the
institutions and activities associated with mobilization of money among different sectors
in the economy through various channels.

Monetary system consists of the government, central bank and commercial banking
system. Financial system consists mainly of financial intermediaries and financial markets.

If the monetary system is not managed efficiently to ensure optimal level of money supply,
it could hamper economic activities, due to either inflation, if the supply exceeds the
optimal level or deflation, if the supply is not sufficient to facilitate economic activities.
Therefore, the central bank is responsible for maintaining a stable monetary system.

Both financial intermediaries and financial markets facilitate mobilization of money

between the surplus units and deficit units, so that institutions under both sides can
manage their financial resources with confidence as per their expectations. The modern
financial system is very complex with high degree of integration among institutions and
activities within and across national boundaries. However, the reliance of economic agents
on the financial system to meet their needs depends on the trust they have on it.

People can lose their trust in a financial system, doubt about the safety and stability of the
system, as a fragile financial system could expose their economic activities to various types
of risks. Once they lose that trust, they start moving away from the system, resulting in
collapse in the entire system. The negative impact of such event will not be limited to an
individual institution but to the financial system as whole, due to contagion effects, that
could harm the entire economy leading to grave and far reaching social and political
problems.

There are two areas associated with the financial system stability. Institutional
mismanagement could expose them to risk. The entire system also could develop some
misalignments exposing the entire to system to risk. Therefore, the central bank is

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responsible for ensuring that financial institutions are managed according to international
standards and also ensuring the entire financial system is resilient to possible shocks of
domestic and/or international origin.

(III) Maintaining Stability in Banking System

The banking system, especially the commercial banking system is important in many
aspects. They come under both monetary system and financial system. Since commercial
banks are capable of creating money through their lending activities, they involve in
producing liquidity in the form of bank money. Hence, they are under monetary system.
Commercial banks also dominate in the financial intermediary process. Hence, they are
under financial system as well. Since, the banking sector dominates in the financial system
its stability is vital. If the banking system is sound and resilient to shocks, it could function
as a protective wall for the entire financial system, even when some non-bank financial
institutions develop financial problems. On the other hand, if the commercial banking
system develop symptoms of instability, it could destabilize other institutions and the
entire financial system as well.

Therefore, maintaining the stability of the banking system is also a prime responsibility of
the central bank.

(IV) Maintaining a Secure Payment system

In a monetary economy, every time two or more parties engage in exchange of goods or
services or assets of different types, they require payments and settlements of dues. Such
payments and settlement could happen in multiple ways ranging from a simple direct
payment of cash, where payment and settlement take place at the same time, to indirect
payments through electronic payments of different types, where many institutions and
systems are involved.

Simple direct payments can be executed with confident as long as the cash involved in the
payment is genuine and not counterfeits. However, the situation of indirect payments and
settlements systems is different. Many institutions and activities are involved is such a
system. Accordingly, people do not have the same degree of confidence that they have

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with direct cash payments in the payments and settlements with systems. There could be
institutions engage in fraudulent activities using such systems, while systems themselves
could experience interruptions affecting timely payments and settlements. Such failures
could have negative effects on the economy.

Therefore, the central bank is also responsible to maintain stable payment systems.

(V) Ensuring Secure Cash

Everything that we discussed up to now involves cash. Cash can be in the form of either
currency coins or notes. They are fiat money or legal tender representing the authority of
the government. Hence, representative money. The intrinsic or material value of legal
tender is much less than the face value it represents. However, people use legal tender in
their transactions with confidence due to the trust they have on the legal authority behind
issuing them. This public trust leaves loopholes for fraudulent acts of counterfeiting legal
tender and cheating in transactions, especially with unobservant people.

If people lose the trust about the genuineness of the currency coins and notes that they
have to use every time they execute an exchange, they experience the painful hazzle of
checking their genuineness. In such a situation, they could deviate from the monetary
system and stick to practices of the barter system, which is proved to be very inefficient.

Therefore, the central bank has the prime responsibility of ensuring that the currency in
circulation either in the form of coins or notes is free from counterfeits and secure to be
used in any type of legal payment and settlement.

3. Other Responsibilities

Central Banks can be responsible for non-central banking activities as well, if governments
entrust them to do so. They are mainly related to agency functions central banks perform
on behalf of the government.

Both core functions and agency functions of central banks will be discussed in detail in the
the next lesson.

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