——_— — We Syste, False: 3 bank. int than price ntral banks. ral banking India. a! ce Of eer ge! Role of Central Banks at Chapter 2 _ Role of Central Banks Determination of Goals =————————— _2e _ Introduction \ 22 2.3 Inflation Targeting, Exchange Rate Targeting, Money Supply Targeting and Money Growth Targeting 2.4 Viable alternatives to Central Bank 2 Central Banking in India 2.6 Questions Ee2.1. INTRODUCTION: The role of central bank in the moder dyn: k as an institution amic world has become more complex and vital. Central ban! has evalved overa period of time. From being an apex body of the tanking and financial system, it manifests itself today as multifaceted organisation. While performing traditional functions, more and more new functions are being added. In today’s globalised world, the role of central bank is very crucial to ensure growth with stability. The central bank of every economy regulates, monitors and supervises the banking and monetary system. The role of central bank and its primary functions are outlined by each country according to its priorities and the stage of economic development. While some central banks give priority to its function as banker to the government, others consider monopoly of note-issue and control of credit as their main objective. At present, however all central banks are entrusted with multiple tasks. The role or functions of central banks are as follows: (1) Traditional Functions: (a) E: ei re Central bank has the Monopoly of note ue. This exclusive right enables the central bank to control and regulate su ipply of currency and credit supply and thereby ensure stability. * y (b) Government's banker: The central bank acts as a banker, agent and advisor to the government. As a banker it ) ; anker i inages the transactions of the government. It is the . custodian of the = Bovernment’s funds. Receipts are © (ad) (e) i Viput’s™ Central Banking (BE!) poje of Central Banks accepted and government. C met by the cer policies of the issue of treasu the governmet also advises inflation, bala rate stability. Banker to th certain percen The percenta; decided by th time dependit These reserve financial crisi commercial bi Custodian of exchange res controlled by the flow of fc needs accordi central bank t Central clear an account W settle their in' transactions surplus deposSE 0 rr ete, Role of Central Banks cor 3B F accepted and payments are made on behalf of the mic world }.. government. Credit requirements of the government are 5 an institutio,, met by the central bank. As an agent it implements the pex body of the policies of the government, manages its public debt and If today as , issue of treasury bills. Foreign exchange transactions of onal function; the government are also managed by the central bank. It id. In today’, also advises the government regarding control of ucial to ensure inflation, balance of payments situation and exchange rate stability. (c) Banker to the banks: All commercial banks hold a Monitors and certain percentage of cash reserve with the central bank. tole of centra’ The percentage to be kept with the central bank is "ach country ; o decided by the central bank and it varies from time to development ; é ‘ time depending upon the requirements of the economy. m as banker to These reserves are used by the central bank to meet any financial crisis and also to regulate credit creation by meeevever all commercial banks. INNA SS Ote-issue and (@) Custodian of foreign exchange reserves: All the foreign vs: exchange reserves of the country are maintained and controlled by the central bank. As a custodian it regulates the flow of foreign exchange to the various sectors and poly of note needs according to priorities. This function facilitates the ntral bank i central bank to maintain stability of the exchange rate. ie (©) Central clearing house: All commercial banks maintain an account with the central bank. This enables them to S as a banke" settle their interbank claims without using cash and the $a banker '* transactions are carried out quickly. They park their ent. It is the surplus deposits with the central bank. Receipts ”° ; cTTT — 2K ee 1m central Banking (B31) vipsl’s it: The central pank controls the t directi 5 both quantitative volume and direc at and qualitative measures t0 control price a () Controller of credit function the central bank aims at rowth and development. stability to promote economic g) (g) Other functions: Apart from the above central banks carryout a number of promotional functions. They a an active role in the establishment of development institutions, bringing about balanced regional development, conducting research related to monetary and banking system, price trends, balance of payments trends etc. Thus central banks perform a variety of functions to build a strong banking and monetary system to meet the requirements of the economy. The role of central banking can further be analysed with reference to the following. ; 2.2 DETERMINATION OF GOALS: All central banks determine the goals according to requirements of the economy and the priorities outlined b x government. Generally the goals are as follows: 2 (i) Stability of the monetary and financial system. (ii) Development and regulation of the financial ma; Ke 1 ket, (iii) Price stability along with economic growth, 1e C\ NER T FR Oe me ral Banking (gg Role of Central Banks controls ~ th, L quantitatiy (iv) Efficient payment system for safe and smooth transactions. % Through ty, (W) Exchange rate stability and regulating international xchange ral liquidity. = evelopment, The goals of the central banks are becoming dynamic in nature entral bank in the present era and they are adapted according to the economic ituation. s. They play situation velopment} d regional 2.3 INFLATION TARGETING, EXCHANGE RATE to monetary TARGETING, MONEY SUPPLY TARGETING AND of payments MONEY GROWTH TARGETING: (1) Inflation targeting: Monetary policy is concerned with functions to money supply, bank credit and cost of credit or rate of 1 to meet the interest. It is framed by the central bank to achieve objectives like price stability, economic growth, full employment, etc. Monetary policy is used by the central bank to control be analysed inflation, ensure price stability and promote economic growth. Price stability and economic growth are conflicting in nature. When price stability is given importance, money supply and credit will be controlled affecting growth. If growth has to be accelerated, more money supply and credit ding to tM should be made available compromising’ price stability. lined by Hence the Central bank has the responsibility of striking a balance between these two objectives. In recent times central banks use ‘inflation targeting’ to achieve the balance. Inflation targeting refers to the policy of the central bank fixing a certain rate of inflation as the target. The central bank estimates the expected rate of inflation, makes it public as the narket.1™ central Banking (881) vipul’s lation is different from the hieve the targeted 10 economists, and greater target rate. If the actual rate of intl taken to ac! target rate, then measures are according rate. Targeting the inflation rate, will ensure transparency, commitment 5 ank in the implementation of accountability of central by ; ina way is nothing but monetary policy. Inflation targeting i forecasting inflation. Price index is used to measure inflation, In the case of inflation targeting also a particular price index needs to be selected. Generally consumer price index is used. Many countries are experimenting with inflation targeting. The Reserve Bank of India has announced an inflation target of 4% with +/-2 percent as the tolerance level. This inflation target is for a period of five years from 2016 to 2021. The government sets the target in consultation with the Reserve Bank of India. Inflation rate in the range of :2% to 6% is considered as a reasonable rate. Such a rate is expected provide stability to encourage consumption and investment. The success of inflation targeting depends on a number of i factors. Some of them are: (a) Well-developed financial system. (b) Autonomy for the Central bank, (©) Adequate and accurate availability of data, . (d) Sufficient technological advancement capacity to forecast inflation, and technical (e) Non-interference of the Govern: iment the Central bank. in the Working ofe targeted conomists, | greater Q) x is used. n targeting. ation target iis inflation » 2021. The the Reserve % to 6% is is expected westment. a number nd technical e working, of Role of Central Banks aw yr 17 (f) Deregulation of the administered price mechanism, etc. Inflation targeting is a complex exercise. It is increasingly adopted by countries as it reduces uncertainty and creates a conducive environment for economic growth. Exchange rate targeting: It refers to a targeted exchange rate against another currency or group of currencies. This policy helps to manage exchange rate fluctuations and protect the economy from a volatile foreign exchange market. For this to succeed ample forex reserves and cooperation from other countries are required. The targeted exchange rate also depends on the nature of the economy, developed or developing — balance of payments position, nature of exports and imports etc. Like inflation targeting, exchange rate targeting aims at stability in the economy. Monetary policy formulated and implemented by the central bank has specific objectives to be attained. Some of the notable objectives are price stability, economic growth, employment generation, financial stability, exchange rate stability and interest rate stability. The objectives differ from country to country depending upon the stage of development and national priorities. For example in the case of India, the key objectives of monetary policy are price stability and economic growth. In the case of the USA employment generation, price stability and interest rate stability are considered as primary objectives: In the present day globalised world, foreign exchange transactions across borders have increased significantly. The fluctuations in the exchange rate cause far reaching effects on the economy. |yiput’s™ Central Banking (Bey e for the central banks tg Hence it has become imperativ fa y to ensure pr stability ang maintain exchange rate s' abilit economic growth Jes of maintaining the externa try to country. The om fixed to flexible The methods and princip! value of the currency differs from count exchange rate mechanism has evolved fr } to managed float system. Fixed exchange rate aS geecatioms under the gold standard till 1931. Under this system the exchange rate between two currencies was determined by the relative weight of gold a country’s currency could buy. After the collapse of this system, in 1944 the International Monetary Fund introduced the gold exchange standard which popularly came to be called as the Bretton Woods System. Under this system, member nations declared the par value of their currency in terms of gold which was pegged to US $. As per this system member countries could convert their dollar holding into gold at the rate of $ 35 to 1 ounce of gold. Thus currencies of member nations were pegged to US $ which emerged as a powerful currency and this system continued 0 work till 1971. Huge deficits in the balance of payments of the USA, flight of capital etc. resulted in the suspension of system. After the collapse of the Bretton Woods S hose exchange rate mechanism emerged. The market forces determine the exchange rate under this system. While some countries have a free float system wherein . supply determine the exchange rate, other ¢ cannand. in the market whenever necessary. The inde :Role of Central Banks roe 19 system where the central bank intervenes is called the managed float system. Most of the developing countries at present adopt this system. To control inflation, exchange rate targeting is one of the methods. Exchange rate targeting implies aligning the monetary policy of a country with that of another country having low inflation. When this happens, monetary policy of the domestic country becomes subservient to the other country and the influence of monetary policy on domestic matters become less significant. In the 1990s exchange rate targeting came into prominence in Europe with the establishment of the Exchange Rate Mechanism (ERM). Nine EU countries became members of the ERM. Later the United Kingdom joined and was able to control inflation successfully. Other countries like Norway, Finland and Sweden were also exploring the possibility of joining the ERM. However uncertainties in the formation of the European Moretary Union and disparities in the European nations slowed down the expansion of the ERM. Towards the later part of 1990s, the momentum picked up. The motive behind the initiative was to build closer ties with each other and ensure low inflation by maintaining stable exchange rate. Often it is suggested that when a currency is pegged to a stable foreign currency or a basket of currencies, low rate of inflation is possible. Some countries like Israel, Poland, Brazil and others experienced this in the 1980s and 1990s, However this pegged exchange rate system cannot be a permanent one. if situation warrants, the pegged rate needs to be charged. S\\ Wil Ui revigul’s™ Central Banking (Ba) 20 or n fixed all the time. Moreover this onetary policy. If the entions of the central | Hence it does not remait system limits the operation of the m interv' domestic situation demands the in! ; i . Di | bank, then the pegged exchange rate may be given up. Due to globalisation, the flow of capital H flow of capital, controlling 1 banks. If a between countries has | I increased substantially. Due to in | inflation has become a big challenge to central ‘ tight monetary policy is followed, domestic rate of interest | | will increase attracting more capital inflow. This will lead to | appreciation of domestic currency against the foreign i currency. To avoid this the central bank will buy the foreign | currency and this will result in more money supply. To control money supply and inflation, the central bank will sell i government securities under the open market operation. | Simultaneous credit creation by commercial banks will also be curtailed by raising the cash reserve ratio. This intervention of the central bank is termed as sterilised ! intervention. / Many countries liberalised their economies in the 1990s. Financial sector liberalisation with more capital enabled the economies to register higher growth rates. At the same time currency crisis was also experienced by various economies The classic example is the East Asian Crisis of 1997. The cri which stared in Thailand, Malaysia, Philippines, and Korea affected others also. In. th » im the beginning these countries registered high liberalisation, capital _ inflows appreciation of their currency. The banks andpS FCCEE INR he centray up. Due tg ntries hag controlling anks. If a of interest ill lead to e foreign he foreign ipply. To k will sell operation, will also tio. This sterilised the 1990s. ‘abled the ame time conomies: Role of Central Banks GB) 21 institutions which borrowed from abroad and provided credit to buy property and stocks could not repay. Export sector could not compete and balance of payments crisis worsened. Foreign investors withdrew their investments resulting in massive outflow of capital. The Thai baht which was pegged earlier was allowed to float in July 1997. This led to depreciation of currencies of other East Asian countries. These economies could bring about recovery only with the assistance provided by the IMF and other countries. Flexible or fixed exchange rate system in its pure form, in today’s world is a rarity. The intervention of the central bank is always there. Even in those countries where the currency is said to be a floating one the central bank intervenes to prevent wide fluctuations. There is no precise answer for the question which system is better — flexible or fixed. While a pegged exchange rate mechanism may ensure low rate of inflation, a flexible exchange rate provides the scope to the central bank to bring about the necessary adjustments required by the economy. Money supply targeting and Money Growth Targeting: Central banks worldwide have monopoly of note issue. They are also the controller of credit created by banks and financial institutions. The control over money supply and credit enable the central banks to control inflation and ensure price stability. In the 1970s many central banks followed the policy of money supply targeting. Money supply targeting “mplies fixing a target or limit for money supply in the ec .my.Fa VEER eee v king (BBI) 14™ Central Ban 22 vigal’s ree hat th ise that there is Peas the premise Money supply targeting is based On foe yy, output and a close relationship between money ney supply, it was prices. By controlling one factor namely money ilised and easy to believed that the other two can be stabilist i. mal value of currency. Dtke ae i d_exte iS maintain the internal an dicates the t in money supply target, money growth targe! : : ) ly. Inflation targeting target for the growth of money supply. Rte | th targeting in the substituted money supply and money gtow . 1980s. Emergence of many financial innovations wes attributed as the main reason for the decline in the popularity of money supply targeting. However in the 1990s some countries like USA, UK, Germany and Sweden followed this : technique. In USA the Federal Reserve announces the money | growth target every year, though it has limited influence om : policy decisions. In Germany, it is adopted by the central bank to influence various policy decisions. At present central banks have to closely monitor various variables like money supply, inflation, rate of interest, exchange rate ete. All variables are inter related and exert influence on each other. Hence the role of central bank is a very challenging and dynamic one. 2.4 VIABLE ALTERNATIVES To CENTRAL BANK: Central banks have emerged as a powerful organi<..: TBanisation a period of time. Modern economies depend on au guidelines in regulating, supervising and moni fing - banks : system. Monetary policy is one of the im financial Portant police; achieve:various socio-economic objectives, C a ae - anks play SSSpear 7A eee anking (BB1) at there is itput and ply, it was d easy to ncy. Like icates the \ targeting ting in the tions was popularity 990s some llowed this: the money nfluence om: the central sent central like money ate etc, All \ each other. lenging and ANK: sation over a tal banks for 3 the financial Nt Policies to ‘banks play a Role of Central Banks re 23 predominant role in today’s world considering the multiple tasks performed by them Economists often debate the need for a central bank. Is it required or is it indispensable - a question often discussed by economists and researchers. While some argue it is dispensable some others argue that it is indispensable. Two schools of thought namely the Free Banking School and Rational Expectations School had divergent views. The Free Banking School argued in favour of freedom to commercial banks and was of the opinion that the restrictions of the central bank were an impediment to the free working of the banking sector. According to them the central banks enjoying monopoly of note issue and controlled by the government would influence the banks according to the priorities of the government which may go against national interest. Instead of one central bank, if multiple banks have the right to issue currency notes, abuse of monopoly power can be avoided. The Rational School on the other hand argued in favour of the central bank to regulate the banking system and ensure stability. A centralised agency, in their opinion would be in a better position to enforce discipline and effective working of the banking system. In the post liberalised era, along with faster growth rates, economic crisis and volatility in the markets have been witnessed in spite of rules and regulations prescribed by central banks. In the recent times the concept of ‘Currency Board’ is being discussed as an alternative to the central bank. Under currency board, the domestic money supply is tied to another currency and is fully covered by the foreign currency. It is like a fixed exchange Tate system wherein the domestic currency is pegged to a ‘oreign ST \\ WA 7ee , vipwl’s™ central Banking (ga) 24 corer lowed to issue CUTFENCY Notes ink is al mé rency for exchange i ni subject to maintaining enough foreign Cun SS , gentina which introduced q i i ice is ATi | classic example of this practice was tied £0 US $ and the / i ich its pe: currency board in 1990 in whic te uit stabil rate was fixed as 1 peso is equal to 18. Though ee ed inancial crisis j the exchange rate, it could not prevent the finan is in Argentina in 1992. Under currency board, : : \ provision to act as the lender of the ast resort. Fluctuations in the \ | demand for domestic currency imposes severe strain on the board and eventually on the banking system. In the absence of a strong banking system and strict regulatory system, currency crisis ' currency. The central ba central bank has no would become a banking crisis plunging the economy into a crisis and creating a contagion effect. In the case of emerging economies like India, there is no doubt about the need for a central bank. They differ from the developed nations in terms of the nature of their financial markets, need to develop institutions and introduce reforms etc. The main objective growth. Central banks are essential for developing countries t0 monitor the financial institutions, regulate the flow of liquidity, h ! | of monetary policy of the RBI is price stability and economic ! | volatility and economy.2.5 CENTRAL BANKING IN INDIA: introg Uss \, The Reserve Bank of India Act 1934 paved the way for the _ “Nd ii) establishment of the Reserve Bank of India in 1934 which became ly it Stabj; operational in 1935. As the apex bank, it has, monopoly of note lity of developing and monitoring the banking issue, respons system and regulating the credit creation of commercial banks. It acts as a banker to the government accepting receipts and making payments on behalf of the government. It also serves as a banker ce of a sg} on to the banks and custodian of foreign exchange reserves. The central clearing house function of the RBI enables the bank to settle their transactions quickly and efficiently. The formulation and implementation of the monetary policy is the responsibility of the RBI. Since 2016, the Monetary Policy Committee is entrusted with the task of formulating the monetary policy. The main objectives of monetary policy namely price stability and economic growth form the basis for the various operations of the central bank. The developing nature of the nd econom®, Indian economy has made it necessary for the RBI to assume ; countries ™ additional functions termed as promotional and developmental functions. Under this many prominent institutions like IDBI, EXIM Bank, NABARD, UTIL, etc. has been established. These institutions are playing a significant role in their Tespective fields with the guidance of the RBI. Along with the banking system, non-banking financial companies are also regulated by the central bank. alised era ™ eveloped a ross bord! ns, kets gi The central bank is managed by the Board of Directors, the tioning of © governor and four deputy governors. The role of central bank has become very significant in the post liberalisation era due to 25 Role of Central Banks roo ~+¢™ Central Banking (BB) a vipul’s ) 26 ww fies, f financial a is in the forefront in expansion of banking activiti innovation and integration © globalisation. The Reserve Bank of Indi. sector to face the challenges of introducing reforms in the financial liberalisation, privatisation and 8! h history of the Indian economy. Jobalisation- Its re crucial in the growtl ! 2.6 QUESTIONS: (1) Define the following concepts: (a) Inflation targeting. (b) Exchange rate targeting. (c) Money supply and money growth targeting. j J (2) (A) Fill inthe blanks: J (@) Forecasting oF fixing rate of infiation is called 14 1G. ta (b) When exchange rate is pegged to another currency it is cal Pachomne Ree Anecltia- / (c) Inflation target for india is ‘ ’ (d) _______is considered as an alterng aes in the forex market. (f) Monetary policy in India is formulated by [Ans.: (a) inflation targeting (b) exchange rate 2 : (d) Currency Board (e) central bank (f) uonsiay (B) Choose the correct alternative and rewrite (1) Forecasting or fixing tate of inflation = (May 19) *¢ {a) Inflation targeting (b) CRR (¢) g, policyRole of Central Banks Of : faa kets dip 4 (2) The exchange rate mechanism followed by India at present is e forefy, : (a) Fixed exchange rate (b) Flexible exchange rate (c) Managed float system (d) None of the above [Ans.: (1 - a); (2-¢)] (3) Explain ‘inflation targeting’ adopted by central banks to control inflation. é (4) What is meant by exchange rate targeting? How does it work? (5) Why do central banks use money supply targeting and money growth targeting? (6) Write short notes on: (a) Central banking in India. (b) Viable alternative to central banking. Central banks and determination of goals. i <| 3 13