FM 130 – Monetary Policy and Banking
Lesson 1
Introduction to Monetary Policy and Central Banking
What is a Bank?
Definition:
 Institution
 Providing loans to lend
 And create the credit money
 A BANK is an organization, usually a corporation, chartered by a state or federal government, which
does most or all of the following: receives demand deposits and time deposits, honors instruments
drawn on them, and pays interest on them; discounts notes, makes loans, and invests in securities;
collects checks, drafts, and notes; certifies depositor's checks; and issues drafts and cashier's
checks.
 A BANK is a financial establishment that uses money deposited by customers for investment, pays it
out when required, makes loans at interest, and exchanges currency
What is a Central Bank or central bank?
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A national bank that provides financial and banking services for its country's government and
commercial banking system, as well as implementing the government's monetary policy and issuing
currency.
An institution charged with the responsibility of managing the expansion and contraction of the
volume of money in the interest of general public welfare
A bank that does business with other banks and with the government and that controls a country's
money supply and interest rates
Functions of a Central Bank
Function of a central bank is to control the nation's money supply (monetary policy), through active duties
such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the
banking sector during times of bank insolvency or financial crisis.
Functions:
1. Bank of Issue
Central Bank has the exclusive monopoly of note issue and the currency notes issued by the Central
Bank are declared unlimited legal tender throughout the country.
2. Banker, Agent and Adviser to the Government
As Banker and Agent, keeps the banking accounts of the Central and State governments and makes
and receives payments on behalf of the government. As an Agent to the government, the central
bank collects taxes and other payments on behalf of the government. It provides short-term
advances to the govt to tide over temporary shortage of funds. It advises the govt on all monetary
and banking matters.
3. Care of the Cash Reserves of Commercial Banks
All Commercial Banks keep part of their deposits as reserves with the Central Banks. Centralised
cash reserves serve as the basis of a larger and more elastic credit structure and helps Commercial
Banks to meet crises and emergencies.
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FM 130 – Monetary Policy and Banking
Lesson 1
4. Care of Foreign Balances of the Country
CB holds the foreign exchange assets of all commercial and non-Commercial Banks of the country. It
is the responsibility of CB to maintain the rate of exchange and manage exchange control and other
restrictions imposed by the State.
5. Lender of the last resort
As a lender of last resort, Central Bank assumes the responsibility of meeting directly or indirectly
all reasonable demands for accommodation by the Commercial Banks.
6. Controller of Credit
It controls the level of credit in the economy by either expanding or contracting bank deposits.
7. Central Clearance, Settlement and Transfer
As the Central Bank keeps cash reserves of Commercial Banks, it is easier for member banks to
settle their mutual claims in the books of the Central Bank. These are the clearing house operations
of CB where in cheques are cleared, claims settled and funds transferred in the books of the
member banks.
Other Functions:
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It brings uniformity in the monetary system of note issue and note circulation.
It economies the use of cash by banks while settling their claims and counter-claims.
It enables the commercial banks to carry on their activities even with their limited cash reserves.
It provides financial help to the commercial banks in times of emergency.
The central bank also earns profit from the issue of paper currency.
Difference between Central and Commercial Bank
Central Bank
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It is apex institution of monetary systems
It is owned by the government
It is a non profit org.
It is banker and agent to government
It controls credit created by commercial
banks
It has monopoly to note issue
It has no competition
There is only one central bank in economy
Commercial Bank
 It is operating as per guideline of central
bankIt owned by private sector or
government
 It is a profit seeking org.
 It is banker and agent to public
 It creates credit
 It has no power to issue credit
 There is a competition among themselves.
 Commercial banks are many in number
Conclusion
1. Central bank plays important role in achieving economic growth of a developing country.
2. It promotes economic growth with stability.
3. It helps in attaining full employment of resources, in overcoming balance of payment disequilibrium
& in stabilizing exchange rates.
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FM 130 – Monetary Policy and Banking
Lesson 1
Monetary Policy
Definition:
“Monetary policy is concerned with deciding how much money the economy should have or
perhaps more correctly deciding whether to increase or decrease the purchasing power of money.”
According to McConnell:
“Changing the money supply to assist the economy to achieve a full employment”
Types of Monetary Policy
1. Contractionary / Tight monetary policy
Tight monetary policy, also called contractionary monetary policy, tends to curb inflation by
contracting/reducing the money supply
2. Expansionary /Easy monetary policy
Easy monetary policy, also called expansionary monetary policy, tends to encourage growth by
expanding the money supply.
Targets of Monetary Policy
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Money supply
There are several standard measures of the money supply, including the monetary base, M1, and M2.
The monetary base is defined as the sum of currency in circulation and reserve balances.
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Interest rate
The proportion of a loan that is charged as interest to the borrower, typically expressed as an annual
percentage of the loan outstanding.
 Employment, economic growth, and inflation can not control directly, it must choose settings, or
targets, for variables that it can control in order to best achieve its goals.
 In practice, there are two types of targets:
1. Money supply targets
2. Interest rate targets
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FM 130 – Monetary Policy and Banking
Lesson 1
Tools of Monetary Policy
Quantitative Tools or Traditional Tools:
 Open Market Operations
 Bank Rate
 Cash Reserve Requirement
Qualitative Tools or Selective Tools:
 Credit rationing
 Credit ceiling
 Moral persuasion
 Liquidity ratio
 Special deposit
 Direct action
 Advertisement
Direct Policy Tools
These tools are used to establish limits on interest rates, credit and lending. These include direct credit
control, direct interest rate control and direct lending to banks as lender of last resort, but they are rarely
used in the implementation of monetary policy by the Bank.
 Interest rate controls
 Lending to domestic banks
 Credit controls
Indirect Policy Tools
Used more widely than direct tools, indirect policy tools seek to alter liquidity conditions. While the use of
reserve requirements has been the traditional monetary tool of choice, more recently, the Bank shifted
towards the use of open market operations to manage liquidity in the financial system and to signal its
policy stance.
 Secondary reserve requirement
 Cash reserve requirements
 Asecurities requirement
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