Monetary and Fiscal Policy

The economic decisions of households can have a significant impact on an economy. For
example, a decision on the part of households to consume more and to save less can lead to an
increase in employment, investment, and ultimately profits. Equally, the investment decisions
made by corporations can have an important impact on the real economy and on corporate
profits. But individual corporations can rarely affect large economies on their own; the decisions
of a single household concerning consumption will have a negligible impact on the wider
economy.

By contrast, the decisions made by governments can have an enormous impact on even the
largest and most developed of economies for two main reasons. First, the public sectors of most
developed economies normally employ a significant proportion of the population, and they are
usually responsible for a significant proportion of spending in an economy. Second, governments
are also the largest borrowers in world debt markets.

Government policy is ultimately expressed through its borrowing and spending activities. In this
reading, we identify and discuss two types of government policy that can affect the
macroeconomy and financial markets: monetary policy and fiscal policy. 

Monetary policy refers to central bank activities that are directed toward influencing the
quantity of money and credit in an economy. By contrast, fiscal policy refers to the
government’s decisions about taxation and spending. Both monetary and fiscal policies are used
to regulate economic activity over time. They can be used to accelerate growth when an
economy starts to slow or to moderate growth and activity when an economy starts to overheat.
In addition, fiscal policy can be used to redistribute income and wealth.

The overarching goal of both monetary and fiscal policy is normally the creation of an economic
environment where growth is stable and positive and inflation is stable and low. Crucially, the
aim is therefore to steer the underlying economy so that it does not experience economic booms
that may be followed by extended periods of low or negative growth and high levels of
unemployment. In such a stable economic environment, householders can feel secure in their
consumption and saving decisions, while corporations can concentrate on their investment
decisions, on making their regular coupon payments to their bond holders and on making profits
for their shareholders.

The challenges to achieving this overarching goal are many. Not only are economies frequently
buffeted by shocks (such as oil price jumps), but some economists believe that natural cycles in
the economy also exist. Moreover, there are plenty of examples from history where government
policies—either monetary, fiscal, or both—have exacerbated an economic expansion that
eventually led to damaging consequences for the real economy, for financial markets, and for
investors.

The balance of the reading is organized as follows. Section 2 provides an introduction to

monetary policy and related topics. Section 3 presents fiscal policy. The interactions between
monetary policy and fiscal policy are the subject of Section 4. A summary and practice problems
conclude the reading. 
In this reading, we have sought to explain the practices of both monetary and fiscal policy. Both
can have a significant impact on economic activity, and it is for this reason that financial analysts
need to be aware of the tools of both monetary and fiscal policy, the goals of the monetary and
fiscal authorities, and most important the monetary and fiscal policy transmission mechanisms.

 Governments can influence the performance of their economies by using combinations of

monetary and fiscal policy. Monetary policy refers to central bank activities that are
directed toward influencing the quantity of money and credit in an economy. By contrast,
fiscal policy refers to the government’s decisions about taxation and spending. The two sets
of policies affect the economy via different mechanisms.
 Money fulfills three important functions: It acts as a medium of exchange, provides
individuals with a way of storing wealth, and provides society with a convenient unit of
account. Via the process of fractional reserve banking, the banking system can create
money.
 The amount of wealth that the citizens of an economy choose to hold in the form of money
—as opposed to, for example, bonds or equities—is known as the demand for money. There
are three basic motives for holding money: transactions-related, precautionary, and
speculative.
 The addition of 1 unit of additional reserves to a fractional reserve banking system can
support an expansion of the money supply by an amount equal to the money multiplier,
defined as 1/reserve requirement (stated as a decimal).
 The nominal rate of interest is comprised of three components: a real required rate of return,
a component to compensate lenders for future inflation, and a risk premium to compensate
lenders for uncertainty (e.g., about the future rate of inflation).
 Central banks take on multiple roles in modern economies. They are usually the monopoly
supplier of their currency, the lender of last resort to the banking sector, the government’s
bank and bank of the banks, and they often supervise banks. Although they may express
their objectives in different ways, the overarching objective of most central banks is price
stability.
 For a central bank to be able to implement monetary policy objectively, it should have a
degree of independence from government, be credible, and be transparent in its goals and
objectives.
 The ultimate challenge for central banks as they try to manipulate the supply of money to
influence the economy is that they cannot control the amount of money that households and
corporations put in banks on deposit, nor can they easily control the willingness of banks to
create money by expanding credit. Taken together, this also means that they cannot always
control the money supply. Therefore, there are definite limits to the power of monetary
policy.
 The concept of money neutrality is usually interpreted as meaning that money cannot
influence the real economy in the long run. However, by the setting of its policy rate, a
central bank hopes to influence the real economy via the policy rate’s impact on other
market interest rates, asset prices, the exchange rate, and the expectations of economic
agents. 
 Inflation targeting is the most common monetary policy—although exchange rate targeting
is also used, particularly in developing economies. Quantitative easing attempts to spur
aggregate demand by drastically increasing the money supply.
 Fiscal policy involves the use of government spending and revenue raising (taxation) to
impact a number of aspects of the economy: the overall level of aggregate demand in an
 economy and hence the level of economic activity; the distribution of income and wealth
among different segments of the population; and hence ultimately the allocation of
resources between different sectors and economic agents.
 The tools that governments use in implementing fiscal policy are related to the way in
which they raise revenue and the different forms of expenditure. Governments usually raise
money via a combination of direct and indirect taxes. Government expenditure can be
current on goods and services or can take the form of capital expenditure, for example, on
infrastructure projects.
 As economic growth weakens, or when it is in recession, a government can enact an
expansionary fiscal policy—for example, by raising expenditure without an offsetting
increase in taxation. Conversely, by reducing expenditure and maintaining tax revenues, a
contractionary policy might reduce economic activity. Fiscal policy can therefore play an
important role in stabilizing an economy.
 Although both fiscal and monetary policy can alter aggregate demand, they work through
different channels, the policies are therefore not interchangeable, and they conceivably can
work against one another unless the government and central bank coordinate their
objectives. 

Monetary Policy in Developing Countries

There has been significant progress made toward the liberalization and deepening of financial
markets over the past twenty years. But according to the IMF, greater central bank independence,
reduced fiscal dominance, and increased exposure to global capital markets have put pressure on
an increasing number of lower income countries to modernize their policy frameworks.

Sound principles of monetary policy still apply

The study by IMF staff, Evolving Monetary Policy Frameworks in Low-Income and Other
Developing Countries, aims to provide guidance to this group of countries, and uses the same set
of principles that characterize effective monetary policy frameworks in countries with scope for
independent monetary policy. “These principles encapsulate the key characteristics of any sound
forward-looking monetary policy framework,” the authors say, adding countries should consider
how best they can follow them to support their reform agendas.

The principles that characterize effective monetary policy frameworks by central banks,
according to the report, include:

• a clear mandate and operational independence to pursue its goals;

• price stability as the primary objective of monetary policy over the medium term;

• a medium-term inflation objective that guides monetary policy actions and communications;

• macroeconomic and financial stability considerations when determining policy;

• clear and effective operational framework aligned with market conditions and policy stance;

• transparent forward-looking policy strategy; and

• clear communications, which enhances the overall effectiveness of monetary policy.

While these principles are consistent with an inflation-targeting framework, the paper
emphasizes that these frameworks are not the only way to implement them. “For one thing, the
meaning of the term ‘inflation targeting’ varies and has evolved over time. The principles stated
in the paper stress the primacy of a medium-term inflation objective, but do not require an
unduly narrow focus on inflation at the expense of considering the impact on the real economy
and the financial system,” the study says.

Price stability a critical first step in reform agenda

The report also emphasizes the importance of price stability as a primary objective in a country’s
reform agenda—as it moves to an interest-rate based operating framework and greater exchange
rate flexibility. The development of analytical tools for policy making and techniques for
effective communication are also critical to help anchor inflation expectations, the paper says.

There is substantial difference in how countries have managed to modernize the framework for
monetary policy, and the report draws lessons from the experiences of a number of countries in
a background paper. In particular, while there is not a specific set of preconditions that countries
need to meet, critical first steps include a commitment to the primacy of price stability, and the
ability of the central bank to pursue that goal. ”Many of the challenges come from the
coexistence of multiple and often inconsistent targets and objectives,” the study says. The
authors also suggest countries move forward on as many fronts as possible, as progress can be
self-reinforcing, and so those reforms that can have a catalytic role should be conducted early in
the modernization process.

Another important goal in the modernization process, according to the study, is to increase
control over short-term interest rates, by establishing appropriate central bank monetary
instruments (which typically combine standing facilities, open market operations, and reserves
requirement). While the move toward interest-rate based frameworks can be swift, the report
says, the end point should be a framework where policy is signaled with a “policy rate” that
anchors interest rates in the financial system.

Enhancing analytical capacity should also be part of the modernization process, the report says.
Improving the central bank’s capacity to interpret data helps produce coherent medium-term
forecasts and analysis, and provides policy recommendations consistent with current and
expected state of the economy and the policy objectives. This requires the development of
quantitative frameworks for monetary policy analysis and forecasting, including the development
of a quarterly projection model.
The IMF study concludes by offering its continued support to low- and lower-middle income
countries in their process of strengthening and modernizing their frameworks through policy
advice on institutional issues, both in surveillance and program contexts, as well as technical
assistance and training.

Modelling Monetary Policy in Developing Countries

The design of appropriate monetary policy builds on two critical ingredients: 1) a

representation of the economy, characterizing technology, market structure and behaviour
of different actors (households, firms governments); and 2) a normative dimension, which
relies on a welfare function that summarizes the social costs and benefits from different
policy actions.

A natural question is whether the current framework and methodological approach used for
the analysis of monetary policy in developed countries (i.e., New Keynesian DSGE
models) can be exported to the analysis of policy in developing countries. A consensual
view emerged that there are important new dimensions that need to be taken into account in
the evaluation of monetary policy in developing economies. There was a healthy discussion
on whether one needs to “start from scratch or whether part of the existing framework can
be employed in the analysis of monetary policy in LIC”. Towards the end, agreement was
reached on what are some of the ingredients or considerations that have to be part of the
framework needed to study monetary policy in LIC (some might think of this as ‘starting
from scratch,’ or fundamental deviations from canonical New Keynesian DSGE).

1) High Volatility
DSGE techniques typically focus on small perturbations from non-stochastic
steady state in (log-) linearized versions of the model. But LICs are subject to high
volatility related to both supply and demand shocks. There may be important
theoretical non-linearities. Large movements in spreads and risk premia.

2) Nature of Shocks and growth effects

A common practice in macroeconomic analysis of developed countries is to isolate the
cyclical component of fluctuations. However, in LIC the trend is far from stable and
can be hardly separated from the cycle. The current crisis in East Africa is a case in
point: a seasonal drought has killed a sizable part of the cattle (a key asset in this
economies), which will have repercussions for growth in years to come.

An important issue is whether monetary policy should factor in that countries are
still far below their longer-term steady states.

Supply shocks are at least as important as demand shock (the key shock in NK
models to which monetary policy optimally reacts).
3) Non-homotheticities: subsistence level
Many houselholds in LIC live at or near subsistence levels. Contractionary
monetary policies are then particularly problematic in these economies and have to
be thoroughly thought-through. Redistributionary measures may have to be taken
along with monetary contractions.
 Inequality is an important dimension in the conduct of monetary policy in LIC, both
because it is much higher than in developed economies, and because a large fraction of the
population is at subsistence levels.

4) International dimension
Critically, economic models for LIC should feature the international dimension, with the
inherent exposure to terms-of-trade shocks, financial flows, changes in interest rates, etc.
The choice of the exchange rate regime is still a critical issues on which developing
countries need guidance. In studying exchange rate issues the balance-sheet effect should
receive as much emphasis as the competitiveness effect. Finally, most LIC have quite
closed capital accounts and hence they operate under conditions of near financial autarky---
in big contrast with the literature and assumptions in the international business cycle
literature.

5) The sectoral composition of the economy

Many LIC are highly concentrated in agriculture, an inherently highly volatile sector, with
little scope for prices to adjust to supply shocks.

6) Credit-constrained consumers and firms.

Financial constraints are very important and can play a key role in the transmission
mechanism.

7) Objective function
For many of the reasons highlighted above, we should be open to the possibility that the
optimal relative weight on output stabilization (relative to inflation) is higher in poor
countries.

Other research question

8) Limit to central bank independence/Fiscal dominance

Broadly speaking, central banks enjoy less independence in poorer countries. This raises
both normative questions (should central banks be independent in developing countries?)
and positive ones, as the lack of independence may be a factor in explaining
macroeconomic outcomes in some of these countries. A closely related issue is the issue of
fiscal dominance. The political economy of decision making and the interaction between
the bank and the fiscal authority and other interest groups deserve special attention.

9) Banks and the transmission of policy.

 Due to undeveloped financial markets monetary policy is mostly transmitted through the banking
sector, and it is important to keep this into account in analysing monetary policy. Perhaps most
importantly, in these often financially repressed economies it is not uncommon for central banks
to operate through “unconventional” tools (e.g. interest rate caps on banks). Hence, a rethinking
of the transmission channel is needed in the presence of such tools is needed. Such rethinking
should also take into account the often monopolistic structure of banking system/ government-
owned banks.

10) Policy tool and role of monetary aggregates

Related to the point above, it is often not clear whether it makes sense to think of policy as
targeting a specific interest rate. Is there a role for monetary aggregates? A

possible positive answer to this question may be constructed around the observation that data is
very poor (see next point). Monetary aggregates may be easier to measure.

11) Data
Data on LIC are of much lower quality. Limits on data quality and quantity are perhaps the
greatest limitation for researchers. Improve the data collection and dissemination process is
then highest priority in this area. It was reported that the IMF is engaged in a large-scale
effort to improve the supply of high-frequency macroeconomic data in LICs.

12) Growth and monetary policy

Can monetary policy be part of a growth strategy? Can it play a role in the provision of credit? There
were many divided views on this issue, with the ones against pointing to classic results on long ‐run
monetary neutrality and in favour stressing the role of exchange ‐rate policy for exploiting potential
increasing returns to scale.

13) Mobile banking

This is an exciting new development. The implications it might have for monetary policy are not well
understood. This seems to be an “up for grabs” question that deserves urgent attention.

14) Forecasting
It was reported that major “asks” from policy makers in LICs include (i) empirical tools for
inflation forecasting and (ii) empirical models of the monetary transmission mechanism.
 Monetary policies of developed countries

The international linkages between money stocks (and inflation rates) has received much attention.
Focuses on the advantages and disadvantages of fixed and flexible exchange rate regimes. Fixed
rate systems require credible commitments to the rules of the game by the central banks involved.
Credible commitment can be achieved through cooperative (symmetric) or coercive (asymmetric)
regimes. Did the USA (Germany) dominate other developed (European) countries during the
Bretton Woods (European Monetary) system? Examines the linkages, if any, between the USA
(German) money stock and money stocks in other developed (European) countries, using the
cointegration and error‐correction methodology. Finds evidence that USA (German) money stock
did affect other (European) countries′ money stocks during fixed exchange rates. Finds, also,
reverse causality which raises serious questions about either the dominance of the USA (Germany)
within the Bretton Woods (European Monetary) system, or the usefulness of causality tests is
answering such questions.

Monetary policy Framework of Ethiopia

Monetary policy of central banks in a simplified analysis amounts to the determination of the
“optimal” quantity of money or (in a dynamic sense) the optimal rate of growth of the money stock.
But there is more to monetary policy than the determination of the optimal stock or growth rate of
money. More generally, monetary policy refers to a bundle of actions and regulatory stances taken by
the central bank including all of the following:

Setting minimum interest rates on deposits or the rediscount rate charged to Commercial
banks borrowing reserves;

Setting reserve requirements on various classes of deposits;

Increasing or decreasing commercial bank reserves through open market purchases or sales of
government securities.

Regulatory actions to constrain commercial bank financial activity or to set minimum capital
requirements;

Intervention in foreign exchange markets to buy and sell domestic currency for foreign
exchange;
 Decide on level of required reserve of commercial banks total deposit
It is self-evident that monetary policy plays an important role in the performance of an economy.
However, the effectiveness of the policy in achieving the intended goal largely depends on the
institutional factors that constrain or facilitate the implementation process of the policy. In what
follows the monetary policy framework of the National Bank of Ethiopia will be described detailing
the monetary policy objectives, the targeting framework, the instruments of monetary policy and
legal & institutional framework of the monetary policy decision-making structure as well as the
exchange rate regime of the country.

II. Monetary Policy Objective

The principal objective of the monetary policy of the National Bank of Ethiopia is to maintain price
& exchange rate stability and support sustainable economic growth of Ethiopia. Price stability is a
proxy for macroeconomic stability which is vital in private sector economic decision on investment,
consumption, international trade and saving. Finally, macroeconomic stability fosters employment
and economic growth. Maintaining exchange rate stability on the other hand is considered as the
principal policy objective of NBE so as to be competitive in the international trade and to use
exchange rate intervention as policy tools for monetary policy to affect both foreign reserve position
and domestic money supply.

More specifically, the objectives of Ethiopia’s monetary policy are to:

Foster monetary, credit and financial conditions conducive to orderly, balanced and sustained
economic growth and development.

Preserve the purchasing power of the national currency – ensuring that the level of money
supply is generally consistent with developments in the macro- economy and intervening in
the foreign exchange rate market for the purpose of stabilizing the rate when conditions
necessitate.

Encourage the mobilization of domestic and foreign savings and their efficient allocation for
productive economic activities through the implementation of a prudent market-driven
interest rate policy.
 Facilitate the emergence of financial and capital markets that are capable of responding to the
needs of the economy through appropriate policy measures. These measures would ensure the
gradual introduction of trading instruments on a short-term basis.

8) Monetary Policy Strategy/Targeting Framework

Monetary policy strategy of a central bank depends on a number of factors that are unique and
contextual to the country. Given the policy objective, any good strategy depends on the
macroeconomic and the institutional structure of the economy. An important factor in this

context is the degree of openness of the economy. The more open the economy is, the more the
external sector plays a dominant role in monetary management.

Within a country’s monetary management framework, there are basically three targets: the ultimate
or final target, the intermediate target and the operating target.

3.1 Final and Intermediate targets

The final targets of monetary policy in Ethiopia are to maintain price and exchange rate stability and
support sustainable economic growth. In achieving these objectives, the NBE sets money supply as
an intermediate target. It should be noted that intermediate targets are not directly controlled by the
central bank.

Traditionally, money supply is defined from its narrow and broader sense. Narrow money (M1) is a
measure of money stock intended primarily for use in transactions. It consists of currency held by the
public, traveler’s checks, demand deposits and other checkable deposits. Broad Money (M2) is a
measure of the domestic money supply that includes M1 plus Quasi-money (savings and time
deposits), overnight repurchase agreements, and personal balances in money market accounts.
Basically, M2 includes money that can be used for spending (M1) plus items that can be quickly
converted to M1.

NBE takes the broader definition of money or M2 as money supply. The current target is to ensure
that the money supply growth is in line with nominal GDP growth rate.

3.2 Operational target

The operational target is an economic variable that the central bank wants to influence, largely on a
day-to-day basis, through its monetary policy instruments. They can be used to link instruments of
monetary policy to intermediate targets set by the central bank and represent the first impulse in the
transmission process of monetary policy. The growth of base money/reserve money is being used as
operational target of the National Bank of Ethiopia. Reserve money (Base money) is defined as the
sum of currency in circulation and deposits of commercial banks

at NBE. The practice of targeting reserve money is based on the assumption that there will be a stable
money demand function in the economy. If the money demand happens to be unstable over the medium to
long term, then the NBE will shift its targeting in to another workable framework such as interest rate
1
targeting or multiple ndicator approach .

In addition, the Bank shall maintain the international reserves at a level which, in its opinion, is
adequate for Ethiopia’s international transactions. In this regard, a minimum threshold at which
foreign reserves are considered adequate is set at three months of imports of goods and services.

IV. Monetary Policy Instruments

The introduction of a wide range of monetary instruments by central banks engenders competition,
efficiency and transparency and broadens financial intermediation in the banking system. It also
promotes liquidity management of commercial banks and gradually leads to the development of well
functioning money and financial markets which could serve as catalysts for economic growth and
development.

So far, the use of such instruments has been extremely limited in Ethiopia due to the
underdevelopment of the money market and the virtual non-existence of a financial market. Thus, it
is envisaged to use a mix of diversified monetary policy instruments so as to effectively carry out the
monetary management function of the NBE.

Open Market Operation (Sale & purchase of bonds or securities issued by governments)
has generally been used by countries as one of the main instruments for the development of money
markets. Trading in these instruments liquefies the financial system in particular and the national
economy in general and increases financial intermediation among market participants. In light of this,
the NBE will use open market operations (sale and purchase of governmen

securities) as one of its monetary policy instruments. In the absence of its own securities, certain
amount of government treasury bills needs to be allocated to NBE by the government for its
monetary policy purpose. To prepare the ground for enhanced open market operations, the yield on
government securities should be at least close to the minimum interest rate. As a next step, secondary
market for government securities needs to be established.

A standing central bank credit facility is another instrument used to enhance the financial capacity
of commercial banks and to promote financial intermediation and efficiency. The key advantages of
such standing credit facility are transparency and predictability of accessing central banks’ resources
to cover short-term needs. This credit facility gives banks an assurance that, when confronted with
problems of shortfall in the clearing and a lack of alternatives for raising immediate funds in the
inter-bank market, they can settle the clearing with the central bank’s funds at a reasonable interest
rate which has a clear relationship with short term market interest rates. The NBE will use this
facility as one of its monetary policy instrument

Other monetary policy instruments used and to be used include:

Reserve requirement

Setting of floor deposit interest rate (until interest rate is fully deregulated)

Direct borrowing/lending in the inter-bank money market and introducing re-purchase agreement
(repo/reverse repo operations),

Use of selected credit control when necessary, and

Moral Suasion

13) Legal and Institutional Framework

5.1 Board of Directors

According to NBE Establishment proclamation No. 591/2008 (as amended), a Board of Directors
composed of seven members governs the National Bank of Ethiopia. The Governor and Vice
Governor of the Bank are as permanent ex-officio members while the Chairperson of

the Board of Directors as well as the remaining four members are to be appointed by the
Government.

The Board of Directors plays a role in monetary policy formulation, as it is the highest decision
making body of the Bank. To this end, the Monetary Policy Committee shall submit regular
information & policy proposals to the Board regarding developments in the monetary sector, BOP,
exchange rate, price, interest rate and financial sector as well as the reasons for the proposed stance of
monetary policy,. The Board of Directors will meet regularly at least once every three months and
required within short intervals to discuss and decide on monetary policy stance. The monetary policy
stance will be published as Monetary Policy Statement in hard copy and posted on NBE’s website as
per the pre-announced calendar. A press statement will also be given on the date of issuance of
monetary policy statement.

5.2 Monetary Policy Committee

The Monetary Policy Committee (MPC) of the National Bank of Ethiopia is responsible for the
periodic review of monetary, BOP, exchange rate, price, interest rate and financial sector
developments of the country and propose monetary policy stance to the Bank’s Board of Directors on
regular basis as per a pre-announced calendar. The MPC will be chaired by the Governor of the Bank,
and will have the following members:

15) Chief Economist and Vice Governor of Monetary Stability (member and vice chairman);

16) Vice Governor of Financial Stability (member);

17) Vice Governor of Corporate Services (member),

18) Senior Advisor to the Governor (member);

19) Director of Foreign Exchange Monitoring and Reserve Management Directorate (member)

20) Director of Monetary & Financial Analysis Directorate (member);

 21) Director of Bank Supervision (member); and

22) Director of Economic Modeling and Policy Analysis Directorate (member and secretary). The
Governor may assign additional members to the MPC on the basis of their expertise in the area of
monetary policy as the case may be
The MPC meets quarterly based on a pre-announced calendar to deliberate on monetary policy
matters. The Governor may also call for extraordinary MPC meetings at his/her discretion to discuss
emerging domestic and global economic challenges. At each meeting, the committee shall take
decisions on the appropriate stance of monetary policy for the next three months. The decision will be
based on consensus unless it is absolutely necessary to take majority votes. If there is a tie, then the
Governor shall have a final say.

During an MPC meeting, the Chief Economist makes presentations to the MPC on recent economic
developments in the world and domestic economies, and on the inflation outlook. The MPC may also
invite other professional staffs of the Bank to make additional presentations on selected issues. In
terms of domestic economic developments, indicators such as the performance of the real sector,
interest and exchange rate developments, the balance of payments, monetary aggregates, financial
sector issues and fiscal trends will be taken into account

As a routine activity of the Bank, all major economic and financial indicators will be monitored and
the MPC briefed on these issues every quarter. These indicators include liquidity of the banking
system, inflation and exchange rate trends, financial market developments, foreign exchange reserve
position, real sector indicators, balance of payments, and fiscal trends. In addition, the Bank makes
use of monthly and quarterly internal inflation forecasts. Forecasts will be based on price
developments in selected commodities, using econometric methods. From time to time, the MPC may
also request additional presentations relating to monetary policy, financial stability and reserve
management issues by other invited staff of the Bank. However, only the views of MPC members
shall be taken into consideration when making decisions on the stance of monetary policy. All
decisions relating to monetary policy matters are taken by consensus. Where consensus does not
emerge, the Chairperson will have the final say. Each member also needs to state his/her decision
clearly, along with the reasons for taking such decision.

Responsible body for monetary and fiscal policy

The most responsible body Monetary and fiscal policy in economy is central bank and the

government

Central banks play a crucial role in ensuring economic and financial stability. They conduct
monetary policy to achieve low and stable inflation. In the wake of the global financial crisis,
central banks have expanded their toolkits to deal with risks to financial stability and to manage
volatile exchange rates

The central bank has been described as the "lender of last resort," which means it is responsible for
providing its nation's economy with funds when commercial banks cannot cover a supply shortage. In
other words, the central bank prevents the country's banking system from failing.

However, the primary goal of central banks is to provide their countries' currencies with price stability by
controlling inflation. A central bank also acts as the regulatory authority of a country's monetary
policy and is the sole provider and printer of notes and coins in circulation.

Time has proved that the central bank can best function in these capacities by remaining independent
from government fiscal policy and therefore uninfluenced by the political concerns of any regime. A
central bank should also be completely divested of any commercial banking interests.

KEY TAKEAWAYS

 Central banks carry out a nation's monetary policy and control its money supply, often mandated
with maintaining low inflation and steady GDP growth.
 On a macro basis, central banks influence interest rates and participate in open market operations
to control the cost of borrowing and lending throughout an economy.
 Central banks also operate on a micro-scale, setting the commercial banks' reserve ratio and
acting as lender of last resort when necessary.

How the Central Bank Influences an Economy

A central bank can be said to have two main kinds of functions: (1) macroeconomic when regulating
inflation and price stability and (2) microeconomic when functioning as a lender of last resort.

Macroeconomic Influences
As it is responsible for price stability, the central bank must regulate the level of inflation by controlling
money supplies by means of monetary policy. The central bank performs open market
transactions (OMO) that either inject the market with liquidity or absorb extra funds, directly affecting
the level of inflation.

To increase the amount of money in circulation and decrease the interest rate (cost) for borrowing, the
central bank can buy government bonds, bills, or other government-issued notes. This buying can,
however, also lead to higher inflation. When it needs to absorb money to reduce inflation, the central
bank will sell government bonds on the open market, which increases the interest rate and discourages
borrowing.

Open market operations are the key means by which a central bank controls inflation, money supply, and
prices.

Microeconomic Influences
The establishment of central banks as lenders of last resort has pushed the need for their freedom from
commercial banking. A commercial bank offers funds to clients on a first-come, first-serve basis.

If the commercial bank does not have enough liquidity to meet its clients' demands (commercial banks
typically do not hold reserves equal to the needs of the entire market), the commercial bank can turn to
the central bank to borrow additional funds. This provides the system with stability in an objective way;
central banks cannot favor any particular commercial bank. As such, many central banks will hold
commercial-bank reserves that are based on a ratio of each commercial bank's deposits.

Thus, a central bank may require all commercial banks to keep, for example, a 1:10 reserve/deposit ratio.
Enforcing a policy of commercial bank reserves functions as another means to control the money supply
in the market. Not all central banks, however, require commercial banks to deposit reserves.

The United Kingdom, for example, does not, while the United States traditionally does. However, the
U.S. Central Bank dropped its reserve requirements to zero percent effective March 26, 2020, during the
2020 COVID-19 pandemic.23

The rate at which commercial banks and other lending facilities can borrow short-term funds from the
central bank is called the discount rate (which is set by the central bank and provides a base for interest
rates).

It has been argued that, for open market transactions to become more efficient, the discount rate should
keep the banks from perpetual borrowing, which would disrupt the market's money supply and the central
bank's monetary policy. By borrowing too much, the commercial bank will be circulating more money in
the system. The use of the discount rate can be restricted by making it unattractive when used repeatedly.

Transitional Economies

Today developing economies are faced with issues such as the transition from managed to free
market economies. The main concern is often controlling inflation. This can lead to the creation of an
independent central bank but can take some time, given that many developing nations want to maintain
control over their economies. But government intervention, whether direct or indirect through fiscal
policy, can stunt central bank development.
Unfortunately, many developing nations are faced with civil disorder or war, which can force a
government to divert funds away from the development of the economy as a whole. Nonetheless, one
factor that seems to be confirmed is that, for a market economy to develop, a stable currency (whether
achieved through a fixed or floating exchange rate) is needed. However, the central banks in both
industrial and emerging economies are dynamic because there is no guaranteed way to run an economy,
regardless of its stage of development.

The Bottom Line

Central banks are responsible for overseeing the monetary system for a nation (or group of nations),
along with a wide range of other responsibilities, from overseeing monetary policy to implementing
specific goals such as currency stability, low inflation, and full employment. The role of the central bank
has grown in importance in the last century. To ensure the stability of a country's currency, the central
bank should be the regulator and authority in the banking and monetary systems.

Contemporary central banks are government-owned, but separate from their country's ministry or
department of finance. Although the central bank is frequently termed the "government's bank" because it
handles the buying and selling of government bonds and other instruments, political decisions should not
influence central bank operations.

Of course, the nature of the relationship between the central bank and the ruling regime varies from
country to country and continues to evolve with time.