Report of

Money & Banking

Submitted To:

Sir Atif Rafiqe

Submitted BY:
Saim Rasheed

BE-13-03

Muhammad Atiqe

BE-13-16

Nauman Ayyaz

BE-13-38

Waseem Bashir

BE-13-54

Jarhan Azeem

BE-13-62

Topic:
Central Bank

BBA 7th Semester

(Evening)

Central Bank:
A central bank is the term used to describe the authority responsible for policies that affect a
countrys supply of money and credit. Central bank, reserve bank, or monetary authority is
an institution that manages a state's currency, money supply, and interest rates. Central banks
also usually oversee the commercial banking system of their respective countries. In contrast
to a commercial bank, a central bank possesses a monopoly on increasing the monetary base in
the state, and usually also prints the national currency, which usually serves as the state's legal
tender. More specifically, a central bank uses its tools of monetary policy open market
operations, discount window lending, changes in reserve requirements to affect short term
interest rates and the monetary base (currency held by the public plus bank reserves) in order
to achieve important policy goals.

Beginnings & History:

The story of central banking goes back at least to the seventeenth century, to the founding of
the first institution recognized as a central bank, the Swedish Riksbank. Established in 1668 as
a joint stock bank, it was chartered to lend the government funds and to act as a clearing house
for commerce. A few decades later (1694), the most famous central bank of the era, the Bank
of England, was founded also as a joint stock company to purchase government debt. Other
central banks were set up later in Europe for similar purposes, though some were established
to deal with monetary disarray. For example, the Banque de France was established by
Napoleon in 1800 to stabilize the currency after the hyperinflation of paper money during the
French Revolution, as well as to aid in government finance. Early central banks issued private
notes which served as currency, and they often had a monopoly over such note issue.

Transition:
The Federal Reserve System belongs to a later wave of central banks, which emerged at the
turn of the twentieth century. These banks were created primarily to consolidate the various
instruments that people were using for currency and to provide financial stability. Many also
were created to manage the gold standard, to which most countries adhered.
The gold standard, which prevailed until 1914, meant that each country defined its currency in
terms of a fixed weight of gold. Central banks held large gold reserves to ensure that their notes
could be converted into gold, as was required by their charters. When their reserves declined

because of a balance of payments deficit or adverse domestic circumstances, they would raise
their discount rates (the interest rates at which they would lend money to the other banks).
Doing so would raise interest rates more generally, which in turn attracted foreign investment,
thereby bringing more gold into the country.

The Genesis of Modern Central Banking Goals:

Before 1914, central banks didnt attach great weight to the goal of maintaining the domestic
economys stability. This changed after World War I, when they began to be concerned about
employment, real activity, and the price level. The shift reflected a change in the political
economy of many countries suffrage was expanding, labour movements were rising, and
restrictions on migration were being set. In the 1920s, the Fed began focussing on both external
stability (which meant keeping an eye on gold reserves, because the U.S. was still on the gold
standard) and internal stability (which meant keeping an eye on prices, output, and
employment). But as long as the gold standard prevailed, external goals dominated.
After the Great Depression, the Federal Reserve System was reorganized. The Banking Acts
of 1933 and 1935 shifted power definitively from the Reserve Banks to the Board of Governors.
In addition, the Fed was made subservient to the Treasury.
The Fed regained its independence from the Treasury in 1951, where upon it began following
a deliberate countercyclical policy under the directorship of William McChesney Martin.
During the 1950s this policy was quite successful in ameliorating several recessions and in
maintaining low inflation. The picture changed dramatically in the 1960s when the Fed began
following a more activist stabilization policy. In this decade it shifted its priorities from low
inflation toward high employment.

Pakistan Central bank:

Before independence, Reserve Bank of India was the central bank of sub-continent. It was not
easy to setup a central bank from the day of independence, therefore, at the time of partition
reserves of central bank were divided between both the countries i.e. India and Pakistan with a
ratio of 70:30. Further, Reserve Bank of India continued its duties as central bank for both the
countries. However, working for own central bank had been started in Pakistan and finally on
July 01, 1948 Quaid-e-Azam Mohammad Ali Jinnah inaugurated State Bank of Pakistan at
Karachi since then it is working as Central Bank of the country.

Initially, under State Bank of Pakistan order 1948, SBP was charged with the duty related to
issuance of currency notes and keeping reserves with a view of securing monetary stability in
the country.

However, State Bank of Pakistan Act 1956 further strengthened the bank by giving it authority
to regulate the credit and monetary policy of the country. In 1997, State Bank of Pakistan was
given full autonomy through an amendment ordinance in the Act of 1956. After these
amendments SBP has full and exclusive authority to regulate the banking sector, conduct an
independent monetary policy and set limits on government borrowings from State Bank of
Pakistan. In 2005, an ordinance has given the money exchange companies a legal status in the
country and now all money exchange companies are also working under the umbrella of
SBP. Hence, since 2005 central bank of Pakistan is acting as a regulatory and controlling
authority for money exchange companies just like commercial banks of the country.

ADMINISTRATIVE ORGANISATION OF SBP

State Bank of Pakistan is governed by a central board of directors consisting of nine members,
appointed by Federal Government of the country. The board is chaired by Governor, SBP.
Secretary Finance, Federal Government is also a member of the board. Further it has seven
directors, including one director from each province ensuring representation of banking,
agricultural and industrial sector of the country. And current governor of State Bank of Pakistan
is Ashraf Mahmood Wathra.

Objectives of Central Bank:

The economic objectives of most central banks are to maintain financial stability in the
economy, while maximizing growth and employment. Stability is important because financial
instability is a systemic risk that affects the economy as a whole and cannot be diversified
away. For instance, booms and busts in the past, most often brought about by individual banks,
have caused the entire economy to expand and contract. Such events characterized the history
of the United States before the creation of the Federal Reserve in 1913.
Consequently, central bank objectives have adopted objectives to accomplish their purpose,
including: low and stable inflation, high growth, high employment, and stable financial markets
and institutions. These factors must be optimized to achieve maximal effect.
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Stable Inflation:
When the amount of money increases faster than the economy, then inflation results. That high
inflation is bad for growth is evident from history, such as Germany after World War I, the
Ukraine in 1983, or Bolivia in 1985. The result of these cases of hyperinflation was economic
contraction.
Low stable inflation and price stability are desirable so that money can be useful as a means
of exchange, unit of account and as a store of value. If inflation is not stable, then money
cannot function as money: the use of barter will increase, and assets will be purchased, even
when they are not needed, to preserve value. Neither businesses nor individuals can plan for
the future; prices no longer indicate supply and demand of products and services, causing
economic inefficiency and stress. Higher inflation also varies more than low inflation, creating
greater uncertainty about the future. An uncertain future will cause businesses to be reluctant
to undergo long-term projects. High inflation makes it difficult to plan for retirement. Indeed,
it could be almost impossible, since there is no way to know what the purchasing power of any
given amount will be 30, 40 or 50 years from now. People on fixed incomes will suffer.
Although inflation should be low, it should not be negative because deflation makes loans
difficult to repay, which increases the default rate and people would hold on to their money
rather than spend it to let it increase in value. The government also profits from the inflation
since the government creates money, it is the 1st to profit from it. Employers can also benefit
since wages always lags inflation, allowing them to collect higher revenues for their products
or services, thereby earning more profits before they increase wages.
One objective of the central banks is to maintain low interest rates. However, low interest
rates are frequently a secondary concern, because the manipulation of interest rates is a main
tool that central banks use to moderate the economy. When the economy is running hot, and
inflation threatens, the central bank raises the interest rate to decrease demand, and when the
economy is sluggish, interest rates are lowered to stimulate the economy.

Growth and Employment:

Highest sustainable growth is desirable. When the economy fluctuates too much, the cycles
tend to reinforce each other. When the economy contracts, consumers stop spending, thereby
causing businesses to restrain their spending, thereby causing the economy to contract even
more. The output of any economy depends on technology, capital, and people. However, these
5

factors of production have to be optimized to lead to the greatest potential output. When the
economy reaches its maximum potential output, then unemployment will generally be at its
lowest rate, and the benefit of the economy to society will be maximized.

Stable Financial Markets and Institutions:

Financial stability is also important because financial intermediation is what brings borrowers
and lenders together, or investors and businesses. If financial institutions are not stable, then
neither people nor businesses will rely on them, and without them, economic growth and
efficiency will decline dramatically.

Exchange Rate Stability:

Exchange rate stability facilitates international trade, but is not a main objective of most
central banks of developed countries, since domestic goals usually have greater priority.
Exchange rates are more important to emerging markets that depend on favorable exchange
rates for their export businesses. For instance, the Central Bank of China actively buys United
States Treasuries to keep its currency, the yuan, pegged at steep discount to the United States
dollar.

Primary Functions:
Issue Notes
Sole Authority to Issue Notes One of the primary responsibilities of the State Bank is the
regulation of currency in accordance with the requirements of business and the general public.
For this purpose the Bank has been granted the sole right of issuing notes in the country under
Section 24 of the State Bank of Pakistan Act, 1956. The overall affairs with respect to the
issuing of notes are conducted through two notionally separate departments of SBP, viz., Issue
Department which deals with the issue of notes, and the Banking Department which undertakes
general banking business2. There are four issue departments one each in four provincial
capitals viz., Karachi, Lahore, Peshawar and Quetta. Under section 30 of the State Bank Act,
1956 the assets of the Issue Department should at no time fall short of its liabilities, i.e., total
notes issued.
The notes issued by the Bank constitute by far the largest portion of the currency in circulation
in the country the other components being one-rupee coins, two-rupee coins, and subsidiary
coins. The issue of one rupee and subsidiary coins is the prerogative of the Federal
6

Government. The Bank merely looks after the management of their issue on behalf of the
Government. The State Bank also issues "Commemorative (Yadgari)" notes and coins of
different denominations at occasions of national importance.

Conduct of Monetary and Credit Policies:

The State Bank of Pakistan is responsible to regulate the monetary and credit system of the
country in such a manner that ensures monetary stability in the economy4. Section 9A of SBP
Act, 1956 entrusts the Central Board of the Bank to formulate and monitor monetary and credit
policy by taking into account the Federal Government's targets for growth and inflation, in
accordance with the recommendation of the Monetary and Fiscal Policies Co-ordination Board
(MFPCB). The State Bank has a number of instruments at its disposal to regulate the volume
of credit and to ensure its flow to the priority sectors.
SBP is conducting regular Open Market Operations (OMOs) since January 1995. The State
Bank of Pakistan is using Market Treasury Bills (MTBs) both on an outright basis as well as
under Repo contracts (generally for the short term maturities) to control liquidity through Open
Market Operations.

Regulation and Supervision of the Financial System:

Another principal task of the Bank is to safeguard the soundness of the financial system. To
perform this crucial role effectively and efficiently, State Bank of Pakistan has been given vast
powers under the State Bank of Pakistan Act, 1956, Banking Companies Ordinance, 1962,
Banks Nationalization (Amendment) Act, 1974 and Microfinance Institutions Ordinance 2001
to regulate and supervise the activities of Banks, Development Finance Institutions and
Microfinance Banks.
These laws have been subject to amendments over time to meet changing circumstances.
During the year 1997 some major amendments were made in the banking laws, which gave
autonomy to the State Bank in the area of banking supervision. Under Section 40-A of the said
ordinance it is the responsibility of State Bank to systematically monitor the performance of
every banking company to ensure its compliance with the statutory criteria, and banking rules
& regulations (See Section 5 on Autonomy of the SBP).

Off-site & On-site monitoring:

The Bank monitors the banking activities through a combination of off-site monitoring and onsite inspection. Off-site surveillance is conducted by the State Bank through various periodical
returns received from banks and DFIs. On the other hand, on-site inspection is undertaken on
the premises of the concerned banks. The purpose of inspection is to check the assets and
liabilities as they appear on the books, to evaluate the quality of the assets, to determine
compliance with laws, regulations, directives and policy guidelines provided by the State Bank,
to judge the soundness of operations and the prudence of lending and investment policies, to
appraise the quality of the management.

Prudential Regulations:
Prudential Regulations In order to safeguard the interest of depositors and to ensure the safety
and soundness of the banks/DFIs, the State Bank has issued Prudential Regulations. These
Prudential Regulations present a prudent operating framework for the banks/DFIs. The
regulations incorporate the spirit and essence of Bank of International Settlement (BIS)
regulations and are constantly watched for possible improvement so that their enforcement
yields the best possible results to promote the overall objectives of financial sector supervision.
The State Bank has devised separate Prudential Regulations for different areas viz. Corporate
and Commercial Banking, Small and Medium Enterprise Financing, Consumer Financing and
Micro Financing while those for Agriculture Financing. Such services were financed by the
World Bank under Financial Sector Deepening and Intermediation Project (FSDIP).

Bankers' Bank:
The Bank also functions as the bankers bank. Banks are classified as scheduled and nonscheduled. The Bank maintains an updated list of all scheduled banks at its various offices.
These banks are entitled to certain facilities from the State Bank and in return they have some
obligations to it. State Bank provides the following three important services to the scheduled
banks;
1. It keeps the deposits of commercial banks, which primarily constitute the statutory reserves
of scheduled banks. Scheduled banks are required to keep with the State Bank certain
percentage of their demand and time liabilities under Section 36 of SBP Act, 1956. Normally,
the statutory reserves are kept with the Bank free of any return.
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2. The State Bank also provides extensive remittances facilities to banks at a concessional rate
under the Remittance Facilities Scheme introduced since 1948. This facility helps the flow of
funds smoothly and efficiently between various centres in the country. The Bank provides this
facility through the media of its own offices, the branches of National Bank of Pakistan acting
as its agents, and treasuries and sub-treasuries holding permanent currency chests at places
where the State Bank has no office. Telegraphic Transfers (T.T.), Mail Transfers (M.T.),
Demand Draft (D.D.) and Government Draft (G.D.) are the principal instruments used for
remittances.
3. In order to streamline payments through the financial system, the Bank also manages the
operations of clearing houses. In the five major cities, the functions of SBP clearing house has
been handed over to a private agency namely National Institutional Facilitation Technologies
Private Limited (NIFT) to the extent of sorting of payments instruments and preparing clearing
schedules. Presently NIFT covers 80 percent of clearing services.

Lender of the Last Resort:

One of the important characteristics of a central bank is its being the lender of the last resort.
The State Bank provides loan and re-discount facilities to scheduled banks in times of dire need
when they find no other source of funds. These facilities are ordinarily provided by the Bank
against government securities, trade bills, agriculture bill, etc. These loans are essentially shortterm in nature and are advanced to enable the banks to meet their temporary requirements of
funds arising out of seasonal expansion in trade, commerce, agricultural operations, and other
economic activities. These operations are carried out in accordance with the provisions of
Section 17 of the State Bank of Pakistan Act, 1956. Notwithstanding any limitations contained
in different sub-clauses of the Section 17, the Section 18 of the act gives the Bank the power
of direct discount for undertaking this function.

Banker to Government:
The State Bank conducts the banking business of Federal and Provincial Government and some
government agencies. These functions performed by the Bank are akin to those ordinarily
performed by commercial banks for their customers. The Bank provides the following services
to the governments:
1. It accepts the deposits of cash, cheques and drafts by the Government and undertakes the
collection of cheques and drafts drawn on other banks. The Bank transfers government funds
9

from one account to another or from one centre to another as advised by them. The statutory
provisions for this function were made first in the State Bank of Pakistan Order, 1948 and then
in the SBP Act, 1956. Federal and Provincial governments keep their deposits with the Bank
free of interest. In turn, the Bank does not charge any commission to the governments for the
banking services rendered to them.
2. The Federal and Provincial governments can obtain advances from the Bank subject to
mutual agreements in respect of the terms and conditions for such advances. The Bank makes
ways and means advances to the Federal as well as to the Provincial governments without any
collateral security.

Secondary Functions:
Public Debt Management:
The Bank is responsible for the management of government debt under sub- section 13(e) of
section 17, and section 21 of the SBP Act, 1956. The Public Debt Act 1944 also defines the
responsibilities of SBP for public debt management. In order to efficiently manage the public
debt, a department namely, Securities Department was set up in December, 1990 for the
business of government securities7. This department was subsequently merged with foreign
exchange dealing room and a new department Exchange & Debt Management Department
(EDMD) was created in February, 2000.

Management of Foreign Exchange:

Being responsible for maintaining the external value of the currency, the State Bank of Pakistan
assumed the charge of management and administration of the exchange system of the country
in line with the Foreign Exchange Regulation Act, 1947 which was originally enacted by the
British Government and subsequently adopted by Pakistan. As an agent to the Government,
the Bank has been authorized to purchase and sell gold, silver or foreign exchange and
transactions of special drawing rights with the International Monetary Fund under sub-sections
3(a) and 13(a,f) of section 17, and section 23 of the SBP Act, 1956.

Exchange Rate Regimes:

The Bank is responsible to keep the exchange rate of the rupee at an appropriate level and
prevent it from wide fluctuations in order to maintain competitiveness of our exports and
maintain stability in the foreign exchange market. Various exchange policies have been
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adopted at different times for this purpose keeping in view the circumstances. With the collapse
of Bretton-Woods arrangements in early 1970s and adoption of floating exchange rate regime
by major trading countries of the world, Pakistan did not float the rupee but linked it to US
Dollar to avoid the adverse impact of appreciating Pound Sterling to which rupee remained
linked up to September, 1971. This link continued till January 7, 1982.

Development of Forex Market:

A new foreign currency accounts scheme has been introduced under which banks the funds
with them and pay return keep keeping in view their earnings and cost of funds. The funds
under this scheme have been allowed to be used for financing of trade-related activities. The
traders, particularly the exporters, can now avail foreign currency loans at cheaper rates.

Advisor to Government:
The State Bank of Pakistan, also acts as an advisor to the Government on financial and
economic matters particularly with reference to their monetary aspects. The Bank counsels the
Government on loan operations and advises it with regard to the timings, terms and conditions
and rate of return on these loans. The advice is also tendered on matters like agricultural credit,
cooperative credit, industrial finance, exchange regulations, banking and credit control,
mobilization of savings, financial aspects of planning and development and similar other
economic issues. State Bank of Pakistan also tenders advice to the Government on debt
management issues. The advisory role of the Bank has been made mandatory in accordance
with the Section 9A (d,e) of the SBP Act 1956.

Relationships with International Financial Institutions:

Pakistan is the member of International Monetary Fund. The State Bank of Pakistan deals with
the IMF on behalf of the Government of Pakistan (sub- sections 13(f) and 15 of Section 17 of
the act). As a member of the Fund, the Government accepted the obligations of Article-VIII,
Sections 2, 3 and 4 of the IMF Articles of Agreement, July 1, 1994.
The State Bank of Pakistan also deals with other international financial organizations including
Bank for International Settlement, the World Bank, Central Banks of foreign countries, etc.
Almost all the agreements of Provincial and Federal Government with International Financial
Institutions (IFIs) are executed through the State Bank of Pakistan.

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Role of Central Bank in Economic Development:

The central bank in a developing country aims at the promotion and maintenance of a rising
level of production, employment and real income in the country. The central banks in the
majority of underdeveloped countries have been given wide powers to promote the growth of
such economies. They, therefore, perform the following functions towards this end.

Creation and Expansion of Financial Institutions:

One of the aims of a central bank in an underdeveloped country is to improve its currency and
credit system. More banks and financial institutions are required to be set up to provide larger
credit facilities and to divert voluntary savings into productive channels. Financial institutions
are localized in big cities in underdeveloped countries and provide credit facilities to estates,
plantations, big industrial and commercial houses.
In order to remedy this, the central bank should extend branch banking to rural areas to make
credit available to peasants, small businessmen and traders. In underdeveloped countries, the
commercial banks provide only short-term loans. Credit facilities in rural areas are mostly
non-existent. The only source is the village moneylender who charges exorbitant interest rates.
The hold of the village moneylender in rural areas can be slackened if new institutional
arrangements are made by the central bank in providing short-term, medium term and longterm credit at lower interest rates to the cultivators. A network of co-operative credit societies
with apex banks financed by the central bank can help solve the problem.
Similarly, it can help the establishment of lead banks and through them regional rural banks
for providing credit facilities to marginal farmers, landless agricultural workers and other
weaker sections. With the vast resources at its command, the central bank can also help in
establishing industrial banks and financial corporations in order to finance large and small
industries.

Proper Adjustment between Demand for and Supply of Money:

The central bank plays an important role in bringing about a proper adjustment between
demand for and supply of money. An imbalance between the two is reflected in the price level.
A shortage of money supply will inhibit growth while an excess of it will lead to inflation. As
the economy develops, the demand for money is likely to go up due to gradual monetization

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(act of authorizing money for legal use) of the non-monetized sector and the increase in
agricultural and industrial production and prices.
The demand for money for transactions and speculative (risky investment) motives will also
rise. So the increase in money supply will have to be more than proportionate to the
increase in the demand for money in order to avoid inflation. There is, however, the
likelihood of increased money supply being used for speculative purposes, thereby inhibiting
growth and causing inflation.
The central bank controls the uses of money and credit by an appropriate monetary policy.
Thus in an underdeveloped economy, the central bank should control the supply of money in
such a way that the price level is prevented from rising without affecting investment and
production adversely.

A Suitable Interest Rate Policy:

In an underdeveloped country the interest rate structure stands at a very high level. There are
also vast disparities between long-term and short-term interest rates and between interest rates
in different sectors of the economy. The existence of high interest rates acts as an obstacle to
the growth of both private and public investment, in an underdeveloped economy.
A low interest rate is, therefore, essential for encouraging private investment in agriculture and
industry. Since in underdeveloped country businessmen have little savings out of undistributed
profits, they have to borrow from the banks or from the capital market for purposes of
investment and they would borrow only if the interest rate is low. A low interest rate policy is
also essential for encouraging public investment. A low interest rate policy is a cheap money
policy. It makes public borrowing cheap, keeps the cost of servicing public debt low and thus
helps in financing economic development.
In order to discourage the flow of resources into speculative borrowing and investment, the
central bank should follow a policy of discriminatory interest rates, charging high rates for
non-essential and unproductive loans and low rates for productive loans. But this does not
imply that savings are interest-elastic in an underdeveloped economy.
Since the level of income is low in such economies, a high rate of interest is not likely to raise
the propensity to save. In the context of economic growth, as the economy develops, a
progressive rise in the price level is inevitable. The value of money falls and the propensity to
save declines further. Money conditions become tight and there is a tendency for the rate of
13

interest to rise automatically. This would result in inflation. In such a situation any effort to
control inflation by raising the rate of interest would be disastrous. A stable price level is,
therefore, essential for the success of a low interest rate policy which can be maintained by
following a judicious monetary policy by the central bank.

Debt Management:
Debt management is one of the important functions of the central bank in an underdeveloped
country. It should aim at proper timing and issuing of government bonds, stabilizing their prices
and minimizing the cost of servicing public debt. It is the central bank which undertakes the
selling and buying of government bonds and making timely changes in the structure and
composition of public debt.
In order to strengthen and stabilize the market for government bonds, the policy of low
interest rates is essential. For, a low rate of interest raises the price of government bonds,
thereby making them more attractive to the public and giving an impetus to the public
borrowing programs of the government. The maintenance of structure of low interest rates is
also called for minimizing the cost of servicing the national debt.
Further, it encourages funding of debt by private firms. However, the success of debt
management would depend upon the existence of well-developed money and capital markets
in which wide range of securities exist both for short and long periods. It is the central bank
which can help in the development of these markets.

Credit Control:
Central Bank should also aim at controlling credit in order to influence the patterns of
investment and production in a developing economy. Its main objective is to control
inflationary pressures arising in the process of development. This requires the use of both
quantitative and qualitative methods of credit control.
Open market operations are not successful in controlling inflation in underdeveloped countries
because the bill market is small and undeveloped. Commercial banks keep an elastic cashdeposit ratio because the central banks control over them is not complete. They are also
reluctant to invest in government securities due to their relatively low interest rates.

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Moreover, instead of investing in government securities, they prefer to keep their reserves in
liquid form such as gold, foreign exchange and cash. Commercial banks are also not in the
habit of rediscounting or borrowing from the central bank.
The bank rate policy is also not so effective in controlling credit in LDCs due to: (a) the lack
of bills of discount; (b) the narrow size of the bill market; (c) a large non-monetized sector
where barter transactions take place; (d) the existence of a large unorganized money market;
(e) the existence of indigenous banks which do not discount bills with the central banks; and
(f) the habit of commercial banks to keep large cash reserves.
The use of variable reserve ratio as method of credit control is more effective than open
market operations and bank rate policy in LDCs. Since the market for securities is very small,
open market operations are not successful. But a rise or fall in the reserve ratio by the central
bank reduces or increases the cash available with the commercial banks without affecting
adversely the prices of securities.
Again, the commercial banks keep large cash reserves which cannot be reduced by a raise in
the bank rate or sale of securities by the central bank. But raising the cash-reserve ratio reduces
liquidity with the banks. However, the use of variable reserve ratio has certain limitations in
LDCs.
First, the non-banking financial intermediaries do not keep deposits with the central bank so
they are not affected by it. Second, banks which do not maintain excess liquidity are not
affected than those who maintain it.
The qualitative credit control measures are, however, more effective than the quantitative
measures in influencing the allocation of credit, and thereby the pattern of investment. In
underdeveloped countries, there is a strong tendency to invest in gold, jewelry, inventories, real
estate, etc., instead of in alternative productive channels available in agriculture, mining,
plantations and industry.
The selective credit controls are more appropriate for controlling and limiting credit facilitates
for such unproductive purposes. They are beneficial in controlling speculative activities in
food-grains and raw materials. They prove more useful in controlling sectional inflations in
the economy.
They curtail the demand for imports by making it obligatory on importers to deposit in advance
an amount equal to the value of foreign currency. This has also the effect of reducing the
15

reserves of the banks in so far as their deposits are transferred to the central banks in the
process. The selective credit control measures may take the form of changing the margin
requirements against certain types of collateral, the regulation of consumer credit and the
rationing of credit.

Solving the Balance of Payments Problem:

The central bank should also aim at preventing and solving the balance of payments problem
in a developing economy. Such economies face serious balance of payments difficulties to
fulfil the targets of development plans. An imbalance is created between imports and exports
which continue to widen with development.
The central bank manages and controls the foreign exchange of the country and also acts as the
technical adviser to the government on foreign exchange policy. It is the function of the central
bank to avoid fluctuations in the foreign exchange rates and to maintain stability. It does so
through exchange controls and variations in the bank rate. For instance, if the value of the
national currency continues to fall, it may raise the bank rate and thus encourage the inflow of
foreign currencies.

Conclusion:
Thus the central bank plays an important role in achieving economic growth of a developing
country through the various measures discussed above. It should promote economic growth
with stability, help in attaining full employment of resources, in overcoming balance of
payments disequilibrium, and in stabilizing exchange rates.

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