1

FUNCTIONS OF NATIONAL SAVING ORGANIZATION.

ABOUT US
The history of National Savings Organization dates back to the year 1873 when the Government
Savings Bank Act, 1873 was promulgated.During the first world war, the British Government
introduced several Schemes for collection of funds to meet the expenditure. It was in this context
that the Post Office Cash Certificates and, during the second world war, Post Office Defence
Savings Certificates were floated. The need to setup a separate agency was felt and a National
Savings Bureau was established in 1943- 44 as an attached department of the Ministry of
Finance of the undivided Government of India. The department was headed by National Savings
Commissioner with the status of a Joint Secretary. At that time the main functions of the Savings
Department were to initiate all policy matters and issue directives for the execution of policy
decisions of the Central Government, and to review the Savings Schemes from time to time.
Gradually, Savings Organization were established in almost all the Provinces of the subcontinent with the objective of popularizing the Savings Schemes among the masses as well as to
supervise, guide and control the working of authorized agents under their jurisdiction. The
agents, who were appointed by the local authorities. They were paid commission @ 2 1/2 on the
investment secured by them. These authorized agents were in those days the only agency for
securing investment in terms of Savings Certificates from the general public. In nutshell the
central agency viz. National Savings Bureau, Simla, was mainly concerned with the policy and
planning matters of the Savings Schemes whereas the responsibility of execution of various
Savings Schemes vested with Provincial authorities .
At the time of Independence there was no time for any sort of innovations in the field of
administration. Thus an organization with the name of 'Pakistan savings Central Bureau' was
created and the Savings work was entrusted to it by the Government of Pakistan, but this Bureau
had its own peculiarities. The Pakistan Savings Central Bureau had no independent entity and
was not given the same status as enjoyed by Savings Bureau, Simla. The head of the Pakistan
Savings Central Bureau was then called Central National Savings Officer, a Junior Officer of the
Ministry of Finance with the status of an Under Secretary to the Government of Pakistan. He was
assisted by a Superintendent having some auxiliary staff. In 1953, the Pakistan Savings Control
Bureau was re-named as Central Directorate of National Savings and it carried out the functions

on the lines of National Savings Bureau Simla but as a part and parcel of the Finance Division,
Central Directorate of National Savings was only responsible for publicity, and the operative
agents were the Provincial Governments as well as Pakistan post Offices. However, the entire
expenditure in this regard was borne by the Central Government. Such an arrangement created a
large number of administrative difficulties and stunted the growth of savings. In view of these
difficulties the Central Directorate of National Savings was given the status of an Attached
Department in September, 1960, and was made responsible for all policy matters and execution
of various National Savings Schemes.
Subsequently, it was also declared a Technical Department by the Government. The Director
General, National Savings (BPS-20) now enjoys full powers of a Head of the Department.
Till December, 1971, the National Savings Organization functioned as a Publicity organization
and its activities were merely promotional in nature. But in early 1972, the scope of its activities
was enlarged as the Central Directorate started selling II-Rupee Prize Bonds, and subsequently
engaged in the operations of other savings schemes. This resulted in considerable expansion of
the National Savings Organization.
At present, this Organization has a total sanctioned strength of 3377 employees in various grades
and its main component units are as under:
a. Central Directorate of National Savings, Islamabad.
b. Directorate of Inspection and Accounts, Islamabad.
c. Training Institute of National Savings, Islamabad alongwith a sub-Training Institute at
Karachi.
d. 12 Regional Directorates (located at Peshawar, Abbottabad, Islamabad, Gujranwala, Lahore,
Faisalabad, Multan, Bahawalpur, Sukkur, Hyderabad, Karachi, Quetta)
e. 367 National Savings Centers spread throughout the country.

PUBLIC FINANCE
Public finance is the study of the role of the government in the economy.[1] It is the branch of
economics which assesses the government revenue and government expenditure of the public
authorities and the adjustment of one or the other to achieve desirable effects and avoid
undesirable ones.[2]
The purview of public finance is considered to be threefold: governmental effects on (1) efficient
allocation of resources, (2) distribution of income, and (3) macroeconomic stabilization.

OVERVIEW
The proper role of government provides a starting point for the analysis of public finance. In
theory, under certain circumstances, private markets will allocate goods and services among
individuals efficiently (in the sense that no waste occurs and that individual tastes are matching
with the economy's productive abilities). If private markets were able to provide efficient
outcomes and if the distribution of income were socially acceptable, then there would be little or
no scope for government. In many cases, however, conditions for private market efficiency are
violated. For example, if many people can enjoy the same good at the same time (non-rival, nonexcludable consumption), then private markets may supply too little of that good. National
defense is one example of non-rival consumption, or of a public good.
"Market failure" occurs when private markets do not allocate goods or services efficiently. The
existence of market failure provides an efficiency-based rationale for collective or governmental
provision of goods and services. Externalities, public goods, informational advantages, strong
economies of scale, and network effects can cause market failures. Public provision via a
government or a voluntary association, however, is subject to other inefficiencies, termed
"government failure."
Under broad assumptions, government decisions about the efficient scope and level of activities
can be efficiently separated from decisions about the design of taxation systems (DiamondMirlees separation). In this view, public sector programs should be designed to maximize social
benefits minus costs (cost-benefit analysis), and then revenues needed to pay for those
expenditures should be raised through a taxation system that creates the fewest efficiency losses
caused by distortion of economic activity as possible. In practice, government budgeting or
public budgeting is substantially more complicated and often results in inefficient practices.
Government can pay for spending by borrowing (for example, with government bonds), although
borrowing is a method of distributing tax burdens through time rather than a replacement for
taxes. A deficit is the difference between government spending and revenues. The accumulation
of deficits over time is the total public debt. Deficit finance allows governments to smooth tax
burdens over time, and gives governments an important fiscal policy tool. Deficits can also
narrow the options of successor governments.

Public finance is closely connected to issues of income distribution and social equity.
Governments can reallocate income through transfer payments or by designing tax systems that
treat high-income and low-income households differently.
The public choice approach to public finance seeks to explain how self-interested voters,
politicians, and bureaucrats actually operate, rather than how they should operate.

PUBLIC FINANCE MANAGEMENT

Collection of sufficient resources from the economy in an appropriate manner along with
allocating and use of these resources efficiently and effectively constitute good financial
management. Resource generation, resource allocation and expenditure management (resource
utilization) are the essential components of a public financial management system.
Public Finance Management (PFM) basically deals with all aspects of resource mobilization and
expenditure management in government. Just as managing finances is a critical function of
management in any organization, similarly public finance management is an essential part of the
governance process. Public finance management includes resource mobilization, prioritization of
programmes, the budgetary process, efficient management of resources and exercising controls.
Rising aspirations of people are placing more demands on financial resources. At the same time,
the emphasis of the citizenry is on value for money, thus making public finance management
increasingly vital. The following subdivisions form the subject matter of public finance.
1.
2.
3.
4.
5.

Public expenditure
Public revenue
Public debt
Financial administration
Federal finance

GOVERNMENT EXPENDITURES
Economists classify government expenditures into three main types. Government purchases of
goods and services for current use are classed as government consumption. Government
purchases of goods and services intended to create future benefits such as infrastructure
investment or research spending are classed as government investment. Government
expenditures that are not purchases of goods and services, and instead just represent transfers of
money such as social security payments are called transfer payments.[3]
GOVERNMENT OPERATIONS
Government operations are those activities involved in the running of a state or a functional
equivalent of a state (for example, tribes, secessionist movements or revolutionary movements)
for the purpose of producing value for the citizens. Government operations have the power to
make, and the authority to enforce rules and laws within a civil, corporate, religious, academic,
or other organization or group.[4]

INCOME DISTRIBUTION

Income distribution Some forms of government expenditure are specifically intended to

transfer income from some groups to others. For example, governments sometimes
transfer income to people that have suffered a loss due to natural disaster. Likewise,
public pension programs transfer wealth from the young to the old. Other forms of
government expenditure which represent purchases of goods and services also have the
effect of changing the income distribution. For example, engaging in a war may transfer
wealth to certain sectors of society. Public education transfers wealth to families with
children in these schools. Public road construction transfers wealth from people that do
not use the roads to those people that do (and to those that build the roads).
Income Security
Employment insurance
Health Care
Public financing of campaigns

FINANCING OF GOVERNMENT EXPENDITURES

Government expenditures are financed primarily in three ways:

Government revenue
o Taxes
o Non-tax revenue (revenue from government-owned corporations, sovereign
wealth funds, sales of assets, or seigniorage)
Government borrowing
Printing of Money or inflation

How a government chooses to finance its activities can have important effects on the distribution
of income and wealth (income redistribution) and on the efficiency of markets (effect of taxes on
market prices and efficiency). The issue of how taxes affect income distribution is closely related
to tax incidence, which examines the distribution of tax burdens after market adjustments are
taken into account. Public finance research also analyzes effects of the various types of taxes and
types of borrowing as well as administrative concerns, such as tax enforcement.
TAXES
Taxation is the central part of modern public finance. Its significance arises not only from the
fact that it is by far the most important of all revenues but also because of the gravity of the
problems created by the present day tax burden [5]. The main objective of taxation is raising
revenue. A high level of taxation is necessary in a welfare State to fulfill its obligations. Taxation
is used as an instrument of attaining certain social objectives i.e. as a means of redistribution of
wealth and thereby reducing inequalities. Taxation in a modern Government is thus needed not
merely to raise the revenue required to meet its ever-growing expenditure on administration and
social services but also to reduce the inequalities of income and wealth. Taxation is also needed
to draw away money that would otherwise go into consumption and cause inflation to rise.[6]

A tax is a financial charge or other levy imposed on an individual or a legal entity by a state or a
functional equivalent of a state (for example, tribes, secessionist movements or revolutionary
movements). Taxes could also be imposed by a subnational entity. Taxes consist of direct tax or
indirect tax, and may be paid in money or as corve labor. A tax may be defined as a "pecuniary
burden laid upon individuals or property to support the government [ . . .] a payment exacted by
legislative authority."[7] A tax "is not a voluntary payment or donation, but an enforced
contribution, exacted pursuant to legislative authority" and is "any contribution imposed by
government [ . . .] whether under the name of toll, tribute, tallage, gabel, impost, duty, custom,
excise, subsidy, aid, supply, or other name."[8]

There are various types of taxes, broadly divided into two heads direct (which is
proportional) and indirect tax (which is differential in nature):
Stamp duty, levied on documents
Excise tax (tax levied on production for sale, or sale, of a certain good)
Sales tax (tax on business transactions, especially the sale of goods and services)
o Value added tax (VAT) is a type of sales tax
o Services taxes on specific services
Road tax; Vehicle excise duty (UK), Registration Fee (USA), Regco (Australia), Vehicle
Licensing Fee (Brazil) etc.
Gift tax
Duties (taxes on importation, levied at customs)
Corporate income tax on corporations (incorporated entities)
Wealth tax
Personal income tax (may be levied on individuals, families such as the Hindu joint
family in India, unincorporated associations, etc.)

DEBT
Governments, like any other legal entity, can take out loans, issue bonds and make financial
investments. Government debt (also known as public debt or national debt) is money (or credit)
owed by any level of government; either central or federal government, municipal government or
local government. Some local governments issue bonds based on their taxing authority, such as
tax increment bonds or revenue bonds.
As the government represents the people, government debt can be seen as an indirect debt of the
taxpayers. Government debt can be categorized as internal debt, owed to lenders within the
country, and external debt, owed to foreign lenders. Governments usually borrow by issuing
securities such as government bonds and bills. Less creditworthy countries sometimes borrow
directly from commercial banks or international institutions such as the International Monetary
Fund or the World Bank.
Most government budgets are calculated on a cash basis, meaning that revenues are recognized
when collected and outlays are recognized when paid. Some consider all government liabilities,
including future pension payments and payments for goods and services the government has
contracted for but not yet paid, as government debt. This approach is called accrual accounting,

meaning that obligations are recognized when they are acquired, or accrued, rather than when
they are paid. This constitutes public debt.
SEIGNIORAGE
Seigniorage is the net revenue derived from the issuing of currency. It arises from the difference
between the face value of a coin or bank note and the cost of producing, distributing and
eventually retiring it from circulation. Seigniorage is an important source of revenue for some
national banks, although it provides a very small proportion of revenue for advanced industrial
countries.[citation needed]
PUBLIC FINANCE THROUGH STATE ENTERPRISE
Public finance in centrally planned economies has differed in fundamental ways from that in
market economies. Some state-owned enterprises generated profits that helped finance
government activities. The government entities that operate for profit are usually manufacturing
and financial institutions, services such as nationalized healthcare do not operate for a profit to
keep costs low for consumers. The Soviet Union relied heavily on turnover taxes on retail sales.
Sales of natural resources, and especially petroleum products, were an important source of
revenue for the Soviet Union.
In market-oriented economies with substantial state enterprise, such as in Venezuela, the staterun oil company PSDVA provides revenue for the government to fund its operations and
programs that would otherwise be profit for private owners. In various mixed economies, the
revenue generated by state-run or state-owned enterprises are used for various state endeavors;
typically the revenue generated by state and government agencies goes into a sovereign wealth
fund. An example of this is the Alaska Permanent Fund and Singapore's Temasek Holdings.
Various market socialist systems or proposals utilize revenue generated by state-run enterprises
to fund social dividends, eliminating the need for taxation altogether.

GOVERNMENT FINANCE STATISTICS AND METHODOLOGY

Macroeconomic data to support public finance economics are generally referred to as fiscal or
government finance statistics (GFS). The Government Finance Statistics Manual 2001 (GFSM
2001) is the internationally accepted methodology for compiling fiscal data. It is consistent with
regionally accepted methodologies such as the European System of Accounts 1995 and consistent
with the methodology of the System of National Accounts (SNA1993) and broadly in line with its
most recent update, the SNA2008.
MEASURING THE PUBLIC SECTOR
The size of governments, their institutional composition and complexity, their ability to carry out
large and sophisticated operations, and their impact on the other sectors of the economy warrant
a well-articulated system to measure government economic operations.

The GFSM 2001 addresses the institutional complexity of government by defining various levels
of government. The main focus of the GFSM 2001 is the general government sector defined as
the group of entities capable of implementing public policy through the provision of primarily
nonmarket goods and services and the redistribution of income and wealth, with both activities
supported mainly by compulsory levies on other sectors. The GFSM 2001 disaggregates the
general government into subsectors: central government, state government, and local government
(See Figure 1). The concept of general government does not include public corporations. The
general government plus the public corporations comprise the public sector (See Figure 2).

The general government sector of a nation includes all non-private sector institutions,
organisations and activities. The general government sector, by convention, includes all the
public corporations that are not able to cover at least 50% of their costs by sales, and, therefore,
are considered non-market producers.[9]
In the European System of Accounts,[10] the sector general government has been defined as
containing:

All institutional units which are other non-market producers whose output is intended for
individual and collective consumption, and mainly financed by compulsory payments made by
units belonging to other sectors, and/or all institutional units principally engaged in the
redistribution of national income and wealth.[9]

Therefore, the main functions of general government units are :

to organise or redirect the flows of money, goods and services or other assets among
corporations, among households, and between corporations and households; in the purpose of
social justice, increased efficiency or other aims legitimised by the citizens; examples are the
redistribution of national income and wealth, the corporate income tax paid by companies to
finance unemployment benefits, the social contributions paid by employees to finance the pension
systems;
to produce goods and services to satisfy households' needs (e.g. state health care) or to
collectively meet the needs of the whole community (e.g. defence, public order and safety).[9]

The general government sector, in the European System of Accounts, has four sub-sectors:
1.
2.
3.
4.

central government
state government
local government
social security funds

"Central government"[11] consists of all administrative departments of the state and other
central agencies whose responsibilities cover the whole economic territory of a country, except
for the administration of social security funds.
"State government"[12] is defined as the separate institutional units that exercise some
government functions below those units at central government level and above those units at
local government level, excluding the administration of social security funds.
"Local government"[13] consists of all types of public administration whose responsibility
covers only a local part of the economic territory, apart from local agencies of social security
funds.
"Social security fund"[14] is a central, state or local institutional unit whose main activity is to
provide social benefits. It fulfils the two following criteria:

by law or regulation (except those about government employees), certain population groups must
take part in the scheme and have to pay contributions;
general government is responsible for the management of the institutional unit, for the payment or
approval of the level of the contributions and of the benefits, independent of its role as a
supervisory body or employer.

The GFSM 2001 framework is similar to the financial accounting of businesses. For example, it
recommends that governments produce a full set of financial statements including the statement
of government operations (akin to the income statement), the balance sheet, and a cash flow
statement. Two other similarities between the GFSM 2001 and business financial accounting are

10

the recommended use of accrual accounting as the basis of recording and the presentations of
stocks of assets and liabilities at market value. It is an improvement on the prior methodology
Government Finance Statistics Manual 1986 based on cash flows and without a balance sheet
statement.
USERS OF GFS

The GFSM 2001 recommends standard tables including standard fiscal indicators that meet a
broad group of users including policy makers, researchers, and investors in sovereign debt.
Government finance statistics should offer data for topics such as the fiscal architecture, the
measurement of the efficiency and effectiveness of government expenditures, the economics of
taxation, and the structure of public financing. The GFSM 2001 provides a blueprint for the
compilation, recording, and presentation of revenues, expenditures, stocks of assets, and stocks
of liabilities. The GFSM 2001 also defines some indicators of effectiveness in governments
expenditures, for example the compensation of employees as a percentage of expense. The
GFSM 2001 includes a functional classification of expense as defined by the Classification of
Functions of Government (COFOG) .
This functional classification allows policy makers to analyze expenditures on categories such as
health, education, social protection, and environmental protection. The financial statements can
provide investors with the necessary information to assess the capacity of a government to
service and repay its debt, a key element determining sovereign risk, and risk premia. Like the
risk of default of a private corporation, sovereign risk is a function of the level of debt, its ratio to
liquid assets, revenues and expenditures, the expected growth and volatility of these revenues
and expenditures, and the cost of servicing the debt. The governments financial statements
contain the relevant information for this analysis.
The governments balance sheet presents the level of the debt; that is the governments
liabilities. The memorandum items of the balance sheet provide additional information on the
debt including its maturity and whether it is owed to domestic or external residents. The balance
sheet also presents a disaggregated classification of financial and non-financial assets.
These data help estimate the resources a government can potentially access to repay its debt. The
statement of operations (income statement) contains the revenue and expense accounts of the
government. The revenue accounts are divided into subaccounts, including the different types of
taxes, social contributions, dividends from the public sector, and royalties from natural resources.
Finally, the interest expense account is one of the necessary inputs to estimate the cost of
servicing the debt.

11

CENTRAL BANK
A 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 amount of money in the nation, and usually also prints
the national currency[citation needed], which usually serves as the nation's legal tender.[1][2] Examples
include the European Central Bank (ECB) and the Federal Reserve of the United States.[3]
The primary function of a central bank is to manage 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. Central banks usually also have supervisory powers, intended to prevent bank
runs and to reduce the risk that commercial banks and other financial institutions engage in
reckless or fraudulent behavior. Central banks in most developed nations are institutionally
designed to be independent from political interference.[4][5] Still, limited control by the executive
and legislative bodies usually exists.[6][7]
The chief executive of a central bank is normally known as the Governor, President or Chairman.

History
Prior to the 17th century most money was commodity money, typically gold or silver. However,
promises to pay were widely circulated and accepted as value at least five hundred years earlier
in both Europe and Asia. The Song Dynasty was the first to issue generally circulating paper
currency, while the Yuan Dynasty was the first to use notes as the predominant circulating
medium. In 1455, in an effort to control inflation, the succeeding Ming Dynasty ended the use of
paper money and closed much of Chinese trade. The medieval European Knights Templar ran an
early prototype of a central banking system, as their promises to pay were widely respected, and
many regard their activities as having laid the basis for the modern banking system.
As the first public bank to "offer accounts not directly convertible to coin", the Bank of
Amsterdam established in 1609 is considered to be the precursor to modern central banks.[8] The
central bank of Sweden ("Sveriges Riksbank" or simply "Riksbanken") was founded in
Stockholm from the remains of the failed bank Stockholms Banco in 1664 and answered to the
parliament ("Riksdag of the Estates").[9] One role of the Swedish central bank was lending
money to the government.[10]
BANK OF ENGLAND
In England in the 1690s, public funds were in short supply and were needed to finance the ongoing
conflict with France. The credit of William III's government was so low in London that it was impossible
for it to borrow the 1,200,000 (at 8 per cent) that the government wanted. In order to induce subscription
to the loan, the subscribers were to be incorporated by the name of the Governor and Company of the
Bank of England. The bank was given exclusive possession of the government's balances, and was the
only limited-liability corporation allowed to issue banknotes.[11] The lenders would give the government

12
cash (bullion) and also issue notes against the government bonds, which can be lent again. The 1.2M
was raised in 12 days; half of this was used to rebuild the Navy.
The establishment of the Bank of England, the model on which most modern central banks have been
based, was devised by Charles Montagu, 1st Earl of Halifax, in 1694, to the plan which had been
proposed by William Paterson three years before, but had not been acted upon.[12] He proposed a loan of
1.2M to the government; in return the subscribers would be incorporated as The Governor and Company
of the Bank of England with long-term banking privileges including the issue of notes. The Royal Charter
was granted on 27 July through the passage of the Tonnage Act 1694.[13]
Although some would point to the 1694 establishment Bank of England as the origin of central banking, it
did not have the functions as a modern central bank, namely, to regulate the value of the national
currency, to finance the government, to be the sole authorised distributor of banknotes, and to function as
a 'lender of last resort' to banks suffering a liquidity crisis. The modern central bank evolved slowly
through the 18th and 19th centuries to reach its current form.[14]
Although the Bank was originally a private institution, by the end of the 18th century it was increasingly
being regarded as a public authority with civic responsibility toward the upkeep of a healthy financial
system. The currency crisis of 1797, caused by panicked depositors withdrawing from the Bank led to the
government suspending convertibility of notes into specie payment. The bank was soon accused by the
bullionists of causing the exchange rate to fall from over issuing banknotes, a charge which the Bank
denied. Nevertheless, it was clear that the Bank was being treated as an organ of the state.
Henry Thornton, a merchant banker and monetary theorist has been described as the father of the modern
central bank. An opponent of the real bills doctrine, he was a defender of the bullionist position and a
significant figure in monetary theory, his process of monetary expansion anticipating the theories of Knut
Wicksell regarding the "cumulative process which restates the Quantity Theory in a theoretically coherent
form". As a response 1797 currency crisis, Thornton wrote in 1802 An Enquiry into the Nature and
Effects of the Paper Credit of Great Britain, in which he argued that the increase in paper credit did not
cause the crisis. The book also gives a detailed account of the British monetary system as well as a
detailed examination of the ways in which the Bank of England should act to counteract fluctuations in
the value of the pound.[15]
Until the mid-nineteenth century, commercial banks were able to issue their own banknotes, and notes
issued by provincial banking companies were commonly in circulation.[16] Many consider the origins of
the central bank to lie with the passage of the Bank Charter Act of 1844.[14] Under this law, authorisation
to issue new banknotes was restricted to the Bank of England. At the same time, the Bank of England was
restricted to issue new banknotes only if they were 100% backed by gold or up to 14 million in
government debt. The Act served to restrict the supply of new notes reaching circulation, and gave the
Bank of England an effective monopoly on the printing of new notes.[17]
The Bank accepted the role of 'lender of last resort' in the 1870s after criticism of its' lacklustre response
to the Overend-Gurney crisis. The journalist Walter Bagehot wrote an influential work on the subject
Lombard Street: A Description of the Money Market, in which he advocated for the Bank to officially
become a lender of last resort during a credit crunch (sometimes referred to as "Bagehot's dictum"). Paul
Tucker phrased the dictum as follows:[18]

13
"to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good
collateral, and at 'high rates'".
Spread around the world
Central banks were established in many European countries during the 19th century. The War of the
Second Coalition led to the creation of the Banque de France in 1800, in an effort to improve the public
financing of the war.
Although central banks today are generally associated with fiat money, the 19th and early 20th centuries
central banks in most of Europe and Japan developed under the international gold standard, elsewhere
free banking or currency boards were more usual at this time. Problems with collapses of banks during
downturns, however, lead to wider support for central banks in those nations which did not as yet possess
them, most notably in Australia.
The US Federal Reserve was created by the U.S. Congress through the passing of The Federal Reserve
Act in the Senate and its signing by President Woodrow Wilson on the same day, December 23, 1913.
Australia established its first central bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and
Canada and New Zealand in the aftermath of the Great Depression in 1934. By 1935, the only significant
independent nation that did not possess a central bank was Brazil, which subsequently developed a
precursor thereto in 1945 and the present central bank twenty years later. Having gained independence,
African and Asian countries also established central banks or monetary unions.
The People's Bank of China evolved its role as a central bank starting in about 1979 with the introduction
of market reforms, which accelerated in 1989 when the country adopted a generally capitalist approach to
its export economy. Evolving further partly in response to the European Central Bank, the People's Bank
of China has by 2000 become a modern central bank. The most recent bank model, was introduced
together with the euro, involves coordination of the European national banks, which continue to manage
their respective economies separately in all respects other than currency exchange and base interest rates.
NAMING OF CENTRAL BANKS

There is no standard terminology for the name of a central bank, but many countries use the
"Bank of Country" form (for example: Bank of England (which is in fact the central bank of the
United Kingdom as a whole), Bank of Canada, Bank of Mexico; But the Bank of India is a
(government-owned) commercial bank and not a central bank). Some are styled "national"
banks, such as the National Bank of Ukraine, although the term national bank is also used for
private commercial banks in some countries. In other cases, central banks may incorporate the
word "Central" (for example, European Central Bank, Central Bank of Ireland, Central Bank of
Brazil); but the Central Bank of India is a (government-owned) commercial bank and not a
central bank. The word "Reserve" is also often included, such as the Reserve Bank of India,
Reserve Bank of Australia, Reserve Bank of New Zealand, the South African Reserve Bank, and
U.S. Federal Reserve System. Other central banks are known as monetary authorities such as the
Monetary Authority of Singapore, Maldives Monetary Authority and Cayman Islands Monetary
Authority. Many countries have state-owned banks or other quasi-government entities that have
entirely separate functions, such as financing imports and exports.

14

In some countries, particularly in some Communist countries, the term national bank may be
used to indicate both the monetary authority and the leading banking entity, such as the Soviet
Union's Gosbank (state bank). In other countries, the term national bank may be used to indicate
that the central bank's goals are broader than monetary stability, such as full employment,
industrial development, or other goals.

ACTIVITIES AND RESPONSIBILITIES

Functions of a central bank may include:

Implementing monetary policies.

Determining interest rates
Controlling the nation's entire money supply
The government's banker and the bankers' bank ("lender of last resort")
Managing the country's foreign exchange and gold reserves and the government's stock register
Regulating and supervising the banking industry
Setting the official interest rate used to manage both inflation and the country's exchange rate
and ensuring that this rate takes effect via a variety of policy mechanisms

15

16

MONETARY POLICY
Central banks implement a country's chosen monetary policy. At the most basic level, this
involves establishing what form of currency the country may have, whether a fiat currency, goldbacked currency (disallowed for countries with membership of the International Monetary Fund),
currency board or a currency union. When a country has its own national currency, this involves
the issue of some form of standardized currency, which is essentially a form of promissory note:
a promise to exchange the note for "money" under certain circumstances. Historically, this was
often a promise to exchange the money for precious metals in some fixed amount. Now, when
many currencies are fiat money, the "promise to pay" consists of the promise to accept that
currency to pay for taxes.
A central bank may use another country's currency either directly (in a currency union), or
indirectly (a currency board). In the latter case, exemplified by Bulgaria, Hong Kong and Latvia,
the local currency is backed at a fixed rate by the central bank's holdings of a foreign currency.
The expression "monetary policy" may also refer more narrowly to the interest-rate targets and
other active measures undertaken by the monetary authority.

GOALS OF MONETARY POLICY

HIGH EMPLOYMENT:
Frictional unemployment is the time period between jobs when a worker is searching for, or
transitioning from one job to another. Unemployment beyond frictional unemployment is
classified as unintended unemployment.
For example, structural unemployment is a form of unemployment resulting from a mismatch
between demand in the labour market and the skills and locations of the workers seeking
employment. Macroeconomic policy generally aims to reduce unintended unemployment.
Keynes labeled any jobs that would be created by a rise in wage-goods (i.e., a decrease in realwages) as involuntary unemployment:
Men are involuntarily unemployed if, in the event of a small rise in the price of wagegoods relatively to the money-wage, both the aggregate supply of labour willing to work
for the current money-wage and the aggregate demand for it at that wage would be
greater than the existing volume of employment.
John Maynard Keynes, The General Theory of Employment, Interest and Money p11
PRICE STABILITY:
Inflation is defined either as the devaluation of a currency or equivalently the rise of prices
relative to a currency. Since inflation lowers real wages, Keynesians view inflation as the
solution to involuntary unemployment. However, "unanticipated" inflation leads to lender losses

17

as the real interest rate will be lower than expected. Thus, Keynesian monetary policy aims for a
steady rate of inflation.
ECONOMIC GROWTH:
Economic growth can be enhanced by investment in capital, such as more or better machinery. A
low interest rate implies that firms can loan money to invest in their capital stock and pay less
interest for it. Lowering the interest is therefore considered to encourage economic growth and is
often used to alleviate times of low economic growth. On the other hand, raising the interest rate
is often used in times of high economic growth as a contra-cyclical device to keep the economy
from overheating and avoid market bubbles.
Interest Rate Stability
Financial Market Stability
Foreign Exchange Market Stability
CONFLICTS AMONG GOALS:
Goals frequently cannot be separated from each other and often conflict. Costs must therefore be
carefully weighed before policy implementation.
CURRENCY ISSUANCE
Similar to commercial banks, central banks hold assets (government bonds, foreign exchange,
gold, and other financial assets) and incur liabilities (currency outstanding). Central banks create
money by issuing interest-free currency notes and selling them to the public in exchange for
interest-bearing assets such as government bonds. When a central bank wishes to purchase more
bonds than their respective national governments make available, they may purchase private
bonds or assets denominated in foreign currencies.
The European Central Bank remits its interest income to the central banks of the member
countries of the European Union. The US Federal Reserve remits all its profits to the U.S.
Treasury. This income, derived from the power to issue currency, is referred to as seigniorage,
and usually belongs to the national government. The state-sanctioned power to create currency is
called the Right of Issuance. Throughout history there have been disagreements over this power,
since whoever controls the creation of currency controls the seigniorage income.
INTEREST RATE INTERVENTIONS
Typically a central bank controls certain types of short-term interest rates. These influence the
stock- and bond markets as well as mortgage and other interest rates. The European Central Bank
for example announces its interest rate at the meeting of its Governing Council; in the case of the
U.S. Federal Reserve, the Federal Reserve Board of Governors. Both the Federal Reserve and the
ECB are composed of one or more central bodies that are responsible for the main decisions

18

about interest rates and the size and type of open market operations, and several branches to
execute its policies. In the case of the Federal Reserve, they are the local Federal Reserve Banks;
for the ECB they are the national central banks.
LIMITS ON POLICY EFFECTS
Although the perception by the public may be that the "central bank" controls some or all interest
rates and currency rates, economic theory (and substantial empirical evidence) shows that it is
impossible to do both at once in an open economy. Robert Mundell's "impossible trinity" is the
most famous formulation of these limited powers, and postulates that it is impossible to target
monetary policy (broadly, interest rates), the exchange rate (through a fixed rate) and maintain
free capital movement. Since most Western economies are now considered "open" with free
capital movement, this essentially means that central banks may target interest rates or exchange
rates with credibility, but not both at once.
In the most famous case of policy failure, Black Wednesday, George Soros arbitraged the pound
sterling's relationship to the ECU and (after making $2 billion himself and forcing the UK to
spend over $8bn defending the pound) forced it to abandon its policy. Since then he has been a
harsh critic of clumsy bank policies and argued that no one should be able to do what he
did.[citation needed]
The most complex relationships are those between the yuan and the US dollar, and between the
euro and its neighbours. The situation in Cuba is so exceptional as to require the Cuban peso to
be dealt with simply as an exception, since the United States forbids direct trade with Cuba. US
dollars were ubiquitous in Cuba's economy after its legalization in 1991, but were officially
removed from circulation in 2004 and replaced by the convertible peso.

POLICY INSTRUMENTS
The main monetary policy instruments available to central banks are open market operation,
bank reserve requirement, interest rate policy, re-lending and re-discount (including using the
term repurchase market), and credit policy (often coordinated with trade policy). While capital
adequacy is important, it is defined and regulated by the Bank for International Settlements, and
central banks in practice generally do not apply stricter rules.
To enable open market operations, a central bank must hold foreign exchange reserves (usually
in the form of government bonds) and official gold reserves. It will often have some influence
over any official or mandated exchange rates: Some exchange rates are managed, some are
market based (free float) and many are somewhere in between ("managed float" or "dirty float").
INTEREST RATES
By far the most visible and obvious power of many modern central banks is to influence market
interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. Although the
mechanism differs from country to country, most use a similar mechanism based on a central
bank's ability to create as much fiat money as required.

19

The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is
generally to lend money or borrow money in theoretically unlimited quantities, until the targeted
market rate is sufficiently close to the target. Central banks may do so by lending money to and
borrowing money from (taking deposits from) a limited number of qualified banks, or by
purchasing and selling bonds. As an example of how this functions, the Bank of Canada sets a
target overnight rate, and a band of plus or minus 0.25%. Qualified banks borrow from each
other within this band, but never above or below, because the central bank will always lend to
them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity
to borrow and lend at the extremes of the band are unlimited.[19] Other central banks use similar
mechanisms.
It is also notable that the target rates are generally short-term rates. The actual rate that borrowers
and lenders receive on the market will depend on (perceived) credit risk, maturity and other
factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but
rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield
curves, even below the short-term rate. Many central banks have one primary "headline" rate that
is quoted as the "central bank rate". In practice, they will have other tools and rates that are used,
but only one that is rigorously targeted and enforced.
"The rate at which the central bank lends money can indeed be chosen at will by the central
bank; this is the rate that makes the financial headlines." Henry C.K. Liu.[20] Liu explains
further that "the U.S. central-bank lending rate is known as the Fed funds rate. The Fed sets a
target for the Fed funds rate, which its Open Market Committee tries to match by lending or
borrowing in the money market ... a fiat money system set by command of the central bank. The
Fed is the head of the central-bank because the U.S. dollar is the key reserve currency for
international trade. The global money market is a USA dollar market. All other currencies
markets revolve around the U.S. dollar market." Accordingly the U.S. situation is not typical of
central banks in general.
A typical central bank has several interest rates or monetary policy tools it can set to influence
markets.

Marginal lending rate (currently 0.30% in the Eurozone[21]) a fixed rate for institutions to
borrow money from the central bank. (In the USA this is called the discount rate).
Main refinancing rate (0.05% in the Eurozone[21]) the publicly visible interest rate the central
bank announces. It is also known as minimum bid rate and serves as a bidding floor for
refinancing loans. (In the USA this is called the federal funds rate).
Deposit rate, generally consisting of interest on reserves and sometimes also interest on excess
reserves (-0.20% in the Eurozone[21]) the rates parties receive for deposits at the central bank.

These rates directly affect the rates in the money market, the market for short term loans.
OPEN MARKET OPERATIONS
Through open market operations, a central bank influences the money supply in an economy.
Each time it buys securities (such as a government bond or treasury bill), it in effect creates

20

money. The central bank exchanges money for the security, increasing the money supply while
lowering the supply of the specific security. Conversely, selling of securities by the central bank
reduces the money supply.
Open market operations usually take the form of:

Buying or selling securities ("direct operations") to achieve an interest rate target in the
interbank market .
Temporary lending of money for collateral securities ("Reverse Operations" or "repurchase
operations", otherwise known as the "repo" market). These operations are carried out on a
regular basis, where fixed maturity loans (of one week and one month for the ECB) are
auctioned off.
Foreign exchange operations such as foreign exchange swaps.

All of these interventions can also influence the foreign exchange market and thus the exchange
rate. For example the People's Bank of China and the Bank of Japan have on occasion bought
several hundred billions of U.S. Treasuries, presumably in order to stop the decline of the U.S.
dollar versus the renminbi and the yen.
CAPITAL REQUIREMENTS
All banks are required to hold a certain percentage of their assets as capital, a rate which may be
established by the central bank or the banking supervisor. For international banks, including the
55 member central banks of the Bank for International Settlements, the threshold is 8% (see the
Basel Capital Accords) of risk-adjusted assets, whereby certain assets (such as government
bonds) are considered to have lower risk and are either partially or fully excluded from total
assets for the purposes of calculating capital adequacy. Partly due to concerns about asset
inflation and repurchase agreements, capital requirements may be considered more effective than
reserve requirements in preventing indefinite lending: when at the threshold, a bank cannot
extend another loan without acquiring further capital on its balance sheet.
RESERVE REQUIREMENTS
Historically, bank reserves have formed only a small fraction of deposits, a system called
fractional reserve banking. Banks would hold only a small percentage of their assets in the form
of cash reserves as insurance against bank runs. Over time this process has been regulated and
insured by central banks. Such legal reserve requirements were introduced in the 19th century as
an attempt to reduce the risk of banks overextending themselves and suffering from bank runs, as
this could lead to knock-on effects on other overextended banks. See also money multiplier.
As the early 20th century gold standard was undermined by inflation and the late 20th century
fiat dollar hegemony evolved, and as banks proliferated and engaged in more complex
transactions and were able to profit from dealings globally on a moment's notice, these practices
became mandatory, if only to ensure that there was some limit on the ballooning of money
supply. Such limits have become harder to enforce. The People's Bank of China retains (and
uses) more powers over reserves because the yuan that it manages is a non-convertible currency.

21

Loan activity by banks plays a fundamental role in determining the money supply. The centralbank money after aggregate settlement "final money" can take only one of two forms:

physical cash, which is rarely used in wholesale financial markets,

central-bank money which is rarely used by the people

The currency component of the money supply is far smaller than the deposit component.
Currency, bank reserves and institutional loan agreements together make up the monetary base,
called M1, M2 and M3. The Federal Reserve Bank stopped publishing M3 and counting it as part
of the money supply in 2006.[22]
Exchange requirements
To influence the money supply, some central banks may require that some or all foreign
exchange receipts (generally from exports) be exchanged for the local currency. The rate that is
used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is
generally used in countries with non-convertible currencies or partially convertible currencies.
The recipient of the local currency may be allowed to freely dispose of the funds, required to
hold the funds with the central bank for some period of time, or allowed to use the funds subject
to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be
otherwise limited.
In this method, money supply is increased by the central bank when it purchases the foreign
currency by issuing (selling) the local currency. The central bank may subsequently reduce the
money supply by various means, including selling bonds or foreign exchange interventions.
MARGIN REQUIREMENTS AND OTHER TOOLS
In some countries, central banks may have other tools that work indirectly to limit lending
practices and otherwise restrict or regulate capital markets. For example, a central bank may
regulate margin lending, whereby individuals or companies may borrow against pledged
securities. The margin requirement establishes a minimum ratio of the value of the securities to
the amount borrowed.
Central banks often have requirements for the quality of assets that may be held by financial
institutions; these requirements may act as a limit on the amount of risk and leverage created by
the financial system. These requirements may be direct, such as requiring certain assets to bear
certain minimum credit ratings, or indirect, by the central bank lending to counterparties only
when security of a certain quality is pledged as collateral.

BANKING SUPERVISION AND OTHER ACTIVITIES

In some countries a central bank through its subsidiaries controls and monitors the banking
sector. In other countries banking supervision is carried out by a government department such as
the UK Treasury, or an independent government agency (for example, UK's Financial Conduct
Authority). It examines the banks' balance sheets and behaviour and policies toward consumers.

22

Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes
and coins or foreign currency. Thus it is often described as the "bank of banks".
Many countries such as the United States will monitor and control the banking sector through
different agencies and for different purposes, although there is usually significant cooperation
between the agencies. For example, money center banks, deposit-taking institutions, and other
types of financial institutions may be subject to different (and occasionally overlapping)
regulation. Some types of banking regulation may be delegated to other levels of government,
such as state or provincial governments.
Any cartel of banks is particularly closely watched and controlled. Most countries control bank
mergers and are wary of concentration in this industry due to the danger of groupthink and
runaway lending bubbles based on a single point of failure, the credit culture of the few large
banks.

INDEPENDENCE
In the 2000s there has been a trend towards increasing the independence of central banks as a
way of improving long-term economic performance. However, while a large volume of
economic research has been done to define the relationship between central bank independence
and economic performance, the results are ambiguous.
Advocates of central bank independence argue that a central bank which is too susceptible to
political direction or pressure may encourage economic cycles ("boom and bust"), as politicians
may be tempted to boost economic activity in advance of an election, to the detriment of the
long-term health of the economy and the country. In this context, independence is usually
defined as the central bank's operational and management independence from the government.
The literature on central bank independence has defined a number of types of independence.

Legal independence
The independence of the central bank is enshrined in law. This type of independence is
limited in a democratic state; in almost all cases the central bank is accountable at some
level to government officials, either through a government minister or directly to a
legislature. Even defining degrees of legal independence has proven to be a challenge
since legislation typically provides only a framework within which the government and
the central bank work out their relationship.

Goal independence
The central bank has the right to set its own policy goals, whether inflation targeting,
control of the money supply, or maintaining a fixed exchange rate. While this type of
independence is more common, many central banks prefer to announce their policy goals
in partnership with the appropriate government departments. This increases the
transparency of the policy setting process and thereby increases the credibility of the

23

goals chosen by providing assurance that they will not be changed without notice. In
addition, the setting of common goals by the central bank and the government helps to
avoid situations where monetary and fiscal policy are in conflict; a policy combination
that is clearly sub-optimal.

Operational independence
The central bank has the independence to determine the best way of achieving its policy
goals, including the types of instruments used and the timing of their use. This is the most
common form of central bank independence. The granting of independence to the Bank
of England in 1997 was, in fact, the granting of operational independence; the inflation
target continued to be announced in the Chancellor's annual budget speech to Parliament.

Management independence
The central bank has the authority to run its own operations (appointing staff, setting
budgets, and so on.) without excessive involvement of the government. The other forms
of independence are not possible unless the central bank has a significant degree of
management independence. One of the most common statistical indicators used in the
literature as a proxy for central bank independence is the "turn-over-rate" of central bank
governors. If a government is in the habit of appointing and replacing the governor
frequently, it clearly has the capacity to micro-manage the central bank through its choice
of governors.

It is argued that an independent central bank can run a more credible monetary policy, making
market expectations more responsive to signals from the central bank. Recently, both the Bank of
England (1997) and the European Central Bank have been made independent and follow a set of
published inflation targets so that markets know what to expect. Even the People's Bank of China
has been accorded great latitude due to the difficulty of problems it faces, though in the People's
Republic of China the official role of the bank remains that of a national bank rather than a
central bank, underlined by the official refusal to "unpeg" the yuan or to revalue it "under
pressure". The People's Bank of China's independence can thus be read more as independence
from the USA which rules the financial markets, than from the Communist Party of China which
rules the country. The fact that the Communist Party is not elected also relieves the pressure to
please people, increasing its independence.
Governments generally have some degree of influence over even "independent" central banks;
the aim of independence is primarily to prevent short-term interference. For example, the Board
of Governors of the U.S. Federal Reserve are nominated by the President of the U.S. and
confirmed by the Senate.[23] The Chairman and other Federal Reserve officials often testify
before the Congress.[24]
International organizations such as the World Bank, the Bank for International Settlements (BIS)
and the International Monetary Fund (IMF) are strong supporters of central bank independence.
This results, in part, from a belief in the intrinsic merits of increased independence. The support
for independence from the international organizations also derives partly from the connection

24

between increased independence for the central bank and increased transparency in the policymaking process. The IMF's Financial Services Action Plan (FSAP) review self-assessment, for
example, includes a number of questions about central bank independence in the transparency
section. An independent central bank will score higher in the review than one that is not
independent.