The Central Bank of Kenya (CBK), like most other central banks around the world, is entrusted with the responsibility of formulating and implementing monetary policy directed to achieving and maintaining low inflation as one of its two principal objectives; the other being to maintain a sound market-based financial system. Since its establishment in 1966, the CBK has essentially used a monetary –targeting framework to pursue the inflation objective. The use of this monetary policy strategy has been and continues to be based on the presumption that money matters, that the behavior of monetary aggregates has major bearing on the performance of the economy, particularly on inflation.
What are the main functions of a central bank?
A central bank can generally be defined as a financial institution responsible for overseeing the monetary system for a nation, or a group of nations, with the goal of fostering economic growth without inflation.
The main functions of a central bank can be listed as follows:
i. The central bank controls the issue of notes and coins (legal tender). Usually, the central bank will have a monopoly of the issue, although this is not essential as long as the central bank has power to restrict the amount of private issues of notes and coins.
ii. It has the power to control the amount of credit-money created by banks. In other words, it has the power to control, by either direct or indirect means, the money supply.
iii. A central bank should also have some control over non-bank financial intermediaries that provide credit.
iv. Encompassing both parts 2 and 3, the central bank should effectively use the relevant tools and instruments of monetary policy in order to control:
The money supply of an economy.
v. The central bank should oversee the financial sector in order to prevent crises and act as a lender-of-last-resort in order to protect depositors, prevent widespread panic withdrawal, and otherwise prevent the damage to the economy caused by the collapse of financial institutions.
vi. A central bank acts as the government’s banker. It holds the government’s bank account and performs certain traditional banking operations for the government, such as deposits and lending. In its capacity as banker to the government it can manage and administer the country’s national debt.
vii. The central bank also acts as the official agent to the government in dealing with all its gold and foreign exchange matters. The government’s reserves of gold and foreign exchange are held at the central bank. A central bank, at times, intervenes in the foreign exchange markets at the behest of the government in order to influence the exchange value of the domestic currency.
Major macro-economy policies
There are five major forms of economic policy (or, more strictly macroeconomic policy) conducted by governments that are of relevance. These are: monetary policy; fiscal policy; exchange rate policy; prices and incomes policy; and national debt management policy.
i. Monetary policy is concerned with the actions taken by central banks to influence the availability and cost of money and credit by controlling some measure (or measures) of the money supply and/or the level and structure of interest rates.
ii. Fiscal policy relates to changes in the level and structure of government spending and taxation designed to influence the economy. As all government expenditure must be financed, these decisions also, by definition, determine the extent of public sector borrowing or debt repayment. An expansionary fiscal policy means higher government spending relative to taxation. The effect of these policies would be to encourage more spending and boost the economy. Conversely, a contractionary fiscal policy means raising taxes and cutting spending.
iii. Exchange rate policy involves the targeting of a particular value of a country‟s currency exchange rate thereby influencing the flows within the balance of payments. In some countries it may be used in conjunction with other measures such as exchange controls, import tariffs and quotas.
iv. Prices and incomes policy is intended to influence the inflation rate by means of either statutory or voluntary restrictions upon increases in wages, dividend and/or prices.
v. National debt management policy is concerned with the manipulation of the outstanding stock of government debt instruments held by the domestic private sector with the objective of influencing the level and structure of interest rates and/or the availability of reserve assets to the banking system.