The Central Bank

Financial systems in an economy transfer the resources over space, time and sectors. The flow of funds in financial systems occurs through financial markets and financial intermediaries. It is a circulatory system that links together the goods, services and finance in domestic and international markets. A financial system encompasses the markets, firms and other institutions which carry out the financial decisions of household, businesses and the governments. Important parts of the financial system are money market, market for fixed interest assets, stock markets for the ownership of firms, and foreign exchange markets.

Government can carry out the macroeconomic policies which to increase the revenue generation capability using the mechanisms to spur domestic investment and economic growth. To conduct the monetary policy by influencing financial conditions in pursuit of low inflation, high employment and stable financial systems a nation requires a strong central bank. Central Bank has four major functions

1. To Conduct the monetary policy by setting the short term interest rates
2. To maintain the stability of the financial system and contain the systematic risk as a lender of the last resort
3. To supervise and regulate banking institutions
4. To provide the financial services to banks and the government

Central bank can use following policy instruments to influence the financial conditions:

1. Open market operations
2. Providing the discount window for borrowing by the banks and primary dealers
3. To impose the reserve requirements for depository institutions

Money transmission system: Process by which monetary policy undertaken by the central bank interacts with the banks and the rest of the economy to determine the interest rates, other financial conditions, aggregate demand, output and the inflation:

1. The central bank announces the target short term interest rate chosen in accordance with its objectives and the state of the economy.
2. The central bank undertakes daily open market operations to meet are interest rate target.
3. The interest rate target and the future financial condition expectations determine the short and long term interest rates, asset prices and the exchange rates.
4. The level of interest rates, credit conditions, asset prices and exchange rates affect the investment, consumption and the net exports.
5. Investment, consumption and the net exports affect the path of output and inflation through the AD-AS mechanism.

The financial sector plays an important part in economic growth as it can reduce the cost of acquiring information, conducting transactions and facilitating savings mobilisation. By providing these services, the financial sector can enhance resource allocation and increase aggregate savings.