. unfortunately we do not have that ability and as observed by some, we are more like early navigators who operate in a world of huge uncertainty with no reliable maps or compasses. because of lags in the availability of statistics, we cannot know precisely, all the information we need. policy instruments in our possession operate with time lags which are also not entirely precise. over the years, we have acquired powers and independence, but there are limitations in any central bank ’ s ability to steer its economy with precision. hence, central banking indeed is a challenging task, which requires continued efforts to explore how our economies work and how our policy instruments operate. there is a school of thought that suggests the sole objective of central banks should be price stability. accordingly many countries have adopted the inflation targeting approach in their conduct of monetary policy. price stability indeed is essential for sustained economic growth and there is no argument that it should be pursued. moreover, the inflation targeting approach has the benefit of building up the credibility and commitment of a central bank. however, there is a risk that central banks may concentrate on achieving price stability as measured by a consumer price index, which may not necessarily guarantee economic and financial stability. with globalization and improvement in productivity, there has been a general tendency for inflation to remain relatively low. though, price stability in terms of a consumer price index is achieved, there could be other imbalances arising from excessive demand pressure which may be reflected in assets price inflation and external payment imbalances. there could also be a danger of developing deflationary conditions which depresses growth. therefore, it is important that central banks take into account other signs of economic imbalances in designing their policies, even though the sole objective may be defined as price stability. the central bank of sri lanka has defined its key objective, not simply as price stability, but as economic and price stability. this is expected to prevent the bank from trying to stabilize a price index rather than ensuring overall price stability in the economy. though some central banks have delegated the bank supervision function to a separate agency, it is vital that financial system stability is also ensured. this, in fact is the other objective of the central bank of sri lanka. it is important that the inter dependence of the price stability and financial system stability, is well recognized. it would not be possible for a central bank to use its instruments to ensure price stability without financial system stability as these instruments operate through a well functioning stable financial system. further

of this century there were only 18 central banks. the usa managed without a central bank until 1913. private banks issued their own currency notes and coins and banking crises were fairly frequent. the federal reserve bank of usa was established mainly to supervise banks and act as lender of last resort. today, only a few central banks, including fed reserve is still responsible for bank supervision. others have handed this job to a separate agency. in the 1960 ’ s the conventional economic wisdom was that monetary policy could reduce unemployment and directly promote economic growth. the theoretical basis for this was provided by the famous phillips curve, which depicted an inverse relationship between inflation and unemployment in britain ; when unemployment was high inflation was low and vice versa. this appeared to have suggested that central banks could permanently reduce unemployment by tolerating a bit more inflation. in fact, many countries attempted to do so. we all have our experience in attempting to directly promote economic activities by releasing high powered money through various credit schemes and direct involvement in development activities. however, at the end we had more inflation, either visible or hidden, without an appreciable reduction in unemployment or improvement in growth. in fact, the rate of inflation associated with a given level of unemployment had risen through the 1970 ’ s and policy makers had to abandon the philip curve. this in fact was predicted by milton friedman and edmund phelps who challenged the phillip curve. as they pointed out, the trade off between inflation and unemployment was only short term. as soon as people come to expect higher inflation they would demand higher wages, and unemployment would rise again. there is no trade off between inflation and unemployment. in the long run, monetary policy could influence only inflation. today most central banks are concentrating their monetary policies on maintaining price stability ; and maintaining inflation at lower stable levels. john exter, founder governor of the central bank of sri lanka emphasized on the very first day of the establishment of the central bank, “ there is no financial wizardry by which the bank can suddenly pull out of a hat a higher standard of living for everybody. the bank ’ s contribution must necessarily be a long - run contribution. the bank does not itself produce goods and services, but it should, by creating the right monetary conditions enable the country …. to do so ”. central bankers would like very much to have the ability of a captain or a pilot who knows exactly where he is heading, how his craft ( i. e. economy ) works and how his actions affect it course