Functions of a Central Bank: Key Roles and Responsibilities
In the banking system, the central bank is recognized as the most powerful financial institution. It is considered to be an important part of a country's economic and financial structure. The central bank is an independent authority in charge of supervising, regulating, and stabilizing the country's monetary and banking framework. The Reserve Bank of India is the country's central bank. It was founded in 1935. Central banks are in charge of ensuring the country's Financial Stability and Economic sovereignty.
The meaning of central bank is a financial institution that has the privilege of producing and distributing money (and credit) for a country or a group of countries. The central bank, in the modern economy, is also responsible for regulating member banks and formulating monetary policies. This article will acquaint you with the importance of the central bank with a focus on the functions of the central bank of India.
Features of Central Bank
The basic nature of Central banks is that they are non-market-based and also anti-competitive institutions. The key features of a central bank are:
Most central banks are centralized though there could be central banks that are not government agencies.
Even if the central government does not own a central bank, the law establishes and protects the privileges of a central bank.
It has a legal monopoly status that enables it to issue cash and banknotes as opposed to private commercial banks that can issue only demand liabilities, for example, checking deposits.
Function of Central Bank
A central bank is deemed as the lender of the last resort, as per Hawtrey ( a British economist). The central bank is the organ of the government which controls major financial operations of the government. Through its various operations, the objectives of the central bank are to support the economic policy of a country by influencing the way financial institutions behave.
The central bank of India is RBI or Reserve bank of India and it is a statutory bank. The primary role of RBI in India is to print currency notes and manage the money supply in the economy of India. Let us now delve into the central bank and its functions where we will discuss the role of the central bank in the money market:
The functions of a central bank can be discussed as follows:
1. Currency regulator or bank of issue
2. Bank to the government
3. Custodian of Cash reserves
4. Custodian of International currency
5. Lender of last resort
6. Clearing house for transfer and settlement
7. Controller of credit
8. Protecting depositors interests
Currency regulator or bank of issue- The main function of the central bank is to print currency notes and RBI has the sole right in the country for this operation. RBI prints money of all denominations apart from 1 rupee note. It is the ministry of finance that issues 1 rupee note.
Bank to the government- This role of the central bank is of a fiscal agent to the government where the RBI keeps the deposits of both central and state governments. It also makes payments on behalf of the government, along with buying and selling foreign currencies. The various functions of a reserve bank as an advisor is to tender useful suggestions to the government regarding monetary policies and other economic matters.
Custodian of Cash reserves- As per law, commercial banks need to keep a reserve that is equal to a certain percentage of the NDTL (net demand and time liabilities). These reserves help commercial banks clear cheques by transferring funds from one bank to another. The resee bank facilitates these transactions as it acts as a custodian and lender of cash reserves to the commercial banks.
Custodian of International currency- To keep the rates of foreign exchange stable, the reserve bank buys and sells foreign currencies at international prices. If the supply of foreign currency decreases in the economy, RBI sells them at foreign exchanges, and in case of surplus supply, it buys them. RBI is also an official reservoir of foreign currencies and gold. RBI sells gold to monetary authorities of other countries at fixed prices.
Lender of the Last Resort- The RBI grants accommodation to commercial banks, financial institutions, bill brokers, etc. in the form of collateral advances or re-discounts. This step is taken in times of stress so that the financial structure of the country is saved from collapsing. This lending is done on the basis of government securities, treasury bills, government bonds, etc.
Controller of Credit- The Reserve bank of India controls the credit created by commercial banks. The credit flow in the country is regulated by means of two methods; quantitative method and qualitative method. RBI applies tight monetary policies when it observes that there is enough supply of money which may cause an inflationary situation. It squeezes the money supply to keep inflation in check.
Protecting depositors interests- The central bank acts as a “clearinghouse” by providing free services to commercial banks in transferring and settling their mutual claims. Since the RBI holds reserves of commercial banks, it facilitates the clearing of cheques by transferring funds between banks. The principle of bookkeeping is followed in this procedure to make transfer entries into their accounts. There is a separate department operated by the central bank in big cities and trade centers to transfer and settle the claims of one bank on the other.
Importance of Central Bank
The central bank is the heart of the monetary system of any country. A country’s economy is influenced heavily by the actions taken by its central bank. They are the key governing body that ensures the boom and bust cycle of the economy and financial markets does not hamper the direction of the country’s economy. Its central bank ensures the steady and stable growth of the economy of a country.
The Functions of a Central Bank can be discussed as follows:
Currency regulator or bank of issue
Bank to the government
Custodian of Cash reserves
Custodian of International currency
Lender of last resort
Clearing house for transfer and settlement
Controller of credit
Protecting depositors interests
Examples of Central Banks
Some of the well known central banks across the world are:
Federal Reserve (USA)
Reserve Bank of India (India)
People’s Bank of China (China)
Bank of England (UK)
European Central Bank (EU or European Union)
Conclusion
The central bank plays a crucial role in ensuring the stability and growth of a nation's economy. By managing monetary policy, regulating financial institutions, and overseeing currency issuance, central banks maintain price stability and promote economic development. Their role in acting as a lender of last resort and managing government debt further contributes to financial system stability. Overall, the central bank's functions are key to fostering a secure, efficient, and balanced economic environment, benefiting both businesses and individuals alike.
FAQs on Function of Central Bank
1. What is the primary role of a central bank in a country's economy?
The primary role of a central bank, like the Reserve Bank of India (RBI), is to act as the apex financial institution that manages a country's currency, money supply, and credit systems. Its main goal is to maintain economic stability and foster growth, not to earn profits.
2. What are the main functions of a central bank as per the Class 12 syllabus?
The main functions of a central bank include:
- Issuing Currency: It has the sole authority to issue currency notes, ensuring uniformity in circulation.
- Banker to the Government: It manages the government's accounts, makes payments on its behalf, and provides short-term credit.
- Banker's Bank and Supervisor: It holds cash reserves of commercial banks, supervises their operations, and acts as a lender of last resort.
- Controller of Credit: It regulates the money supply to control inflation and deflation.
- Custodian of Foreign Exchange: It manages the country's foreign currency reserves to maintain a stable exchange rate.
3. Why is the central bank called the 'Banker to the Government'?
The central bank is called the 'Banker to the Government' because it performs the same banking functions for the government that a commercial bank performs for its customers. It maintains government accounts, accepts receipts, makes payments for the government, and provides advice on financial matters.
4. How does the central bank act as the 'lender of last resort'?
The central bank acts as a 'lender of last resort' by providing emergency financial assistance to commercial banks that are unable to get funds from other sources. This function is crucial for preventing bank failures and protecting the stability of the entire financial system.
5. What is the importance of the central bank in controlling credit?
Controlling credit is a vital function to ensure economic stability. The central bank uses tools like the repo rate, cash reserve ratio (CRR), and open market operations to influence the amount of money commercial banks can lend. This helps manage inflation and support economic growth.
6. What does the 'clearing house function' of the central bank mean?
The 'clearing house function' means the central bank settles the mutual claims and debts between commercial banks. Since all banks have an account with the central bank, it can easily settle inter-bank payments by making simple debit and credit entries, which avoids the need for large physical cash transfers between banks.
7. What is the main difference in objective between a central bank and a commercial bank?
The main difference lies in their primary objective. A central bank's main goal is to ensure the economic stability and welfare of the country, not to make a profit. In contrast, a commercial bank is a for-profit institution that aims to earn money by accepting deposits and lending to the public.
8. Why is it important for only the central bank to have the authority to issue currency?
Granting the sole authority to issue currency to the central bank ensures uniformity and public faith in the nation's money. It prevents the confusion and instability that would arise if multiple banks issued their own notes. It also gives the central bank direct control over the money supply, a key tool for managing the economy.
9. How does the central bank's management of foreign exchange reserves impact the Indian economy?
By managing foreign exchange reserves, the central bank helps stabilise the external value of the Rupee. A stable exchange rate is important for international trade and investment. It also ensures the country can meet its international payment obligations, boosting global confidence in the economy.
