[Commerce Class Notes] on Functions of Central Bank – Explanation, Importance, and FAQs Pdf for Exam

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.

 

Functions 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:

• Regulator of Currency- 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.

• Banker and Advisor 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 Commercial Banks- 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 and Manager of Foreign Exchange Reserves- 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.

• Transfer and Settlements- 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:

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

Examples of Central Banks

Some of the well known central banks across the world are:

1. Federal Reserve (USA)

2. Reserve Bank of India (India)

3. People’s Bank of China (China)

4. Bank of England (UK)

5. European Central Bank (EU or European Union)