CHAPTER 5: CENTRAL BANK

5.1. Introduction of Central Bank

In every country, there is one bank which acts as the leader of the money market -
supervising, controlling and regulating the activities of Commercial Banks and other
financial institutions. It acts as a banker of issue and is in close touch with the
government, as banker, agent and adviser to the latter. Such a bank is known as the
Central Bank of the country.
5.1.1. Central Bank and Commercial Bank - Differences
- Central Bank does not work for profits though it might secure profits. While
Commercial Banks aim at securing maximum profit for their shareholders, the Central
Bank aims at controlling the banking system and supporting the economic policy of the
government.
- Central Bank is generally an organization of the government and forms part of the govt.
machinery. Commercial Banks may be owned by the govt. or are privately owned.
- The Organization and Management of the Central Bank is fully controlled by the
Government.
5.1.2 Functions of a Central Bank
1. Bank of Issue
Central Bank (CB) has the exclusive monopoly of note issue and the currency notes
issued by the Central Bank are declared unlimited legal tender throughout the country.
This monopoly brings about:
i. Uniformity of note issue which in turn facilitates trade and exchange within the
country
ii. Enables the Central Bank to influence and control the credit creation of
Commercial Banks
iii. Gives distinctive prestige to the currency notes
iv. Enables govt. to appropriate partly or fully the profits of note issue.
2. Banker, Agent and Adviser to the Government

As Banker and Agent, CB keeps the banking accounts of the Central and State
governments and makes and receives payments on behalf of the government. It provides
short-term advances to the govt. (ways and means advances) to tide over temporary
shortage of funds. It advises the govt. on all monetary and banking matters.
 3. Custodian of the Cash Reserves of Commercial Banks
All Commercial Banks keep part of their deposits as reserves with the Central Banks.
Centralized cash reserves serve as the basis of a larger and more elastic credit structure
and helps Commercial Banks to meet crises and emergencies. Centralized cash reserves
aids the Central Bank to control credit creation and implement monetary policy.
4. Custodian of Foreign Balances of the Country
CB holds the foreign exchange assets of all commercial and non-Commercial Banks of
the country. It is the responsibility of CB to maintain the rate of exchange and manage
exchange control and other restrictions imposed by the State. It also maintains reserves
with the IMF and obtains normal drawing and special drawing rights.
5. Lender of the last resort
Central Bank never refuses to accommodate any eligible Commercial Bank
experiencing cash shortage. In the absence of a Central Bank, Commercial Banks will
have to carry substantial cash reserves which imply restricted lending and reduced
income. As a lender of last resort, Central Bank assumes the responsibility of meeting
directly or indirectly all reasonable demands for accommodation by the Commercial
Banks.
6. Central Clearance, Settlement and Transfer
As the Central Bank keeps cash reserves of Commercial Banks, it is easier for member
banks to settle their mutual claims in the books of the Central Bank. These are the
clearing house operations of CB wherein cheques are cleared, claims settled and funds
transferred in the books of the member banks. However, this function can also be
performed by any leading bank in a locality or area.
7. Controller of Credit
CB controls the level of credit in the economy by either expanding or contracting bank
deposits. In modern times, bank deposits have become the most important source of
money in the country. As controller of credit, CB seeks to influence and control the
volume of bank credit and also to stabilize business conditions in the country.
5.1.3 Roles of Central Bank
- Central bank plays a critical role in every transaction, business and daily activities,
whether it is Economic activity or Individual activity (saving schemes or return matters)
- Central banks monitors the purchase and repurchase so that loss would not be there in
the exchange rates.
- Central bank gives money to commercial banks in the time of crises to avoid panic life
situations in the markets.
- Reserves are just like savings help to fall back upon from difficult or contingent
situations.
- Banks itself has no money , for this there are some legislations required, that are issued
in the form of Prudential regulations by Central Bank for determining credit policy.
- The central bank has a number of policy instruments that can effect the major objectives
of monetary policy:
 Stability of prices
 Stability of exchange rate
- Central banks can focus on:
 Quantitative monetary policy: central banks regulate monetary base
 Qualitative monetary policy: central banks regulate market interest rate and provide
monetary base which respond to money demand
5.2. Monetary Policy
5.2.1. Objective of Monetary Policy
To maintain price stability is the primary objective of the monetary policy. Ensuring
price stability is the most important contribution that monetary policy can make to
achieve a favorable economic environment and a high level of employment.
5.2.2. Monetary Policy Instruments
- The main monetary policy instruments available to central bank is
 Open market operation,
 Bank reserve requirement,
 Interest-rate policy,
 Re-lending and re-discount (including using the term repurchase market)
 Credit policy (often coordinated with trade policy).
- Direct, administrative instruments:
 Credit limits
 Interest rates limits
 Liquidity rules
 Investment regulation
- Indirect, market instruments:
 Open - Market Operations
 Legal Reserve Requirements
 Discount Rate Policy
5.2.3. Monetary Policy
5.2.3.1. Legal Reserve Requirements
- All banks are required to hold a minimum percentage of deposits as reserve. Changes in
required reserve ratios can have an important influence on the money supply.
- Changes in reserve requirements are made sparingly because they present too large
change in monetary policy.
5.2.3.2.Reserve Requirement
- Another significant power that Central bank hold is the ability to establish reserve
requirement for other banks.
- The other requirement is that a percentage of liability is being held as cash or deposited
with the Central bank or other agency , limits are set on the money supply.
5.2.3.3. Capital Requirement
- All banks are required to hold a certain percentage of their assetsas capital.
- A rate which may be established by the Central bank or banking supervisor.
5.2.3.4. Capital Adequacy
- Is important, it is defined and regulated by the Bank for International Settlements, and
central bank in practice generally apply strict rules.
- To enable open market operations, a central bank must hold foreign exchange reserves.
- It will often have some influence over any official or mandated exchange rates: Some
exchange rates are managed, some are market based (free float) and many are somewhere
in between ("managed float" ).
5.2.3.5. Discount Rate Policy
- Discount rate is the interest rate at which the central bank stands ready to lend reserves
to commercial banks.
- There are the three key interest rates for the banks:
 The interest rate on the main refinancing operations.
 The rate on the deposit facility, which banks may use to make overnight deposits.
 The rate on the marginal lending facility, which offers overnight credit to banks.
5.2.3.6. Exchange Rate
Accordingly there are certain exchange requirements to influence the money supply,
some Central Banks may require that some or all foreign exchange receipts generally
from exports be exchanged for the local currency ,the rate that is used to purchase local
currency may be market based or arbitrarily set by bank.
5.2.3.7. Open - Market Operations
- Open-market operations represent purchases or sale of government securities and
treasuries to influence the money supply.
- These operations are a central bank the most important stabilizing instruments.
- Open market operations serve the purpose of managing interest rate, the liquidity
situation in the market and signaling the stance of monetary policy.
- Through open market operations, a central bank influences the money supply in an
economy directly. Each time it buys securities, exchanging money for the security, it
raises the money supply.
- Conversely, selling of securities lowers the money supply.
- Buying of securities thus amounts to printing new money while lowering supply of the
specific security.
- Temporary lending of money for collateral securities ("Reverse Operations" or
"repurchase operations", otherwise known as the "repo" market).
- These operations are carried out on a regular basis, with fixed maturity time periods.
5.3. Monetary Policy Management
5.3.1. The Monetary Transmission Mechanism
The monetary transmission mechanism represents the way by which changes in the
supply of money are translated into changes in output, employment, prices and inflation.
5.3.2. Expansionary Monetary Policy
When the central bank raises the money supply, interest rates fall. The economy moves
down the money demand schedule. Lower interest rates reduces the costs of investment;
thus higher investment raises aggregate demand curve.
5.3.3. Tight Monetary Policy
Central bank contracts the money supply in response to fears of rising prices. The
lower money supply increases interest rates. The result of a tighter monetary policy is
lower investment and decrease in the nation’s output.