Chap 2 Central Bank

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Q1 Questions for Discussion What is a Central Bank?

Explain the main functions of the


Central Bank.

A central bank is a bank which constitutes the apex of the monetary and banking structure of its
country and which performs, best it can in the national economic interest, the following functions.
Functions of Central Bank:
1. Monopoly of Note Issue: The issue of money was always the prerogative of the
government. Keeping the minting of coins with itself, the government delegated the right
of printing currency notes to the central bank. In fact the right and privilege of note issue
was always associated with the origin and development of central banks which were
originally called as banks of issue. Nowadays, central banks everywhere enjoy the
exclusive monopoly of note issue and the currency notes issued by the central banks are
declared unlimited legal tender throughout the country.
2. Custodian of Exchange Reserves: The central bank holds all foreign exchange reserves-
key currencies such as U.S. dollars, British pounds and other prominent currencies, gold
stock, gold bullion, and other such reserves-in its custody. This right of the central bank
enables it to exercise a reasonable control over foreign exchange, for example, to maintain
the country’s international liquidity position at 30 Banking a safe margin and to maintain
the external value of the country’s currency in terms of key foreign currencies.

3. Banker to the Government: Central banks everywhere perform the functions of banker,
agent and adviser to the government. As a banker to the government, the central bank of
the country keeps the banking accounts of the government both of the Centre and of the
States performs the same functions as a commercial bank ordinarily does for its customers.
As a banker and agent to the government, the central bank makes and receives payments
on behalf of the government. It helps the government with short-term loans and advances
(known as ways and means advances) to tide over temporary difficulties and also floats
public loans for the government. It also manages the public debt (i.e., floats services and
redeems government loans). It advises the government on monetary and economic matters.

4. Banker to Commercial Banks: Broadly speaking, the central bank acts as the banker’s
bank in three different capacities: (a) It acts as the custodian of the cash reserves of the
commercial banks (b) It acts as the lender of the last resort (c) It is the bank of central
clearance, settlement and transfer. We shall now discuss these three functions one by one

a. It acts as the custodian of the cash reserves of commercial banks


b. Lender of the last resort:
c. Clearing agent:
5. Controller of Credit: Probably the most important of all the functions performed by a
central bank is that of controlling the credit operations of commercial banks. In modern
times, bank credit has become the most important source of money in the country,
relegating coins and currency notes to a minor position. Moreover, it is possible, as we
have pointed out in a previous chapter, for commercial banks to expand credit and thus
intensify inflationary pressure or contract credit and thus contribute to a deflationary
situation. It is, thus, of great importance that there should be some authority which will
control the credit creation by commercial banks. As controller of credit, the central bank
attempts to influence and control the volume of bank credit and also to stabilise business
conditions in the country.

6. Promoter of Economic Development: In developing economies the central bank has to


play a very important part in the economic development of the country. Its monetary policy
is carried out with the object of serving as an instrument of planned economic development
with stability. The central bank performs the function of developing long-term financial
institutions, also known as development banks, to make available adequate investible funds
for the development of agriculture, industry, foreign trade, and other sectors of the
economy. The central bank has also to develop money and capital markets.

Q2 State and explain the various quantitative and qualitative methods of credit control
generally adopted by central banks.

It means the regulation of the creation and contraction of credit in the economy.
Methods of Credit Control
1.Quantitative Methods:
Quantitative methods aim at controlling the total volume of credit in the country. They relate to
the volume and cost of bank credit in general, without regard to the particular field of enterprise
or economic activity in which the credit is used. The important quantitative or general methods
of credit control are as follows:
1.Bank Rate
Bank rate refers to the official minimum lending rate of interest of the central bank. It is the rate
at which the central bank advances loans to the commercial banks by rediscounting the approved
first class bills of exchange of the banks. Hence, bank rate is also called as the discount rate.
by manipulating the bank rate it is possible to effect changes in the supply of credit in the
economy. During a period of inflation, to arrest the rise in the price level, the central bank raises
the bank rate. When the bank rate is raised, all other interest rates in the economy also go up. As
a result, the commercial bank also raise their lending rates. The consequence is an increase in the
cost of credit. This discourages borrowing and hence investment activity is curbed in the
economy. This will bring about a reduction in the supply of credit and money in the economy and
therefore in the level of prices. On the other hand, during a period of deflation, the central bank
will lower the bank rate in order to encourage business activity in the economy. When the bank
rate is lowered, all other interest rates in the economy also come down. The banks increase the
supply of credit by reducing their lending rates. A reduction in the bank rate stimulates investment
and the fall in the price level is arrested.

2.Open Market Operations


Open market operations refer to the purchase and sale of securities by the central bank. In its
broader sense, the term includes the purchase and sale of both government and private securities.

The theory underlying the operation of open market operations is that by the purchase and sale of
securities, the central bank is in a position to increase or decrease the cash reserves of the
commercial banks and therefore increase or decrease the supply of credit in the economy. The
modus operandi of open market operations can now be explained. During a period of inflation,
the central bank seeks to reduce the supply of credit in the economy. Hence, it sells the securities
to the banks, public and others. As a result of the sale of securities by the central bank, there will
be a transfer of cash from the buyers to the central bank. This will reduce the cash reserves of the
commercial banks. The public has to withdraw money from their accounts in the banks to pay for
the securities purchased from the central bank. And the commercial banks themselves will have
to transfer some amount to the central bank for having purchased the securities. All this shrinks
the volume of cash in the vaults of the banks. As a result the banks will be unable to expand the
supply of credit. When the supply of credit is reduced by the banking system, the consequences
on the economy will be obvious. Investment activity is discouraged ultimately leading to a fall in
the price level.

3.Variable Cash Reserve Ratio


Variable Reserve Ratio refers to the percentage of the deposits of the commercial banks to be
maintained with the central bank, being subject to variations by the central bank. In other words,
altering the reserve requirements of the commercial banks is called variable reserve ratio.

It is interesting to examine the working of variable reserve ratio as a technique of quantitative


credit control. During a period of inflation, the central bank raises the reserve ratio in order to
reduce the supply of credit in the economy and therefore to reduce the price level. When the
reserve requirements of the banks are raised, the excess reserves of the banks shrink and hence
the size of their credit multiplier decreases. It should be noted that the size of credit multiplier is
inversely related to the reserve ratio prescribed by the central bank. An increase in the reserve
ratio, therefore, discourages the commercial banks from expanding the supply of credit. On the
contrary during a period of deflation, the central bank lowers the reserve requirements of the
banks in order to inject more purchasing power into the economy. When the reserve ratio is
lowered, the excess reserves with the banks increase and hence the size of credit multiplier
increases. This will have an encouraging effect on the ability of the banks to create credit. Thus,
the central bank seeks to combat deflation in the economy.

Selective or Qualitative Methods


1.Margin Requirements:
Banks are required by law to keep a safety margin against securities on which they lend. The
central bank may direct banks to raise or reduce the margin.
2.Regulation of Consumer Credit:
3.Rationing of Credit: Rationing of credit, as a tool of selective credit control, originated in
England in the closing years of the 18th century. Rationing of credit implies two things. First, it
means that the central bank fixes a limit upon its rediscounting facilities for any particular bank.
Second, it means that the central bank fixes the quota of every affiliated bank for financial
accommodation from the central bank.
4.Control through Directives: In the post-war period, most central banks have been vested with
the direct power of controlling bank advances either by statute or by mutual consent between the
central bank and commercial banks.
5.Moral Suation: This is a form of control through directive. In a period of depression, the central
bank may persuade commercial banks to expand their loans and advances, to accept inferior types
of securities which they may not normally accept, f ix lower margins and in general provide
favourable conditions to stimulate bank credit and investment.
6. Direct Action: Direct action or control is one of the extensively used methods of selective
control, by almost all banks at sometime or the other. In a broad sense, it includes the other
methods of selective credit controls. But more specifically, direct action refers to controls and
directions which the central bank may enforce on all banks or any bank in particular concerning
lending and investment.
7. Publicity: Under this method, the central bank gives wide publicity regarding the probable
credit control policy it may resort to by publishing facts and figures about the various economic
and monetary condition of the economy. The central bank brings out this publicity in its bulletins,
periodicals, reports etc.
Q3 What do you mean by quantitative controls? Explain the different methods of
quantitative credit controls.

Quantitative Methods:
Quantitative methods aim at controlling the total volume of credit in the country. They relate to
the volume and cost of bank credit in general, without regard to the particular field of enterprise
or economic activity in which the credit is used. The important quantitative or general methods
of credit control are as follows:
1.Bank Rate
Bank rate refers to the official minimum lending rate of interest of the central bank. It is the rate
at which the central bank advances loans to the commercial banks by rediscounting the approved
first class bills of exchange of the banks. Hence, bank rate is also called as the discount rate.
by manipulating the bank rate it is possible to effect changes in the supply of credit in the
economy. During a period of inflation, to arrest the rise in the price level, the central bank raises
the bank rate. When the bank rate is raised, all other interest rates in the economy also go up. As
a result, the commercial bank also raise their lending rates. The consequence is an increase in the
cost of credit. This discourages borrowing and hence investment activity is curbed in the
economy. This will bring about a reduction in the supply of credit and money in the economy and
therefore in the level of prices. On the other hand, during a period of deflation, the central bank
will lower the bank rate in order to encourage business activity in the economy. When the bank
rate is lowered, all other interest rates in the economy also come down. The banks increase the
supply of credit by reducing their lending rates. A reduction in the bank rate stimulates investment
and the fall in the price level is arrested.

2.Open Market Operations


Open market operations refer to the purchase and sale of securities by the central bank. In its
broader sense, the term includes the purchase and sale of both government and private securities.

The theory underlying the operation of open market operations is that by the purchase and sale of
securities, the central bank is in a position to increase or decrease the cash reserves of the
commercial banks and therefore increase or decrease the supply of credit in the economy. The
modus operandi of open market operations can now be explained. During a period of inflation,
the central bank seeks to reduce the supply of credit in the economy. Hence, it sells the securities
to the banks, public and others. As a result of the sale of securities by the central bank, there will
be a transfer of cash from the buyers to the central bank. This will reduce the cash reserves of the
commercial banks. The public has to withdraw money from their accounts in the banks to pay for
the securities purchased from the central bank. And the commercial banks themselves will have
to transfer some amount to the central bank for having purchased the securities. All this shrinks
the volume of cash in the vaults of the banks. As a result the banks will be unable to expand the
supply of credit. When the supply of credit is reduced by the banking system, the consequences
on the economy will be obvious. Investment activity is discouraged ultimately leading to a fall in
the price level.

3.Variable Cash Reserve Ratio


Variable Reserve Ratio refers to the percentage of the deposits of the commercial banks to be
maintained with the central bank, being subject to variations by the central bank. In other words,
altering the reserve requirements of the commercial banks is called variable reserve ratio.

It is interesting to examine the working of variable reserve ratio as a technique of quantitative


credit control. During a period of inflation, the central bank raises the reserve ratio in order to
reduce the supply of credit in the economy and therefore to reduce the price level. When the
reserve requirements of the banks are raised, the excess reserves of the banks shrink and hence
the size of their credit multiplier decreases. It should be noted that the size of credit multiplier is
inversely related to the reserve ratio prescribed by the central bank. An increase in the reserve
ratio, therefore, discourages the commercial banks from expanding the supply of credit. On the
contrary during a period of deflation, the central bank lowers the reserve requirements of the
banks in order to inject more purchasing power into the economy. When the reserve ratio is
lowered, the excess reserves with the banks increase and hence the size of credit multiplier
increases. This will have an encouraging effect on the ability of the banks to create credit. Thus,
the central bank seeks to combat deflation in the economy.

Q4 What do you understand by selective or qualitative control? Explain fully the various
methods of qualitative credit control.

Selective or Qualitative Methods


The central bank may assume that the inflationary pressure in the country is due to artificial
scarcities created by speculators and hoarders who may hoard and black market essential goods
through the use of bank credit.
1.Margin Requirements:
Banks are required by law to keep a safety margin against securities on which they lend. The
central bank may direct banks to raise or reduce the margin.
2.Regulation of Consumer Credit:
3.Rationing of Credit: Rationing of credit, as a tool of selective credit control, originated in
England in the closing years of the 18th century. Rationing of credit implies two things. First, it
means that the central bank fixes a limit upon its rediscounting facilities for any particular bank.
Second, it means that the central bank fixes the quota of every affiliated bank for financial
accommodation from the central bank.
4.Control through Directives: In the post-war period, most central banks have been vested with
the direct power of controlling bank advances either by statute or by mutual consent between the
central bank and commercial banks.
5.Moral Suation: This is a form of control through directive. In a period of depression, the central
bank may persuade commercial banks to expand their loans and advances, to accept inferior types
of securities which they may not normally accept, f ix lower margins and in general provide
favourable conditions to stimulate bank credit and investment.
6. Direct Action: Direct action or control is one of the extensively used methods of selective
control, by almost all banks at sometime or the other. In a broad sense, it includes the other
methods of selective credit controls. But more specifically, direct action refers to controls and
directions which the central bank may enforce on all banks or any bank in particular concerning
lending and investment.
7. Publicity: Under this method, the central bank gives wide publicity regarding the probable
credit control policy it may resort to by publishing facts and figures about the various economic
and monetary condition of the economy. The central bank brings out this publicity in its bulletins,
periodicals, reports etc.

Q5 Distinguish between bank rate policy and open market operation as methods of credit
control.

1. Bank Rate Policy:


• Definition: The bank rate, also known as the discount rate or the base rate, is the
rate at which a central bank lends money to commercial banks. It's the rate at which
commercial banks can borrow funds from the central bank.
• Control Mechanism: By altering the bank rate, the central bank can influence the
cost of borrowing for commercial banks. A higher bank rate makes borrowing more
expensive, leading to a decrease in borrowing by commercial banks and a
subsequent decrease in the money supply. Conversely, a lower bank rate encourages
borrowing and increases the money supply.
• Effect on Credit: Changing the bank rate affects the interest rates at which
commercial banks lend to consumers and businesses. Higher rates can dampen
borrowing and spending, while lower rates can stimulate economic activity by
making borrowing cheaper.
• Visibility and Directness: Bank rate policy is a direct and visible tool of monetary
policy. Central banks announce changes in the bank rate, which can have an
immediate impact on financial markets and borrowing costs.
2. Open Market Operations (OMO):
• Definition: Open market operations involve the buying and selling of government
securities (such as treasury bills and bonds) by the central bank in the open market.
• Control Mechanism: When the central bank buys government securities, it injects
money into the banking system, increasing the reserves of commercial banks. This
lowers the interest rates in the interbank market, encouraging banks to lend more to
consumers and businesses, thereby increasing the money supply. Conversely, when
the central bank sells government securities, it absorbs money from the banking
system, reducing reserves and pushing up interest rates, which can reduce lending
and decrease the money supply.
• Effect on Credit: OMO influences the liquidity in the banking system, which affects
the ability and willingness of commercial banks to extend credit. By buying
securities, central banks can inject liquidity and stimulate lending, while selling
securities can reduce liquidity and restrain lending.
• Visibility and Directness: OMOs are typically less direct and visible compared to
changes in the bank rate. Central banks usually conduct OMOs on a regular basis as
part of their monetary policy operations, and their effects on interest rates and credit
conditions can be more gradual and indirect.

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