Central Bank

A central bank controls the supply of money as well as how it reaches the

consumer. It can not only print and inject money into the economy, but also

regulate commercial banks distribution of it.

The central bank controls monetary policy, which includes power over inflation,

exchange rates, and the money supply. It has a number of tools by which it uses

to control such. For example, it can set interest rates to control inflation, buy

foreign currencies to weaken the domestic currency, and engage in open market

operations by purchasing assets from financial institutions.

In turn, the central bank uses monetary tools to meet its objectives. These range

from country to country, but generally include targets for inflation,

unemployment, economic growth, and financial stability.

A central bank is in charge of monetary policy.

The central bank’s main functions are to set the base rate, control the money

supply through open market operations, set private banks’ reserve requirements,

and control the nation’s foreign exchange reserves.

The main objectives of the central bank is to maintain price and economic

stability.
Introduction and History of Central Banks

In 1668, Sweden founded the first ever central bank, called Sveriges Riksbank.

Its foundation stems from the failure of Swedens first bank, Stockholms Banco

in 1656. Shortly after its inception, Stockholms Banco became the first bank to

formally introduced banknotes to Europe in 1661.

The banknote was initially very popular as it replaced coins which were heavy

and difficult to handle. However, in the subsequent years, Stockholms Banco

issued more banknotes than it could cover its deposits. As a result, consumers

became wary of the increasing number of notes in circulation and therefore

went to claim their original coins.

What happened in the 1660s was what we call a ‘run on the bank’. It didn’t

have enough coins to meet its obligations and therefore went bankrupt. As a

result, consumers were left with banknotes that were worth nothing. This

subsequently led to the nobility of Sweden taking over the bank and the creation

of the Sveriges Riksbank.

The Sveriges Riksbank took charge of monetary policy, taking official control

of coinage and the supply of money. It also banned the use of all banknotes due

to the severe crisis caused by its initial adaptation. However, two centuries later

in 1874, it was to re-introduce banknotes into the market.

Objectives of Central Bank

The objectives of central banks have largely changed over the years, due to

disastrous economic events. For example, back in the 1970s, the main goal of

central banks was to ensure full employment. However, the focus on

employment blinded central banks attention on inflation. Rather than maintain

price stability, central banks would pump money into the economy to ensure

people were being employed. Yet this came at the cost of inflation.

For example, in 1973, there was a massive oil crisis that was to be named the

‘OPEC crisis’. It led to a sharp increase in the unemployment rates across the

developed world. In retaliation, central banks opened the taps and supplied the

economy with money in the hope of boosting investment and jobs.

Whilst the plan worked, it boosted employment in the short-term, but created

long-term effects. Double digit inflation occurred into the 1980s and

employment equally suffered. As a result, central banks learnt that a more

balanced approach is needed – one that focuses on several objectives rather than

one.

Central banks objectives include:

Price Stability

Full Employment

Financial Stability
Economic Growth

Exchange Rate Stability

1. Price Stability

Price stability is probably one of the leading objectives of central banks. After

the high levels of inflation in the 1970s and 1980s, and the disaster that was the

Great Depression of 1929, control over prices is a key element of central

banking policy.

Now, through most of the developed world, the target rate of inflation is 2

percent. The reason for this is that it is high enough to encourage consumption,

but not too high to cause panic buying, thereby creating a cycle of greater

inflation. Yet it is not too low so as to cause an excessive amount of saving.

2. Full Employment

Going back through history, full employment was one of the leading objectives

of the central bank. However, as the welfare state has expanded and the

understanding of monetary policy increased, it has taken a backwards step.

Nevertheless, full employment is still a relatively important objective. Most

central banks would take action if employment starts keeping up. Usually, this

is done by lowering the interest rates to fuel cheaper credit to businesses. In

turn, businesses would use the cheap credit to invest and expand its operations,

thereby stimulating jobs in the process.

3. Financial Stability

The central bank often acts as lender of last resort in order to maintain financial

stability. For instance, most commercial banks need short-term loans in order

for them to be able to align their assets and liabilities.

On occasion, a commercial bank may have to pay a loan to another financial

institution, but their assets are tied up in long-term loans and other illiquid

assets. As a result, they need some short-term liquidity to meet their obligations,

which is where the central bank comes into play.

This is crucial in the private sector as some short-term mis-payments could

cause severe consequences. One small short-term default may lead other

institutions to stop doing business with them, and customers may start to go

elsewhere. It can destroy the firms reputation and hence the confidence in it as

an organisation. So the central bank plays an important role in ensuring

confidence remains and banks remain stable.

4. Economic Growth

Economic growth is important to central banks as it generally means more jobs

and better living conditions. When there is economic growth, it is often

associated with increased business investment, improving employment, and

increasing demand.

Now economic growth is an objective for central banks but is not necessarily its

main one. They often have to weigh up the pros and cons, as controlling

inflation and prices may be more beneficial than stimulating the economy.

Nevertheless, central banks will often look to prop up the economy if they can

do so whilst also maintaining price stability.

5. Exchange Rate Stability

For one reason or another, a nation may face a currency shock by which the

demand for its currency declines rapidly. This may be due to a domestic

political output or a financial crisis. In turn, this creates instability within the

markets, which central banks look to avoid.

Exchange rate instability can lead to lower levels of business confidence as they

are unable to adequately plan their investments or business strategy. This is an

even more important factor in today’s inter-connected economies that rely

heavily on international supply chains.

When the exchange rate falls heavily, the central bank may look to buy the

domestic currency from the exchange market in a bid to increase its demand and

value. This can help create stability in the market, which could significantly

affect importers, the supply chain, and exporters alike.

Functions of a Central Bank:

A central bank performs the following functions, as given by De Kock and

accepted by the majority of economists.

1. Regulator of Currency:

The central bank is the bank of issue. It has the monopoly of note issue. Notes

issued by it circulate as legal tender money. It has its issue department which

issues notes and coins to commercial banks. Coins are manufactured in the

government mint but they are put into circulation through the central bank.

Central banks have been following different methods of note issue in different

countries. The central bank is required by law to keep a certain amount of gold

and foreign securities against the issue of notes. In some countries, the amount

of gold and foreign securities bears a fixed proportion, between 25 to 40 per

cent of the total notes issued.

In other countries, a minimum fixed amount of gold and foreign currencies is

required to be kept against note issue by the central bank. This system is

operative in India whereby the Reserve Bank of India is required to keep Rs 115

crores in gold and Rs 85 crores in foreign securities. There is no limit to the

issue of notes after keeping this minimum amount of Rs 200 crores in gold and

foreign securities.

The monopoly of issuing notes vested in the central bank ensures uniformity in

the notes issued which helps in facilitating exchange and trade within the

country. It brings stability in the monetary system and creates confidence

among the public. The central bank can restrict or expand the supply of cash

according to the requirements of the economy. Thus it provides elasticity to the

monetary system. By having a monopoly of note issue, the central bank also

controls the banking system by being the ultimate source of cash. Last but not

the least, by entrusting the monopoly of note issue to the central bank, the

government is able to earn profits from printing notes whose cost is very low as

compared with their face value.

2. Banker, Fiscal Agent and Adviser to the Government:

Central banks everywhere act as bankers, fiscal agents and advisers to their

respective governments. As banker to the government, the central bank keeps

the deposits of the central and state governments and makes payments on behalf

of governments. But it does not pay interest on governments deposits. It buys

and sells foreign currencies on behalf of the government.

It keeps the stock of gold of the government. Thus it is the custodian of

government money and wealth. As a fiscal agent, the central bank makes short-

term loans to the government for a period not exceeding 90 days. It floats loans,

pays interest on them, and finally repays them on behalf of the government.

Thus it manages the entire public debt. The central bank also advises the

government on such economic and money matters as controlling inflation or

deflation, devaluation or revaluation of the currency, deficit financing, balance

of payments, etc. As pointed out by De Kock, “Central banks everywhere

operate as bankers to the state not only because it may be more convenient and

economical to the state, but also because of the intimate connection between

public finance and monetary affairs.”

3. Custodian of Cash Reserves of Commercial Banks:

Commercial banks are required by law to keep reserves equal to a certain

percentage of both time and demand deposits liabilities with the central banks.
It is on the basis of these reserves that the central bank transfers funds from one

bank to another to facilitate the clearing of cheques.

Thus the central bank acts as the custodian of the cash reserves of commercial

banks and helps in facilitating their transactions. There are many advantages of

keeping the cash reserves of the commercial banks with the central bank,

according to De Kock.

In the first place, the centralisation of cash reserves in the central bank is a

source of great strength to the banking system of a country. Secondly,

centralised cash reserves can serve as the basis of a large and more elastic credit

structure than if the same amount were scattered among the individual banks.

Thirdly, centralised cash reserves can be utilised fully and most effectively

during periods of seasonal strains and in financial crises or emergencies.

Fourthly, by varying these cash reserves the central bank can control the credit

creation by commercial banks. Lastly, the central bank can provide additional

funds on a temporary and short term basis to commercial banks to overcome

their financial difficulties.

4. Custody and Management of Foreign Exchange Reserves:

The central bank keeps and manages the foreign exchange reserves of the

country. It is an official reservoir of gold and foreign currencies. It sells gold at

fixed prices to the monetary authorities of other countries. It also buys and sells

foreign currencies at international prices. Further, it fixes the exchange rates of

the domestic currency in terms of foreign currencies.

It holds these rates within narrow limits in keeping with its obligations as a

member of the International Monetary Fund and tries to bring stability in

foreign exchange rates. Further, it manages exchange control operations by

supplying foreign currencies to importers and persons visiting foreign countries

on business, studies, etc. in keeping with the rules laid down by the government.

5. Lender of the Last Resort:

De Kock regards this function as a sine qua non of central banking. By granting

accommodation in the form of re-discounts and collateral advances to

commercial banks, bill brokers and dealers, or other financial institutions, the

central bank acts as the lender of the last resort.

The central bank lends to such institutions in order to help them in times of

stress so as to save the financial structure of the country from collapse. It acts as

lender of the last resort through discount house on the basis of treasury bills,

government securities and bonds at “the front door”.

The other method is to give temporary accommodation to the commercial banks

or discount houses directly through the “back door”. The difference between the
two methods is that lending at the front door is at the bank rate and in the

second case at the market rate. Thus the central bank as lender of the last resort

is a big source of cash and also influences prices and market rates.

6. Clearing House for Transfer and Settlement:

As bankers’ bank, the central bank acts as a clearing house for transfer and

settlement of mutual claims of commercial banks. Since the central bank holds

reserves of commercial banks, it transfers funds from one bank to other banks to

facilitate clearing of cheques. This is done by making transfer entries in their

accounts on the principle of book-keeping. To transfer and settle claims of one

bank upon others, the central bank operates a separate department in big cities

and trade centres. This department is known as the “clearing house” and it

renders the service free to commercial banks.

When the central bank acts as a clearing agency, it is time-saving and

convenient for the commercial banks to settle their claims at one place. It also

economises the use of money. “It is not only a means of economising cash and

capital but is also a means of testing at any time the degree of liquidity which

the community is maintaining.”

7. Controller of Credit:

The most important function of the central bank is to control the credit creation

power of commercial bank in order to control inflationary and deflationary

pressures within this economy. For this purpose, it adopts quantitative methods

and qualitative methods. Quantitative methods aim at controlling the cost and

quantity of credit by adopting bank rate policy, open market operations, and by

variations in reserve ratios of commercial banks.

Qualitative methods control the use and direction of credit. These involve

selective credit controls and direct action. By adopting such methods, the

central bank tries to influence and control credit creation by commercial banks

in order to stabilise economic activity in the country.

Besides the above noted functions, the central banks in a number of developing

countries have been entrusted with the responsibility of developing a strong

banking system to meet the expanding requirements of agriculture, industry,

trade and commerce.

Accordingly, the central banks possess some additional powers of supervision

and control over the commercial banks. They are the issuing of licences; the

regulation of branch expansion; to see that every bank maintains the minimum

paid up capital and reserves as provided by law; inspecting or auditing the

accounts of banks; to approve the appointment of chairmen and directors of

such banks in accordance with the rules and qualifications; to control and

recommend merger of weak banks in order to avoid their failures and to protect

the interest of depositors; to recommend nationalisation of certain banks to the

government in public interest; to publish periodical reports relating to different

aspects of monetary and economic policies for the benefit of banks and the

public; and to engage in research and train banking personnel etc..