Functions of Central Bank

Functions of Central Bank

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Rashmi
Rashmi Karan
Manager - Content
Updated on Jun 28, 2024 15:27 IST

The main functions of a central bank are to Regulate monetary policy, Oversee banks and financial institutions, Provide emergency funding to banks, Issue and manage the national currency, Conduct economic analysis and research, Manage payment systems for smooth transactions, Promote economic growth and stability, etc. Central banks are critical in ensuring a stable and healthy financial system, fostering economic growth, and promoting financial development. The article discusses the primary functions of the central bank and explains why those functions are crucial for uplifting a country’s economy.

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A country has only one central bank. In India, it is the Reserve Bank of India or RBI. The functions of the central bank are crucial, and they form the backbone of the banking system of any country. The central banks perform eight significant functions in an economy, which are – 

Functions of Central Bank

Listed are some of the crucial functions of the Central Bank.

1. Bank of Issue

Central banks nowadays have a monopoly over issuing notes in every country. In India, RBI is responsible for printing and issuing currency notes.

A single bank is given the exclusive monopoly of notes to ensure uniformity, better control, and simplicity. It will also ensure that no individual bank is over-issuing the notes.

The central banks, thus, regulate the country’s currency and the economy’s total money supply. The central bank keeps gold, silver, or other securities like properties against the notes issued. The system of note-issue varies from country to country.

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2. Banker, Agent, and Advisor to the Government

The RBI in India performs the functions of a banker, agent, and adviser to the government. It ensures a safe and intimate connection between public finance and monetary affairs while being convenient and economical.

Central banks also perform the below functions as a banker to the government – 

  • Receives and makes payments for the government
  • Allocates short-term loans to the government in case of emergencies
  • Floats public loans and manages public debts 
  • Maintains the banking accounts and balances of the government after disbursements and remittances
  • Advises the government on economic matters
  • Act as a government agency where general exchange control is in force
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3. Custodian of Cash Reserves

Commercial banks of a country keep a part of their cash balances in the form of deposits with the central bank as a legal compulsion or convention. They draw the cash balances during busy seasons and pay them back during low seasons. These balances are used for clearing purposes. The central banks also help and guide other member banks in need.

It affects the centralization of cash reserves of the member banks. These centralized cash reserves form the base of a vast and flexible credit structure. Suh cash reserves would not be useful if scattered amongst the individual banks.

It is evident when bank reserves are pooled in one institution, which is, moreover, charged with safeguarding the country’s economic interests. Such reserves can be used to the fullest extent and most effectively during seasonal strain, financial crises, or general emergencies. The centralization of cash reserves is conducive to the economy in their use and increased elasticity and liquidity of the banking system.

4. Custodian of Foreign Balances

The central bank is responsible for securing the stability of the exchange rate under the gold standard. 

After World War I, central banks kept gold and foreign currencies as reserve note-issue and met the adverse balance of payment with other countries whenever needed. The central bank also maintains the exchange rate fixed by the government and manages exchange control and other restrictions imposed by the state. Thus, it becomes a custodian of the nation’s international currency reserves or foreign balances.

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5. Lender of Last Resort

The central bank helps the member banks strengthen their cash reserve position by rediscounting first-class bills in emergencies. Member banks can also take money or credit on approved short-term securities. These banks can then add this amount to their cash resources quickly. This way, the member banks can turn their assets into cash on short notice. Such a process promotes elasticity and liquidity in the banking and credit system economy.

Thus, we can say that the central bank is responsible for meeting commercial banks’ urgent and reasonable demands for accommodation.

According to Sir Ralph George Hawtrey, the essential duty of the central bank as the lender of last resort is to make a cash shortage among the competitive banks.

6. Clearing House

The central bank is a banker’s bank that keeps the cash balances of commercial banks and helps the member banks. It is also responsible for settling the accounts of commercial banks. Its function is that of a clearing house, an organization where the banks can offset the mutual claims against one another and make a settlement by paying the difference. 

Let us understand this through an example –

Suppose there are two banks. They draw cheques on each other. Suppose bank A has Rs. 10,000 from Bank B and is obligated to pay Rs. 12,000 to Bank B. At the clearing house, they can offset the mutual claims, where bank A pays off Rs. 2,000 to bank B, and the account is settled. The central bank’s clearinghouse contributes to the economy through cash, avoiding hectic communications and inconvenience.

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7. Controller of Credit

Money and credits can play a huge role in determining income and employment levels. Currency expansion or contraction can lead to business fluctuations. Credit control is essential since commercial banks generate a lot of credit, resulting in higher inflation.  

The central bank also controls or oversees commercial banks’ credit adjustment.

Central banks can influence the deposits of commercial banks by performing open market operations and changing CRR to control various economic conditions. This control of the central bank over commercial banks, as regards their deposits, is called the controller of credit.

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8. Protection of Depositor’s Interests

The central bank supervises the functioning of commercial banks to protect the interest of the depositors and ensure the development of banking on sound lines.

The banking business has, therefore, been recognized as a public service necessitating legislative safeguards to prevent bank failures.

The central bank is authorized to inspect commercial banks to ensure an efficient banking system with sufficient financial resources operating under proper management by the banking laws and regulations.

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FAQs

How does a central bank regulate commercial banks?

Central banks regulate commercial banks by setting and enforcing prudential regulations, such as capital adequacy requirements, reserve ratios, and liquidity standards. They also conduct bank inspections and provide supervision to ensure the stability and soundness of the banking system.

Why does a central bank issue currency?

A central bank has the authority to issue and manage the country's currency. It ensures an adequate supply of currency to facilitate smooth transactions, maintains the currency's integrity, and often acts as the sole issuer of legal tender.

How does a central bank contribute to economic growth?

Central banks contribute to economic growth by ensuring price stability, maintaining a stable financial system, and providing an enabling monetary policy environment. Central banks support economic growth by managing inflation, promoting stable financial conditions, and facilitating efficient payment systems.

Can a central bank influence the exchange rate?

A central bank can influence the exchange rate through its foreign exchange operations. By buying or selling foreign currencies in the market, a central bank can influence the supply and demand for its domestic currency, thus impacting the exchange rate.

What does it mean for a central bank to act as a lender of last resort?

Acting as a lender of last resort, a central bank provides emergency liquidity assistance to commercial banks or financial institutions facing severe liquidity shortages. This function helps maintain confidence in the banking system and prevents financial crises.

About the Author
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Rashmi Karan
Manager - Content

Rashmi is a postgraduate in Biotechnology with a flair for research-oriented work and has an experience of over 13 years in content creation and social media handling. She has a diversified writing portfolio and aim... Read Full Bio