Question

Answer in detail.
Explain the functions of the Central Bank. 

Answer 1

The following are the seven major functions of a central bank:

i. Issue of currency notes - The central bank of a country has the exclusive authority to issue currency. The currency issued by the central bank is known as 'legal tender money' i.e. the value of such currency is backed by the central bank.

ii. Banker to the commercial banks - The central bank accepts deposits from the commercial banks and holds it as reserves for them. In addition to this:
a. Custodian of the cash reserves of the banks - Commercial banks are required to deposit a fixed percentage of their deposits with the Central Bank. These deposits can be used by the central banks to make inter-bank transfers. b. Lender of last resort - As the lender of last resort, the central bank is under the obligation to provide funds against securities to the commercial banks as and when needed by them. c. Clearing house function - Central Bank acts as a clearing house for the commercial banks. As a clearing house, it settles inter-bank claims and reduces the need for cash reserves by the commercial banks.

iii. Banker to the government - Central bank acts as a banker and financial advisor to the government. In addition to this, it buys and sells securities on behalf of the government, maintains its books of accounts, manages its public debt and also grants loans and advances to the government.

iv. Custodian of foreign exchange - All the transactions in foreign exchange are routed through the central bank and any earnings from the foreign exchange are to be deposited with the central bank. By having the custody of foreign exchange reserves, the central bank maintains exchange rate stability and promotes international trade.

v. Controller of credit - The central bank controls the supply of money and credit in an economy through various policy instruments (Qualitative and Quantitative instruments). By controlling the supply of money and credit, the central bank controls various economic variables such as prices and interest rate in the economy.

vi. Collection of data and publicity - Central banks collect different statistical information related to banking, currency and foreign exchange. Thereby, they help in the development of suitable monetary and fiscal policies.

vii. Developmental and promotional functions - In addition to the above mentioned functions, the Central bank also supports a variety of developmental and promotional activities like promoting banking habits among people, establishing specialised financial institutions, providing training to bank professionals etc.