The central bank enjoys single authority and thereby it avoids the danger of over-issue by individual commercial banks. Central bank along has the privilege to expand and contract the volume of currencies in accordance with the requirement of the general public.
Uniformity is also maintained because of single authority. The central bank regulates the total money supply of the country. Issue of currency notes and coins by the central bank is based on some principles like (i) fixed fiduciary system, (ii) proportional reserve system are (iii) minimum reserve system. Different principles were adopted by different countries from time to time. Since 1956, our central bank follows minimum reserve system.
Under this system central bank has to keep gold and foreign exchange reserve of Rs. 200 crore, out of which go worth of Rs. 115 crore has been kept and the rest constitutes foreign exchange reserve.
The system of note-issue differs from country to country. Under this system people’s confidence in currency is maintained and the supply of money is adjusted to demand in the economy.
2. Banker to the Government:
Central bank acts as banker, agent and adviser to the government.
(i) As a banker to the government, the central bank maintains the accounts of the central and state governments. It receives and makes payments on behalf of the government.
It advances short-term loans to the government to tide over difficulties. It gives ways and means loans to govt. during war and emergency. These are short-term loans.
(ii) As an agent to the government, the central bank raises loans from the public and manages public debt. It keeps the record of taxes collected and other payments on behalf of the govt.
It undertakes the responsibility of buying and selling of govt. securities through open market operations. The central bank also represents the government in international financial institutions and conferences.
(iii) There is an intimate connection between public finance and monetary affairs (monetary policy). As a financial adviser to the government, the central bank gives advice to the government on economic, monetary, financial and fiscal matters such as deficit financing, devaluation, trade policy, foreign exchange policy etc.
3. Banker’s Bank:
The central bank is the apex monetary institution. It is empowered to exercise control over the banking system of the country. The central bank acts as the bank of all commercial banks of a country.
The commercial bank is a constituent unit of the banking system. So commercial banks as per law (i) are required to keep a certain proportion of their reserves with the central bank, (ii) secondly, the central bank helps them at the time of emergency and (iii) the central bank acts as the clearing house for the commercial banks.
The cash reserves with the central bank are a matter of convention or legal compulsion. So there is a centralisation of cash reserves in the central bank. It is a great source of strength to the banking system of the country. This centralisation of cash reserves has several advantages.
1. These cash reserves can be utilised by the commercial banks in times of emergency and temporary difficulties.
2. These cash reserves enable the central bank to influence credit creation by the commercial banks through changing the cash reserve ratio (CRR).
3. The centralised cash reserves with the central bank are an effective instrument of credit control. At present the cash-reserve ratio (CRR) is 7.5% of the aggregate deposits of all commercial banks. Variable cash-reserve ratio stabilises the economy and promotes national welfare.
4. The centralised cash reserves provide a solid base for broad and more elastic credit structure.
However, such reserves are extremely useful to the central bank in providing temporary accommodation to commercial banks through rediscounting bills of exchange and other securities.
The central bank also settles the inter-bank unsettled obligations. This becomes easier for the central bank as all commercial banks have their accounts with the central bank.
As per Reserve Bank of India Act, all scheduled banks are required to deposit 3 to 15 percent of their total deposits with the central bank. Thus, central bank is the be-all and end-all of all commercial banks. The central bank is fully informed about the liquidity position of the commercial banks.
4. Lender of the Last Resort:
Walter Bagehot used the term ‘lender of last resort’ for the first time in this book. ‘Lombard Street’ in 1873. It is the responsibility of central bank to come to the rescue of the commercial banks when they are not able to meet their financial requirements from other sources, they can approach the central bank for financial accommodation. The central bank can solve the temporary difficulties of commercial banks by rediscounting bills of exchange and other securities.
Thus, the central bank by acting as the lender of the last resort assumes the responsibility of meeting demands for financial accommodation by commercial banks in times of difficulties and strains.
There are some advantages of the central banks functioning as the lender of the last resort. (1) It increases the elasticity and liquidity of the whole credit structure. (2) It enables the central bank to exercise its control over the whole banking system. (3) It enables the commercial banks to carry on business with their limited cash reserves.
5. Custodian of Foreign Exchange Reserves:
Since 1956, in our country the central bank has been keeping gold and foreign currencies as reserves for note-issue (that is minimum reserve system). The central bank keeps a systematic record of all kinds of transactions. All receipts and payments due to exports and imports (all kinds of economic transactions) are also recorded.
The central bank meets the payments involved due to adverse balance of payments with other countries in terms of foreign currencies. So the central bank maintains stability in the exchange rate (It is a rate at which the domestic currency will be exchanged for the currencies of other countries.
For example $1 = Rs. 39.32, 1 Euro = Rs. 57.22, ?1 = Rs. 82.13 etc). To meet imports, exports and various kinds of payment obligations and remittances of foreign funds, the central bank acts as a custodian of foreign exchange and gold reserves.
6. Promotional Functions:
After the Second World War, the role of the central bank multiplied. India got independence and was dent on achieving a high rate of growth. So the urgency of economic development of underdeveloped countries like India compelled the central bank to act as a stabilizer as well as the promoter of economic development. The promotional functions include:
1. Creation and development of specialised institutions for the supply of agricultural credit at a lower rate of interest;
2. Central bank marshalled resources and created special financial institutions to meet the requirement of long-term finance to the industrial sector and also made special arrangements to supply credit to small-scale and cottage industries;
3. It is widely felt that high rate of savings is necessary to achieve a high rate of growth through high rate of investment. The central bank formulates suitable monetary policy to boost savings and to stimulate investment necessary to achieve a high rate of growth; and
4. The central bank looks upon establishing well organised money market and capital markets in order to accelerate economic growth.
Further, the central bank publishes statistical information’s with regard to various sectors.. This helps the government to formulate suitable policies for economic growth and stability.
Thus, the central bank acts as the agent of economic development. NABARD (National Bank for Agriculture and Rural Development) for agriculture, IDBI, IFCI etc. have been set up to finance industrial development.
7. Controller of Credit:
It is the most important function of the central bank. According to De Kock, “the control and adjustment of credit is accepted by most economists and bankers as the main function of a central bank”.
Commercial banks create credit which sometimes results in inflation (inflation means a state of general rise in the price level and fall in the value of money). The expansion and contraction of currency and credit create inflation and deflation (It is known as business fluctuation) and both are harmful for the economy.
So the central bank uses two types of credit control measures like (i) quantitative credit control and (ii) qualitative or selective credit control to combat economic fluctuations. Using the two methods the central bank exercises control over commercial banks as regards to their deposits and loans and advances.
This function of keeping control over commercial banks is popularly known as credit control function of the central bank. The quantitative credit weapons are (i) bank rate, (ii) open market operation and (iii) variation of cash reserve ratio.
Using these weapons the central bank can control both inflation and deflation and can maintain economic stability. The selective credit control measures are designed to distinguish essential and non-essential use of credit.
The central bank directs the commercial banks to channalise resources in productive and essential lines and to check the flow of credit to unproductive non-essential lines. The weapons of selective credit control method include margin requirement, consumer credit regulation, credit rationing, moral suasion etc.
The selective credit control method is discriminatory in character while the central bank controls the volume of credit and currency through the quantitative credit control measures. Such are the ways through which the central bank can effectively control both inflation and deflation.
The central bank performs these functions without any profit motive and in fact, the central bank does it for the larger interest of the general public.