Central Bank | UGC NET Economics – Notes

Introduction

• A central bank is the apex institution of a country’s monetary and financial system. It plays a leading role in organising, running, supervising and regulating the activities of commercial banks and other financial institutions in the country. The design and conduct of monetary and credit policies are its special responsibilities. Hence, the central bank plays a very important role in the balanced development of a modern economy.

What is Central Bank

• All developed and most of developing countries have a central bank. However, in most countries the central bank is a 20th century financial institution. The Bank of England, the oldest central bank in the world, was set up in 1694 as a joint stock company by an Act of Parliament. The Federal Reserve Bank in USA was established in 1913. In India, the Reserve Bank of India was set up on April 1, 1935 under the Reserve Bank of India Act, 1934.

• The central bank occupies a pivotal position in the monetary and banking structure of every country. It is the highest monetary institution and a leader of the financial system of the country. However, it is not easy to give any precise and accurate definition of central bank. The definition of a central bank is largely derived from its functions. As functions of central banks vary between countries and over time, so does the definition of a central bank.

• Different economists have defined central bank differently. In the opinion of W.A. Shah, ‘Central Bank is that bank which controls credit’ whereas Hawtrey holds the view that ‘the central bank is the lender of the last resort’. In the statutes of the Bank for International Settlements, a central bank has been defined as ‘the bank in any country to which has been entrusted the duty of regulating the volume of currency and credit in the country.’

• According to Kisch and Elkin a central bank is ‘that bank the essential duty of which is maintenance of stability of monetary standard,’. R.P. Kent has defined it as an ‘institution charged with the responsibility of managing the expansion and contraction of the volume of money in the interest of the general public welfare.’

• It is evident from all these definitions that various economists have defined central banking by laying emphasis on its different functions like control of credit, lender of the last resort, note issue, regulation of currency and credit, and stability of the value of money in the interest of general public welfare. However, we may conclude that central bank is that highest financial institution of a country whose main function is to regulate, coordinate, integrate and guide the monetary and banking structure so as to realise certain desired goals of national and public welfare.

• The banking system can work efficiently only if there is an institution at the top to direct and coordinate its activities. Failing this, the banking system would be nothing but a collection of unconnected units, each following an independent policy, often contradictory to each other. At present there is hardly any country in the world which has not set up a central bank of its own. The government seeks to influence the working and policies of the central bank directly by active participation in the formulation of broad policy framework within which the bank has to function. The government can also influence indirectly through appointment of directors, governor and other high officials of the bank.

• Distinction between a Central Bank and Commercial Banks:

  1. Where the commercial banks mainly aim to earn maximum profit for its shareholders, the prime objective of a central bank is the economic interest of the nation and not profit maximisation. The central bank aims at controlling the banking system and support economic policy of the government.

  2. The central bank is generally an organ of the government. Its actions are, therefore, closely coordinated with those of the other departments of the government, particularly with the departments of finance, industry and foreign trade. However, unless nationalised, the commercial banks are joint stock banks which are privately owned and privately managed.

  3. An important requisite of a real central bank is that it should not perform such banking transactions which are meant to be performed by commercial banks e.g., accepting deposits from general public and accommodating regular commercial customers with discounts and advances. Except under such circumstances when it becomes absolutely necessary to have direct dealing with the general public, the central bank deals with the public only indirectly through the commercial banks and money market.

  4. The central bank enjoys the monopoly power of issuing currency notes and regulating the working of the commercial banking system of the country. No such powers are vested in commercial banks; rather they operate under the supervision and within the policy framework of the central bank.

  5. Generally there are a number of commercial banks, but only one central bank in a country, the USA being an exception where there is a group of 12 Federal Reserve Banks functioning as central banks.