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Book Name – Macroeconomics (HL Ahuja)
What’s Inside the Chapter? (After Subscription)
1. INTRODUCTION
2. THE PRINCIPLES OF CENTRAL BANKING
3. FUNCTIONS OF CENTRAL BANK
3.1. Note Issuing Agency
3.2. Banker to the Government
3.3. Bankers’ Bank
3.4. Control of Credit
3.5. Lender of the Last Resort
3.6. To Promote Economic Growth
3.7. Managing Exchange Rate of the National Currency
4. METHODS OF CREDIT CONTROL
4.1. Bank Rate Policy
4.2. Open Market Operations
4.3. Changing the Cash Reserve Ratio (CRR)
5. SELECTIVE CREDIT CONTROLS
5.1. Conditions Necessary for Success of Selective Credit Controls
5.2. Moral Suasion
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Central Banking
Chapter – 19
INTRODUCTION
The central bank is the apex monetary authority that regulates and supervises the functioning of commercial banks within a country’s financial system.
In India, the central bank is the Reserve Bank of India, established in 1935, which oversees monetary stability and banking operations.
Commercial banks operate under the fractional reserve system, keeping only a fraction of deposits as cash and lending the rest to traders and investors.
Because banks hold limited cash reserves, they may face difficulties during sudden mass withdrawals, creating the need for a central authority to provide emergency support.
The central bank acts as a lender of last resort, supplying funds to commercial banks during crises to maintain public confidence and financial stability.
In modern times, the central bank also regulates the cost and availability of credit and controls the growth of money supply to ensure economic stability.
THE PRINCIPLES OF CENTRAL BANKING
The central bank holds a special position in the banking structure and operates on principles different from ordinary profit-oriented commercial banks.
Unlike commercial banks, which aim to maximise profits, a central bank functions in the public interest, focusing on financial stability, economic welfare, and national development.
Profit earning is only a secondary objective; the central bank is not a competitor to other banks but the monetary authority guiding and regulating them.
The Reserve Bank of India performs expanded roles, including regulation of credit and money supply, promotion of economic development, and maintenance of price stability.
Its policies and instruments are guided by national economic objectives set by the Government and planning authorities, ensuring alignment with overall economic policy.
FUNCTIONS OF CENTRAL BANK
The following are the main functions of a central bank :
- It acts as a note issuing agency.
- It acts as the banker to the state.
- It acts as the bankers’ bank.
- It controls credit.
- It acts as the lender of the last resort.
- It manages exchange rate.
Note Issuing Agency
The central bank has the monopoly of issuing paper currency, enabling it to control the supply of money in the economy.
In India, the Reserve Bank of India issues all currency notes except one-rupee notes, which are issued by the Ministry of Finance.
Earlier, central banks maintained gold and foreign exchange reserves against note issuance under the proportional reserve system, where a fixed percentage (e.g., 40% in India before 1956) backed the currency.
Modern paper currency is inconvertible into gold or precious metals, and its value depends on purchasing power rather than metallic backing.
Since 1956, India follows the minimum reserve system, under which the RBI maintains only a minimum reserve in gold and foreign exchange and can issue currency according to economic needs.
The real value and credibility of a currency depend on its stability and ability to purchase goods and services, not on the quantity of gold reserves.
Effective monetary control and maintenance of price stability are essential to sustain public confidence in a country’s currency.
Banker to the Government
The central bank acts as the banker to the Government, maintaining all government balances and conducting receipts and payments on its behalf.
It pays no interest on government deposits but provides essential banking services, including fund transfers and financial management.
The central bank manages the public debt, arranges the issue of new government loans, and supports borrowing programmes.
It provides short-term credit to the Government by discounting treasury bills directly or through commercial banks.
As the Government’s fiscal agent and adviser, the central bank offers guidance on currency, exchange, and financial matters.
Bankers’ Bank
The central bank acts as a bankers’ bank by holding cash reserves of commercial banks, providing emergency lending, and facilitating clearing and settlement among banks.
Commercial banks are legally required to keep a fixed portion of their deposits as reserves with the central bank, enabling control over credit expansion and ensuring financial stability.
As the lender of last resort, the central bank provides loans or rediscounts bills for banks facing liquidity shortages, offering support when no other institution can help.
In India, scheduled banks must maintain minimum reserves with the Reserve Bank, and in return they can rediscount bills and obtain loans against approved securities during financial stress.
The central bank performs clearing and settlement by adjusting debits and credits in its books, allowing interbank payments to be settled efficiently.
If a bank’s clearing position reduces its reserves below the required level, it must restore the deficiency to maintain compliance and stability.