Functions of a Central Bank (Traditional and Development Functions)

It is now considered essential for every country to have a Central Bank.

The banking system of a country without a Central Bank at the top is like a human body without a head.

A Central Bank performs many important and essential functions, which are described below:

1. Traditional Functions:

Monopoly of Note-Issue:

Formerly, in certain countries like the U.K., even ordinary banks used to issue notes. This resulted in uncontrolled confusion. Hence gradually the right of note-issue was withdrawn from other banks and conferred on the Central Bank. Thus, note-issue became the sole privilege of the Central Bank in a country and its notes became full legal tender.

In issuing notes, the Central Bank has to follow rules laid down by law. It has compulsorily to maintain reserves of gold, silver, and selected securities in fixed proportions to inspire confidence among the people in the paper currency to maintain its internal and external value.

The system of note-issue differs from country to country and is governed by its peculiar circumstances. Thus in India, the Reserve Bank of India (RBI) which is its central bank, is now (since October, 1957) required to keep a minimum reserve of Rs. 200 crores, of which not less than Rs. 115 crores must be in gold.

Government Banker:

Previously Governments in a country had to maintain a large number of treasuries all over the country. Now their funds are kept with the Central Bank free of interest. This is a privilege for the Bank as well as a responsibility. It receives payment on behalf of the government and also makes payments on its behalf.

A Central Bank is required to lend money to Central and State governments when called upon to do so. Taxes flow to Government only in certain parts of year, while funds are wanted at all times. Hence, Government borrows temporarily from the-Central Bank in times of need.

These loans are called “ways and means advances”. Besides these, all other government loans, temporary (like treasury bills) and permanent, are floated through the Central Bank. In addition, it remits government funds, purchases foreign currencies, as well as manages the public debt. It also acts as the financial adviser of the government. The Reserve Bank of India performs all these functions for the Central and State Governments in India.

Bankers’ Bank:

All other banks in the country are bound either by law or by convention to keep a certain proportion of their total deposits as reserve with me Central Bank. These reserves help the Central Bank to control the issue of credit by commercial banks. They also keep their spare cash with the Central Bank on which they draw as and when needed. This is how the Central Bank serves as a bankers’ bank.

Lender of Last Resort:

The other banks in the country depend upon the Central Bank for support in times of emergency. This help may be in the form of a loan on the security of approved securities or through a rediscount of bills of exchange. The Central Bank is thus the “lender of last resort” for other banks in difficult times, because on such occasions, there is no hope of getting help from any competing institution.

To turn to India:

Here the scheduled, banks have to keep in deposit as reserve with the Reserve Bank of India not less than 3 per cent of their total deposit liabilities. In return, they enjoy the privilege of rediscounting their paper with the Reserve Bank as well as securing loans against approved securities when in need.

Control of Credit:

Perhaps the most important function of a Central Bank today is the control of credit, i.e., regulating the volume and direction of bank loans. On the volume of credit depends largely the level of employment and the level of prices in the country? (In view of the importance of credit control, it is discussed in detail below in a separate section.)

Maintenance of Exchange Rate:

Another very important function of a Central Bank is to keep stable the external value of the home currency. A stable exchange rate is necessary to maintain and promote a country’s foreign trade and to encourage the inflow of foreign investments, which is so essential for accelerating the pace of economic growth, particularly in the under-developed countries.

In order to maintain the rate of exchange stable, a Central Bank is always prepared to buy and sell foreign currencies at the rates fixed by it. However, when the cost-price situation in the country as also the balance of payments position, undergo a substantial change, the old rate of exchange may have to be changed.

Custodian of National Reserves:

It is the Central Bank which serves as the custodian of nation’s reserves of gold and international currency. It is its duty to take appropriate measures to safeguard these reserves.

Provision of Clearing House Facilities:

The Central Bank performs the duty of a Clearing House for cheques. It settles the accounts of commercial banks and enables them to clear their dues by the process of book entries. It should be carefully noted that a Central Bank does not come in competition with other banks. That is why it does not pay interest on the money kept with it.

If it is a government-owned institution, it pays no dividends and if a private one, it distributes low dividends, and hands over extra profits to the government. The Reserve Bank of India is now a government-owned bank and whatever be its profits, they go to the government treasury.

2. Developmental Functions:

Additional Functions in Under-developed Countries:

Above have been given what are known as the traditional functions of a Central Bank. In the advanced countries, it is these functions which their Central Banks have been performing. Largely these functions are regulatory in nature.

In the under-developed countries, whose main concern is the quick 428 Elementary Economic Theory development of their economic potentials, are Central banks have a very important role to play, which is not merely regulatory to maintain stability, but developmental and promotional.

The main task of Central Banks in such countries is to bring about a rapid expansion of banking facilities and also to make adequate funds available to finance development programmes in respect of agriculture, trade, transport and industry, and to create specialized financial institutions for the purpose.