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Essay on Central Bank | Banking

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In this essay we will discuss about central bank. After reading this essay you will learn about: 1. Essay on the Definition of a Central Bank 2. Essay on the Functions of a Central Bank 3. Essay on the Objectives of Credit Control by the Central Bank 4. Essay on the Role of Central Bank in a Developing Economy 5. Essay on the Need for Central Bank.

Essay Contents:

  1. Essay on the Definition of a Central Bank
  2. Essay on the Functions of a Central Bank
  3. Essay on the Objectives of Credit Control by the Central Bank
  4. Essay on the Role of Central Bank in a Developing Economy
  5. Essay on the Need for Central Bank


1. Essay on the Definition of a Central Bank:

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A central bank has been defined in terms of its functions. According to Vera Smith, “The primary definition of central banking is a banking system in which a single bank has either complete control or a residuary monopoly of note issue.” W.A. Shaw defines a central bank as a bank which control credit. To Hawtrey, a central bank is that which is the lender of the last resort. According to A.C.L. Day, a central bank is “to help control and stabilise the monetary and banking system.”

According to Sayers, the central bank “is the organ of government that undertakes the major financial operations of the government and by its conduct of these operations and by other means, influences the behaviour of financial institutions so as to support the economic policy of the Government.” Sayers refers only to the nature of the central bank as the government’s bank. All these definitions are narrow because they refer only to one particular function of a central bank.

On the other hand, Samuelson’s definition is wide. According to him, a central bank “is a bank of bankers. Its duty is to control the monetary base…. and through control of this ‘high-powered money’ to control the community’s supply of money.” But the broadest definition has been given by De Kock.

In his words, a central bank is “a bank which constitutes the apex of the monetary and banking structure of its country and which performs as best as it can in the national economic interest, the following functions:

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(i) The regulation of currency in accordance with the requirements of business and the general public for which purpose it is granted either the sole right of note issue or at least a partial monopoly thereof,

(ii) The performance of general banking and agency for the state,

(iii) The custody of the cash reserves of the commercial banks,

(iv) The custody and management of the nation’s reserves of international currency,

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(v) The granting of accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and dealers, or other financial institutions and the general acceptance of the responsibility of lender of the last resort,

(vi) The settlement of clearance balances between the banks,

(vii) The control of credit in accordance with the needs of business and with a view to carrying out the broad monetary policy adopted by the state.” De Kock’s definition is too long to be called a definition. For, a definition must be brief.


2. Essay on the Functions of Central Bank:

A central bank performs the following functions, as given by De Kock and accepted by the majority of economists:

1. Regulator of currency:

The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the government mint but they are put into circulation through the central bank.

Central banks have been following different methods of note issue in different countries. The centred bank is required by law to keep a certain amount of gold and foreign securities against the issue of notes. In some countries, the amount of gold and foreign securities bears a fixed proportion, between 25 to 40 per cent of the total notes issued.

In other countries, a minimum fixed amount of gold and foreign currencies is required to be kept against note issue by the central bank. This system is operative in India whereby the Reserve Bank of India is required to keep Rs115crores in gold and Rs85crores in foreign securities. There is no limit to the issue of notes after keeping this minimum amount of Rs200crores in gold and foreign securities.

The monopoly of issuing notes vested in the central bank ensures uniformity in the notes issued which helps in facilitating exchange and trade within the country. It brings stability in the monetary system and creates confidence among the public.

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The central bank can restrict or expand the supply of cash according to the requirements of the economy. Thus it provides elasticity to the monetary system. By having a monopoly of note issue, the central bank also controls the banking system by being the ultimate source of cash. Last but not the least, by entrusting the monopoly of note issue to the central bank, the government is able to earn profits from printing notes whose cost is very low as compared with their face value.

2. Banker, fiscal agent and adviser to the government:

Central banks everywhere act as bankers, fiscal agents and advisers to their respective governments. As banker to the government, the central bank keeps the deposits of the central and state governments and makes payments on behalf of governments. But it does not pay interest on governments deposits. It buys and sells foreign currencies on behalf of the government., It keeps the stock of gold of the government.

Thus it is the custodian of government money and wealth. As a fiscal agent, the central bank makes short-term loans to the government for a period not exceeding 90 days. It floats loans, pays interest on them, and finally repays them on behalf of the government. Thus it manages the entire public debt.

The central bank also advises the government on such economic and money matters as controlling inflation or deflation, devaluation or revaluation of the currency, deficit financing, balance of payments, etc. As pointed out by De Kock, “Central banks everywhere operate as bankers to the state not only because it may be more convenient and economical to the state, but also because of the intimate connection between public finance and monetary affairs.”

3. Custodian of cash reserves of commercial banks:

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Commercial banks are required by law to keep reserves equal to a certain percentage of both time and demand deposits liabilities with the central banks. It is on the basis of these reserves that the central bank transfers funds from one bank to another to facilitate the clearing of cheques. Thus the central bank acts as the custodian of the cash reserves of commercial banks and helps in facilitating their transactions.

There are many advantages of keeping the cash reserves of the commercial banks with the central bank, according to De Kock.

In the first place, the centralisation of cash reserves in the central bank is a source of great strength to the banking system of a country.

Secondly, centralised cash reserves can serve as the basis of a large and more elastic credit structure than if the same amount were scattered among the individual banks.

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Thirdly, centralised cash reserves can be utilised fully and most effectively during periods of seasonal strains and in financial crises or emergencies.

Fourthly, by varying these cash reserves the central bank can control the credit creation by commercial banks. Lastly, the central bank can provide additional funds on a temporary and short term basis to commercial banks to overcome their financial difficulties.

4. Custody and management of foreign exchange reserves:

The central bank keeps and manages the foreign exchange reserves of the country. It is an official reservoir of gold and foreign currencies. It sells gold at fixed prices to the monetary authorities of other countries. It also buys and sells foreign currencies at international prices. Further, it fixes the exchange rates of the domestic currency in terms of foreign currencies.

It holds these rates within narrow limits in keeping with its obligations as a member of the International Monetary Fund and tries to bring stability in foreign exchange rates. Further, it manages exchange control operations by supplying foreign currencies to importers and persons visiting foreign countries on business, studies, etc. in keeping with the rules laid down by the government.

5. Lender of the last resort:

De Kock regards this function as a sine qua non of central banking. By granting accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and dealers, or other financial institutions, the central bank acts as the lender of the last resort. The central bank lends to such institutions in order to help them in times of stress so as to save the financial structure of the country from collapse.

It acts as lender of the last resort through discount house on the basis of treasury bills, government securities and bonds at “the front door”. The other method is to give temporary accommodation to the commercial banks or discount houses directly through the “back door”.

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The difference between the two methods is that lending at the front door is at the bank rate and in the second case at the market rate. Thus the central bank as lender of the last resort is a big source of cash and also influences prices and market rates,

6. Clearing house for transfer and settlement:

As bankers’ bank, the central bank acts as a clearing house for transfer and settlement of mutual claims of commercial banks. Since the central bank holds reserves of commercial banks, it transfers funds from one bank to other banks to facilitate clearing of cheques.

This is done by making transfer entries in their accounts on the principle of book-keeping. To transfer and settle claims of one bank upon others, the central bank operates a separate department in big cities and trade centres. This department is known as the “clearing house” and it renders the service free to commercial banks.

When the central bank acts as a clearing agency, it is time-saving and convenient for the commercial banks to settle their claims at one place. It also economises the use of money. “It is not only a means of economising cash and capital but is also a means of testing at any time the degree of liquidity which the community is maintaining.”

7. Controller of credit:

The most important function of the central bank is to control the credit creation power of commercial bank in order to control inflationary and deflationary pressures within this economy. For this purpose, it adopts quantitative methods and qualitative methods.

Quantitative methods aim at controlling the cost and quantity of credit by adopting bank rate policy, open market operations, and by variations in reserve ratios of commercial banks. Qualitative methods control the use and direction of credit. These involve selective credit controls and direct action. By adopting such methods, the central bank tries to influence and control credit creation by commercial banks in order to stabilise economic activity in the country.

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Besides the above noted functions, the central banks in a number of developing countries have been entrusted with the responsibility of developing a strong banking system to meet the expanding requirements of agriculture, industry, trade and commerce. Accordingly, the central banks possess some additional powers of supervision and control over the commercial banks.

They are the issuing of licences; the regulation of branch expansion; to see that every bank maintains the minimum paid up capital and reserves as provided by law; inspecting or auditing the accounts of banks; to approve the appointment of chairmen and directors of such banks in accordance with the rules and qualifications; to control and recommend merger of weak banks in order to avoid their failures and to protect the interest of depositors; to recommend nationalisation of certain banks to the government in public interest; to publish periodical reports relating to different aspects of monetary and economic policies for the benefit of banks and the public; and to engage in research and train banking personnel etc.


3. Essay on the Objectives of Credit Control by the Central Bank:

Credit control is the means to control the lending policy of commercial banks by the central bank.

The central bank controls credit to achieve the following objectives:

1. To stabilise the internal price level:

One of the objective of controlling credit is to stabilise the price level in the country. Frequent changes in prices adversely affect the economy. Inflationary or deflationary trends need to be prevented. This can be achieved by adopting a judicious policy of credit control.

2. To stabilise the rate of foreign exchange:

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With the change in the internal prices level, exports and imports of the country are affected. When prices fall, exports increase and imports decline. Consequently, the demand for domestic currency increases in the foreign market and its exchange rate rises. On the contrary, a rise in domestic prices leads to a decline in exports and an increase in imports.

As a result, the demand for foreign currency increases and that of domestic currency falls, thereby lowering the exchange rate of the domestic currency. Since it is the volume of credit money that affects prices, the central bank can stabilise the rate of foreign exchange by controlling bank credit.

3. To protect the outflow of gold:

The central bank holds the gold reserves of the country in its vaults. Expansion of bank credit leads to rise in prices which reduce exports and increase imports, thereby creating an unfavourable balance of payments. This necessitates the export of gold to other countries. The central bank has to control credit in order to prevent such outflows of gold to other countries.

4. To control business cycles:

Business cycles are a common phenomenon of capitalist countries which lead to periodic fluctuations in production, employment and prices. They are characterised by alternating periods of prosperity and depression. During prosperity, there is large expansion in the volume of credit, and production, employment and prices rise.

During depression, credit contracts, and production, employment and prices fall. The central bank can counteract such cyclical fluctuations through contraction of bank credit during boom periods, and expansion of bank credit during depression.

5. To meet business needs:

According to Burgess, one of the important objectives of credit control is the “adjustment of the volume of credit to the volume of business.” Credit is needed to meet the requirements of trade and industry. As business expands, larger quantity of credit is needed, and when business contracts less credit is needed. Therefore, it is the central bank which can meet the requirements of business by controlling credit.

6. To have growth with stability:

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In recent years, the principal objective of credit control is to have growth with stability. The other objectives, such as price stability, foreign exchange rate stability, etc., are regarded as secondary. The aim of credit control is to help in achieving full employment and accelerated growth with stability in the economy without inflationary pressures and balance of payments deficits.


4. Essay on the Role of Central Bank in a Developing Economy:

The central bank in a developing economy performs both traditional and non-traditional functions. The principal traditional functions performed by it are the monopoly of note issue, banker to the government, bankers’ bank, lender of the last resort, controller of credit and maintaining stable exchange rate. But all these functions are related to the foremost function of helping in the economic development of the country.

The central bank in a developing country aims at the promotion and maintenance of a rising level of production, employment and real income in the country. The central banks in the majority of underdeveloped countries have been given wide powers to promote the growth of such economies.

They, therefore, perform the following functions towards this end:

Creation and expansion of financial institutions:

One of the aims of a central bank in an underdeveloped country is to improve its currency and credit system. More banks and financial institutions are required to be set up to provide larger credit facilities and to divert voluntary savings into productive channels. Financial institutions are localised in big cities in underdeveloped countries and provide credit facilities to estates, plantations, big industrial and commercial houses.

In order to remedy this, the central bank should extend branch banking to rural areas to make credit available to peasants, small businessmen and traders. In underdeveloped countries, the commercial banks provide only short-term loans. Credit facilities in rural areas are mostly non-existent.

The only source is the village moneylender who charges exorbitant interest rates. The hold of the village moneylender in rural areas can be slackened if new institutional arrangements are made by the central bank in providing short-term, medium term and long-term credit at lower interest rates to the cultivators.

A network of co-operative credit societies with apex banks financed by the central bank can help solve the problem. Similarly, it can help the establishment of lead banks and through them regional rural banks for providing credit facilities to marginal farmers, landless agricultural workers and other weaker sections.

With the vast resources at its command, the central bank can also help in establishing industrial banks and financial corporations in order to finance large and small industries.

Proper adjustment between demand for and supply of money:

The central bank plays an important role in bringing about a proper adjustment between demand for and supply of money. An imbalance between the two is reflected in the price level. A shortage of money supply will inhibit growth while an excess of it will lead to inflation. As the economy develops, the demand for money is likely to go up due to gradual monetization of the non-monetized sector and the increase in agricultural and industrial production and prices.

The demand for money for transactions and speculative motives will also rise. So the increase in money supply will have to be more than proportionate to the increase in the demand for money in order to avoid inflation. There is, however, the likelihood of increased money supply being used for speculative purposes, thereby inhibiting growth and causing inflation.

The central bank controls the uses of money and credit by an appropriate monetary policy. Thus in an underdeveloped economy, the central bank should control the supply of money in such a way that the price level is prevented from rising without affecting investment and production adversely.

A suitable interest rate policy:

In an underdeveloped country the interest rate structure stands at a very high level. There are also vast disparities between long-term and short-term interest rates and between interest rates in different sectors of the economy. The existence of high interest rates acts as an obstacle to the growth of both private and public investment, in an underdeveloped economy. A low interest rate is, therefore, essential for encouraging private investment in agriculture and industry.

Since in an underdeveloped country businessmen have little savings out of undistributed profits, they have to borrow from the banks or from the capital market for purposes of investment and they would borrow only if the interest rate is low.

A low interest rate policy is also essential for encouraging public investment. A low interest rate policy is a cheap money policy. It makes public borrowing cheap, keeps the cost of servicing public debt low, and thus helps in financing economic development.

In order to discourage the flow of resources into speculative borrowing and investment, the central bank should follow a policy of discriminatory interest rates, charging high rates for non-essential and unproductive loans and low rates for productive loans.

But this does not imply that savings are interest-elastic in an underdeveloped economy. Since the level of income is low in such economies, a high rate of interest is not likely to raise the propensity to save.

In the context of economic growth, as the economy develops, a progressive rise in the price level is inevitable. The value of money falls and the propensity to save declines further. Money conditions become tight and there is a tendency for the rate of interest to rise automatically. This would result in inflation. In such a situation any effort to control inflation by raising the rate of interest would be disastrous. A stable price level is, therefore, essential for the success of a low interest rate policy which can be maintained by following a judicious monetary policy by the central bank.

Debt management:

Debt management is one of the important functions of the central bank in an underdeveloped country. It should aim at proper timing and issuing of government bonds, stabilizing their prices and minimizing the cost of servicing public debt. It is the central bank which undertakes the selling and buying of government bonds and making timely changes in the structure and composition of public debt.

In order to strengthen and stabilize the market for government bonds, the policy of low interest rates is essential. For, a low rate of interest raises the price of government bonds, thereby making them more attractive to the public and giving an impetus to the public borrowing programmes of the government.

The maintenance of structure of low interest rates is also called for minimizing the cost of servicing the national debt. Further, it encourages funding of debt by private firms. However, the success of debt management would depend upon the existence of well-developed money and capital markets in which wide range of securities exist both for short and long periods. It is the central bank which can help in the development of these markets.

Credit control:

Central Bank should also aim at controlling credit in order to influence the patterns of investment and production in a developing economy. Its main objective is to control inflationary pressures arising in the process of development. This requires the use of both quantitative and qualitative methods of credit control.

Open market operations are not successful in controlling inflation in underdeveloped countries because the bill market is small and undeveloped. Commercial banks keep an elastic cash-deposit ratio because the central bank’s control over them is not complete. They are also reluctant to invest in government securities due to their relatively low interest rates.

Moreover, instead of investing in government securities, they prefer to keep their reserves in liquid form such as gold, foreign exchange and cash. Commercial banks are also not in the habit of rediscounting or borrowing from the central bank.

The bank rate policy is also not so effective in controlling credit in LDCs due to:

(a) The lack of bills of discount;

(b) The narrow size of the bill market;

(c) A large non-monetized sector where barter transactions take place;

(d) The existence of a large unorganised money market;

(e) The existence of indigenous banks which do not discount bills with the central banks; and

(f) The habit of commercial banks to keep large cash reserves.

The use of variable reserve ratio as method of credit control is more effective than open market operations and bank rate policy in LDCs. Since the market for securities is very small, open market operations are not successful. But a rise or fall in the reserve ratio by the central bank reduces or increases the cash available with the commercial banks without affecting adversely the prices of securities. Again, the commercial banks keep large cash reserves which cannot be reduced by a raise in the bank rate or sale of securities by the central bank.

But raising the cash-reserve ratio reduces liquidity with the banks. However, the use of variable reserve ratio has certain limitations in LDCs. First, the non-banking financial intermediaries do not keep deposits with the central bank so they are not affected by it. Second, banks which do not maintain excess liquidity are not affected than those who maintain it.

The qualitative credit control measures are, however, more effective than the quantitative measures in influencing the allocation of credit, and thereby the pattern of investment. In underdeveloped countries, there is a strong tendency to invest in gold, jewellery, inventories, real estate, etc., instead of in alternative productive channels available in agriculture, mining, plantations and industry.

The selective credit controls are more appropriate for controlling and limiting credit facilitates for such unproductive purposes. They are beneficial in controlling speculative activities in food grains and raw materials. They prove more useful in controlling ‘sectional inflations’ in the economy. They curtail the demand for imports by making it obligatory on importers to deposit in advance an amount equal to the value of foreign currency.

This has also the effect of reducing the reserves of the banks in so far as their deposits are transferred to the central banks in the process. The selective credit control measures may take the form of changing the margin requirements against certain types of collateral, the regulation of consumer credit and the rationing of credit.

Solving the balance of payments problem:

The central bank should also aim at preventing and solving the balance of payments problem in a developing economy. Such economies face serious balance of payments difficulties to fulfill the targets of development plans. An imbalance is created between imports and exports which continues to widen with development.

The central bank manages and controls the foreign exchange of the country and also acts as the technical adviser to the government on foreign exchange policy. It is the function of the central bank to avoid fluctuations in the foreign exchange rates and to maintain stability. It does so through exchange controls and variations in the bank rate. For instance, if the value of the national currency continues to fall, it may raise the bank rate and thus encourage the inflow of foreign currencies.


5. Essay on the Need for Central Bank:

It is widely recognised that the central bank is a valuable and indispensable institution for the proper functioning of a modern economy. But, there is a difference of opinion regarding the necessity and usefulness of the central bank in economically backward countries having underdeveloped money markets.

Some people argue that the central bank is not necessary in such countries for various reasons: such as the absence of well-organised banking institutions over which the central bank exercises its supervision and control, the absence of short-term money markets and of well-developed bill markets to enable the central bank to perform the rediscounting operations properly, the fear of political pressure of the governments of these countries over the normal working of the central bank, and others. For all these reasons it is argued that the central bank in the under-developed countries cannot execute its monetary policy and control-techniques properly and effectively.

But, the fact remains that the central bank is as indispensable in the underdeveloped countries as it is in the developed countries.

For this reason it is now established that every country, whether developed or underdevel­oped, must set up a central bank for the following reasons:

(a) Economic stability:

The central bank is indispensable for maintaining stability in the economy of a country. It can maintain both price and foreign exchange stability through the exercise of proper and effective control over the country’s total money supply.

Such economic stability is as essential for underdeveloped countries as for developed ones, for promoting rapid economic growth. No other institutions except the central bank is competent enough to maintain this overall economic stability.

(b) Control over bank credit:

The central bank is necessary to exercise a judicious control over bank credit. As bank credit constitutes the most important component of the money supply, its supply is to be properly regulated in time for avoiding instability in the price-level and for regulating its supply in accordance with the country’s requirements.

(c) Control and supervision over the activities of other banks:

The central bank of a country can develop the banking system by exercising proper control and supervision over the operations of other banks. In the absence of the central bank, it becomes a difficult task to bring about proper co-ordination among the banks and to develop these institutions along a sound line.

(d) Proper execution of the monetary policy:

The central bank is the leader of the money market of a country. Therefore, its existence is of utmost importance for pursuing the country’s monetary (credit) policy.

(e) Special role of the central bank in a developing economy:

The central bank has a special role to play in a developing economy in promoting economic growth with stability, in providing special finance for agriculture, industry and other top priority sectors.

(f) Foreign exchange regulations and international dealings:

Every country, whether a developed or an underdeveloped one, must have a monetary institution like the central bank for foreign exchange regulations Sid for dealing with international institutions like the International Mone­tary Fund and the Bank for International Settlements. When the gold standard was in existence, it had some special importance.

(g) Control over the money supply:

The central bank is also necessary for the control over the money supply and for the regulation of the country s interest rates. For this reason the central bank enjoys the monopoly power regarding the issue of paper notes, and its rate of interest (i.e., the bank rate) acts as the pace-setter to other rates such as market rates of interest.

Conclusion:

The above description shows that every country, whether a developed or an underdeveloped one, must set up a Central Bank of its own.


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