CENTRAL BANK
1. Definition of Central Bank
A Central Bank is the principal banking institution of a country. It operates under some degree of state control and is responsible for regulating the financial and monetary system of the country.
It is mainly responsible for maintaining economic stability, price stability, and the overall financial interests of the country.
2. Nature / Characteristics of Central Bank
The main characteristics of a Central Bank are:
1. Principal Banking Institution
The Central Bank is the principal banking institution of a country. It supervises and regulates the country's banking and monetary system.
2. State Control
A Central Bank generally operates under some degree of government or state control. The ownership and management structure may differ from country to country.
3. Economic and Price Stability
The Central Bank is responsible for maintaining economic equilibrium and stability in prices. It regulates the supply of money and credit to achieve these objectives.
4. Works in the National Interest
Unlike commercial banks, the main purpose of a Central Bank is not to earn profit. It works primarily in the overall interest of the country.
5. Reservoir of Credit
The Central Bank acts as a reservoir of credit. Commercial banks can obtain financial accommodation from it when they face financial difficulties.
3. Functions of Central Bank
The Central Bank is the pivot of the banking system. Its major functions are:
1. Issuing Notes
The Central Bank has the sole responsibility and monopoly of issuing currency notes within the country. It acts as the country's currency authority.
It regulates the supply of currency according to the needs of the economy. It can increase the money supply by issuing currency and can reduce it through the sale of government securities.
The monopoly of note issue also provides uniformity in the country's currency system.
2. Government's Banker
The Central Bank acts as the banker, financial adviser, and fiscal agent of the government.
Its duties include:
Collecting and making payments on behalf of the government.
Keeping government funds in its custody.
Managing public debt.
Providing loans to the government.
Advising the government on financial and monetary matters.
Assisting in the formulation of economic and fiscal policies.
3. Banker's Bank
The Central Bank acts as a bank for commercial banks.
Commercial banks are required to maintain a certain portion of their deposits as reserves with the Central Bank. The Central Bank also provides short-term financial assistance to commercial banks by rediscounting eligible bills and providing loans against approved securities.
Therefore, it acts as the custodian of commercial banks' reserves and their lender when necessary.
4. Management of Gold Standard
When a country's currency operates under the gold standard, the Central Bank is responsible for managing the gold reserves and maintaining exchange-rate stability.
It regulates and supervises the movement of gold.
According to the source, this function is less important in modern monetary systems.
5. Credit Control
Credit control is one of the most important functions of the Central Bank.
The Central Bank regulates the volume and flow of credit according to the needs of the economy. It uses different methods, such as:
Changing the bank rate.
Buying and selling securities.
Changing reserve requirements.
The purpose is to maintain stability in prices and economic conditions.
6. Clearing House
The Central Bank acts as a clearing house for banks.
It facilitates the settlement of cheques and other claims between commercial banks. This reduces the need for banks to make separate payments to one another.
7. Exchange Control
The Central Bank controls and regulates foreign exchange.
Its responsibilities include:
Managing foreign exchange reserves.
Buying and selling approved foreign currencies.
Maintaining exchange-rate stability.
Regulating foreign exchange transactions.
8. Lender of Last Resort
The Central Bank acts as the lender of last resort.
When a commercial bank faces serious financial difficulties and cannot obtain sufficient funds from other sources, the Central Bank may provide financial assistance.
Thus, it helps maintain confidence and stability in the banking system.
9. Custodian of National Reserves
The Central Bank acts as the custodian of the country's national reserves.
It may hold reserves in the form of:
Gold
Foreign exchange
Securities
Other official reserves
This function helps maintain the financial strength of the country.
4. Credit Control
Credit plays an important role in determining economic activity and the price level.
Therefore, the Central Bank regulates the volume and direction of credit in order to maintain economic and price stability.
Objectives of Credit Control
1. Safeguarding Gold Reserves
The Central Bank uses credit-control measures to protect the country's reserves against internal and external pressures.
2. Stability in Price Level
Credit control helps maintain stability in the general price level.
3. Exchange Stability
One objective of credit control is to maintain stability in the foreign exchange rate.
4. Stability in Investment and Production
Proper control of credit helps promote stability in investment and production by supporting stable economic conditions.
5. International Cooperation
Credit control can also contribute to cooperation with other countries in maintaining international economic stability.
5. Methods / Techniques of Credit Control
The Central Bank uses different methods to control the volume of credit. The major methods given in the source are:
1. Bank Rate Policy
Bank Rate Policy is also called Discount Rate Policy.
The bank rate is the rate of interest charged by the Central Bank when it rediscounts eligible bills of exchange or provides loans against approved securities to other banks.
Importance of Bank Rate
Changes in the bank rate influence the interest rates charged by commercial banks.
Increase in bank rate → higher interest rates → borrowing becomes more expensive → credit demand tends to decrease.
Decrease in bank rate → lower interest rates → borrowing becomes cheaper → credit demand tends to increase.
Effects of Changes in Bank Rate
a. Changes in Deposits
Changes in interest rates can affect the volume of deposits held by commercial banks.
b. Control of Borrowing
A rise in the bank rate increases borrowing costs and tends to discourage businessmen from borrowing. A fall in the bank rate encourages borrowing.
c. Changes in Prices of Shares and Securities
Changes in the bank rate can influence the market prices of shares and securities.
d. Changes in Speculative Business
A rise in the bank rate restricts credit and tends to discourage speculative activities, while easier credit conditions may encourage them.
e. Changes in Foreign Trade
Changes in the bank rate can influence the exchange rate, borrowing conditions, imports, and exports.
f. Changes in Balance of Payments
Changes in interest rates and foreign trade can affect the country's balance of payments.
2. Open Market Operations
Open Market Operations mean the buying and selling of securities by the Central Bank to influence the supply of money and credit in the economy.
When the Central Bank buys securities, money and credit in the banking system tend to increase.
When the Central Bank sells securities, money and credit tend to decrease.
This method can be used to influence monetary conditions during inflationary or deflationary situations.
3. Change in Reserve Ratio
Commercial banks are required to keep a certain percentage of their deposits as reserves with the Central Bank. This is known as the Cash Reserve Ratio (CRR).
Higher reserve ratio → banks have fewer funds available for lending → credit tends to decrease.
Lower reserve ratio → banks have more funds available for lending → credit tends to increase.
6. Clearing House
A Clearing House is an arrangement through which banks settle their mutual claims arising from cheques and other payments.
For example:
National Bank receives cheques worth Rs. 6,000 drawn on Habib Bank.
Habib Bank receives cheques worth Rs. 5,000 drawn on National Bank.
Instead of making separate payments for the full amounts, the banks can settle their obligations by paying only the net difference.
Therefore:
Rs. 6,000 − Rs. 5,000 = Rs. 1,000
The bank that owes the larger amount pays the difference.
The source states that in Pakistan, the State Bank of Pakistan performs the clearing-house function.
7. Role of Central Bank in Economic Development
The Central Bank plays an important role in the economic development of a country by regulating the monetary and banking system.
1. Capital Formation
Economic development requires sufficient capital for agriculture, industry, trade, and other productive activities.
The Central Bank helps regulate the flow of capital and credit so that financial resources can be directed toward productive sectors.
2. Credit Control
Credit is an important source of finance for trade and industry.
The Central Bank can use credit-control measures to encourage financing in particular sectors of the economy.
3. Development of Banking System
The Central Bank acts as the guardian and regulator of the banking system.
It helps promote the development and proper functioning of commercial banks.
4. Protection of Depositors' Interests
The Central Bank protects depositors' interests by supervising, regulating, and monitoring the operations of banks.
5. Stability in Prices
The Central Bank attempts to maintain price stability by regulating the supply of money and credit.
Stable prices create more predictable economic conditions for consumers, businesses, and investors.
6. Advice to the Government
The Central Bank provides advice to the government regarding economic, financial, and monetary policies.
7. Personnel Training
In some countries, the Central Bank provides training facilities and professional development opportunities for banking personnel.
Quick Revision — Central Bank
Definition
Central Bank = Principal banking institution responsible for regulating the monetary and banking system of a country.
Main Characteristics
Principal banking institution
Operates under state control
Maintains economic and price stability
Works in the national interest
Acts as a reservoir of credit
Main Functions
Issuing notes
Government's banker
Banker's bank
Management of gold standard
Credit control
Clearing house
Exchange control
Lender of last resort
Custodian of national reserves
Methods of Credit Control
Bank Rate Policy
Open Market Operations
Change in Reserve Ratio
Role in Economic Development
Capital formation
Credit control
Development of banking system
Protection of depositors
Price stability
Advice to government
Personnel training
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