THEORY OF CENTRAL BANKING

Central Bank

 is a national bank that provides financial and banking services for its
country's government and commercial banking system, as well as
implementing the government's monetary policy and issuing currency.
 In modern economies, the central bank is usually responsible for the formulation of
monetary policy and the regulation of member banks.

 Central banks are inherently non-market-based or even anti-competitive institutions.

Although some are nationalized, many central banks are not government agencies, and
so are often touted as being politically independent. However, even if a central bank is
not legally owned by the government, its privileges are established and protected by
law.

 Central banks enact monetary policy, by easing or tightening the money supply and
availability of credit, central banks seek to keep a nation's economy on an even keel.
 A central bank sets requirements for the banking industry, such as the amount of cash
reserves banks must maintain vis-à-vis their deposits.
 A central bank can be a lender of last resort to troubled financial institutions and even
governments.

CENTRAL BANKING PRINCIPLE

1. Primarily meant to shoulder the responsibility of safeguarding the financial and

economic stability of the country
2. It is a reservoir of credit
3. It must follow an active policy. It cannot remain as an idle spectator during economic
crisis.
4. It is provided with special equipment. It has monopoly on currency issue, banker to
Govt. and banker to banks
5. It is independent of all political influence and it can act freely with out fear or favour in
the best interest of the nation

Functions of Central Bank

A central bank is deemed as the lender of the last resort, as per Hawtrey (a British
economist). The central bank is the organ of the government which controls major financial
operations of the government. Through its various operations, the objectives of the central
bank are to support the economic policy of a country by influencing the way financial
institutions behave. The central bank of India is RBI or Reserve bank of India and it is a
statutory bank. The primary role of RBI in India is to print currency notes and manage the
money supply in the economy of India. Let us now delve into the central bank and its
functions where we will discuss the role of the central bank in the money market:

 Regulator of Currency- The main function of the central bank is to print currency
notes and RBI has the sole right in the country for this operation. RBI prints money
of all denominations apart from 1 rupee note. It is the ministry of finance that issues
1 rupee note.
 Banker and Advisor to the Government - This role of the central bank is of a fiscal
agent to the government where the RBI keeps the deposits of both central and state
governments. It also makes payments on behalf of the government, along with
buying and selling foreign currencies. The various functions of a reserve bank as an
advisor is to tender useful suggestions to the government regarding monetary
policies and other economic matters.
 Custodian of Commercial Banks - As per law, commercial banks need to keep a
reserve that is equal to a certain percentage of the NDTL (net demand and time
liabilities). These reserves help commercial banks clear cheques by transferring
funds from one bank to another. The resee bank facilitates these transactions as it
acts as a custodian and lender of cash reserves to the commercial banks
 Custodian and Manager of Foreign Exchange Reserves - To keep the rates of foreign
exchange stable, the reserve bank buys and sells foreign currencies at international
prices. If the supply of foreign currency decreases in the economy, RBI sells them at
 foreign exchanges, and in case of surplus supply, it buys them. RBI is also an official
reservoir of foreign currencies and gold. RBI sells gold to monetary authorities of
other countries at fixed prices.
 Lender of the Last Resort - the RBI grants accommodation to commercial banks,
financial institutions, bill brokers, etc. in the form of collateral advances or re-
discounts. This step is taken in times of stress so that the financial structure of the
country is saved from collapsing. This lending is done on the basis of government
securities, treasury bills, government bonds, etc.
 Controller of Credit- The Reserve bank of India controls the credit created by
commercial banks. The credit flow in the country is regulated by means of two
methods; quantitative method and qualitative method. RBI applies tight monetary
policies when it observes that there is enough supply of money which may cause an
inflationary situation. It squeezes the money supply to keep inflation in check.
 Clearing House: The central bank is a banker’s bank that keeps the cash balances of
commercial banks and helps the member banks. It is also responsible for settling the
accounts of commercial banks. Its function is that of a clearing house, an organization
where the banks can offset the mutual claims against one another and make a
settlement by paying the difference.
Let us understand this through an example –
Suppose there are two banks. They draw cheques on each other. Suppose bank A has
Rs. 10,000 from Bank B and is obligated to pay Rs. 12,000 to Bank B. At the clearing
house, they can offset the mutual claims, where bank A pays off Rs. 2,000 to bank B,
and the account is settled. The central bank’s clearinghouse contributes to the
economy through cash, avoiding hectic communications and inconvenience.
 Other Functions:-The Reserve Bank performs a number of other developmental works.
These works include the function of clearinghouse arranging credit for agriculture (which
has been transferred to NABARD) collecting and publishing the economic data, buying
and selling of Government securities (gilt edge, treasury bills etc) and trade bills, giving
loans to the Government buying and selling of valuable commodities etc. It also acts as
the representative of the Government in the International Monetary Fund (I.M.F.) and
represents the membership of India.
Role of RBI in Economy Development

1. Monetary Policy: The RBI formulates and implements monetary policy in India, which
aims to maintain price stability while supporting economic growth. By regulating key
monetary variables such as interest rates, money supply, and inflation, the RBI influences
the overall macroeconomic environment, which can impact investment, savings,
consumption, and business decisions, thereby contributing to economic development.

2. Banking Regulation and Supervision: The RBI regulates and supervises banks and
financial institutions in India to ensure their stability, soundness, and efficiency. It sets
prudential norms, conducts inspections, and monitors financial institutions to maintain
the stability of the financial system, promote transparency, and protect the interests of
depositors and investors. A stable and healthy banking sector is essential for mobilizing
savings, facilitating credit flow, and supporting economic growth.

3. Foreign Exchange Management: The RBI manages the foreign exchange reserves of
India and formulates policies related to foreign exchange management. It regulates and
controls foreign exchange transactions, manages the exchange rate, and formulates
policies to promote external trade and investment. This helps in maintaining stability in
the external sector, facilitating international trade, and attracting foreign investment,
which can contribute to economic development.

4. Payment and Settlement Systems: The RBI regulates and oversees payment and
settlement systems in India, including interbank transfers, electronic fund transfers, and
clearing and settlement of financial transactions. It ensures the safety, efficiency, and
integrity of payment systems, which are critical for facilitating transactions, promoting
economic activities, and supporting financial inclusion.

5. Developmental and Promotional Functions: The RBI undertakes various developmental

and promotional functions aimed at fostering economic development. This includes
providing credit to priority sectors such as agriculture, small and medium enterprises
(SMEs), and housing through policy measures and refinances facilities. The RBI also
 promotes financial inclusion, financial literacy, and consumer protection initiatives to
ensure that a larger section of the population has access to financial services and can
participate in the formal financial system.

6. Regulatory Framework and Policy Formulation: The RBI plays a significant role in
formulating and implementing regulatory frameworks and policies related to banking,
finance, and monetary matters. It formulates regulations, guidelines, and policies to
ensure financial stability, safeguard the interests of consumers and investors, and promote
a conductive environment for economic development.

7. Research and Data Analysis: The RBI conducts research and analysis related to
macroeconomic trends, financial stability, and monetary policy. It generates economic
data and disseminates information, which helps in informed decision-making by
policymakers, market participants, and other stakeholders. This contributes to evidence-
based policymaking, which can have a positive impact on economic development.

In summary, the RBI plays a critical role in India's economic development through its functions
and responsibilities related to monetary policy, banking regulation and supervision, foreign
exchange management, payment and settlement systems, developmental and promotional
functions, regulatory framework and policy formulation, as well as research and data analysis.
The RBI's efforts aim to maintain macroeconomic stability, foster a stable and efficient financial
system, promote financial inclusion, and support economic growth and development in India.