Central Bank

Definition

• The bank which is responsible for the financial

and economical stability of country.
• It has a pivotal position in the banking system
and regulates and formulates policies for the
scheduled commercial banks in the country.
Origin and growth

• The bank of England came into being as first

ever central bank in 1694.
• The central bank includes the issue of currency
notes.
• But at later stages it was entrusted with other
crucial functions like credit control, clearing
house, management of public debts.
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• Now a central bank has become a must for

every country and its economy.
• It controls other banks, inflation and formulates its
economic and fiscal policies and advises the
government on foreign trade, development of
financial and capital market, balance of trade,
foreign aids etc.
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• The world bank (IBRD) and international monetary

funds (IMF) have their full control over all central
banks, especially those in the Third World countries.
• Every country, being the member of the UN, has no
option except to follow the dictates of the IMF and
the World Bank.
Functions of Central Bank

• Central bank can be placed in two broad

categories.
• 1- Government’s bank

• 2- Banker’s bank
1- Government’s Bank

• 1 Monopoly of note issue

• 2 Controller of credit

• 3 Custodian of foreign exchange

• 4Issue and management of public debts 5-

• Development of financial institutions

1- Monopoly of note issue

• Issue currency notes for the country.

• Notes are issued on certain principal including a

fixed ratio of a reserve of gold, silver and approved
foreign exchange.
2- Controller of credit
• The central bank controls and regulates
credit money in the country in order to expand or
contract it to maintain the requirement of
economy.
• It controls:

• Bank rate policy

• Open market operation

• Bank reserve ratio

3- Custodian of foreign exchange

• Every country exports goods and services to

earn profit.
• This earned and other foreign exchange is held in
the custody of the central bank
4-Issue and management of public debts

• Central bank manage issue of debts, payment of

interest and retirement.
• Pay annual interest and return the principal
amount on maturity.
5-Development of financial institutions

• Central bank is responsible to develop financial

institution which play vital role in industrial,
agriculture and capital development of economy.
• It also facilitates the establishment and running of
money market and stock exchange.
2- Banker’s bank

• Capacity to performs valuable services to its

scheduled commercial banks.
• 1- Lender of last resort

• 2- Rediscounting bill of exchange

• 3- Clearing housing services

• 4- Cash reserve

• 5- Counseling services
1- Lender of last resort

• The central bank provides loan to the bank in crises

to enable it to discharge its obligation and thus
prevents it to go bankrupt.
2- Rediscounting bill of exchange
3- Clearing housing services

• Every bank receives cheques drawn on other

bank, because of which every bank becomes
creditor or debtor of other banks.
• All these cheques are sent to the central bank
where it settles all the accounts of the bank.
• Clearing services is possible because the
central bank possess cash reserver of
commercial bank.
4- Cash reserve

• Every bank is bound to deposited a certain

percentage of all its deposits with the central
bank
• In this manner central bank finds itself in better
position to control credit money.
5- Counseling services

• The central bank offers advice and counseling

services in the light of experts and advice
commercial banks to formulates and readjust their
polices.
Advantages

• Money supply is in complete control of the

central bank.
• The currency system become uniform

• The system enjoys complete confidence of

public which is necessary for the success of
currency.
Method of issuing currency

• Minimum reserve system

• Fixed fiduciary system

• Proportional reserve system

• Simple deposit method

Minimum reserve system

• Certain level of gold reserve is fixed against

which any amount of currency can be issued.
• Advantage

• Facilitates saving of gold

• Flexible and allow contraction and expansion of

money supply.
Limitation

• This system cause inflation

• It may lose public confidence for over-issue of

the currency.
Fixed fiduciary system

• Currency is issued up to a certain amount

without any reserve of gold.
• Currency is needed more than the fixed level it
must be backed by gold penny for penny.
• This method was adopted by Japan and
Norway.
Merits

• It is safe system

• Inflation is well controlled

• It enjoys public confidence to the highest.

Demerits

• The system is inelastic

• It adversely affects industrial growth.

• It lacks frugality because it requires much gold

• It is a costly system
Proportional reserve system

• This system call for a proportionate gold and

silver reserve to the total issue of currency.
• Due to its strong benefits it has become
internationally accepted currency-issuing
system.
Counties deposited reserve ratio

• U.S 40%
• France 35%
• Germany 40%
• Russia 25%
• Pakistan 30%
• India 40%
Advantage

• It is flexible.

• It is helpful in industrial growth.

• Gold and silver are required in comparatively

small amount.
Disadvantage

• Inflation to some extent is possible

• Keynes declared it an extravagant and wasteful

system
• Government have tendency to violate the
system.
Simple deposit system

• This system requires a hundred percent gold

reserve for the issue of currency.

• Pros

• It is safe

• Inflation is not possible

Cons

• It is inelastic and cannot be changed to the

requirement.
• It restricts business and industrial growth.

• A large amount of gold and silver is needed.

• Costly and wasteful.

• Risk of deflation.

• It is impracticable.