Central Bank : An

Introduction

Wahono Diphayana

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.

Role of Central Bank

• 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

• 4- Issue 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

• Bill of Exchange is a non-interest-bearing written

order used primarily in international trade that

binds one party to pay a fixed sum of money to

another party at a predetermined future date.

2- Rediscounting bill of exchange

Bills of exchange are similar to checks and promissory notes.

They can be drawn by individuals or banks and are generally

transferable by endorsements.

The difference between a promissory note and a bill of

exchange is that this product is transferable and can bind one

party to pay a third party that was not involved in its creation.

If these bills are issued by a bank, they can be referred to as

bank drafts. If they are issued by individuals, they can be

referred to as trade drafts.

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.

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