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To introduce the role and function of a central bank
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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.
Continue…. • 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.
