Courses for Kids
Free study material
Offline Centres
Store Icon

Functions of Central Bank – Explanation, Importance, and FAQs

Reviewed by:
Last updated date: 22nd Jul 2024
Total views: 393.3k
Views today: 7.93k
hightlight icon
highlight icon
highlight icon
share icon
copy icon

Functions of Central Bank Introduction

In the banking system, the central bank is recognized as the most powerful financial institution. It is considered to be an important part of a country's economic and financial structure. The central bank is an independent authority in charge of supervising, regulating, and stabilizing the country's monetary and banking framework. The Reserve Bank of India is the country's central bank. It was founded in 1935. Central banks are in charge of ensuring the country's Financial Stability and Economic sovereignty.

The meaning of central bank is a financial institution that has the privilege of producing and distributing money (and credit) for a country or a group of countries. The central bank, in the modern economy, is also responsible for regulating member banks and formulating monetary policies. This article will acquaint you with the importance of the central bank with a focus on the functions of the central bank of India.

Features of Central Bank

The basic nature of Central banks is that they are non-market-based and also anti-competitive institutions. The key features of a central bank are:

  • Most central banks are centralized though there could be central banks that are not government agencies.

  • Even if the central government does not own a central bank, the law establishes and protects the privileges of a central bank.

  • It has a legal monopoly status that enables it to issue cash and banknotes as opposed to private commercial banks that can issue only demand liabilities, for example, checking deposits.


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.

  • Transfer and Settlements- The central bank acts as a “clearinghouse” by providing free services to commercial banks in transferring and settling their mutual claims. Since the RBI holds reserves of commercial banks, it facilitates the clearing of cheques by transferring funds between banks. The principle of bookkeeping is followed in this procedure to make transfer entries into their accounts. There is a separate department operated by the central bank in big cities and trade centers to transfer and settle the claims of one bank on the other.

Importance of Central Bank

The central bank is the heart of the monetary system of any country. A country’s economy is influenced heavily by the actions taken by its central bank. They are the key governing body that ensures the boom and bust cycle of the economy and financial markets does not hamper the direction of the country’s economy. Its central bank ensures the steady and stable growth of the economy of a country.

The Functions of a Central Bank can be discussed as follows:

  1. Currency regulator or bank of issue

  2. Bank to the government

  3. Custodian of Cash reserves

  4. Custodian of International currency

  5. Lender of last resort

  6. Clearing house for transfer and settlement

  7. Controller of credit

  8. Protecting depositors interests

Examples of Central Banks

Some of the well known central banks across the world are:

  1. Federal Reserve (USA)

  2. Reserve Bank of India (India)

  3. People’s Bank of China (China)

  4. Bank of England (UK)

  5. European Central Bank (EU or European Union)

FAQs on Functions of Central Bank – Explanation, Importance, and FAQs

1. What is a Central Bank?

A central bank is a financial institution that has sole control over the generation and distribution of money and credit in a country or group of countries. The central bank is normally in charge of establishing monetary policy and regulating member banks in modern economies.

Central banks are inherently anti-competitive, if not anti-market. Because many central banks are not government bodies, they are sometimes seen as politically independent.

Regardless of whether the central bank is technically owned by the government, its rights are enshrined and guaranteed by law. 

The legal monopoly that allows central banks to issue banknotes and cash is a unique feature that sets them apart from other banks. Only sight liabilities, such as check deposits, are permitted to be issued by private commercial banks.

2. What are the key takeaways of the Central Bank?

Key takeaways are-

  • A central bank is a financial entity in charge of monitoring a country's or group of countries' monetary system and policy, as well as regulating the money supply and establishing interest rates.

  • To keep a country's economy on track, central banks use monetary policy to loosen or limit the money supply and credit availability.

  • Central banks have legislation governing the banking industry, including the amount of cash that banks must hold in connection with their deposits.

  • A central bank can lend to failing financial institutions and even governments as a lender of last resort.

3. What are a few functions of the Central Bank?

Functions are-

  1. Custodian of International Currency: Maintaining a minimal foreign currency balance is an important function of the central bank. The goal of maintaining such a balance is to manage unexpected or emergency foreign reserve requirements, as well as to avoid any negative balance-of-payments deficits.

  2. Lender of Last Resort: In times of cash shortages, the central bank serves as a lender of last resort, giving funds to its member banks. It carries out this job through issuing loans secured by securities, treasury bills, and rediscounting bills. This is considered one of the central bank's most important functions, as it assists in preventing the financial structure of the economy from collapsing.

  3. Clearinghouse for Transfer and Settlement: The central bank serves as a clearinghouse for commercial banks, assisting in the settlement of mutual indebtedness. To settle interbank payments, representatives from several institutions gather in a clearinghouse.

  4. Controller of Credit: Central banks also serve as credit regulators in the economy. Commercial banks create a lot of credit in the economy, which causes inflation to rise. By engaging in open market operations or modifying the CRR, the central bank can influence how commercial banks create credit.

4. What is the role of a bank for the government?

The role is as follow-

  • Currency Regulator or Bank of issue: In a given economy, central banks have sole authority over the production of currency. The world's central banks are all involved in issuing currency notes to the economy.

This is one of the central bank's most significant duties in an economy, and it is for this reason that the central bank is sometimes known as the bank of issue.

Previously, all banks were free to print their own notes, resulting in an unorganized economy. To avoid this, governments around the world authorized central banks to act as currency issuers, resulting in consistency in circulation and a balanced supply of money in the economy.

  • Bank to the Government: One of the central bank's most essential functions is to serve as the government's bank. The central bank is a financial institution that receives deposits and distributes funds to the government. It's also in charge of making and collecting government payments. Central banks also provide short-term loans to the government to help it recover from economic downturns.

In addition to serving as the government's bank, it also serves as an advisor and agent for the government, giving guidance on economic policy, capital markets, money markets, and government loans.

Furthermore, the central bank plays an important role in the design of monetary and fiscal policies that aid in the regulation of money in the market and inflation control.

  • Custodian of Cash Reserves: Commercial banks in a country's commercial banks hold a portion of their cash balances in the form of deposits with the central bank. When there is a strong demand for cash, commercial banks can draw on that sum and pay it back when there is a low demand for cash.

The central bank is known as the banker's bank as a result of this. The central bank also has a significant impact on commercial banks' loan creation policies.

5. What are the objectives of the Central Bank?

Due to calamitous economic events, central banks' goals have shifted dramatically throughout time. In the 1970s, for example, central banks' primary purpose was to ensure full employment. The concentration on employment, on the other hand, diverted central banks' attention to inflation. Instead of maintaining price stability, central banks would inject money into the economy to keep people employed. However, this came at a price: inflation.

In 1973, for example, there was a severe oil crisis known as the 'OPEC crisis.' It resulted in a significant increase in unemployment rates throughout the industrialized countries. In response, central banks opened the taps and pumped money into the economy in the hopes of spurring investment and job creation.

While the plan was successful in increasing employment in the near term, it had long-term consequences. Throughout the 1980s, there was double-digit inflation, and employment suffered as a result. As a result, central banks have realized that a more balanced approach is required, one that concentrates on multiple goals rather than just one.

6. Give a Brief History of Central Banks.

The Bank of England and the Swedish Riksbank were the prototypes of central banks in the world. These banks were established in the 17th century. The Bank of England first acknowledged the role of the central bank as the lender of last resort. Some of the other early central banks are Germany's Reichsbank and Napoleon's Bank of France. These banks were established as the means to finance military operations of the respective countries, which were quite expensive.

The reserve bank of India was nationalized on January 1st, 1949 by the RBI Act 1948. Before RBI, the Imperial Bank of India was performing all the functions of a central bank. The main purpose of the nationalization of RBI was to prevent the centralization of shares in the hands of non-government shareholders.

7. What are District Central Cooperative Bank Functions?

The DCCB or district cooperative central banks are the cooperative banks that operate at the district level in several parts of India. They have the following functions:

  • They fulfill the credit requirements of the member societies.

  • Provide financial and banking support for the livelihood in rural areas, especially the agricultural sector.

  • They act as a balancing center for PACS (Primary Agricultural Credit Societies). There is close and continuous contact between DCCBs and PACS where DCCB provides leadership and guidance support to PACS.

  • They can also perform non-credit activities.