Role of the central bank

Role of the central bank

The central bank in an economy plays both traditional and non-traditional roles. Its traditional function is to act as governor of the credit apparatus to ensure price stability. It regulates the volume of credit and money, pumping in more money when the market is short on liquidity and sucking in money when there is excess credit.

The main traditional functions that it fulfills are the monopoly of the note issue, the banker of the government, the bankers' bank, the lender of last resort, the controller of credit and the maintenance of a stable rate of exchange.

However, its non-traditional functions are to contribute to the economic development of countries. In summary, here are the different roles of a central bank. But before you start, here is a premium training that will allows you to know all the secrets to succeed in the Podcast.

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Creation and expansion of financial institutions

One of the objectives of a central bank is to improve the currency system and credit of the country. More banks and financial institutions need to be created to provide greater credit facilities and to divert voluntary savings into productive channels.

Financial institutions are located in major cities of developing countries and provide credit facilities to estates, plantations, large industrial and commercial houses. To address this, the central bank should extend branch banking to rural areas to make credit available to farmers, small entrepreneurs and traders. In developing countries, commercial banks only provide short-term loans.

Credit facilities in rural areas are mostly non-existent. The only source is the village moneylender who charges exorbitant interest rates.

The hold of the village lender in rural areas can be loosened if new institutional arrangements are made by the central bank to provide farmers with short, medium and long term credit at lower interest rates. A network of cooperative credit societies with apex banks financed by the central bank can help solve the problem.

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Similarly, it can help in the establishment of lead banks and through them, regional rural banks to provide credit facilities to marginal farmers, landless agricultural laborers and other weaker sections. With the vast resources at its disposal, the central bank can also help create industrial banks and financial companies to finance large and small industries.

Appropriate fit between demand and supply of money

The central bank plays an important role in causing an appropriate adjustment between the demand and the supply of money. An imbalance between the two is reflected in the price level. A shortage of money supply will inhibit growth while an excess will lead to inflation.

As the economy develops, the demand for money will likely increase due to the gradual monetization of the non-monetized sector and the increase in agricultural and industrial production and prices.

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The demand for money for transactions and speculative motives will also increase. The increase in the money supply will therefore have to be more than proportional to the increase in the demand for money in order to avoid inflation. However, it is likely that an increase in the money supply will be used for speculative purposes, which will hinder growth and cause inflation.

The central bank controls the uses of money and credit through an appropriate monetary policy. Thus, in a developing economy, the central bank should control the money supply in such a way that the price level cannot rise without negatively affecting investment and production.

An appropriate interest rate policy

In a developing country, the interest rate structure is at a very high level. There are also large disparities between long and short-term interest rates and between interest rates in different sectors of the economy. The existence of high interest rates hinders the growth of investment, both private and public, in a developing economy.

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A low interest rate is therefore essential to encourage private investment in agriculture and industry. As in developing countries, businessmen have little savings from retained profits, they have to borrow from banks or capital market for investment purposes and they would borrow only if the rate of interest is low.

A low interest rate policy is also essential to encourage public investment. A rate policy of interest low is a cheap money policy. It makes public borrowing cheap, keeps the cost of servicing public debt low and thus contributes to the financing of economic development.

To discourage the flow of resources to speculative borrowing and investment, the central bank should follow a discriminatory interest rate policy, charging high rates for non-essential and non-performing loans and low rates for performing loans. But this does not imply that savings are interest elastic in a developing economy e.

Since the level of income is low in these economies, a high interest rate should not increase the propensity to save. In the context of economic growth, as the economy grows, a gradual rise in the price level is inevitable. The value of money decreases and the propensity to save decreases further.

Monetary conditions tighten and the interest rate tends to rise automatically. This would cause udon't inflation. In such a situation, any effort to control inflation by raising the interest rate would be disastrous. A stable price level is therefore essential for the success of a low interest rate policy which can be maintained by following a judicious monetary policy of the central bank.

Debt management

Debt management is one of the important functions of the central bank in a developing country. It should aim to ensure the proper timing and issuance of government bonds, stabilize their prices and minimize the cost of servicing government debt. It is the central bank that undertakes the sale and purchase of government bonds and changes the structure and composition of government debt in a timely manner.

In order to strengthen and stabilize the government bond market, the low interest rate policy is essential. For, a low interest rate raises the price of government bonds, making them more attractive to the public and giving impetus to the government's public borrowing programs.

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Maintaining a low interest rate structure is also called upon to minimize the cost of servicing national debt.

the central bank
The central bank

Credit control

The Central Bank should also aim to control credit in order to influence investment and production patterns in a developing economy. Its main objective is to control the inflationary pressures that occur during the development process. This requires the use of both quantitative and qualitative methods of credit monitoring.

Open market operations fail to control inflation in developing countries because the note market is small and developing. Commercial banks maintain an elastic cash deposit ratio because the central bank's control over them is not complete. They are also reluctant to invest in government securities due to their relatively low interest rates.

Also, instead of investing in government securities, they prefer to keep their reserves in liquid form like gold, currencies and cash. Commercial banks are also not used to rediscounting or borrowing from the central bank.

Bank rate policy is also not as effective in controlling credit in LDCs due to:

  • a) the absence of discount coupons;
  • b) the narrow size of the bond market;
  • c) a large non-monetized sector where barter transactions take place;
  • d) the existence of a large unorganized money market;
  • e) the existence of indigenous banks that do not discount bills from central banks;
  • f) the habit of commercial banks to keep large cash reserves.

Using the variable reserve ratio as a method of credit control is more effective than open market operations and bank rate policy in LDCs. Since the securities market is very restricted, open market operations fail. But an increase or decrease in the reserve ratio by the central bank reduces or increases the liquidity available with commercial banks without harming securities prices.

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Again, commercial banks maintain large reserves of cash which cannot be reduced by an increase in the bank rate or by the sale of securities by the central bank. But the increase in the liquidity reserve ratio reduces liquidity with banks. However, the use of the variable reserve ratio has certain limitations in LDCs.

First, non-bank financial intermediaries do not keep deposits with the central bank and are therefore not affected by it. Second, banks that do not maintain excess liquidity are not affected as those that do.

Qualitative credit control measures are, however, more effective than quantitative measures in influencing the allocation of credit and hence the structure of investment. In developing countries, there is a strong tendency to invest in gold, jewelry, stocks, real estate, etc., rather than the alternative production channels available in agriculture, mining, plantations and industry.

Selective credit controls are more appropriate to control and limit credit facilities for these unproductive purposes. These controls are beneficial in controlling speculative activities in food grains and raw materials. They are more useful for controlling “ sectoral swellings " economy.

They reduce the demand for imports by requiring importers to deposit in advance an amount equal to the value of the foreign currency. This also has the effect of reducing banks' reserves as their deposits are transferred to central banks in the process.

Selective credit control measures can take the form of changing margin requirements on certain types of collateral, consumer credit regulation, and credit rationing.

Solving the balance of payments problem

The central bank should also aim to prevent and solve the balance of payments problem in a developing economy. These economies face serious balance of payments difficulties in achieving the goals of development plans. An imbalance is created between imports and exports which continues to widen with development.

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The central bank manages and controls the country's currencies and also acts as the government's technical advisor on foreign exchange policy. It is up to the central bank to avoid exchange rate fluctuations and maintain stability.

It does this through exchange controls and variations in the discount rate. For example, if the value of the national currency continues to fall, this may increase the discount rate and thus encourage the inflow of foreign currency.

Summary: Role of the central bank

Thus, the central bank plays an important role in achieving the economic growth of a developing country through the various measures discussed above. It should promote stable economic growth, help achieve full employment of resources, overcome balance of payments imbalance and stabilize exchange rates.

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