Many of us have wondered what a Central Bank is. The term suggests that it is some kind of bank which is central in nature. A Central Bank in reality is an apex organization in an economy, and is vested with the responsibility of managing the monetary system for a nation or a group of nations. The broad functions of a Central Bank include implementation of monetary policy, managing currency stability, low inflation and full employment.
Key functions of a Central Bank
1. Management of the monetary policy
- Issuance of currency: As a part of its responsibility of managing the monetary system of a nation, the Central Bank is issued with the sole authority of issuing currency notes. In some nations, the governments issue currency notes of smaller denominations and coins, which act as the ultimate legal tender, while the Central Bank issues the larger currency denominations.
- Banker to the state: The Central Bank performs the all important function of being the banker to the government. It conducts all financial transactions for the government and also raises money for the government via instruments like bonds or T-Bills. This last function is also closely linked to the monetary management of the economy, whereby issuance or redemption of T-Bills impact the money supply in the economy.
- Setting of various rates: A Central Bank is usually vested with the authority of setting various rates, which constitute important monetary policy instruments with it. These rates include the interest rate and cash reserve ratio (CRR) amongst other instruments. The interest rate is managed by changing the discount rate at which the Central Bank refinances commercial banks. The CRR is the ratio of all deposits that commercial banks are mandated to keep with the Central Bank. By varying CRR, the Central Bank can automatically change the money supply in the economy. The Central Bank can also use its lever of interest rates to encourage or discourage investment and affect employment levels in the economy.
- Open market operations: This is a key function of a Central Bank, by which it maintains exchange rate stability. The Central Bank steps in to buy or sell foreign exchange such that huge fluctuations in the local currency are avoided. Usually, in mature markets like the US, Europe or Japan, it is rare for a Central Bank to perform this operation as the currency is usually stable. Central Banks can also use open market operations as a monetary policy instrument. They can sell foreign exchange to reduce money supply in the economy and vice versa.
2. Management of inflation
- A Central Bank uses its authority to tweak interest rates to manage the inflation rate in the economy.
3. Management of the credit system in the economy
- Banker to the banks: A Central Bank acts as banker to commercial banks. It refinances their debt at the prevailing discount rates. Central Banks also act as a clearing house for the commercial banking system. Another key function of a Central Bank is that it acts as a lender of the last resort. This becomes important, when commercial banks face a sudden financial crunch or become insolvent. The Central Bank can step in to restore confidence in the system via devising various bailout packages for the commercial bank or banks.