Download Chapter -4 Central Bank

Chapter -4
Central Bank
Q-1
Ans.
Define Central Bank? Explain the various functions of Central Bank?
A central bank or reserve bank is the organization within a specific country that
regulates all of the currency supplies and related policies for that particular area.
Central banks perform various actions, but its most important job is to make certain
that the national currency and money supply remain stable. Depending on the country
these may be government owned and controlled or may be run under regulations that
are specifically created to prevent extensive government interference.
a)-
Functions of Central Bank: The central bank generally performs the following functions:
i)
Bank of Note Issue:
The central bank has the sole monopoly of note issue in almost every country. The
currency notes printed and issued by the central bank become unlimited legal tender
throughout the country.
In the words of De Kock, "The privilege of note-issue was almost everywhere associated
with the origin and development of central banks."
However, the monopoly of central bank to issue the currency notes may be partial in
certain countries. For example, in India, one rupee notes are issued by the Ministry of
Finance and all other notes are issued by the Reserve Bank of India.
The main advantages of giving the monopoly right of note issue to the central bank are
given below:
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It brings uniformity in the monetary system of note issue and note circulation.
The central bank can exercise better control over the money supply in the country. It
increases public confidence in the monetary system of the country.
Monetary management of the paper currency becomes easier. Being the supreme bank
of the country, the central bank has full information about the monetary requirements
of the economy and, therefore, can change the quantity of currency accordingly.
It enables the central bank to exercise control over the creation of credit by the
commercial banks.
The central bank also earns profit from the issue of paper currency.
Granting of monopoly right of note issue to the central bank avoids the political
interference in the matter of note issue.
ii)
Banker, Agent and Adviser to the Government:
The central bank functions as a banker, agent and financial adviser to the
government,
(a)
As a banker to government, the central bank performs the same functions for the
government as a commercial bank performs for its customers. It maintains the
accounts of the central as well as state government; it receives deposits from
government; it makes short-term advances to the government; it collects cheques and
drafts deposited in the government account; it provides foreign exchange resources to
the government for repaying external debt or purchasing foreign goods or making
other payments,
(b)
As an Agent to the government, the central bank collects taxes and other payments on
behalf of the government. It raises loans from the public and thus manages public
debt. It also represents the government in the international financial institutions and
conferences,
(c)
As a financial adviser to the lent, the central bank gives advise to the government on
economic, monetary, financial and fiscal ^natters such as deficit financing,
devaluation, trade policy, foreign exchange policy, etc.
iii)
Bankers' Bank:
The central bank acts as the bankers' bank in three capacities:
(a)
Custodian of the cash preserves of the commercial banks;
(b)
As the lender of the last resort; and (c) as clearing agent. In this way, the central bank
acts as a friend, philosopher and guide to the commercial banks
As a custodian of the cash reserves of the commercial banks the central bank
maintains the cash reserves of the commercial banks. Every commercial bank has to
keep a certain percentage of its cash balances as deposits with the central banks.
These cash reserves can be utilised by the commercial banks in times of emergency.
iv)
Lender of Last Resort:
As the supreme bank of the country and the bankers' bank, the central bank acts as
the lender of the last resort. In other words, in case the commercial banks are not able
to meet their financial requirements from other sources, they can, as a last resort,
approach the central bank for financial accommodation. The central bank provides
financial accommodation to the commercial banks by rediscounting their eligible
securities and exchange bills.
v)
Clearing Agent:
As the custodian of the cash reserves of the commercial banks, the central bank acts
as the clearing house for these banks. Since all banks have their accounts with the
central bank, the central bank can easily settle the claims of various banks against
each other with least use of cash.
Q-2
Ans.
Write down the importance of Central Bank?
A Central Bank (referred to as the Federal Reserve System in the United States), also
known as the Reserve Bank of the government is separate from the country's ministry
of finance. It's still referred to as the government's bank because it manages buying
and selling of government bonds and other instruments. Most developed nations today
have an "independent" central bank, that is one which operates under rules designed
to prevent political interference. Functions of a central bank may include:
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Implementing monetary policy: discussed in detailed
Determining Interest rates: discussed in detailed
Controlling a country's money supply
"Lender of Last Resort"
Regulating and supervising the banking industry
Managing country's foreign reserves and gold reserves
Controlling the nation's entire money supply
Central banks maintain the supply of money in the economy through measures called
"open market operations". When a central bank buys securities such as bonds it
infuses money into the market, which in turn means printing money to acquire a
certain instrument. Conversely, selling of securities lowers the money supply.
The main open market operations are:
Temporary lending of money in exchange for collateral securities (also known as the
"repo" market). These operations are carried out on a regular basis, where fixed
maturity loans (of 1 week and 1 month) are auctioned off.
a)
Buying or selling securities on a case by case basis
Foreign exchange operations such as forex swaps. These operations influence the
foreign exchange market and hence the exchange rate of all currency pairs of that
currency.
b)
Lender of Last Resort"
Central banks are also responsible for maintaining liquidity in the economy. When
commercial banks go insolvent or cannot cover for their debt position (as seen in the
2009 financial crisis), the central banks prevent the financial system from collapsing.
As a "lender of last resort" they protect depositors, avoid credit crisis and prevent
widespread panic caused by financial institutions.
c)
Regulating and supervising the banking industry
In most countries a central bank through its subsidiaries and/or directly regulate and
monitor the banking sector. In some countries like the United Kingdom regulatory
responsibility lies with the UK Treasury, or an independent government agency. The
regulatory body is in charge of verifying bank balance sheets and behaviour and
policies toward consumers. Apart from refinancing, it also provides banks with
services such as transfer of funds, bank notes and coins or foreign currency. Thus it is
often described as the "bank of banks".
d)
Managing country's foreign reserves and gold reserves
Central banks in most countries are required to hold a percentage of their deposits as
reserves. Such legal reserve requirements were introduced in the nineteenth century
to reduce the risk of banks overextending themselves and suffering from bank runs, as
this could lead to knock-on effects on other banks.
Q-3
Ans.
What are the various methods of Issuing Currency?
The main methods of issuing currency are given as under: -
a)
Fixed Fiduciary System:
Under fixed fiduciary system, the government fixes a fixed amount of notes without
keeping any metallic reserve. But this portion of currency must be backed by
government securities, which is called fiduciary Limit.The notes issued other than
fiduciary limit must be fully backed by gold or silver reserves. This system was
introduced in England in 1844 in the Bank charter Act of 1844. Norway and Japan
also adopted this method. This system acted as a brake on the undue expansion of
currency and credit in the time of prosperity. This system also provides security for
the convertibility of notes.
b)
Proportional Reserve System:
Under this system the central bank is required to keep only a certain percentage of
notes issued in the form of gold or silver. The reserve proportion is usually from 30%
to 40%. It means a central bank can issue Rs. 100 note after keeping gold silver
valuing Rs. 30 or 40. This method of currency regulation is the most affordable system
of the present time and is widely used in many countries. It was first of all adopted by
Germany in 1876 and followed with modifications by U.S.A in 1914.
c)
Minimum Reserve System:
Fixed minimum reserve system allows the central bank to keep only a fixed amount of
reserve against whatever the amount of note issue. The reserve is in the form of gold,
silver and-foreign exchange or in the form of any of these types of things. This methodis being used in Pakistan after December 1965. India is also applying it since 1957.
South Africa has adopted it in 1930. Holland has been issuing notes under this
method for many years.
d)
Simple Deposit System: In this system 100% gold reserve for the issue of currency are consider for new money,
d)
Method Of Note Issue Adopted In Pakistan:
Pakistan has used proportional reserve system up to December 1965. Under this
method 30% was to be kept as reserve in the form of gold coin, gold, silver bullion and
approved foreign exchange. The balance was covered by rupee coin and government
security After 1965. State Bank of Pakistan adopted fixed minimum reserve system
Under this system the bank has to keep only legally fixed amount of minimum reserve
in gold, or silver. Moreover the government in consultation with the State Bank can
alter it.