After the First World War, the emergence of central bank with more power and prestige was the most important development in the monetary world. The main business of a central bank is to control the commercial banks in such a way as to promote the general economic policy of the state.
A central bank does not, as a commercial bank does, exist to make the maximum profits for the shareholders. Its main function is to act as a guardian of the monetary system.
The central bank is the agency through which the state enforces its economic policy. To carry out this objective, central bank is entrusted with a number of functions. They are as follows:
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1. Monopoly of Note Issue:
The central bank enjoys the monopoly of note issue in order to secure control over currency. No other bank is allowed to issue notes. Notes are the most effective credit instrument and declared by law as legal tender money.
The central bank issues notes according to the requirements of business and the general public. As a result of the exclusive monopoly of note issue, central bank can exercise a considerable measure of control over the currency and credit structure of the country.
2. It is the banker’s bank:
The central bank acts as the banker’s bank. All other banks are required to have accounts with the central bank and to keep with it a certain percentage of their deposits. The central bank is the custodian of the banking reserves of the country.
Whenever necessary, it also lends money to other banks by rediscounting bills of exchange and against approved commercial papers. The central bank is the lender of the last resort because the money supply of the country is under its control.
3. Banker to the Government:
The central bank acts as the banker, agent and adviser of the government. Government balances are kept with it and it gives short-term loans to the government known as ways and means advances.
The central bank also manages the public debt. The central bank operates everywhere as the government’s banker because of the intimate connection between public finance and monetary affairs.
4. The Lender of the Last Resort:
By rediscounting first class bills or by taking advances on approved short-term securities from the central bank, other banks can increase their cash resources at the shortest possible notice. This makes their position more liquid.
Whenever a panic develops into a run on banks, this facility of turning their assets into cash at a moment’s notice is of great advantage to them.
It is therefore the ultimate source from which emergency credit is obtained by the market to meet the temporary needs for additional credit or demands for cash on the part of the panic-stricken people.
5. Controls the Volume of Credit:
The volume of credit money depends on the lending policy of the commercial banks. The central bank can influence the lending policy of commercial banks.
The central bank controls the volume of credit mainly in three ways—by changing the bank rate, by engaging in open market operations and by varying the reserve ratios of member banks.
6. Maintaining the External Value of the country’s Currency:
Countries under gold standard were to depend on the central bank for managing it. Under managed paper currencies, the central bank has the charge of foreign exchange reserve and exchange control operations.
7. Miscellaneous Functions:
Central bank also performs certain other functions. It employs an efficient staff to carry on research. I publish journals and reports relating to different aspects of monetary and economic policy. It acts as the clearing house for the settlement of cheques and drafts of commercial banks.