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The Central Bank
The primary function of the central bank is to control the money supply in the economy. It is responsible for issuing currency on behalf of the government. In addition to this primary function, the central bank performs the following duties:
- It receives the state revenues, keeps deposits of various departments and makes payments on behalf of the government.
- It keeps the cash reserves of the commercial banks, acts as a clearing-house for the inter-bank transactions and as a lender of last resort. It supervises the commercial banking system and ensures its smooth running.
- It controls the money and capital markets by changing the supply of money and thereby the rate of interest. The objective is to keep equilibrium in these markets.
- It is the custodian of the foreign exchange. It has to keep a closer check on the external value of the domestic currency and prevent its deterioration.
- It is the adviser to the government in all the monetary affairs. It is responsible for the formulation and implementation of the monetary policy.
The objective of the central bank is to ensure the internal and external stability of the currency. Internal stability means keeping the purchasing power of the money intact and preventing its deterioration. In other words, it has to maintain the rate of inflation within tolerable limits, if its curtailment is not feasible altogether. External stability implies keeping a balance between export and import or prevention of the foreign exchange value of domestic currency from depreciation.
In developing countries, the central bank is also concerned with the progress and development of the economy. It provides financial support to various development programs of the government. The central bank adopts various measures to control the money supply and commercial credit. The bank exercises its authority via different instruments of credit control. We discuss these measures very briefly.
Quantitative Measures or Instruments of Credit Control
These measures directly affect the quantity of money supply in the economy:
- Open market operations: This is the most frequently used instrument or the routine practice to control the money supply. However, its effectiveness depends on the perfection of the capital and money markets. The central bank sells government securities (called treasury bills) to the general public if a contractionary policy is desired. In contrast, it buys back these bonds and diffuses extra money into the economy if an expansionary policy is to follow. This is the medium of government borrowing at the market rate of interest.
- The bank rate policy: The rate of interest at which the central bank offers loans to commercial banks or discounts their bills is called ‘bank rate’ and the rate at which the commercial banks extend loans to the general public is called the ‘market rate’. A change in the bank rate is followed by a corresponding change in the market rate. Thus, it is another powerful instrument of credit control; however, it is rarely used.
- Variation in capital reserves: All commercial banks are required (by law) to keep a fixed proportion of deposits as reserves with the central banks. This is known as a reserve ratio; the power of the commercial banks to extend loans is reduced. This instrument is also rarely used.
- Variation in cash reserves: The commercial banks are also required to keep a fixed proportion of their total deposits in cash form, standing ready to honor the checks of customers and to avoid solvency problem. By increasing this cash-reserve proportion, the central bank can limit the autonomy of the commercial banks to credit. However, the banks may not strictly follow the advice of the central bank in this case.
These measures do not affect the quantity of money/ credit percent, rather these can redirect the flow of credit to particular purposes/ channels. These include:
- Moral persuasion: The central bank can advise the commercial banks to follow either a loose or tight credit policy, i.e. to extend loans on easy terms for one purchase/time and on tight terms for some other purchase/time. However, the commercial banks are not obliged to follow such instructions very strictly. If this is the case, then credit rationing may be applied.
- Direct action: The central bank may take a direct action in case the commercial banks do not respond to its instructions carefully. It may refuse to discount the bills of a particular bank or even may blacklist it /debar it from the business.
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The Commercial Banks
The commercial bank is an organized financial institution that deals with the business of credit (borrowing and lending of money). The commercial banks are financial intermediaries between savers and investors.
Like other business firms, the main objective of commercial banks is to earn profits. The bank accepts deposits from its customers and thus raises large funds that can be loaned out. These may be in the form of demand deposit (readily available for checking: often called current accounts on which the banks pay no interest), or time deposits (which can be available only for business/loan extension).
The saving deposits fall in between the two, which can be withdrawn occasionally. The deposits accepted by a bank are its liability and the loan extended to the clients as well as the bonds/shares of firms held by the bank constitute its assets. The bank earns interest/profit on its investment a part of which is passed on to the depositors and the remaining is appropriated.
The Process of Credit Creation
The commercial banks provide an easy medium of exchange in the form of checks, drafts, credit cards etc. These are called bank notes or instruments of credit. These constitute a considerable part of the total money supply in the economy. Anyhow, the banks cannot create money from thin air; they convert physical wealth into liquid money. There must be an initial deposit with the bank to start the process. Further, the power of the banks to create credit is limited by the reserve requirements.
A simple example: Suppose the central bank decides to expand money supply in the economy and purchase back government bonds held by the general public: ∆H=100 thousands. The individuals concerned get checks which they deposit in their accounts held in the commercial banks. The process of credit creation starts since the commercial banks are now in a position to offer loans to interested parties against collateral (documents of physical assets). The banks will transfer a fraction of deposits to the central as legal reserves: z=20% and open ‘supposed account’ worth 80 thousand at the credit of clients and allow them to draw, as they wish, through checks.
Suppose further that the borrowers have to make payments to some other parties and the payments are again made through checks drawn on the commercial banks concerned. A such the banks will receive fresh deposits and therefore enabled to advance further loans against collaterals. The process may continue in geometric progression indefinitely.
The total increase in money supply by the end of the process will be many folds as compared to the original step taken by the central bank. The above model is based on the assumption that all transactions are made through checks and the banks can find individuals at each stage borrowing against collateral. The process will break if these conditions are not fulfilled.
This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.
Lico masinde on October 06, 2018: