A Central bank is the apex bank in the country. It governs and regulates all banks functioning in the country. Examples of central banks are the Federal Reserve Bank in the United States, the Reserve Bank of India in India. Besides regulating banks a central bank performs many other functions that are listed below;
Roles of a central bank
- Printing currency: A central bank has the sole authority to print and supply currency in the country. The currency supplied by the central bank is deemed legal tender.
- Banker to the government: Central banks provide banking services to the government. In India, the central bank also issues government securities on behalf of the government and manages it debt for it.
- Regulating the payments and settlement systems: The central bank regulates and supervises the payment and settlement systems in the country. In some countries, Central counter parties also fall under the jurisdiction of central banks.
You can read more about central counterparties below;
- Lender of last resort: The central bank acts a lender of last resort to the banks. In the event a bank fails or is in danger of failing the central bank infuses capital into the bank and thus protects the interests of the depositors.
- Holder of foreign exchange reserves: The central bank manages the foreign exchange rate of the economy and is also the repository of the country’s foreign exchange reserves. It also acts as a holder of the country’s gold.
- Managing the monetary policy: The central bank manages the short term interest rates in the country through a conjunction of many factors like the signaling of the Federal Funds rate also known as the Fed rate, reserve requirements and through the supply of money in the country. Read below all about the Fed rate and monetary policy of central banks.
In India, monetary policy is managed through the CRR, SLR and LAF repo and reverse repo rates. CRR is short for Cash Reserve Ratio. It is the cash balance that every bank has to maintain with the central bank fortnightly. When the central bank wants to lower the interest rates it can signal it by cutting the CRR and thereby infusing more money into the banks. Reverse is true when it wants the interest rates to move higher. Central bank sucks out liquidity from the economy by hiking the CRR. In India, the general level of short term interest rates desired by the central bank is also signaled via the LAF repo and reverse repo rates. You can read more about CRR, SLR and repo rates below;
- Inflation targeting: Most countries have an inflation target. The central bank and the government act in co-ordination with each other to manage the inflation in the country through the monetary and fiscal policies.
- Managing the foreign exchange rate: Central banks manage the exchange rate of the country by buying and selling currency in the foreign exchange market. Read all about exchange rates below;
Some countries peg their currency to a stronger currency which is most often the U.S. Dollar. By pegging they fix the exchange rate at a certain level. If the currency strays from this level, central banks buy or sell the currency to bring it back to its desired value.
In some countries like India, the policy of Managed Float is followed wherein the exchange rate is allowed to freely float within a band. If the currency rate moves beyond the band the central bank intervenes by buying or selling its dollar reserves to bring the currency back within the band. However India has now gradually progressed to a more mature level of a managed float where the currency is allowed to freely float and the central bank intervenes only in case of massive fluctuations in the foreign exchange market.
Qualities of effective central banks
- Central banks should be independent, i.e. it should be free of political interference. Many a times the policies of the central bank are at crossroads with the agenda of the government. For example in an economy where the inflation is high and economic growth has slowed down, to control the inflation the central bank may want to increase the interest rates and decrease the money supply in the economy. This may have an effect of further slowing down the growth of the economy in the short term. Therefore it may not go down well with the government.Independence can be in terms of operational independence and target independence. Operational independence means the central bank has the independence to decide the policy rate. Target independence means the central bank also sets the inflation target and the horizon over which the target is to be achieved
- Central banks should be credible. A central bank can achieve credibility by following through on its stated intentions.
- A transparent central bank is more credible. A central bank has to be transparent about the tools that it uses in setting the monetary policy rates and its reasoning behind the changes it makes to the monetary policy.
As against the monetary policy which is managed by the central bank, fiscal policy is managed by the government. Fiscal policy is the government’s policy for managing its investments and spending in the economy depending upon the situation in the economy and the government’s macro economic goals You can read all about fiscal policy in the posts mentioned below;
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