Central bank: meaning, functions and role in economic development

1. Meaning and definitions

A central bank is the apex institution of a country’s monetary and banking system. It issues the currency, acts as banker to the government and to other banks, and regulates the supply and cost of money and credit in the public interest. Unlike a commercial bank, its aim is not profit.

• Vera Smith (The Rationale of Central Banking, 1936): a banking system in which a single bank has either a complete or a residuary monopoly of note issue.
• Kisch and Elkin: the essential function of a central bank is the maintenance of the stability of the monetary standard.
• M.H. de Kock (Central Banking): a bank which constitutes the apex of the monetary and banking structure of its country.
• Sayers: the organ of government that undertakes the major financial operations of the government and, by its conduct of these operations and by other means, influences the behaviour of financial institutions so as to support the economic policy of the government.

The Bank of England (1694) is the model; the Riksbank of Sweden (1668) is older. India’s central bank, the Reserve Bank of India, was set up on 1 April 1935 under the Reserve Bank of India Act, 1934, on the recommendation of the Hilton Young Commission (1926), and nationalised from 1 January 1949.

2. Traditional functions

(a) Bank of issue

The central bank has the monopoly of note issue. This gives uniformity in the currency, public confidence, and control over the money supply. Methods of note issue include the fixed fiduciary system, the proportional reserve system and the minimum reserve system. India has followed the minimum reserve system since 1956–57: the RBI must hold gold and foreign securities worth at least Rs. 200 crore, of which at least Rs. 115 crore in gold (sections 22 and 33, RBI Act). The Government issues coins and one-rupee notes; the RBI puts them into circulation.

(b) Banker, agent and adviser to the government

• keeps the government’s accounts and makes and receives payments for it;
• manages the public debt: issues treasury bills and government securities, pays interest and redeems loans;
• gives short-term advances to the government (in India, Ways and Means Advances);
• advises on monetary, banking and financial policy and represents the country at the IMF.

(c) Bankers’ bank and custodian of cash reserves

Commercial banks keep part of their deposits as reserves with the central bank (the cash reserve ratio under section 42, RBI Act). Pooling reserves in one place makes the banking system stronger and gives the central bank a means of controlling credit. It also supervises and regulates banks: licensing, branch expansion, inspection, capital and liquidity norms (Banking Regulation Act, 1949).

(d) Lender of last resort

When a sound bank faces a sudden run, the central bank lends to it against eligible securities so that the panic does not spread. Walter Bagehot (Lombard Street, 1873) gave the rule: lend freely, at a penalty rate, against good collateral. The RBI performs this role through the marginal standing facility and special liquidity windows.

(e) Custodian of foreign exchange reserves

The central bank holds the nation’s reserves of gold and foreign currencies, manages the exchange rate, and administers exchange control. In India the RBI manages the forex reserves and administers the Foreign Exchange Management Act, 1999.

(f) Clearing house

Since all banks keep accounts with it, inter-bank claims are settled by book entries. In India the RBI runs the RTGS and NEFT systems and regulates payment systems under the Payment and Settlement Systems Act, 2007.

(g) Controller of credit

This is the most important modern function. The central bank regulates the volume, cost and direction of credit by quantitative methods (bank rate, open market operations, reserve ratios, repo) and qualitative methods (selective controls, moral suasion), explained in the next note.

(h) Collection of statistics and research

It publishes data on money, credit, banking and the balance of payments (in India, the RBI Bulletin and the annual Report on Currency and Finance) and advises on policy.

3. Promotional and developmental role

In a developing country the central bank does more than maintain stability. The RBI’s promotional functions illustrate the point:

• Building financial institutions: the RBI helped establish UTI (1964), IDBI (1964), NABARD (1982) and the Deposit Insurance and Credit Guarantee Corporation.
• Agricultural and rural credit: support to co-operative banks and regional rural banks; priority sector lending targets.
• Industrial finance for small and medium enterprises.
• Development of the money and capital markets: new instruments and institutions, market reforms.
• Financial inclusion: no-frills accounts, banking correspondents, small finance banks and payments banks, digital payments.
• Price stability with growth: controlling inflation while ensuring adequate credit for investment.

4. Role in economic development (summary points)

1. Capital formation, by mobilising savings through a wide banking network.
2. Creation and regulation of credit for productive purposes.
3. Price stability, which encourages saving and investment.
4. Development of specialised financial institutions.
5. Directing credit to priority sectors (selective credit control).
6. Managing public debt at low cost to finance development plans.
7. Exchange rate stability and management of the balance of payments.
8. A sound banking system through supervision and deposit insurance.

5. Central bank and commercial bank distinguished

How this is examined

For “functions of the central bank”, write the eight traditional functions under headings, each with a line of RBI illustration, and add a paragraph on promotional functions. For “functions of the RBI” the same structure works with more Indian detail. For “role in economic development”, lead with section 3 and the summary list in section 4. Do not drift into the RBI Act’s organisation (Central Board, Governor) unless asked: this is an economics paper.