Central Bank – Definition, Functions class 12 CBSE Board

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Are you looking for, what is central bank its definition and functions of it as per the syllabus of economics (Macroeconomics) class 12 CBSE Board.

I have explained this topic strictly to the syllabus of class 12.

Table of Contents

Definition of Central Bank in Economics class 12

Various book has given the definition of Central Bank. I am giving all definition of central bank as per the syllabus of class 12 in various reference books.

“A central bank is a bank specially created by the government to serve as an apex bank to carry out monetary policy of the country in the public interest through the various functions assigned to it.”

SK Aggarwal Book

“Central Bank is the Apex body, that controls operates regulates and directs the entire banking and monetary structure of the country.”

Sandeep Garg Book

“The central bank is an apex bank that controls the entire banking system of a country. It is the sole agency of note issuing and controls the supply of money in the economy. It serves as a banker to the government and manages forex reserves of the country.”

TR Jain

Note:- Name of India’s Central Bank is ‘Reserve Bank of India’ and situated in Delhi.

Functions of Central Bank in Economics class 12

Following are some traditional functions of central bank.

1. Bank of Issue:-

Bank of issue means, a bank which has exclusive legal right to issue currency note. Central bank has the monopoly to issue currency note in a country

Reasons for this monopoly:-

There are two reasons for this exclusive right to central bank to issue note is

  1. It brings uniformity in note circulation.
  2. It given a central bank some direct control over money supply.

2. Government’s banker, agent and advisor:-

Government Banker:- All government departments’ bank accounts are kept by the central bank. It performs the same banking functions for the government as a commercial bank does for its customers.

It performs following functions for government

  1. It accepts deposits of government
  2. It undertakes inter-bank transfers
  3. It also provide loans to government.

Agent:- Central bank also provides various services as an agent to government.

  1. It manages public debt.
  2. It carry out payment of interest on this debt etc.

Advisor:- It also acts as the advisor to the government. It guides government on various financial matters such as

  1. Money market
  2. Capital market
  3. government loans
  4. Economic policy

3. Bankers Bank and Supervisor

Banker’s Bank:- It’s mandatory for commercial banks to keep a certain amount of public deposits as reserves. The reserves percentage is fixed by the central bank. A fixed percentage of these reserves has to be deposited by the commercial banks to the central bank.

Apart from it, if commercial bank has surplus cash. It can deposit it to the central bank.

This reserve is used by central bank to meet emergency cash needs to individual commercial banks by giving them loans. Thus is says central bank performs the functions of bankers bank.

Supervisor:- A central bank is the apex body and supervises the functioning of commercial banks. It formulates various rules and policy for a commercial bank to follow such as

  1. licensing
  2. Management
  3. Branch Expansion
  4. liquidation
  5. Undertakes periodic inspection of banks.

4. Controller of Credit

Central bank has the legal power to regulate of control the credit creation activity, i.e lending activity of commercial banks.

In order to perform this task. The Central bank influences bothe

  1. The lending activity of the commercial bank.
  2. Borrowing demand from these banks.

Following are the main instruments a central bank opt to control credit creation.

Bank Rate:-

Bank rate is the interest rate at which a commercial bank can borrow from central bank to meet its long term needs.

In order to reduce credit creation, the central bank raises the bank rate. when a commercial bank borrows money at a higher rate from the central bank. As a chain effect, commercial banks offer loans to the public at a higher rate of interest. Less public avail loans from the commercial banks due to a higher rate of interest. Credit creation by commercial banks is reduced. less money power goes to the public. The purchasing power of the public is reduced, demand reduces, and as a chain effect, it controls (checks) inflation.

Cash Reserve Ratio (CRR):-

CRR refers to that, percentage of deposits with the commercial banks, which these banks are legally required to keep as a reserve with the central bank.

Central has the power to raise and reduce CRR. Let’s suppose CRR is 5 percent. Central bank raises it to 7%. This reduces funds for credit creation by 2 percent. The landing capacity of commercial banks reduces. less money power goes to the public. Public Demand decreases and as a chain effect, it controls inflation and vice versa.

Statutory Liquidity Ratio (SLR):-

SLR refer to the minimum percentage of deposits with the commercial bank which these are legally required to keep in the form of specified liquid assets as reserves with themselves.

It also works in the same manner as CRR. Let’s suppose SLR is 5 percent. Central bank raises it to 7%. This reduces fund for credit creation by 2 percent. The landing capacity of commercial banks reduces. Less money power goes to the public. Public demand for goods decreases and as a chain effect, it controls inflation and vice versa.

Repo Rate (RR):-

Repo Rate is the interest rate at which the commercial banks can borrow from the central bank to meet their short term needs.

By reducing and raising RR, central bank can control credit creation activity of commercial banks. By Raising RR makes borrowings by the commercial banks from central banks costly. It forces commercial banks to raise the lending interest rate to general public. Borrowings from banks become costly leading to decline in demand for borrowings from the banks. It leads to less money power in the hands of general public leading to fall in demand for goods and services. It helps in checking inflation and vice-versa.

Reverse Repo Rat (RRR):-

Reverse Repo Rate is the interest rate at which the commercial banks can deposit their funds with the central bank.

By raising and reducing RRR, central bank can influence the credit creation power of the commercial banks. Commercial banks has two option to earn from its liquid assets (cash).

Either it can deposit its surplus liquid assets to central bank or offer as borrowing to general public. If central bank raises RRR, it gives incentives to the commercial banks to park their funds with the central bank. It reduces liquid assets of commercial banks reducing its lending capacity to general public. Borrowings from banks decline lowering demand for goods and services in the economy. It helps in checking inflation and vice-versa.

Open Market Operations:-

As the central bank is the bank of government. it has the right to sell and purchase the government securities in open market. General public trust government securities more than other options of investments.

If government wants to check the inflationary situation in the country. It begins the process of selling government securities in the open market. General Public starts to purchase it and payments are made through cheques. Deposits in the commercial banks reduces. It further reduces the landing capacity of the commercial banks. Borrowings from banks decrease leading to decrease in demand for goods and services. It helps in checking inflation and vice-versa.

Margin Requirement:-

Margin requirements refer to the discount fixed by the central bank on the assets mortagaged as security by the government to the commercial banks.

Suppose, a borrower wants to avail loan against its property worth ₹ 1 crore from commercial banks. Margin requirement are 20%. In this case commercial banks is authorized to approve only 80% loan that is ₹ 80 lakh.

Let’s suppose now the central bank wants to control the inflationary situation in the country. As a measure, it would increase the margin requirement as per the situation. let’s assume it raises it to 40%.

As a result, commercial banks are now authorized to approve only 60% of the loans amount against the property. It comes to around ₹ 60 lakh in cash.

It would reduce the borrowing inclination among the general public as loans got costlier. It further would reduce purchasing power capacity, demand would decrease. As a final result, it helps in checking inflation.

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