Central Bank – Definition, Functions class 12 CBSE Board

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

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

Definition of Central Bank in Economics class 12

The various book has given the definition of Central Bank. I am giving all definitions of the 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.”

S.K Aggarwal

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

Sandeep Garg

“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.”

T.R Jain

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

Read Here:- What is Money and its Definition

Functions of Central Bank in Economics class 12

Following are some traditional functions of the central bank.

1. Bank of Issue:-

Bank of issue means, a bank that has the exclusive legal right to issue currency notes. The central bank has the monopoly to issue currency notes in a country

Reasons for this monopoly:-

There are two reasons for this exclusive right to the 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 the 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 the 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 the government on various financial matters such as

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

Read Here:- What is supply of Money, its definition and components

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 the commercial bank has surplus cash. It can deposit it to the central bank.

This reserve is used by the central bank to meet emergency cash needs to individual commercial banks by giving them loans.

Thus is says the central bank performs the functions of bankers’ banks.

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

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

Read Here:- Explain the process of credit creation process by Commercial Bank

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 both

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

Following are the main instruments a central bank opts 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 funds 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.

Read Here:- What is Money Multiplier

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, the central bank can control the credit creation activity of commercial banks.

Raising RR makes borrowings by the commercial banks from central banks costly. It forces commercial banks to raise the lending interest rate to the general public.

Borrowings from banks become costly leading to declining 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 bank has two option to earn from its liquid assets (cash).

Either it can either deposit its surplus liquid assets to the 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 the liquid assets of commercial banks reducing its lending capacity to the 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 government securities in the open market.

General public trust government securities more than other options of investments.

If the 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 reduce.

It further reduces the landing capacity of the commercial banks. Borrowings from banks decrease leading to a 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 mortgaged 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. The margin requirement is 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 amount of the loan 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.

Read Here:- Important MCQs of Money and Banking Chapter class 12

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Anurag Pathak
Anurag Pathak

Anurag Pathak is an academic teacher. He has been teaching Accountancy and Economics for CBSE students for the last 18 years. In his guidance, thousands of students have secured good marks in their board exams and legacy is still going on. You can subscribe his youtube channel and can download the Android & ios app for free lectures.

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