A central bank is a financial institution that regulates the country’s monetary policy and currency, and is also responsible for other important functions including issuance of banknotes and cash, supervision of commercial banks, regulation of the availability and cost of credit, macroeconomic forecasting, protection of financial consumers and prevention of money laundering, terrorism financing, and bank fraud. Reserve Bank of India (RBI) is the central bank in India.
The history of the central bank leads back to the 17th century when the first central banks were established called Sweden’s Riksbank and Bank of England.
The functions of the central bank include currency regulator or bank of issue, bank to the government, custodian of cash reserves, custodian of international currency, and lender of the last resort.
The role of central bank includes regulating monetary policy, ensuring financial stability, safety, efficiency, and accessibility of payment systems, supervision of banks, provide economic advice to the government, dealing and management of foreign exchange and reserves, and issuance of government securities.
What is a central bank?
A central bank is an institution that manages the currency and monetary policy of a country. It also possesses a monopoly on increasing the monetary base and use tools including open market operations, discount window lending and reserve requirements for commercial banks to regulate the country’s money supply.
Investopedia defines central bank or reserve bank as “a financial institution responsible for the formulation of monetary policy and the regulation of member banks.”
As per a European Central Bank article, published on 10 July 2015, “the main objective of many central banks is price stability, however, in some countries, central banks also act in support of full employment. As per monetary policy, the main work of a central bank is to set interest rates, i.e.,“cost of money”.
The central bank is the only provider of the legal means of payment, i.e., “finality of payment”, “ensuring the smooth functioning of the national payments system”, and “maintaining the stability of the banking system”, as per the book “Safeguarding Financial Stability“, written by Mr. Garry J. Schinasi.
For covering short-term needs, commercial banks borrow money from central bank by giving collateral that includes asset such as government bonds and corporate bonds which acts as guarantee to the repayment.
What is the history of central banks?
The history of central banks dates back to the 17th century with the establishment of Swedish Riksbank, founded in 1668, and the Bank of England, established in 1694, making them the first central banks in the world.
The renowned author Charles Goodhart, in his book, “In The Evolution of Central Banks“, states that the Bank of England was established in 1694 with the primary purpose of helping the British government finance its wars. He further emphasizes that the establishment of the Bank was a practical response to the government’s dire need for funds, particularly during war time with France. The Bank of England raised money by issuing bonds and notes, and then lend money to the government while simultaneously acting as a public bank.
In the 19th century, several European countries established central banks to provide financial stability in their economies that led to increase in central banks role to act as lenders of last resort by offering liquidity to commercial banks during financial crises.
The book “A History of Central Banking and the Enslavement of Mankind” written by Stephen Mitford Goodson, details the establishment of the Banque de France in 1800 under the rule of Napoleon Bonaparte, to stabilize the French economy after the upheavals of the French Revolution. He also highlights that the Banque de France, was established to serve the interests of the state and powerful financial elites.
After the major economic and political disruptions including Great Depression and World Wars in the 20th century, the Federal Reserve in the United States was established in 1913.
According to the Pulitzer Prize winning book “Lords of Finance“, authored by Liaquat Ahamed the failure of major central banks to manage gold standard policies and coordinate actions augmented global economic collapse during this time. The authors, Paul Volcker and Toyoo Gyohten, in his book “Changing Fortunes” states the growing integration of financial markets and the need for the Federal Reserve to act as a stabilizing force not just for the U.S. economy, but for the global financial system. Also, the collapse of the Bretton Woods Agreement in the early 1970s, marked the end of fixed exchange rates and the gold standard which enhanced the role of the Federal Reserve in maintaining monetary stability as the global economy shifted to a system of floating exchange rates.
Today, the focus of central banks has shifted to achieve price stability and control inflation using inflation targeting as a policy framework. The independence of central bank from political influence has become a key principle to ensure effective monetary policy.
What is the history of Reserve Bank of India (RBI)?
The Reserve Bank of India (RBI) is the central banking institution of India, and its history start from the idea for the establishment of a central bank in India was first suggested by the Hilton Young Commission in 1926 which led to the passing of Reserve Bank of India Act, 1934 and finally, RBI started its operations on April 1, 1935, having headquartered in Kolkata which later moved to Mumbai in 1937.
During pre-independence (1935-1947) period, the mail role of RBI was to manage the monetary policy and ensuring stability in British India’s economy. The RBI also managed the exchange rate and maintained the currency reserves.
What does a central bank do?
The central bank carry out national monetary policies and regulate the money supply in a country, keeping low inflation rates and consistent GDP growth patterns. The central bank is an apex financial institution and function as an independent authority to control, regulate and stabilise the monetary and banking structure of the country.
The Reserve Bank of India (RBI) is regarded as the central bank in India which was set up in 1935 for maintaining the financial stability and economic sovereignty of the country.
As per Investopedia, article titled “What Central Banks Do“ written by Reem Heakal, reviewed by Michael Boyle, and fact-checked by Amanda Jackson, published on 25th July 2023, “central banks influence interest rates on macro basis and participate in open market operations to control the cost of borrowing and lending throughout an economy.“
The work done by central bank is listed below.
- Monetary policy
- Banking supervision
- Act as Lender of last resort
- Manage foreign exchange
- Manage Payments system
- Issue currency
- Conduct economic research
- Collect statistical date
- Supervise deposit guarantee schemes
- Advise the government on financial policy
What does a central bank do besides monetary policy?
Besides formulating monetary policy, a central bank is responsible for money regulation, ensuring stability in exchange rates, own and control official reserves, produce studies and reports for governments and private organizations about economic conditions, such as inflation, employment, and risks to the financial system, issue banknotes and coins, ensure the smooth functioning of payment systems for banks and traded financial instruments, assistance in economic growth and fueling credit supply and ensuring smooth operations of financial markets.
As per Nils Herger’s book, “Understanding Central Banks”, central banks not only manage inflation and monetary policy but also act as lenders of last resort, regulate commercial banking activities, and manage international monetary policy. The book also provides extensive look into both the macroeconomic and microeconomic responsibilities of central banks and an in-depth exploration of these roles.
Why are central banks important?
Central banks are important as it play a vital role in the global economy, far beyond just setting monetary policy. Charles Goodhart in his nook “The Evolution of Central Banks“, highlights that central banks help maintain financial stability, manage inflation, and act as a lender of last resort during financial crises. A central bank also regulate and supervise the banking system to ensure its soundness and protect depositors which is an essential function for preventing systemic financial crises.
Another renowned author Nils Herger in his book “Understanding Central Banks”, emphasizes on the importance of central banks in managing currency stability, controlling inflation, and providing stability to the broader financial system through tools like reserve requirements and lending facilities. The book also answer “why the independence of central banks is crucial”, as it helps prevent political pressures from interfering with effective economic management. These roles of a central bank make it indispensable for promoting sustainable economic growth and maintaining public trust in the financial system.
What are the functions of central bank?
The central bank plays an important role in a country’s financial and economic stability by implementing monetary policy, issuing currency, acting as banker to the government, lender of last resort and regulating and supervising banks. The functions of central bank is listed below.
- Print and issue currency notes: Central bank have the absolute power to create and release the national money supply, and select the denomination, design, and amount of currency. The central bank is also responsible for the amount of money in circulation including denomination, design, and quantity.
- Act as a banker, agent, and advisor to the Government: The central bank act as the banker, agent, and advisor to the government and manages government accounts, offer advice on economic policies and management of public debts.
- Act as custodian of cash reserves: A central bank act as a custodian of cash reserves by holding a portion of commercial banks deposit as reserve to ensure liquidity and enable monetary policy.
- Act as custodian of the nation’s international currency reserves or foreign balances: The central bank hold the foreign currency reserves of a nation which is important for global commerce, economics, and resolve the imbalance of payments problems. The central bank also engage in buying and selling of foreign currencies with the objective to maintain sufficient reserves and stabilize exchange rates.
- Becomes lender of last resort for banks: The central banks lend money to commercial banks in order to avert outbreaks of global banking crises and keep the trust level up in the banking sector.
- Act as a clearing house: Central banks act as a clearing house by facilitating the settlement of interbank transactions or financial institutions.
- Controls or oversees commercial banks’ credit adjustment: Central banks monitor and restrict commercial banks credit creation for the purpose of regulating inflation and sustaining economic stability.
- Protect the interest of the depositors: The central bank protect the interests of depositors through the oversight and regulation that central banks impose on commercial banks to ensure their stability and security. These functions contribute to the overall stability, efficiency, and integrity of the financial system.
What is the role of a central bank?
The role of central bank is to manage and regulate country’s financial system and economy by maintaining monetary stability, fostering economic growth, and ensuring the soundness of the banking system in the country.
The Reserve Bank of India, also referred as RBI, manage and regulate India’s financial system and economy.
According to the book titled “The Reserve Bank of India, Functions and Working“, published by S. L. Simha, the central bank of India (RBI), introduced legislation to the regulation of moneylending to cut down high interest rates and other unsurious practices by moneylenders.
The role of the India’s central bank (RBI) is listed below.
- Formulation and implementation of monetary policy: India’s central bank (RBI) is responsible for India’s monetary policy that includes managing interest rates, money supply, and inflation. The goal of Reserve Bank of India here is to control inflation, ensure economic growth and maintain price stability in the country.
- Regulation and supervision of banks: Central bank regulate and supervise commercial banks, enforce banking regulations, monitor risk, and make sure banks meet capital and liquidity requirements.
- Issue and manage currency : The issuance and management of currency is the one of the main roles that central bank perform, being the sole authority to issue and manage currency. The central bank also ensure that the currency is stable and trust is maintained in its value.
- Management of foreign exchange: The central bank also manage the country’s foreign exchange reserves and manage exchange rates.
- Financial stability and crisis management: The central banks also act as financial stability and crisis management organization and monitor financial markets for systemic risks and take preemptive or reactive measures to mitigate crises. This role has expanded post the 2008 financial crisis, with central banks taking more active steps to ensure broader financial stability.
What is the difference between a central bank and a commercial bank?
The primary difference between a central bank and a commercial bank is in their functions, roles, and objectives. The responsibilities and activities of both these banks are different, still both are essential components of a country’s financial system.
All the difference between a central bank and a commercial bank is listed below in the table.
| Basis | Central Bank | Commercial Bank |
| Ownership | Central banks are either Government-owned or quasi-governmental. | Commercial banks are privately owned, publicly traded or privately held. |
| Primary Functions | The primary function of a central bank is to formulate and implement monetary policy. | The primary functions of a commercial bank is to accept deposits, provide loans, offer services like checking and savings accounts. |
| Objective | The objective of central banks include country’s economic stability and control inflation. | The objective of commercial bank includes profit maximization through interest on loans and fees for services, provide financial services, liquidity management, economic development, risk management and promoting financial inclusion. |
| Monetary Policy | The central bank has the authority to print or mint money and control interest rates. | The commercial banks implement monetary policy set by central bank and adjusts operations accordingly. |
| Currency Issuance | The central bank is the sole authority to issue and regulate national currency. | The commercial banks operate using currency issued by central bank. |
| Regulatory Role | The central bank regulates and supervises commercial banks to ensure stability and compliance. | The commercial banks have to adhere to regulations set up by the central bank. |
| Public Interaction | The central bank does not directly deal with the public. | The commercial banks interact directly with the public, providing various banking services and products. |
| Number of Institutions | There is only one central bank in a country. | Several commercial banks operats within a country. |
Can a central bank influence the exchange rate?
Yes, a central bank can influence the exchange rate as per the monetary policy structure of the country and the existing exchange rate policy by using its foreign exchange operations.
What are the examples of central banks?
The examples of central banks include Reserve Bank of India (RBI), Federal Reserve (USA), People’s Bank of China (China), bank of England (UK) and European Central Bank (EU or European Union).
Is a central bank a commercial bank?
No, a central bank is not a commercial bank. A central bank is fundamentally different from a commercial bank in several key aspects including purpose and role, ownership, functions and customer interaction. A commercial bank deals directly with individuals, businesses, and organizations, offering retail banking services including loans, savings accounts, and payment processing, whereas a central bank does not deal with the general public and serves primarily to the government, other banks, and financial institutions.
