BANKING II: CENTRAL BANK AND ITS FUNCTIONS
Question 3)What is Central Bank?
Answer- Central Bank is an apex institution which controls and regulate functioning of all commercial bank. Reserve Bank Of India is the Central Bank of India.
Question4) What are the functions of Central Bank?
Answer- The functions of Central Bank are as follows
*Power to issue currency- Central Bank has the power to issue currency to maintain the flow of money supply in the economy.
*Bankers Bank- Central Bank also acts as a Banker. Like General Public Bank is the customer of Commercial Bank and as like Commercial Bank is the customer of RBI. As we can deposit or borrow from the commercial bank can also borrow or deposit to the central bank.
*Banker to the Government- The Central Bank is the banker to the government as the Revenue received by the government in the form of Tax is deposited in the treasury of the government within the central bank. The Central Bank also help the government to borrow by issuing bonds and securities on behalf of the government to meet out the public expenditure.
*Lender of the Last Resort- The Central Bank also act as the lender of last resort because when the commercial bank need some money and doesn’t find it from the near by sources or internal source, then at last, he take help from the Central Bank.
*Clearing House Function- The Central Bank also help in settlement of the payment of the customer with commercial bank. This is known as Clearing House Function.
*Custodian of Foreign Exchange System- The Central Bank is known as Custodian of Foreign Exchange System as all types of Foreign Transactions are done within the country with the help of RBI as foreign currencies are kept with Central Bank Reserve.
*Credit Control Policy/Monetary Policy- The Central Bank also known as Controller of the Credit to maintain economic stability in the economy by controlling the money supply in the economy.
Question5) Describe about the 2 Techniques by which the Central Bank uses to control Inflation and Deflation in the Economy.
OR
MONETARY POLICY
Answer) QUANTITATIVE METHODS
*BANK RATE- The Rate at which the central bank gives loans to the Commercial Bank is known as Bank Rate. During Inflation Bank Rate are increase so that commercial bank seek loan from the central bank and the public will also be not be able to take loan from commercial bank as due to increase in bank rate , then Rate of Interest on Loan will also be increased and the public will be demotivated to take loan. Hence, the money supply will reduce in the economy during inflation and vice versa.
*CASH RESERVE RATIO- It is the amount which every commercial bank has to receive on the amount of total deposit with RBI. It is the amount as a reserve of a part of Cash Deposit only. During Inflation the RBI increases the CRR so that the commercial bank has to keep a larger amount of reserve and will be able to provide less amount of credit to the general public. Hence, the Money Supply will be reduce and Inflation will get continued and vice-versa.
*STATUTORY LIQUIDITY RATIO- Apart from CRR, all commercial bank have to keep a reserve of liquid asset with themselves in the form of cash and other current assets, The rate at which they keep the reserve is Statutory Liquidity Ratio. During Inflation, the Central Bank increases SLR to reduce money supply in the economy and vice-versa.
*OPEN MARKET OPERATION- It indicates the purchase and sale of government securities or treasury bill by the RBI to the Commercial Bank during Inflation to decrease the money supply in the economy and vice-versa.
QUALITATIVE METHODS
*Margin Requirement- It implies the minimum margin to be kept by the lender to lend the money against securities with the commercial bank. The Difference between the amount of security and the amount borrowed is known as Margin Requirement. During Inflation, the Central Bank increase the Margin Money to decrease the Money Supply in the economy and vice-versa.
*Moral Suasion- It is a moral appeal for issuing the general guidelines from the central bank requesting the Commercial Bank to restrict or to follow the certain guidelines of the credit creation/operations.
*Direct Action- If any Commercial bank fails to abide with the guidelines given by the RBI. The Central Bank may charge Penal Interest on the amount given as a loan to the commercial bank. Further Violation of these guidelines may led to cancellation of the banking license.
QUESTION6) How do Commercial Bank create Credit? {VERY IMPORTANT QUESTION}
Answer) The term CREDIT CREATION simply means multiple expansion of the bank deposit. In the modern economy, most of the money is in the form of bank deposit.
PROCESS OF CREDIT CREATION
Let us assume a simple model, in which there are multiple bank, all multiple transaction are going through banking system. Suppose, a bank HDFC has an initial deposit of RS 10,000 ; assuming CRR of 10%; The Bank has to maintain a reserve of RS 1000 and it can provide a loan of RS 9000 to its customer.
Now the customer spends that money will get deposited in their bank (SBI) from another customer who received money. So now SBI has a deposit of RS 9000 by keeping a mandatory requirement of CRR of 10% of 9000 i.e 900. The SBI can provide a loan of amounting RS 8,100 to the customer.
Now the customer who has borrowed from B, spends that money and the person who deposited in his account in Union Bank can provide a loan amounting of RS 7290 to its customer.
This process will go On &On till the amount of TOTAL CRR = INITIAL DEPOSIT.
And this can be calculated with the MONEY MULTIPLIER FORMULA
MONEY MULTIPLIER= INITIAL DEPOSIT X 1/LIQUIDITY RESERVE RATIO
