The Central Bank

These are usually owned and operated by governments and their functions are:

i.      Government's banker:  Government's need to hold their funds in an account into which they can make deposits and against which they can draw cheques.  Such accounts are usually held by the Central Bank

ii      Banker's Bank:  Commercial banks need a place to deposit their funds; they need to be able to transfer their funds among themselves; and they need to be able to borrow money when they are short of cash.  The Central Bank accepts deposits from the commercial banks and will on order transfer these deposits among the commercial banks.  Consider any two banks A and B.  On any given day, there will be cheques drawn on A for B and on B for A.  If the person paying and the person being paid bank with the same bank, there will be a transfer of money from the account or deposit of the payee.  If the two people do not bank with the same bank, such cheques end up in the central bank.  In such cases, they cancel each other out.  But if there is an outstanding balance, say in favour of A, then A's deposit with the central bank will go up, and B's deposit will go down.  Thus the central bank acts as the Clearing House of commercial banks.

iii.   Issue of notes and coins:  In most countries the central bank has the sole power to issue and control notes and coins.  This is a function it took over from the commercial banks for effective control and to ensure maintenance of confidence in the banking system.

iv.    Lender of last resort:  Commercial banks often have sudden needs for cash and one way of getting it is to borrow from the central bank.  If all other sources failed, the central bank would lend money to commercial banks with good investments but in temporary need of cash.  To discourage banks from over-lending, the central bank will normally lend to the commercial banks at a high rate of interest which the commercial bank passes on to the borrowers at an even higher rate.  For this reason, commercial banks borrow from the central bank as the lender of the last resort.

v.     Managing national debt:  It is responsible for the sale of Government Securities or Treasury Bills, the payment of interests on them and their redeeming when they mature.

vi.    Banking supervision:  In liberalized economy, central banks usually have a major role to play in policing the economy.

vii    Operating monetary policy:  Monetary policy is the regulation of the economy through the control of the quantity of money available and through the price of money i.e. the rate of interest borrowers will have to pay.  Expanding the quantity of money and lowering the rate of interest should stimulate spending in the economy and is thus expansionary, or inflationary.  Conversely, restricting the quantity of money and raising the rate of interest should have a restraining, or deflationary effect upon the economy.