Functions of Central Bank in an Economy
In the name of Allaah, the most beneficent, the most merciful
Introduction:
All praise and thanks is due to Allaah subhanahu wa ta’ala; and may peace and
blessings of Allaah be upon His Prophets.
Modern fiat money and electronic money plays the most common role as the
medium of exchange in any country of the world. The central bank, also called reserve
bank or monetary authority, is the institution that is primarily responsible for the supply
and control of monetary currency. It formulates the monetary policies and regulates the
member banks. It possess monopoly and mostly or should be independent from Political
influences.
Sweden is the first country to establish a central bank; it was named as Riks,
established in 1668. The Bank of England was established in 1694. The central bank,
Federal Reserve Bank, which prints and supplies the most popular currency, US Dollar,
was established in 1913.
Main functions of the Central Bank:
Central bank does not deal with the citizens directly but it functions with the help
of the commercial banks that it regulates. Although the range of responsibilities of a
central bank varies among countries but the main and common functions can divided into
the following areas:
1. The most important duty of central bank is to control and manipulate the money
supply.
2. Regulation of member banks or commercial banks.
3. In case of any emergency in financial or banking market, central bank lends debts
to commercial banks and other financial institutions or even governments.
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4. Central banks also advise government regarding economic policies, monetary
issues, capital market etc.
5. It also helps in settling the mutual debt issues among the commercial banks.
6. Central bank together with government also decide what type or types of currency
the country will have; whether it will be fiat currency or commodity money or
electronic money or combinations of more than one type.
Tools used by the Central Bank in order to achieve its monetary policies:
As we have seen and understood that the roles and functions played by the central
bank of a country are of huge importance in terms of economic development of any
country. To carry out these responsibilities, the central bank uses some tools and
techniques in order to achieve the monetary policies.
1. Interest Rate: Central bank not only issue currency, but also sets the interest rate
on loans and bonds which is a major tool to control and manipulate the monetary
system of a country. During the period of Inflation¹, central bank increases the
interest rate which results in the decrease of money supply in the market, hence
controls the inflation. Although the reduced interest rate controls the inflation, but
it also reduces employment rate in a credit based banking and economic system.
In this case, central bank needs to choose the option wisely.
2. Sell and purchase of Bonds: Central Bank purchases Bonds from governments
(mainly) and increase the money supply; and sells bonds to reduce it.
3. Fractional Reserve: Another tool used by central bank is the process of fractional
reserve requirement. How much money from the deposits should be kept by
commercial banks and how much can be loaned to customers is decided and
instructed by the central bank; and sisters banks are obliged to abide by so that
availability of liquid funds can be assured.
Central bank manipulates the reserve requirement mainly for two reasons.
Firstly, it is to affect the credit money creation potential of commercial banks; and
secondly, to affect the demand of fiat money. Central bank increases money
supply by purchasing Bonds and increases the interest rate to increase the reserve
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requirement simultaneously when situation demands; in this case, the effect of
change in reserve requirement outweighs the effect of the purchased bonds. On
the contrary, it can also decrease money supply by selling the bonds and reduce
the interest rate to reduce the reserve requirement. Thus, it controls the money
supply in the economy and suffices the liquidity in the market.
4. Emergency Lender: The central bank is the emergency lender to the commercial
banks and governments in the times of distress and economic crisis. It purchases
bonds from the government and issues new currency in the market to increase the
economic activities.
5. Reserve of Foreign Currency: Central bank reserves foreign currency such US
Dollar, Euro etc to maintain the foreign exchange and national currency value.
Note-1: Inflation means a continuing rise in prices caused by an increase in the money
supply and demand for goods.
(https://dictionary.cambridge.org/dictionary/english/inflation)
Countries with high Foreign Direct Investment (FDI) need to reserve more foreign
currency in case of the sudden withdrawal of FDI; otherwise it may lead to economic
collapse.
Conclusion:
Monetary system and supply of fiat money in the modern world is one of the
critical subject and area of improvement. The current debt and interest based system has
artificially created so much confusion and crisis. The requirement of a central bank in an
economic and banking system is a political issue; but if the system is based on a wrong
and unjust philosophy, it fails to achieve its policies in real sense. The central bank is
supposed to work to achieve the goals like high employment, price stability, economic
growth, Interest rate stability, financial market stability, foreign exchange stability etc;
but practically this never happens. In actual, the credit based banking system causes
forceful transfer of assets, either crisis of money leading to high prices of goods or excess
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supply/creation of money by commercial banks leading to inflation, devaluation of
national currency etc.
References:
1. www.investopedia.com/terms/c/centralbank.asp
2. www.economicsdiscussion.net/banks/central-bank-and-its-functions/4165
3. https://dictionary.cambridge.org/dictionary/english/inflation
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