Securities include domestic securities as well as foreign securities. Domestic securities comprise treasury bills of the central government with the central bank. In the event the budgeted government expenditure exceeds its budgeted revenue, a deficit is said to have been incurred. To finance this deficit, government resorts to borrowing from Central Bank by issuing documents called the treasury bills.
The Central Bank issues fresh currency worth the value of these securities. This method of financing the budgetary deficit is known as monetizing the deficit.
2. Banker, Agent and Adviser to the Government:
A central bank acts as a banker for the central and the state governments. It performs the same functions for government as the commercial banks do for their depositors.
It accepts government deposits, collects cheques and drafts deposited in government accounts and transfers government funds from one account to another or from one place to another. It also advances short-term loans to government to enable government to fill the gap between its receipts and payments. In addition, a central bank also provides foreign exchange to government to enable it to settle external debts or to purchase foreign goods.
In its capacity as agent to government, a central bank organizes sale of treasury bills in open market to enable the government to manage its public debt. As its fiscal agent, a central bank also receives taxes and other payments from public on behalf of the government.
In its capacity as a financial adviser to government, a central bank provides advice to government on important economic issues such as those pertaining to devaluation of currency, commercial policies, foreign exchange policies, and budgetary policies.
3. Banker’s Bank:
A Central Bank acts as a banker for the commercial banks in three ways:
(a) As a Custodian of Cash Reserves of Commercial Banks: As stated earlier, central bank requires all commercial banks to keep a certain proportion of their net demand and time deposits as cash reserves with it. In compliance, commercial banks maintain such reserves under the custody of the central bank. It is a different matter that such reserves are used by the commercial banks themselves in times of emergency.
(b) As Lender of the Last Resort: When commercial banks are not able to secure financial accommodation from other sources, they can approach the central bank for the same as a last resort. The central bank in such cases grants the desired credit against the eligible securities.
(c) As a Bank of Central Clearance, Settlement and Transfers: Since Central Bank holds the cash reserves of the commercial banks, it becomes easier and more convenient for it to act as a clearing house for them for settling the interbank liabilities without involving cash transfers for the purpose. It is due to this function of the central bank that the commercial banks are able to create a large volume of credit.
4. Custodian of Nation’s Gold and Foreign Exchange Reserves:
All the gold and the foreign exchange reserves of the nation are kept under the custody of the central bank. This helps it to minimize fluctuations in foreign exchange rates. To demonstrate, suppose dollar-rupee exchange rates is Rs 40 per dollar at a point of time. Now suppose demand for dollars increases with the result that the exchange rate raises to Rs 50 per dollar. Under the fixed exchange rate system,
Reserve Bank of India (the central bank of the nation), in its attempt to retain the original rate of exchange, must supply dollars in the foreign exchange market at Rs 40 a dollar. This results in an increase in supply of dollars with the result that the exchange rate begins to fall below Rs 50 per dollar.
The trend would continue until the original level of Rs 40 per dollar is reached. If the opposite happens, that is, the demand for dollars falls, the exchange rate may dip down, say, to as low as Rs 30 a dollar. To stabilize the rate, the central bank of the nation must start buying dollars at Rs 40 a dollar so that dollar demand may rise and so may the exchange rate to the original level. No central bank can fulfill the commitments of fixed exchange rate regime without maintaining adequate foreign exchange reserves.
Possession of gold reserves may also come handy in stabilizing the value of currency in relation to other currencies as also in the domestic territory. An increase in gold reserves with the central bank may help it to issue more currency while a decrease in them may force it to issue less of it. If gold prices fall, a central bank may buy gold at specified rate so as to stabilize gold prices and hence the general price level. In the process, the central bank may have to issue more currency to buy the precious metal. Exactly opposite is the case when gold prices shoot up.
5. As a Source of authentic Statistics about Economic Activities:
In almost every country, the central bank collects and publishes statistics about various aspects of functioning of the national economy. This provides valuable information about the economic activities in the nation and thus helps the government to formulate suitable economic policies.
6. As a Controller of Credit:
As explained already in Section 9.2, a central bank is an apex body of a country to control and regulate the volume of credit in the nation. Credit Control is the most important function of a central bank.