Central Bank is the single most important unit in the whole financial system. It is very easy to understand the need and importance of a central bank. You must have seen a football or a wrestling match. Ever tried to imagine what would happen if the referee is not present? In wrestling, a wrestler can easily cheat and use wrong moves to defeat his opponent. Similarly, in a football match, a goal might be claimed, even if scored after offside. Central bank is the big boss and can be considered as referee of the banking system. The Central bank drafts rules that all participants of the system need to adhere to and ensures implementation of these rules.
Let us reconsider the example that we discussed in our previous article. We understood everything about how money flows within the system and its multiplier effect, but we still don’t know how money came into your hand, in the first place. It is the central bank of a country that has all the rights and power to print money. A currency note is a promise by the Governor of central bank of India that he will pay you the same amount of money in exchange for this note. Suppose, I write on a stamp paper that I will give INR 1,000 to the holder of this stamp paper and pass it on to you as a gift. You owe INR 1,000 to your friend Neha and decide to pay her using the stamp paper, which can be converted to money any time. Neha accepted the stamp paper and decided to buy groceries using the same and passed it on the shopkeeper, who in turn used it for some other purpose. This is how paper currency got accepted in the society and circulation began.
So far we have discussed two important functions of the Central bank. First one is to draft and implement regulations for the banking system. Central bank decides criteria regarding who should be allowed to operate a bank, minimum documents required to open a bank account, amount of money banks should hold as reserve to safeguard depositors money in case of crisis etc. They provide a level playing field to all banks and also ensure that customer interest is safeguarded. The second function of Central bank is to print money.
In addition to this, central bank is also responsible for controlling inflation in a country. As discussed previously, inflation can be of two types: demand pull and cost push. If central bank prints too much of money and this extra money flows into the system, it will result in a case of too much money chasing too few goods. This is exactly what happens in the case of demand pull inflation. So when inflation is high, central banks reduce injecting money into the economy. When inflation is low central bank pumps more money into the economy to drive up inflation. As discussed earlier in our article on forex, if central bank prints too much money thereby increasing its supply, the currency will depreciate and its value will come down. Too little printing can lead to appreciation of currency as well. Thus, another important job of the central bank is to control currency fluctuations in the forex market.
To conclude central banks are the big boss of the banking system, they design rules of the game, ensure all banks follow the same, control money supply, target inflation and closely watch and safeguard the economy against unwanted currency fluctuations.
Read on to understand how central banks inject money in the economy.