Instruments central bank uses to control commercial banks – The Central Bank is the apex financial system in an economy. The Central Bank is the agent of monetary policy.
This can be defined as the attempt to regulate the supply of money, the terms and availability of credit. However, the instrument by which the Central Bank performs its role varies from one country to another.
Functions of the Central Bank
Here are the general functions of Central Bank:
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Banker to the Government
Governments, like other economic agents, need to hold their funds in an amount into which they can make deposits and against which they can draw cheques. Such government deposits are usually held by the Central Bank.
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Manager of the Public Debt
The Central Bank helps the government with its debt management. It helps the government in raising new funds and managing its debt.
For Instance, the Central Bank usually purchases any part of new issues of public debt that is not taken up by other lenders on the day of issue at what seems like a reasonable interest rate.
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Lender of Last Resort
Commercial banks often have sudden needs for cash and one way of getting it is to borrow from the Central Central Bank.
Central Bank is a lender of last resort because when other sources have failed the Central Bank would lend money to commercial banks with good investments but in temporary need of cash.
Those commercial banks pay interest on the loan at a rate that used to be called the bank rate but is now called the minimum lending rate.
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Regulator of the Money Supply
The Central Bank has great power to influence the money supply. By this power the Central Bank tries to control inflation in the economy.
Instruments Central Bank Uses to Control Commercial Banks
The following are the instruments central bank uses to control commercial banks;
1. Currency Control
Currency control is one of the instruments central bank uses to control commercial banks. In most countries, the Central Bank has the sole power to issue paper money. No attempt is made, however, to control the overall money supply by controlling the quantity of bank notes in circulation.
Suppose that the public wishes to increase the fraction of total money supply it holds as notes and coins. Faced with a cash drain to the public, the commercial banks will withdraw deposits from the Central Bank and the bank will print the necessary bank notes.
2. The Reserve Base
Much more importantly than the currency control is the Central Bank’s control over the reserves available to the banking system.
The Central Bank requires commercial banks to hold reserves against their deposit liabilities.
These reserves are called the reserve base of the money supply.
Through the manipulation of this reserve base, the Central Bank can influence the money supply in an economy.
3. Monetary Policy
The Central Bank is responsible for the operation of monetary policy.
One major objective of monetary policy is to influence the aggregate demand and through the national income, employment and prices.
Another objective is to provide a cushion for the country’s financial system from the kinds of panics and crashes that have caused occasional financial havocs.
The major tools of monetary policy have changed over the years. In the past, the Central Bank sought to influence the economy by influencing the term and availability of credit.
It was believed that aggregate expenditure could be raised by making it easy to get credit on easy terms and vice-versa.
4. Open Market Operations
These involve the sale or purchase of government securities in the open market.
Through this, the Central Bank would be able to influence commercial bank reserves and indirectly, the money suppy in an economy.
An open market operation is very effective, particularly, in countries with well developed money markets.
5. Bank Rate
This is the price paid by the owner of securities to the Central Bank for converting the securities into cash. Interest rates charged by the banks follow the bank rate.
Hence, by varying the bank rate, the central bank influences the availability and cost of credit and hence the money supply.
6. Reserve Requirement
This is the ratio of its deposits that a commercial bank must keep in the form of cash and common interest earning balances with the Central Bank.
This requirement reserve ratio pre determines the maximum amount of credit that can be created by banking system.
By the manipulation of the reserve requirement ratio, the Central Bank influences the money supply in the economy.
7. Moral Suasion
A persuasive attempt by the Central Bank to the commercial banks to reduce the amount of their credit to the public.
Credit guideline is also used to control the amount of credit given by the commercial banks and to which sectors of the economy it is given.
