Central Bank Questions and Answers [With PDF]

Every country has one bank that sits above all the others: it issues the currency, serves the government, supervises the banking system and steers the economy through interest rates. That is the central bank. This chapter covers its features, objectives and functions, why it is called the government’s bank, the banker’s bank and the lender of last resort, and the tools it uses to control credit: the bank rate, open market operations and reserve requirements. Here are 30 important questions with clear answers, tables and worked examples, ready for exams, vivas and job interviews.

This is Chapter 2 of our Banking course. It follows Primary Concepts of Banking and comes before Commercial Bank.

Meaning, Features and Functions

Q1. What is a central bank?

A central bank is the apex (top) bank of a country. It issues the currency, manages the government’s accounts and debt, supervises the banking system and controls the money supply and credit to support the government’s economic policy. Examples: the Bank of England (UK), the Federal Reserve System (USA) and the Reserve Bank of India (India).

Q2. What are the features of a central bank?

• It is a single, unique institution at the head of the banking system.
• It is owned and controlled by the government, or works under its supervision.
• It works in the public interest, not to earn profit, which makes its objectives different from commercial banks.
• It has the sole right to issue notes.
• It acts as the government’s bank and the bank of other banks.
• It is the lender of last resort.
• It controls credit and the money supply, and guards foreign exchange reserves.

Q3. What are the objectives of a central bank?

• Price stability: keep inflation under control.
• Monetary stability: maintain the value of the currency.
• Financial stability: keep the banking system sound.
• Support economic growth and employment.
• Maintain the exchange rate and foreign exchange reserves.
• Develop and supervise the money market and the banking sector.
• Guide commercial banks so that credit goes to productive sectors.

Q4. What are the functions of a central bank?

Q5. Why does the central bank have the monopoly of note issue?

A single issuer makes the currency uniform and trusted, and it lets the central bank control the money supply. With many issuers, over-issue and confusion could occur. The central bank issues notes on behalf of the government and keeps backing assets such as gold, foreign currency and government securities.

Q6. How does the central bank decide how many notes to issue?

It issues enough notes to meet the needs of the economy. If too few notes are issued, there is a shortage of money. Transactions are hampered, investment falls and unemployment can rise. If too many are issued, prices rise and inflation occurs. The central bank therefore keeps a careful balance between the two.

Relations with the Government and Banks

Q7. Why is the central bank called the government’s bank?

Because it does for the government what a commercial bank does for its customers. It keeps the government’s accounts, receives and pays money on its behalf, gives it loans in time of need, manages the public debt, buys and sells foreign exchange for it and gives financial advice. It is usually owned and controlled by the government.

Q8. Why is the central bank called the banker of other banks?

Just as people open accounts in commercial banks, commercial banks open accounts in the central bank. They keep their statutory reserves there, settle debts between themselves through it, and borrow from it when needed. So the central bank is the bank of banks.

Q9. Why is the central bank called the lender of last resort?

When a commercial bank faces a sudden shortage of cash and cannot borrow from anywhere else, the central bank steps in with emergency loans against good securities. This prevents a bank failure from spreading panic and bank runs through the whole system.

Q10. Why is the central bank called the guardian of the money market?

The money market is where short-term funds are traded among banks, bill markets and other institutions. The central bank helps form and develop this market, regulates it, keeps it stable and protects it from shocks. It does this by planning, lending, setting rules and monitoring the market.

Q11. How does the central bank act as custodian of foreign exchange?

It holds the country’s foreign currency and gold reserves, buys and sells foreign exchange to keep the exchange rate stable, and enforces foreign exchange regulations, so that the country can pay for its imports and protect the value of its currency.

Q12. What is the relationship between the central bank and commercial banks?

• Commercial banks keep a statutory reserve with the central bank.
• The central bank provides clearing house services.
• The central bank licenses commercial banks and approves new branches.
• Commercial banks send regular returns, so the central bank can monitor their liquidity and protect depositors.
• The central bank lends to them and acts as lender of last resort.
• Commercial banks carry out the central bank’s monetary policy.

Q13. What is a scheduled bank?

A scheduled (listed) bank is a bank included in the list (schedule) of the central bank because it meets its requirements and agrees to follow its directions. Its features:

• It is registered under the country’s banking law.
• It has a minimum paid-up capital and reserves.
• It keeps a prescribed share of its deposits with the central bank as cash reserve.
• It holds a prescribed share of deposits in liquid assets, such as treasury bills.
• It follows the central bank’s rules and is eligible for its loans and facilities.

Credit Control and Monetary Policy

Q14. What is credit control?

Credit control means regulating the quantity and cost of credit that banks create in the economy. Too little credit hampers production and investment, while too much credit fuels inflation. The central bank controls the credit supply to keep the economy stable.

Q15. What are the methods of credit control?

Quantitative methods affect the total volume of credit. Qualitative methods control where credit goes.

Q16. What is the bank rate policy?

The bank rate is the interest rate at which the central bank lends to commercial banks or discounts their eligible bills. The bank rate policy means raising or lowering this rate to control credit. It is one of the oldest quantitative tools, developed by the Bank of England in the 19th century.

Q17. How does the bank rate control credit?

The central bank raises the rate to cool inflation and lowers it to revive a slow economy.

Q18. What are the limitations of the bank rate policy?

• It needs a well-organized money market.
• If commercial banks hold large excess reserves, they do not need to borrow from the central bank, so the policy loses its effect.
• Market interest rates may not follow the bank rate.
• Lenders outside the banking system, such as informal moneylenders, are not affected.

Q19. What is the open market operation (OMO) policy?

The central bank buys and sells government securities, bills and bonds in the open market to change the amount of money that banks hold, and so to control credit.

Q20. How does OMO affect credit?

Q21. What are the limitations of OMO?

• It needs a well-developed securities market with enough securities to trade.
• It is ineffective if people do not use banks.
• Banks with large excess reserves may not respond.
• It may be less effective if banks can get loans from other sources.

Q22. What is the reserve ratio changing policy?

Commercial banks must keep part of their deposits as reserves. The central bank changes these ratios to control how much banks can lend. Raising the ratio reduces lending capacity and lowering it increases it. The two main ratios are the cash reserve requirement (CRR) and the statutory liquidity ratio (SLR).

Q23. What is the difference between CRR and SLR?

Example: A bank has deposits of 1,000 million. If CRR is 5%, it must deposit 50 million with the central bank. If SLR is 15%, it must hold 150 million in liquid assets. Only the rest, 800 million, is available for lending. If the central bank raises CRR to 8%, the bank must deposit 80 million, and its lending capacity falls by 30 million.

Q24. What is rationing of credit?

A selective control where the central bank fixes limits on the credit that banks can give, or directs credit to priority sectors such as agriculture and export industries, while restricting it for speculative activities.

Q25. What is consumer credit control?

Consumers often buy goods on instalment credit. The central bank can control such credit by setting a minimum down payment and a maximum number of instalments. Example: raising the minimum down payment from 20% to 40% on a car loan discourages borrowing.

Q26. What are margin requirements, direct action, moral persuasion and publicity?

• Margin requirement: the part of the value of a security that the borrower must pay himself. If the margin is 40%, a bank lends only 60% against shares, which limits speculation.
• Direct action: the central bank penalizes or restricts banks that break its rules.
• Moral persuasion: advice and requests, without force.
• Publicity: publishing information to influence public and bank behaviour.

Clearing House and Monetary Conditions

Q27. What is a clearing house?

A clearing house is a system, operated or supervised by the central bank, through which banks settle their mutual claims arising from cheques and other payments, by exchanging them and paying only the net balance. Example: Bank A holds cheques worth 100 drawn on Bank B, while Bank B holds cheques worth 80 drawn on Bank A. Instead of paying 180 in total, only the difference of 20 is paid: Bank B pays Bank A 20 by a transfer between their accounts at the central bank.

Q28. What are the features and importance of a clearing house?

• Banks settle their mutual claims in one place, usually daily.
• The central bank supervises it.
• Only net balances are paid, by debiting and crediting the banks’ accounts at the central bank.
• It speeds up settlement and saves time, cash and effort.
• It reduces the need to move cash around, and so it supports the smooth flow of funds.

Q29. When do inflation and deflation occur?

Inflation is a sustained rise in the general price level. It tends to occur when the money supply grows faster than the output of goods and services. Deflation is a sustained fall in the general price level. It tends to occur when the money supply is too small compared with output. The central bank uses its credit control tools to prevent both.

Q30. How does the central bank supervise the money market?

• Plans and helps with the formation and development of the money market.
• Helps in its management.
• Maintains the stability of the market.
• Protects the value of money.
• Acts as an agent and adviser for the government in the market.

Quick Revision Points

• The central bank is the apex bank. It issues currency, is the government’s banker and the bankers’ bank, and is the lender of last resort.
• Credit control tools: bank rate, open market operations, CRR and SLR, plus selective controls.
• Raising the bank rate makes borrowing costlier and reduces credit. Selling securities reduces credit.
• CRR is cash deposited with the central bank. SLR is liquid assets held by the bank itself.
• A clearing house settles only the net balance between banks.

Test yourself with the chapter quiz below, then continue to Commercial Bank.