The Central Bank is the nation's principal monetary authority responsible for the monetary policy of the country. It regulates money supply and credit, issues currency, and manages the rate of exchange. Its main duty is to maintain the stability of its national currency and money supply. In addition to its main duty, it also actively works for controlling subsidized loan interest rates, and acts as a "bailout" lender of last resort to the banking sector during times of financial crisis. It supervises to ensure that the banks and other financial institutions comply with the relevant guidelines/regulations and thereby avoid any sort of mischief in their operations.
The Central Bank is normally a state-owned body and is allowed to act independently to a certain extent which means the government can intervene in monetary policy matters as and when it feels necessary to do so in public interest. In fact, an independent central bank is the bank that works as per the rules designed in order to prevent political interference in its operational matters.Open Market Operations
Through open market operations, the Central bank directly influences the money supply in an economy. Whenever it buys securities, it exchanges money for the security and thereby raises the money supply. On the contrary, selling of securities lowers the money supply.
To carry out open market operations, the Central bank holds foreign exchange reserves. These reserves are usually in the form of government bonds and official gold reserves.
The open market operations show their impact on the official or mandated exchange rates. Some of these exchange rates are managed, some of them are market based (free float) and most of them fall in between and are called ‘managed float' or ‘dirty float'.
Bank Reserve Requirement
The Central Bank is empowered to establish reserve requirements for other banks. As per the requirements, a percentage of liabilities be held as cash or deposited with the central bank or with any specified agency. The percentage limits are set based on the money supply.
This statutory requirement was introduced in the 19th century with an objective to reduce the risk of the banks from overextending themselves and suffering from bank runs, as this could lead to knock-on effects on other banks.
Interest Rate Policy
Modern Central Banks tend to influence the market interest rates though the mechanism adopted may differ from country to country. The mechanism adopted may be similar too based on the Central Bank's ability to create fiat money sufficient to it.
The Central Bank adopts the mechanism in order to move the market to its ‘target rate' until the market rate is sufficiently close to the target. It carries out this mechanism by lending money to and borrowing money from a limited number of qualified banks or by purchasing and selling bonds.
Example: State Bank of India (SBI) fixes a target rate at a band of plus or minus 2.5%. Qualified banks borrow from each other within this bond but never above or below because the Central Bank always lends to them above the band and receives deposits at the bottom of the band. Infact, the capacity to borrow and lend at the extremes of the band are unlimited.
The targeted interest rates are generally for short-term. But, the actual rate that borrowers and lenders receive on the market depends upon the various factors like credit risk, maturity and other factors.
The Central Bank, at its discretion, fixes the interest rate at which it can lend money. Usually, a typical central bank has several interest rates or monetary policy tools through which it strives to influence markets. Some of the varied interest rates are:
Marginal Lending Rate: This is the fixed rate for institutions to borrow money from Central Bank.
Main Refinancing Rate: This is the publicly visible interest rate the Central Bank announces. It is a minimum bid rate and serves as a bidding floor for refinancing loans.
Deposit Rate: This is the rate fixed for the deposits for the commercial banks.
It is mandatory for all banks to hold a certain percentage of their assets as capital. This is the rate fixed either by the Central bank or the banking supervisor. This is considered to be more effective than deposit/reserve requirements to prevent indefinite lending. This is because when it is at the threshold, it cannot extend support for another loan without acquiring further capital on its balance sheet.