The Role of Central Bank in a Developing Economy of a Country

We all have heard about central banks; each country has one. But have you ever asked yourself what is their role in driving the development agenda of the country from an economic and monetary view. In an ideal situation the central bank is key in the process of shaping the economic trajectory taken by any given country.

The roles of the central bank can be summed up into two categories of traditional and non-traditional functions. The principal traditional functions performed by it are the monopoly of note issue, banker to the government, bankers’ bank, lender of the last resort, controller of credit and maintaining stable exchange rate.

Economy

All aforementioned functions are related to the foremost function of helping in the economic development of the country.

Role of Central Bank in Economic Development:

The central bank in shaping the development of a country aims at the promotion and maintenance of a rising level of production, employment and real income in the country. The central banks in the majority of underdeveloped countries have been given wide powers to promote the growth of such economies. They, therefore, perform the following functions towards this end.

Creation and Expansion of Financial Institutions:

One of the aims of a central bank in an underdeveloped country is to improve its currency and credit system. More banks and financial institutions are required to be set up to provide larger credit facilities and to divert voluntary savings into productive channels. Financial institutions are localised in big cities in underdeveloped countries and provide credit facilities to estates, plantations, big industrial and commercial houses.

In order to remedy this, the central bank extends branch banking to rural areas to make credit available to peasants, small businessmen and traders. In underdeveloped countries, the commercial banks provide only short-term loans. Credit facilities in rural areas are mostly non-existent. The only source is the village moneylender who charges exorbitant interest rates.

Similarly, central bank can help in the establishment of lead banks and through them regional rural banks are able to provide credit facilities to marginal farmers, landless agricultural workers and other weaker sections. With the vast resources at its command, the central bank can also help in establishing industrial banks and financial corporations in order to finance large and small industries.

Proper Adjustment between Demand for and Supply of Money:

The central bank plays an important role in bringing about a proper adjustment between demand for and supply of money. An imbalance between the two is reflected in the price level. A shortage of money supply will inhibit growth while an excess of it will lead to inflation. As the economy develops, the demand for money is likely to go up due to gradual monetization of the non-monetized sector and the increase in agricultural and industrial production and prices.

The demand for money for transactions and speculative motives will also rise. So the increase in money supply will have to be more than proportionate to the increase in the demand for money in order to avoid inflation. There is, however, the likelihood of increased money supply being used for speculative purposes, thereby inhibiting growth and causing inflation.

The central bank controls the uses of money and credit by an appropriate monetary policy. Thus in an underdeveloped economy, the central bank can control the supply of money in such a way that the price level is prevented from rising without affecting investment and production adversely.

A Suitable Interest Rate Policy:

The interest rate structure stands at the core of development and investment. The existence of high interest rates acts as an obstacle to the growth of both private and public investment, in an economy.

A low interest rate is, therefore, essential for encouraging private investment in agriculture and industry. Since in for instance in an underdeveloped country businessmen have little savings out of undistributed profits, they have to borrow from the banks or from the capital market for purposes of investment and they would borrow only if the interest rate is low. A low interest rate policy is also essential for encouraging public investment. A low interest rate policy is a cheap money policy. It makes public borrowing cheap, keeps the cost of servicing public debt low and thus helps in financing economic development.

In order to discourage the flow of resources into speculative borrowing and investment, the central bank follows a policy of discriminatory interest rates, charging high rates for non-essential and unproductive loans and low rates for productive loans. But this does not imply that savings are interest-elastic in an underdeveloped economy.

In the context of economic growth, as the economy develops, a progressive rise in the price level is inevitable. The value of money falls and the propensity to save declines further. Money conditions become tight and there results a tendency for the rate of interest to rise automatically. This can result in inflation. In such a situation any effort to control inflation by raising the rate of interest would be disastrous. A stable price level is, therefore, essential for the success of a low interest rate policy which can be maintained by following a judicious monetary policy by the central bank.

Debt Management:

Debt management is one of the important functions of the central bank. It aims at proper timing and issuing of government bonds, stabilizing their prices and minimizing the cost of servicing public debt. It is the central bank which undertakes the selling and buying of government bonds and making timely changes in the structure and composition of public debt.

In order to strengthen and stabilize the market for government bonds, the policy of low interest rates is essential. For, a low rate of interest raises the price of government bonds, thereby making them more attractive to the public and giving an impetus to the public borrowing programmes of the government. The maintenance of structure of low interest rates is also called for minimizing the cost of servicing the national debt.

It encourages funding of debt by private firms. However, the success of debt management depends upon the existence of well-developed money and capital markets in which wide range of securities exist both for short and long periods. It is the central bank which can help in the development of these markets.

Credit Control:

Central Bank functions as the controller of credit in order to influence the patterns of investment and production in an economy. Its main objective is to control inflationary pressures arising in the process of development. This requires the use of both quantitative and qualitative methods of credit control. The selective credit control measures may take the form of changing the margin requirements against certain types of collateral, the regulation of consumer credit and the rationing of credit.

Solving the Balance of Payments Problem:

The central bank prevent and work at solving the balance of payments problem in an economy. Economies often can face serious balance of payments difficulties to fulfil the targets of development plans. An imbalance is created between imports and exports which continue to widen with development.

The central bank manages and controls the foreign exchange of the country and also acts as the technical adviser to the government on foreign exchange policy. It is the function of the central bank to avoid fluctuations in the foreign exchange rates and to maintain stability. It does so through exchange controls and variations in the bank rate. For instance, if the value of the national currency continues to fall, it may raise the bank rate and thus encourage the inflow of foreign currencies.

Conclusion:

The central bank plays an important role in achieving economic growth of a country through the various measures discussed above. It promotes economic growth with stability, help in attaining full employment of resources, in overcoming balance of payments disequilibrium, and in stabilising exchange rates.