CENTRAL BANKS - The Mainstay of an Economy

RBI INSIGNIA

Central Banks - simple banks for most of us; their complexity and primordial importance in an economy is what most of us tend to neglect, rather not bother about. And there's no harm in not knowing about a Central Bank's function, especially when we are living in a healthy economy.

But what has the recent trend showed us - the recent economic crises, inflation (as mentioned in my last post), financial stalemates et al; all have in some way or the other brought a nation's Central Bank in the picture.
So what is a Central Bank ? Why is it so important ? I shall answer these questions citing the example of the RESERVE BANK OF INDIA (RBI) wherever necessary.
RBI - the Central Bank of India; a bank that controls money flow in our economy, issues currency, controls foreign exchange & controls the interest rates in our economy.
Hard to decipher ?! Let's see this:

• CONTROLS MONEY FLOW & ISSUES CURRENCY : Pick out a currency note from your pocket; saw the name of RBI written everywhere ?! What does it imply? In simplest of terms it means that the note you just saw has been printed & issued by the RBI. Meaning that all the currency in the form of INDIAN RUPEE (INR) in the Indian as well as the world market is printed and sanctioned by the RBI. (not much important a point)
• CONTROLS FOREX : Every nation has certain amount of its wealth in the form of foreign exchange of some other country like US-dollar, Euro, Dinar etc. Example India has around 318,220million USD as forex reserve.(Source: Wikipedia). USD being the universal trading currency, all forex is measured in terms of this omnipresent US-DOLLAR.
• CONTROL INTEREST RATES : One of the most important functions of the central banks (RBI in India) is to control the rates - rates of lending money and rates of receiving money to and fro an economy. Let's understand this is detail...

In an economy, the banking system enables the flow - in and out of the consumers' hands. Where do these banks get money from ? How do the banks gain profit ? The answer : 

Well the money printing machine i.e the RBI lends money to these banks for them to function. Now lending sure comes at a price. This price is in the form of an interest rate - REPO RATE(RR) - the rate at which RBI lends to different banks. The current repo rate stands at 8% i.e if a bank borrows Rs.1,00,00,000/- from RBI, for a period of 2 years compounded annually, it will have to pay back Rs.1,16,64,000/- after 2 years.

Meaning : more the repo rate more strenuous will the task of borrowing become and vice versa.

REVERSE REPO RATE(RRR) - Rate of interest at which RBI borrows funds from other banks. RBI AND BORROWS MONEY ? Well let's say that banks deposit their money with the RBI at this interest rate to get good returns in the future - depending on the Reverse Repo Rate - the current RRR is 7%.

SO IN A WAY, THE CENTRAL BANKS ARE IN TRUE TERMS THE MONEY CONTROL MACHINES OF AN ECONOMY - by balancing the interest rates, central banks ensure that an economy functions smoothly; by controlling inflation(to be dealt in the next post), ensuring economic growth.

TO KNOW MORE ABOUT RBI's FUNCTIONING - refer to this comic book - issued by RBI itself - RBI - MONETARY POLICY - MONEY KUMAR COMICS