ICAI Notes 8.3 - The Reserve Bank of India (RBI) CA Foundation Notes | EduRev

Economics for CA CPT

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CA Foundation : ICAI Notes 8.3 - The Reserve Bank of India (RBI) CA Foundation Notes | EduRev

The document ICAI Notes 8.3 - The Reserve Bank of India (RBI) CA Foundation Notes | EduRev is a part of the CA Foundation Course Economics for CA CPT.
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Learning Objectives

  • know the meaning of Central Bank.
  • understand the basic functions of a Central Bank.
  • understand how a Central Bank is different a commercial bank.
  • know the role and functions of Reserve Bank of India.


A Central Bank is one which constitutes the apex of the monetary and banking structure of a country and which performs, in the national economic interest, the following functions :

1. The regulation of currency in accordance with the requirements of business and the general public.

2. The performance of general banking and agency services for the State.

3. The custody of cash reserve of the commercial banks.

4. The custody and management of the nation’s reserves of international currency.

5. The granting of accommodation, in the form of rediscounting or collateral advances to commercial banks, bill brokers and dealers.

6. The clearance arrangements among banks; and

7. The control of credit in accordance with the needs of business with a view to carrying out broad monetary policy adopted by the State.

The above is quite comprehensive but, in addition, central banks perform additional functions to meet the specific requirements of the country. Broadly speaking, a central bank has three objectives, namely monetary stability, including stability of domestic price levels, maintenance of the international value of the nation’s currency and issue of currency.


Whereas other banks are largely profit seeking institutions, the central bank is not so. Although, it makes huge contribution to be general revenues, its objective is not to make profit. It does not allow interest on deposits. Its profits are mainly through its dealings in Government securities which it holds in reserve against note issue and interest on advances and loans which it grants to State Governments and other financial institutions, including commercial banks.

The Central Bank acts as the organ of the State. The ultimate responsibility of framing and executing economic policies is that of the State and, therefore, the Central Bank has to advance the policies of the State. For that purpose, the Central Bank has to act in close collaboration with the Finance Ministry and other economic ministries. 

Governments, Central and State banks and other financial institutions. Whereas other banks mobilise savings and channelise them into proper use, the Central Bank’s role is to ensure that the other banks conduct their business with safety, security and in pursuance of the national plan priorities and objectives of economic and social development.


The Reserve Bank of India (RBI) is the Central Bank of India and occupies a pivotal position in the Indian economy. Its role is summarised in the following points:

  • The RBI is the apex monetary institution of the highest authority in India. Consequently, it plays an important role in strengthening, developing and diversifying the country’s economic and financial structure.
  • It is responsible for the maintenance of economic stability and assisting the growth of the economy.
  • It is India’s eminent public financial institution given the responsibility for controlling the country’s monetary policy.
  • It acts as an advisor to the government in its economic and financial policies, and it also represents the country in the international economic forums.
  • It also acts as a friend, philosopher and guide to commercial banks. In fact, it is responsible for the development of an adequate and sound banking system in the country and for the growth of organised money and capital markets.
  • India being a developing country, the RBI has to keep inflationary trends under control and to see that main priority sectors like agriculture, exports and small scale industry get credit at cheap rates.
  • It has also to protect the market for government securities and channelise credit in desired directions.


The Reserve Bank of India being the Central Bank of India performs all the central banking functions. These are :

(i) Issue of currency : The RBI is the sole authority for the issue of currency in India other than one rupee coins and notes and subsidiary coins, the magnitude of which is relatively small.

(ii) Banker to the government : As a banker to the government, the RBI performs the following functions :

(a) It transacts all the general banking business of the Central and State Governments. It accepts money on account of these governments and makes payment on their behalf and carries out other banking operations such as their exchange and remittances 

(b) It manages public debt and is responsible for issue of new loans. For ensuring the successes of the loan operations it actively operates in the gilt-edged market and advises the government on the quantum, timing and terms of new loans.

(c) It also sells Treasury Bills on behalf of the Central Government in order to wipe away excess liquidity in the economy.

(d) The RBI also makes advances to the Central and State Governments which are repayable within 90 days from the date of advance.

(e) The RBI also acts as an adviser to the government not only on policies concerning banking and financial matters but also on a wider range of economic issues including those in the field of planning and resource mobilisation. It has a special responsibility in respect of financial policies and measures concerning new loans, agricultural finance and legislation affecting banking and credit and international finance.

(iii) Banker’s Bank : The RBI has been vested with extensive power to control and supervise commercial banking system under the Reserve Bank of India Act, 1934 and the Banking Regulation Act, 1949. All the scheduled banks are required to maintain a certain minimum of cash reserve ratio with the RBI against their demand and time liabilities. This provision enables the RBI to control the credit position of the country. The RBI provides financial assistance to scheduled banks and state cooperative banks in the form of discounting of eligible bills and loans and advances against approved securities. The RBI also conducts inspection of the commercial banks and calls for returns and other necessary information from banks.

(iv) Custodian of Foreign Exchange Reserves : The RBI is required to maintain the external value of the rupee. For this purpose it functions as the custodian of nation’s foreign exchange reserves. It has to ensure that normal short-term fluctuations in trade do not affect the exchange rate. When foreign exchange reserves are inadequate for meeting balance of payments problem, it borrows from the IMF. The RBI has the authority to enter into exchange transactions on its own account and on account of government. It also administers exchange control of the country and enforces the provisions of Foreign Exchange Management Act.

(v) Controller of Credit : Credit plays an important role in the settlement of business transactions and affects the purchasing power of people. The social and economic consequences of changes in the purchasing power are serious, therefore, it is necessary to control credit. Controlling credit operations of banks is generally considered to be the principal function of a central bank. The RBI, like any other Central Bank, possesses power to use almost all qualitative and quantitative methods of credit controls. (For details discussion on instruments of credit controls please refer to the topic Indian Monetary Policy).

(vi) Promotional Functions : Apart from the traditional functions of a Central Bank, the RBI also performs a variety of developmental and promotional functions. It is responsible for promoting banking habits among people and mobilising savings from every corner of the country. It has also taken up the responsibility of extending the banking system territorially and functionally. Initially, it had also taken up the responsibility for the provision of finance for agriculture, trade and small industries. But now these functions have been handed over to NABARD, EXIM Bank and SIDBI respectively. The Reserve Bank is responsible for over all credit and monetary policy of the economy.

(vii) Collection and publication of Data : It has also been entrusted with the task of collection and compilation of statistical information relating to banking and other financial sectors of the economy.


Monetary Policy is usually defined as the Central Bank’s policy pertaining to the control of the availability, cost and use of money and credit with the help of monetary measures in order to achieve specific goals. In the Indian context, monetary policy comprises those decisions of the government and the Reserve Bank of India which directly influence the volume and composition of money supply, the size and distribution of credit, the level and structure of interest rates, and the effects of these monetary variables upon related factors such as savings and investment and determination of output, income and price.

The broad concerns of monetary policy in India have been -

(a) to regulate monetary growth so as to maintain a reasonable degree of price stability and

(b) to ensure adequate expansion in credit to assist economic growth;

(c) to encourage the flow of credit into certain desired channels including priority and the hitherto neglected sectors; and

(d) to introduce measures for strengthening the banking system and creating institutions for filling credit gaps.

Monetary policy is implemented by the RBI through the instruments of credit control. Generally two types of instruments are used to control credit.

These are (i) quantitative or general measures and (ii) qualitative or selective measures. The quantitative measures are directed towards influencing the total volume of credit in the banking system without special regard for the use to which it is put. Selective or qualitative instruments of credit control, on the other hand, are directed towards the particular use of credit and not its total volume.

I. Quantitative or General Measures : Quantitative weapons have a general effect on credit regulation. They are used for changing the total volume of credit in the economy. Quantitative measures consist of (a) Bank Rate Policy (b) Open Market Operations and (c) Variable Reserve Requirements.

(a) Bank Rate Policy : It is the traditional weapon of credit control used by a Central Bank. The Bank Rate is the rate at which the Central Bank discounts the bills of commercial banks. When the Central Bank wishes to control credit and inflation in the economy, it raises the Bank Rate. Increased Bank Rate increases the cost of borrowings of the commercial banks who in turn charge a higher rate of interest from their borrowers. This means the price of credit will increase. This will affect the profits of the business community who will feel discouraged to borrow. As a result, the demand for credit will go down. Decreased demand for credit will slow down investment activities which in turn will affect production and employment . Consequently, income in general will fall, people’s purchasing power will decrease and aggregate demand will fall and prices will fall down. This in turn will lead to a cumulative downward movement in the economy. On the other hand, if the Central Bank wishes to boost production and investment activities in the economy, it will decrease the Bank Rate. Decreasing the Bank Rate will have a reverse effect. As regards Bank Rate in India, it was 10 percent in 1981, 12 percent in 1991, 11 per cent in 1997 which was reduced (in stages) to 6.5 per cent in April 2001. In April 2003, it was further reduced to 6 per cent. Since then there has been no change.

(b) Open market operations : Open market operations imply deliberate direct sales and purchases of securities and bills in the market by the Central Bank on its own initiative to control the volume of credit. When the Central Bank sells securities in the open market, other things being equal, the cash reserves of the commercial banks decrease to the extent that they purchase these securities. In effect, the credit-creating base of commercial banks is reduced and hence credit contracts.

On the other hand, open market purchases of securities by the Central Bank lead to an expansion of credit made possible by strengthening the cash reserves of the banks. Thus, on account of open market operations, the quantity of money in circulation changes. This tends to bring about changes in money rates. An increase in the supply of money through open market operations causes a down ward movement in the interest rates, while a decrease of money supply raises interest rates. Change in the rate of interest in turn tends to bring about the desired adjustments in the domestic level of prices, costs, production and trade.

(c) Variable reserve requirements : The Central Bank also uses the method of variable reserve requirements to control credit. There are two types of reserves which the commercial banks are generally required to maintain (i) Cash Reserve Ratio (ii) Statutory Liquidity Ratio (SLR). Cash reserve ratio refers to that portion of total deposits which a commercial bank has to keep with the Central Bank in the form of cash reserves. Statutory liquidity ratio refers to that portion of total deposits which a commercial bank has to keep with itself in the form of liquid assets viz - cash, gold or approved government securities. By changing these ratios, the Central Bank controls credit in the economy. If it wants to discourage credit in the economy, it increases these ratios and if it wants to encourage credit in the economy, it decreases these ratios. Raising of the reserve rates will reduce the surplus cash reserves of the banks which can be offered for credit. This will tend to contract credit in the system. Reverse will be effects of reduction in the reserve ratio requirements reflected in the expansion of the bank credit. At present, cash reserve ratio is 5 per cent and statutory liquidity ratio is 24 per cent for entire net demand and time liabilities of the scheduled commercial banks. Cash Reserve Ratio (CRR) was quite low at 4.5 per cent as in March, 2004. Due to inflationary conditions prevailing in the economy, it was hiked (in stages) to 9 per cent in August, 2008. But when situation eased it was again reduced (in stages) to 5 per cent in January 2009.

(d) Repo Rate and Reverse Rate: In addition to these, there are tools of Repo and Reverse Repo Rates. Repo rate is the rate at which our banks borrow rupees from RBI. Whenever the banks have any shortage of funds they can borrow it from RBI. RBI lends money to bankers against approved securities for meeting their day to day requirements or to fill short term gap. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive. At present, Repo rate is 4.75 per cent. [September, 2009]

Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to this attractive interest rates. It can cause the money to be drawn out of the banking system. At present Reverse Repo rate is 3.25 per cent. [September, 2009]

II. Qualitative or Selective Measures : Qualitative or selective measures are generally meant to regulate credit for specific purposes. The Central Bank generally uses the following forms of credit control -

(a) Securing loan regulation by fixation of margin requirements : The Central Bank is empowered to fix the margin and thereby fix the maximum amount which the purchaser of securities may borrow against those securities. Raising of margin curbs the borrowing capacity of the security holder. This is a very effective selective control device to control credit in the speculative sphere without, at the same time, limiting the availability of credit in other productive fields. This device is also useful to check inflation in certain sensitive spots of the economy without influencing the other sectors.

(b) Consumer credit regulation : The regulation of consumer credit consists of laying down rules regarding down payments and maximum maturities of installment credit for the purchase of specified durable consumer goods. Raising the required down payment limits and shortening of maximum period tend to reduce the demand for such loans and thereby check consumer credit.

(c) Issue of directives : The Central Bank also uses directives to various commercial banks. These directives are usually in the form of oral or written statements, appeals, or warnings, particularly to curb individual credit structure and to restrain the aggregate volume of loans.

(d) Rationing of credit : Rationing of credit is a selective method adopted by the Central Bank for controlling and regulating the purpose for which credit is granted or allocated by commercial banks.

(e) Moral suasion : Moral suasion implies persuasion and request made by the Central Bank to the commercial banks to co-operate with the general monetary policy of the former. The Central Bank may also persuade or request commercial banks not to apply for further accommodation from it or not to finance speculative or non-essential activities. Moral suasion is a psychological means of controlling credit; it is a purely informal and milder form of selective credit control.

(f) Direct Action : The Central Bank may take direct action against the erring commercial banks. It may refuse to rediscount their papers, and give excess credit, or it may charge a penal rate of interest over and above the Bank Rate, for the credit demanded beyond a prescribed limit. By making frequent changes in monetary policy, it ensures that the monetary system in the economy functions according to the nation’s needs and goals.


At the apex of banking and monetary structure is the Central Bank of the economy. The Central Bank performs the main functions of note issue, banker for the government, credit control, custodian of cash reserves, lender of the last resort etc., India’s Central Bank ‘The Reserve Bank of India’ performs all these functions. The instruments which it uses for controlling credit in the economy are both general (in the form of bank rate, open market operations, reserve rates) and selective (in the form of margin requirements, variable interest rates, regulation of consumer credit and so on). Credit policy is amended from time to time to suit the needs of the economy.   

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