Distinguish between limited legal tender and unlimited legal tender.

The legal tender status given by the government to money may be limited or unlimited.
i) Limited legal tender. It is that money which no person can be forced to accept beyond a certain maximum limit fixed by law. For instance in India, coins are limited legal tender because coins of 5, 10, 20 and 25 paise can be accepted up to maximum sum of र 1000 as per Coinage bill passed on 11th Aug. 2011. One can refuse payments by an individual in these small coins beyond this limit.
(ii) Unlimited legal tender. It is the money which a person has to accept up to any limit. There is no limit to quantity of money offered in payment. For example in India, paper notes are unlimited legal tender because all currency notes can be used to settle payments of unlimited value.
Note: that currency notes of denomination of र 2 and above are issued by RBI whereas one Rupee note and coins are issued by Ministry of Finance - Government of India.

What monetary system does India follow?

India at present follows the Paper Currency Standard because here standard currency is made of paper. This is also referred to as Managed Currency Standard as any amount of notes can be issued with the minimum backup of gold worth र 115 crores. Remember, a monetary system refers to the form of standard money used in the economy. It is legal money through which government discharges its obligations. The standard money which is used in India is made of paper. In India the monetary authority is Reserve Bank of India (RBI) which has adopted a standard currency made of paper. That is why India is said to be on a paper currency standard. Following points need to be noted in this regard.
(i) Paper currency is the main currency of the country. It is unlimited legal tender which means that it can be used to settle debts and make payments up to an unlimited amount. Coins made of cheap and light metals are used for making smaller payments. Again these coins are limited legal tender because they can be used for making payments and setting debts only up till a limited amount. For instance, it would be inconvenient to settle a debt of र 2,000 with 50 paise and 25 paise coins.
(ii) RBI has the sole monopoly to issue currency notes in India from र 2 and above. The central government (Ministry of Finance) issues the one-rupee note and all coins but the responsibility for putting them into circulation rests with the RBI.
(iii) The system which governs note issue in India is the Minimum Reserve system according to which the Central Bank keeps a minimum reserve of gold and foreign exchange and on this basis can issue notes to any limit. Since paper currency is not convertible into precious metal gold which is backing it, therefore, the currency is said to be inconvertible.


Explain main/following functions of a Central Bank.
‘Issue of currency’ function. 
‘Lender of last resort’ function.  
‘Banker to the government’ function. 
‘Controller of credit’ function.
How does a Central Bank control availability of credit by open market operations?
Banker's bank and Supervisor function. 

Functions of a Central Bank. Main functions of a Central Bank are to act as governor of the machinery of credit in order to secure stability of prices. It regulates the volume of credit and currency, pumping in more money when market is dry of cash, and pumping out money when there is excess of credit. Broadly, a central bank has two departments, namely, issue department and banking department. We discuss below its main functions.
1.    Issue of Currency. The central bank is given the sole monopoly of issuing currency in order to secure control over volume of currency and credit. These notes circulate throughout the country as legal tender money. Note-issuing is governed by Minimum Reserve System i.e. while issuing currency notes, a minimum fixed amount of gold and foreign currency is kept by Central Bank. It has to keep a reserve in the form of gold and foreign securities as per statutory rules against the notes issued by it. It may be noted that RBI issues all currency notes in India except one rupee note. Again it is under directions of RBI that one rupee notes and small coins are issued by government mints. Remember, central government of a country is usually authorised to borrow money from the central bank. When central government expenditure exceeds government revenue and Govt, is unable to reduce its expenditure, then it borrows from RBI. This is done by selling security bills to RBI which creates new currency notes for the purpose. This is called monetisation of budget deficit or deficit financing. The government spends new currency and puts it into circulation to meet its expenditure.
2.    Banker to the Government. Central Bank functions as a banker to the government— both central and state governments. It carries out all banking business of the government. Governments keep their cash balances in the current account with the central bank. Similarly, central bank accepts receipts and makes payment on behalf of the governments. Also central bank carries out exchange, remittance and other banking operations on behalf of the government. Central bank gives loans and advances to governments for temporary periods, as and when necessary, and it also manages the public debt of the country.
3.    Bankers’ Bank and Supervisor. There are usually hundreds of banks in a country. There should be some agency to regulate and supervise their proper functioning. This duty is discharged by the central bank. Central bank acts as banker's bank in three capacities : (i) it is custodian of their cash reserves. Banks of the country are required to keep a certain percentage of their deposits with the central bank; and in this way the central bank is the ultimate holder of the cash reserves of commercial banks. (ii) Central bank is lender of last resort. Whenever banks are short of funds, they can take loans from the central bank and get their trade bills discounted. Thus Central Bank is a source of great strength to the banking system. (iii) It acts as a bank of central clearance, settlements and transfers. Its moral persuasion is usually very effective so far as commercial banks are concerned.
4.    Controller of Credit and Money Supply. It is an important function of a Central Bank to control credit and money supply through its monetary policy. There are two parts of monetary policy, viz., currency and credit. Central Bank has monopoly of issuing notes and thereby can control the volumes of currency. Main objective of credit control function of a Central Bank is stabilising of price level. It controls credit and money supply by adopting quantitative measures and qualitative measures, namely, (i) Bank Rate, (ii) Open Market Operations, and (iii) CRR which influence credit availability and credit creation.Credit creation refers to lending by commercial banks. Following are instruments of monetary policy of RBI.
Instruments of monetary policy:
(i) Bank rate (D 2009; 10C). Bank rate is the rate of interest at which Central Bank lends to commercial banks. Clearly by raising the bank rate, Central Bank raises the cost of borrowing. This forces the commercial banks to raise, in turn, the rate of interest from the public. As lending rate rises, demand for loans for investment and other purposes falls. Thus increase in bank rate by Central Bank adversely affects credit creation by commercial banks. A decrease in bank rate will have opposite effect. Presently — Feburary 2012 — Bank rate (also called Repo Rate) is 8.5% and Reverse Repo Rate (rate at which banks park their surplus funds with RBI) is 7.5%.
(ii) Open market operations. These refer to buying and selling of Government securities by Central Bank. This is done to influence the money supply in the country. Remember, sale of Government securities to commercial banks means flow of money into Central Bank which reduces cash reserves with the banks with the result credit availability of commercial banks is curtailed/controlled.
(iii) Cash Reserve Ratio (CRR). Every commercial bank under law has to deposit with Central Bank a minimum percentage of its demand deposit and time deposit. This percentage is called as CRR. A high CRR means smaller deposits and lesser loans. Higher the CRR, lesser is the banks capacity to create credit. By changing CRR, Central bank controls the lending capacity and credit availability of banks. At present CRR is 5.5% w.e.f. 28th January 2012. Statutory Liquidity Ratio (SLR) is another instrument adopted by RBI to control credit.
5.    Lender of Last Resort. When commercial banks have exhausted all resources to supplement their funds at times of liquidity crisis, they approach Central Bank as a last resort. As lender of last resort Central Bank gives guarantee of solvency and provides financial accommodation to commercial banks (i) by rediscounting their eligible securities and bills of exchange, and (ii) by providing loans against their securities. This saves banks from possible failure and banking system from a possible breakdown. On the other hand, Central Bank, by providing temporary financial accommodation, saves the financial structure of the country from collapse.
6.    Exchange Control. Another duty of a Central Bank is to see that the external value of currency is maintained. For instance, in India, the Reserve Bank of India takes steps to ensure external value of a rupee. It adopts suitable measures to attain this object. The exchange control system is one such measure. Under exchange control system, every citizen of India has to deposit all foreign currency or exchange that he receives with the Reserve Bank of India; and whatever foreign exchange he might need has to be secured from the Reserve Bank by making an application in the prescribed form.
7.    Custodian of Foreign Exchange or Balance. It has been mentioned above that a Central Bank is the custodian of foreign exchange resources and nation’s gold. It keeps a close watch on external value of its currency and undertakes exchange management control. All the foreign currency received by the citizen has to be deposited with the Central Bank; and if citizens want to make payment in foreign currency, they have to apply to the Central Bank. Central Bank also keeps gold and bullion reserves.
8.    Clearing House Function. Banks receive cheque drawn on the other banks from their customers which they have to realise from drawee banks. Similarly, cheques on a particular bank are drawn and pass into the hands of other banks which have to realise them from the drawee banks. Independent and separate realization to each cheque would take a lot of time; and. therefore, Central Bank provides clearing facilities, i.e., facilities for banks to come together everyday and set off their chequing claims.
9.    Collection and Publication of Data. It has also been entrusted with the tasks of collection and compilation of statistical information relating to banking and other financial sectors of economy.


State six points of distinction between central bank and commercial bank. 

For clear and better understanding, a comparison between Central Bank and commercial bank is given below



Central Bank


Commercial Bank


It is the apex bank in the money market of a country.


It is merely a unit in the banking structure of the country.


Its primary aim is general public welfare.


Its primary aim is to make profit.


It has the sole monopoly right to issue currency notes.


A commercial bank is statutorily denied function of issuing notes.


It cannot deal with the public.


It directly deals with the public and business firms.


It acts as a banker to the government.


It has no such responsibility towards the state.


It decides its monetary policy to realise economic stability and full employment in the country.


It plays a supplementary role and is quite often regulated by the Central Bank.


It is custodian of Nation’s Gold and Foreign Exchange Reserve.


It does not perform such function.


What is a Central Bank? Why it is necessary?

Meaning of Central Bank. The Central Bank is the apex institution of monetary system of a country. It is banker to the other banks and to government, it issues notes, controls money supply and credit, and maintains monetary stability.
Central Banks have been established in all financially developed countries. They are known by different names in different countries. In India the Central Bank is known as Reserve Bank of India which was established in 1935 as a shareholder bank and nationalised on first January, 1949. In U.K. it is called Bank of England and in Russia it is known as Gosbank.
Necessity of Central Bank. Since the first world war, the most important development in the field of monetary system is the emergence of Central Banks with added prestige and power. Now-a-days the institution of Central Bank is considered indispensable in every country. Now there is hardly a civilised country which does not possess a Central Bank. Central Banks are necessary because of the following reasons.
(i)    Monetary System requires Management. “Money will not manage itself,” said Begehot long ago. Even gold standard was not fully automatic. The paper standard which is in operation in every country now, has to be directed by some central authority.
(ii)    Banking System requires Control and Regulation. The banks of a country, being private institutions, act by profit motive. Because they are competitive concerns, they cannot follow a common policy according to national requirements. The result is either creation of too much credit sometimes or too little at other times. Therefore, a central coordinating authority, which will compel them to follow the appropriate policy under economic situation is necessary. Hence an institution is established which is called Central Bank.


What is ‘High Powered Money’? 

High Powered Money. The Total liability of the monetary authority of the country, RBI, is called the high powered money or monetary base. It is the money created/produced by RBI and government of India. It consists of currency (notes and coins) in circulation with the public and vault cash of commercial banks and deposits held by government and commercial banks with RBI. It is high powered money because these are liability of RBI to refund deposits on demand from the deposit holders. Again if a person presents a currency note to RBI, the latter has to pay him value equal to the amount printed on the note. Remember, RBI acquires assets against these liabilities.
In short, RBI regulates money supply by controlling stock of high powered money, bank rate and reserve requirements of commercial banks.
Money creation by RBI. Suppose RBI wishes to increase money supply. For this it will inject additional high powered money into the economy. Let us assume that RBI purchases gold worth र 100 crores. It issues currency and makes payment for gold. This results in an increase in currency in circulation equal to र 100 crores. Further suppose that RBI purchases securities worth र 400 crores in the open market. It will issue a cheque of र 400 crores to the seller of the securities. The seller encashes the cheque at his account in, say, Canara Bank which receives this amount. Clearly currency held by the public, thus, goes up. Here comes the part played by money multiplier.