Question

Describe the various functions of a Central Bank, specifically how it controls the money supply through Repo Rate and Open Market Operations.

Hint:

Central Bank control tools:

• Repo $\uparrow$ = Money supply $\downarrow$
• Repo $\downarrow$ = Money supply $\uparrow$
• Sell bonds = Liquidity $\downarrow$
• Buy bonds = Liquidity $\uparrow$

Remember: Repo = Interest tool, OMO = Market tool.

Answer 1

Concept: A Central Bank is the apex monetary authority of a country that regulates the banking system and controls the supply of money and credit in the economy.
Major Functions of a Central Bank:

• 
  Issue of Currency: Sole authority to issue paper currency and coins (except small coins in some countries).
• 
  Banker to the Government: Maintains government accounts and manages public debt.
• 
  Banker’s Bank: Commercial banks keep reserves with the central bank and borrow during emergencies.
• 
  Custodian of Foreign Exchange Reserves: Maintains stability of exchange rate and manages forex reserves.
• 
  Controller of Credit (Monetary Authority): Regulates money supply and inflation using monetary policy tools.

Control of Money Supply: The central bank controls money supply using quantitative tools such as Repo Rate and Open Market Operations (OMO).
1. Repo Rate:
Definition: Repo rate is the rate at which the central bank lends short-term funds to commercial banks against government securities.
Mechanism:

• 
  Increase Repo Rate:
  • Borrowing becomes costly for banks
  • Banks reduce lending
  • Money supply decreases
  • Helps control inflation
• 
  Decrease Repo Rate:
  • Borrowing becomes cheaper
  • Banks lend more
  • Money supply increases
  • Stimulates economic growth

2. Open Market Operations (OMO):
Definition: OMO refers to buying and selling of government securities by the central bank in the open market.
Mechanism:

• 
  Sale of Securities:
  • Central bank sells bonds to public/banks
  • Money flows from market to central bank
  • Liquidity reduces
  • Money supply decreases
• 
  Purchase of Securities:
  • Central bank buys securities
  • Injects money into economy
  • Liquidity increases
  • Money supply rises

Conclusion: Through repo rate and OMO, the central bank manages liquidity, controls inflation, and stabilizes economic growth by expanding or contracting money supply.