A central bank has been described as "lender of last resort", meaning it is responsible for supplying money to the country's economy when commercial banks cannot cover a supply shortage. In other words, the central bank prevents the country's banking system from failing.
The primary purpose withcentral banksis to provide price stability to their country's currency by controlling inflation. A central bank also acts as a regulator for a countrymonetary policyand is the only provider and printer of banknotes and coins in circulation.
Time has shown that the central bank can best function in these capacities by remaining independent of the governmentfiscal policyand therefore unaffected by the political concerns of any regime. A central bank would also need to be completely divested of all commercial banking interests.
Key learning points
- Central banks conduct a country's monetary policy and control the money supply, often with a mandate to keep inflation low and GDP growth stable.
- On a macro basis, central banks influence interest rates and conduct open market operations to control the costs of borrowing and borrowing throughout the economy.
- Central banks also operate on a micro scale, setting the reserve ratios of commercial banks and acting as a last resort when necessary.
The rise of the central bank
Historically, the role of the central bank has been increasing, some might argue, since the Bank of England was founded in 1694. However, it is generally agreed that the concept of the modern central bank first emerged in the 20th century, in response to problems in economics. commercial banking systems.
Between 1870 and 1914, when the world's currencies were pegged to itthe Gold standard(GS), it was much easier to maintain price stability because the amount of gold available was limited. As a result, monetary expansion could not simply result from a political decision to print more money so that inflation could be more easily controlled. The central bank at the time was primarily responsible for maintaining the convertibility of gold into currency; it issued banknotes based on a country's gold reserves.
With the outbreak of World War I, GS was abandoned and it became clear that governments facing budget deficits in times of crisis (because war costs money) and needing more resources would order more money to be printed. When governments did that, they faced inflation.
After the war, many governments chose to return to GS in an attempt to stabilize their economies. With this increased awareness of the importance of central bank independence from any political party or government.
In these difficult timesGreat Depressionand the aftermath of World War II, world governments overwhelmingly supported a return to a central bank dependent on the political decision-making process. This view arose mainly from the need to gain control over war-torn economies; furthermore, newly independent nations chose to maintain control over all aspects of their countries – a backlash against colonialism.
The rise of managed economies in the Eastern Bloc was also responsible for increased government interference in the macroeconomy. Ultimately, however, central bank independence from the government came back into vogue in Western economies and prevailed as the optimal way to achieve a liberal and stable economic regime.
How the central bank influences an economy
It can be said that a central bank has two main types of functions: (1)macroeconomicby regulating inflation and price stability and (2)microeconomicwhen they act as lender of last resort.
Macroeconomic influences
Because it is responsible for price stability, the central bank must regulate the level of inflation by controlling the money supply through monetary policy. Their actions directlyinfluence market sentiment. The central bank executesopen market transactions(OMO) that either add liquidity to the market or absorb additional money, which has a direct impact on the level of inflation.
To increase the amount of money in circulation and reduce the interest (cost) of borrowing, the central bank can purchase government bonds, bills, or other government-issued notes. However, this purchase can also lead to higher inflation. When the central bank needs to absorb money to reduce inflation, it will sell government bonds on the open market, raising interest rates and discouraging borrowing.
Open market operations are the main ways a central bank controls inflation, money supply, and prices.
The Fed raised interest rates from 0.08% in February 2022 to 5.08% in June 2023 to combat high inflation.
Microeconomic consequences
The establishment of central banks as lenders of last resort has increased the need for their freedom of commercial banking. A commercial bank offers money to customers on a first-come, first-served basis.
If the commercial bank does not have sufficient liquidity to meet the demands of its customers (commercial banks generally do not have reserves that correspond to the needs of the entire market), the commercial bank can turn to the central bank for additional funds to borrow. This gives the system stability in an objective way; central banks cannot favor any commercial bank. As such, many central banks will maintain commercial bank reserves based on the ratio of each commercial bank's deposits.
A central bank can therefore require that all commercial banks maintain a ratio of 1:10, for examplereserve/deposito-ratio. Enforcing a commercial bank reserve policy serves as another means of controlling the supply of money in the market. However, not all central banks require commercial banks to deposit reserves.
Great Britain, for example, does not, while the US traditionally does. However, the Federal Reserve reduced its reserve requirements to zero percent during the 2020 COVID-19 pandemic, effective March 26, 2020.
The rate at which commercial banks and othersloan facilitiescan borrow money in the short term from the central bankrabat(which is set by the central bank and forms the basis for interest rates).
It has been argued that in order to make open market operations more efficient, the discount rate should prevent banks from borrowing forever, which would disrupt the money supply in the market and the monetary policy of central banks. By over-lending, the commercial bank will allow more money to circulate in the system. The use of the discount rate can be limited by making it unattractive when used repeatedly.
Transitional economies
Today, developing economies face challenges such as the transition from governance to...Free marketeconomies. The main concern is often controlling inflation. This could lead to the creation of an independent central bank, but this could take some time as many developing countries want to maintain control over their economies. But government intervention, directly or indirectly through fiscal policy, can hinder the development of central banks.
Unfortunately, many developing countries face civil unrest or war, which can force a government to divert funds from developing the economy as a whole. Nevertheless, there is one factor that seems to be confirmed: for the development of a market economy, a stable currency (whether achieved through a fixed orfloating exchange rate) is necessary; However, central banks in both industrial and emerging economies are dynamic because there is no guaranteed way to govern an economy, regardless of its stage of development.
Are central banks state-owned banks?
In general, central banks are not government agencies and operate independently of the government; However, many central bank positions can be appointed by the government and must comply with and be protected by law.
What are the essential roles of a central bank?
The essential functions of a central bank are to influence monetary policy, act as a lender of last resort and oversee the banking system. Central banks set interest rates, lend money to other banks and control the money supply.
How is the Federal Reserve funded?
The Fed is funded primarily by the interest on the securities it owns. It is also funded by fees charged for priced services provided to depository institutions, such as check clearing, money transfers, and automated clearinghouse (ACH) operations. It is not funded by money from Congress.
In short
Central banks are responsible for overseeing the monetary system of a country (or group of countries), in addition to a wide range of other responsibilities, from overseeing monetary policy to implementing specific objectives such as currency stability, low inflation and full employment .
The role of the central bank has become increasingly important over the past century. To ensure the stability of a country's currency, the central bank must be the supervisor and authority in the banking and monetary systems.
Today's central banks are state-owned, but separate from their country's ministry or the ministry of finance. Although the central bank is often referred to as 'the government's bank' because it handles the purchase and sale of government bonds and other instruments, policy decisions should not influence the central bank's activities.
Naturally, the nature of the relationship between the central bank and the ruling regime varies from country to country and continues to evolve over time.
