What Is the Function of a Central Bank?
According to the term “lender of last resort,” the central bank is responsible for supplying funds to the economy of a country’s economy when commercial banks are unable to meet demand due to a scarcity of funds in the marketplace. In other words, the central bank is responsible for ensuring that the country’s banking system does not collapse.
The major purpose of central banks, on the other hand, is to maintain the price stability of their countries’ currencies by keeping inflation under control. An additional function of a central bank is to regulate a country’s monetary policy, as well as to serve as the exclusive provider of and printer of banknotes and coins in circulation.
With the passage of time, it has been demonstrated that the central bank can best serve in these capacities when it is independent of government budgetary policy and, as a result, is not influenced by the political concerns of any regime. A central bank should also be absolutely free of any financial interests in the commercial banking sector.
The Most Important Takeaways
- Central banks are responsible for implementing a country’s monetary policy and controlling its money supply. They are frequently tasked with maintaining low inflation and steady GDP growth.
- On a macroeconomic level, central banks have the ability to influence interest rates and participate in open market operations in order to manage the cost of borrowing and lending across an economy.
- A micro-scale operation is also carried out by central banks, which determine the reserve ratios for commercial banks and, when necessary, function as lenders of last resort.
The Central Bank of the United States
The Ascension of the Central Bank of the United States
Since the founding of the Bank of England in 1694, some may argue, the role of the central bank has grown in importance. However, others may disagree.
It is generally recognized, however, that the notion of the modern central bank did not emerge until the twentieth century, in reaction to issues in commercial banking systems at the time.
Because the amount of gold available was limited between 1870 and 1914, maintaining price stability was more easier during the period when world currencies were tied to the gold standard (GS) throughout that period. The result was that inflationary pressures were easier to control because monetary growth could not be caused merely by a political decision to print more money. At the time, the central bank was largely responsible for ensuring that gold could be converted into currency, and it did so by issuing notes based on a country’s gold reserves.
When World War I broke out, the gold standard was abandoned, and it became clear that governments suffering budget deficits (since it costs money to conduct war) and in need of greater resources would order the printing of more money in times of crisis. Inflation occurred as a result of the actions of governments.
Following World War II, many countries chose to return to the Gold Standard in order to try to stabilize their economy. It was during this period that the importance of the central bank’s independence from any political party or administration became more widely recognized.
As a result of the Great Depression and the immediate postwar period, international governments were overwhelmingly in favor of a return to a central bank that was dependent on the political decision-making process. In part, this viewpoint developed out of the necessity to reestablish control over war-devastated economy; in addition, newly independent nations chose to retain control over all parts of their countries as a form of counter-revolution against colonialism.
The advent of managed economies in the Eastern Bloc was also a contributing factor to the expansion of government intervention in the macroeconomic environment. Eventually, however, the independence of the central bank from the government returned to vogue in Western economies, and it has since been recognized as the most effective method of achieving a liberal and stable economic regime.
What Role Does the Central Bank Play in an Economy?
A central bank’s functions can be divided into two categories: macroeconomic functions, such as managing inflation and maintaining price stability, and microeconomic functions, such as serving as a lender of last resort.
Influences of the macroeconomic environment
Given its responsibility for price stability, the central bank must limit the level of inflation by controlling the amount of money in circulation, which is done through the use of monetary policy. Open market transactions (OMOs) are transactions in which the central bank either injects liquidity into the market or absorbs excess funds, with the outcome having a direct impact on the level of inflation.
The central bank can purchase government bonds, banknotes, and other government-issued notes in order to increase the amount of money in circulation while simultaneously decreasing the interest rate (cost of borrowing). This purchasing, on the other hand, may result in higher inflation. When the central bank has to absorb money in order to curb inflation, it will sell government bonds on the open market, raising the interest rate and discouraging people from borrowing.
Open market operations (OMOs) are the most important tool a central bank may use to control inflation, money supply, and price levels.
Influences of the Microeconomic Environment
The creation of central banks as lenders of last resort has brought the need for their separation from commercial banking to the forefront of public debate. A commercial bank distributes monies to customers on a first-come, first-served basis, according to the bank’s policy.
If a commercial bank does not have enough liquidity to meet the demands of its clients (commercial banks typically do not hold reserves sufficient to meet the needs of the entire market), the commercial bank can turn to the central bank for assistance in raising additional funds to meet those demands. This ensures the stability of the system in an objective manner, as central banks are unable to favor any single commercial bank over another. As a result, many central banks will maintain commercial-bank reserves that are calculated as a percentage of the total deposits of each commercial bank.
As a result, a central bank may compel all commercial banks to maintain, for example, a reserve-to-deposit ratio of 1:10 or higher. Enforcing a policy of commercial bank reserves acts as a second means of controlling the money supply in the market, among other measures. Not all central banks, on the other hand, require commercial banks to make reserve deposits.
While the United Kingdom, for example, does not practice it, the United States has long practiced it. During the 2020 COVID-19 pandemic, however, the United States Central Bank reduced its reserve requirements to zero percent, effective March 26, 2020, according to the Federal Reserve.
The discount rate refers to the rate at which commercial banks and other lending institutions can borrow short-term cash from the central bank on a short-term basis (which is set by the central bank and provides a base for interest rates).
In order for open market transactions to become more efficient, it has been suggested that the discount rate should prevent banks from engaging in a cycle of continuous borrowing, which would disrupt both the market’s money supply and the central bank’s monetary policy. By borrowing an excessive amount of money, the commercial bank will result in the circulation of additional money in the system. The usage of the discount rate can be curtailed by making it undesirable when it is applied on a consistent basis.
Transitional Economies are those that are in the process of transitioning from one stage of development to another.
Developing countries are currently confronted with difficulties such as the shift from managed to free market economy, among others. In many cases, the primary priority is keeping inflation under control. This can lead to the establishment of an independent central bank, but it may take some time due to the desire of many emerging countries to keep influence over their economy during this process. However, government interference, whether direct or indirect through fiscal policy, has the potential to stifle the development of central banks.
Due to the fact that many emerging countries are afflicted by civil unrest or conflict, a government may be forced to redirect finances away from the development of the overall economy. Although there is some disagreement on this point, it appears to be established that, in order for a market economy to thrive, a stable currency (whether accomplished through a fixed or floating exchange rate) is required. Although both industrialized and emerging economies have dynamic central banks, this is due to the fact that there is no sure way to operate an economy, regardless of the level of development in which it finds itself.
What’s the bottom line?
As well as regulating a nation’s (or group of nations’) monetary system, central banks are also tasked with a slew of additional obligations, which range from enacting monetary policy to achieving specific objectives such as currency stability, low inflation, and full employment. In the recent century, the central bank’s position has expanded in relevance and significance. The central bank of a country should be the regulator and authority in the banking and monetary systems in order to ensure the stability of the country’s currency.
Modern central banks are government-owned institutions that are distinct from their respective countries’ ministries or departments of finance. The central bank is commonly referred to as “the government’s bank” since it is responsible for the purchase and sale of government bonds and other financial instruments, but political decisions should not have an impact on the central bank’s operations.
Of course, the nature of the connection between the central bank and the ruling regime differs from nation to country and continues to evolve through time as a result of political and economic developments.