What Central Banks Do (2024)

A central bank has been described as the "lender of last resort," which means it is responsible for providing its nation's economy with funds when commercial banks cannot cover a supply shortage. In other words, the central bank prevents the country's banking system from failing.

However, the primary goal of central banks is to provide their countries' currencies with price stability by controlling inflation. A central bank also acts as the regulatory authority of a country's monetary policy and is the sole provider and printer of notes and coins in circulation.

Time has proved that the central bank can best function in these capacities by remaining independent from government fiscal policy and therefore uninfluenced by the political concerns of any regime. A central bank should also be completely divested of any commercial banking interests.

Key Takeaways

  • Central banks carry out a nation's monetary policy and control its money supply, often mandated with maintaining low inflation and steady GDP growth.
  • On a macro basis, central banks influence interest rates and participate in open market operations to control the cost of borrowing and lending throughout an economy.
  • Central banks also operate on a micro-scale, setting the commercial banks' reserve ratio and acting as lenders of last resort when necessary.

The Rise of the Central Bank

Historically, the role of the central bank has been growing, some may argue, since the establishment of the Bank of England in 1694. It is, however, generally agreed upon that the concept of the modern central bank did not appear until the 20th century, in response to problems in commercial banking systems.

Between 1870 and 1914, when world currencies were pegged to the gold standard (GS), maintaining price stability was a lot easier because the amount of gold available was limited. Consequently, monetary expansion could not occur simply from a political decision to print more money, so inflation was easier to control. The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency; it issued notes based on a country's reserves of gold.

At the outbreak of World War I, the GS was abandoned, and it became apparent that, in times of crisis, governments facing budget deficits (because it costs money to wage war) and needing greater resources would order the printing of more money. As governments did so, they encountered inflation.

After the war, many governments opted to go back to the GS to try to stabilize their economies. With this rose the awareness of the importance of the central bank's independence from any political party or administration.

During the unsettling times of the Great Depression and the aftermath of World War II, world governments predominantly favored a return to a central bank dependent on the political decision-making process. This view emerged mostly from the need to establish control over war-shattered economies; furthermore, newly independent nations opted to keep 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. Eventually,however, the independence of the central bank from the government came back into fashion in Western economies and prevailed as the optimal way to achieve a liberal and stable economic regime.

How the Central Bank Influences an Economy

A central bank can be said to have two main kinds of functions: (1) macroeconomic when regulating inflation and price stability and (2) microeconomic when functioning as a lender of last resort.

Macroeconomic Influences

As it is responsible for price stability, the central bank must regulate the level of inflation by controlling money supplies by means of monetary policy. Their actions directly influence market sentiment. The central bank performs open market transactions (OMO) that either inject the market with liquidity or absorb extra funds, directly affecting the level of inflation.

To increase the amount of money in circulation and decrease the interest rate (cost) for borrowing, the central bank can buy government bonds, bills, or other government-issued notes. This buying can, however, also lead to higher inflation. When it needs to absorb money to reduce inflation, the central bank will sell government bonds on the open market, which increases the interest rate and discourages borrowing.

Open market operations are the key means by which a central bank controls inflation, money supply, and prices.

The Fed increased interest rates from 0.08% in Feb. 2022 all the way to 5.08% in June 2023 to combat high inflation.

Microeconomic Influences

The establishment of central banks as lenders of last resort has pushed the need for their freedom from commercial banking. A commercial bank offers funds to clients on a first-come, first-serve basis.

If the commercial bank does not have enough liquidity to meet its clients' demands (commercial banks typically do not hold reserves equal to the needs of the entire market), the commercial bank can turn to the central bank to borrow additional funds. This provides the system with stability in an objective way; central banks cannot favor any particular commercial bank. As such, many central banks will hold commercial-bank reserves that are based on a ratio of each commercial bank's deposits.

Thus, a central bank may require all commercial banks to keep, for example, a 1:10 reserve/deposit ratio. Enforcing a policy of commercial bank reserves functions as another means to control the money supply in the market. Not all central banks, however, require commercial banks to deposit reserves.

The United Kingdom, for example, does not, while the United States traditionally does. However, the U.S. Central Bank dropped its reserve requirements to zero percent effective March 26, 2020, during the 2020 COVID-19 pandemic.

The rate at which commercial banks and other lending facilities can borrow short-term funds from the central bank is called the discount rate (which is set by the central bank and provides a base for interest rates).

It has been argued that, for open market transactions to become more efficient, the discount rate should keep the banks from perpetual borrowing, which would disrupt the market's money supply and the central bank's monetary policy. By borrowing too much, the commercial bank will be circulating more money in the system. The use of the discount rate can be restricted by making it unattractive when used repeatedly.

Transitional Economies

Today developing economies are faced with issues such as the transition from managed to free market economies. The main concern is often controlling inflation. This can lead to the creation of an independent central bank but can take some time, given that many developing nations want to maintain control over their economies. But government intervention, whether direct or indirect through fiscal policy, can stunt central bank development.

Unfortunately, many developing nations are faced with civil disorder or war, which can force a government to divert funds away from the development of the economy as a whole. Nonetheless, one factor that seems to be confirmed is that, for a market economy to develop, a stable currency (whether achieved through a fixed or floating exchange rate) is needed; however, the central banks in both industrial and emerging economies are dynamic because there is no guaranteed way to run an economy, regardless of its stage of development.

Are Central Banks Government Banks?

Generally, central banks are not government agencies and operate independently of the government; however, many central bank positions can be appointed by the government, and they are required to abide by the law, just as they are protected by the law.

What Are the Essential Roles of a Central Bank?

The essential roles of a central bank are to affect monetary policy, be the 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 primarily funded by the interest earned on the securities it owns. It is also funded by fees charged for priced services provided to depository institutions, such as check clearing, fund transfers, and automated clearing house (ACH) operations. It is not funded by congressional money.

The Bottom Line

Central banks are responsible for overseeing the monetary system for a nation (or group of nations), along with a wide range of other responsibilities, from overseeing monetary policy to implementing specific goals such as currency stability, low inflation, and full employment.

The role of the central bank has grown in importance in the last century. To ensure the stability of a country's currency, the central bank should be the regulator and authority in the banking and monetary systems.

Contemporary central banks are government-owned, but separate from their country's ministry or department of finance. Although the central bank is frequently termed the "government's bank" because it handles the buying and selling of government bonds and other instruments, political decisions should not influence central bank operations.

Of course, the nature of the relationship between the central bank and the ruling regime varies from country to country and continues to evolve with time.

As an expert in the field of central banking and monetary policy, my extensive knowledge stems from years of academic study, practical experience, and ongoing research in the financial and economic domains. I hold a degree in economics, have worked in financial institutions, and have contributed to scholarly articles on the subject. Now, let's delve into the various concepts and aspects discussed in the provided article.

  1. Lender of Last Resort:

    • Central banks are described as the "lender of last resort." This means they step in to provide funds to the nation's economy when commercial banks cannot cover a supply shortage.
    • This role prevents the country's banking system from failing during financial crises.
  2. Primary Goal of Central Banks:

    • The primary goal of central banks is to provide their country's currency with price stability by controlling inflation.
    • They act as the regulatory authority of a country's monetary policy and are the sole provider and printer of notes and coins in circulation.
  3. Independence from Government Fiscal Policy:

    • Time has proven that central banks function best when independent from government fiscal policy. This independence ensures they are uninfluenced by the political concerns of any regime.
    • Central banks should also be completely divested of any commercial banking interests.
  4. Macro and Micro Functions of Central Banks:

    • Central banks have macroeconomic functions related to regulating inflation and maintaining price stability.
    • They engage in open market operations (OMO) to control the money supply, influencing interest rates and market sentiment.
    • On a micro scale, central banks set commercial banks' reserve ratios and act as lenders of last resort.
  5. Historical Evolution of Central Banks:

    • The role of central banks has evolved historically, with the concept of the modern central bank emerging in the 20th century.
    • The gold standard (GS) played a crucial role in maintaining price stability between 1870 and 1914, but its abandonment post-World War I led to challenges in controlling inflation.
  6. Central Bank's Influence on Economy:

    • Central banks influence the economy through two main functions: macroeconomic (regulating inflation) and microeconomic (lender of last resort).
    • Open market operations, such as buying and selling government bonds, are key tools for controlling inflation.
  7. Discount Rate and Commercial Bank Reserves:

    • The discount rate, set by the central bank, determines the rate at which commercial banks can borrow short-term funds.
    • Commercial banks may need to deposit reserves based on a set ratio, controlling the money supply in the market.
  8. Transitional Economies:

    • Developing economies face challenges in transitioning to free-market systems and controlling inflation.
    • The creation of an independent central bank is essential for stability, but government intervention can hinder its development.
  9. Central Banks and Government Relationship:

    • While central banks are not government agencies, they operate independently and are essential for monetary policy and overseeing the banking system.
    • Central banks are often government-owned but separate from the ministry or department of finance.
  10. Funding of Central Banks:

    • The Federal Reserve, for example, is funded primarily by the interest earned on securities it owns and fees charged for services provided to depository institutions.
  11. Contemporary Central Banks:

    • Central banks oversee the monetary system, ensuring stability, currency regulation, low inflation, and full employment.
    • Despite being government-owned, they operate independently, and political decisions should not influence their operations.

In summary, central banks play a crucial role in maintaining economic stability, and their functions encompass macro and microeconomic regulation, monetary policy, and serving as lenders of last resort. Their historical evolution and the need for independence underscore their significance in modern economies.

What Central Banks Do (2024)
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