What Is Central Bank?
The central bank is an autonomous, powerful, government-controlled bank tasked with regulating the banking industry, addressing currency concerns, and advising the government on economic policy. Its primary aim is to stabilize the currency and economy while limiting inflation.
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Other objectives include developing monetary policy, determining an acceptable interest rate, conducting economic research and analysis for the government, and preserving the currency value. Such a bank is apolitical in their economic decision-making. The government appoints a board of directors to govern these banks.
Table of contents
Key Takeaways
- The central bank is an autonomous and apolitical financial institution responsible for maintaining a nation’s economic and financial activities.
- Each nation has its central bank, considered an apex institution that governs its economic and banking issues and is independent in its economic decision-making.
- Their primary responsibilities include management of currency reserves, supervision of the banking sector, payment system management, issuance of new currencies, advising the government on economic issues, setting base rates, managing the money supply, monitoring reserves, and managing foreign currency balances.
Central Bank Explained
A central bank is an independent, non-political financial agency that supervises monetary policy. It is responsible for maintaining cash and foreign currency reserves, thus stimulating the nation’s economic growth and controlling inflation. Each country has its central bank to manage its financial and banking issues.
These banks perform the following operations:
- Maintaining monetary policy by regulating the money supply and interest rates
- Providing financial stability to the government and commercial institutions
- Safeguarding and managing the nation’s gold, foreign currency, and government bonds
- Overseeing the functioning of the banking sector and balancing the nation’s banking system
- Handling financial transactions; locally via clearing houses and globally via networks such as SWIFT
- Issuing new currency and coins inside a nation
- Providing financial advice to the government
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Functions Of Central Bank
In general, any nation’s central bank’s essential tasks include determining the base rate, regulating the money supply through open market operations, maintaining the appropriate reserves, and managing the country’s foreign currency reserves. For better understanding, these functions have been discussed in detail:
1. Base Rate Setting
Base rate setting is the most significant function of the central bank. The base rate sets the rate at which it lends to commercial banks. Commercial banks select the interest rate on credit for the public based on the base rate.
If the central bank raises the base rate for banks, consumers and companies would ultimately face higher interest rates, making commercial loans more expensive. As a result, the market’s money circulation reduces. Consequently, a decrease in the base rate results in cheaper loans. As a result, it increases the market’s money circulation, increasing demand for products and services.
2. Money Supply Control
Central banks conduct open market operations to acquire bad assets by generating liquidity for these assets. After obtaining the funds, the company purchases financial securities or investments. Therefore, the funds get transferred to the buyer’s banking institution. Consequently, it can pump new funds into the economy.
3. Maintaining The Required Level Of Reserves
They regulate commercial banks’ statutory cash reserve requirements to increase or decrease the market’s money supply.
4. Maintaining Foreign Exchange Reserves
They ensures sufficient foreign currency reserves to preserve the value of a nation’s currency. It may begin to purchase the local currency if it loses value; it signals to the market that the local currency is in demand, causing its value to rise.
Examples
Let us look at the following central bank examples to understand the concept better:
Example # 1
Let us take the example of the US central bank, the Federal Reserve (Fed). However, its ability to dominate the economy is not limited to the United States since the dollar is the most powerful currency in the world. Fed ensures overall financial health by regulating monetary policy, assuring solid financial institutions, securing monetary transactions, and operating as a settlement system.
Fed mainly comprises three components:
- Board Of Governors: It consists of seven governors chosen by the U.S. President and confirmed by the Senate. The board is independent of the federal government but directly subordinate to Congress.
- Federal Reserve Banks: There are 12 banks designated as Federal Reserve Banks. These banks administer banking in the 12 allotted regions of the country. The board of the Fed directs its operations.
- The Federal Open Market Committee (FOMC): It comprises the members of the board of governors and the 12 regional Federal Reserve bank presidents, with the chairman being the head of the US federal reserve. It meets eight times yearly to discuss the economy, the financial system, and the prevailing monetary policy.
Example # 2
In recent news, a story by Economic Times emphasized the trend of global central banks to increase interest rates. In their efforts to control inflation, banks like the US Federal Reserve, the Reserve Bank of Australia, and the Bank of England, have made it highly likely for their countries to go into recession due to recent rate increases.
In 2021, central banks emphasized that inflation was merely “temporary” as prices rose due to supply chain inefficiencies after lockdowns imposed amid the COVID-19 pandemic. However, global inflation continued and increased due to Russia’s invasion of Ukraine. As a result, oil and food prices skyrocketed, forcing economists to reduce their global growth forecasts for 2022.
Financial analysts believe central banks do not control factors driving inflation, like high energy and food costs and supply chain bottlenecks.
Frequently Asked Questions (FAQs)
Yes. Central banks print money by acquiring assets on the open market and adding the equivalent amount to commercial banks’ bank reserves. These funds enter the banking system as payment for the assets acquired by them.
Yes. they operate independently to protect themselves from political interference. As a result, they autonomously made monetary policy and associated decisions. However, the country’s president appoints their governors. Hence, such banks have a high degree of autonomy, yet they remain somewhat dependent on the government.
A central bank is a clearing house to transfer and pay commercial banks’ mutual claims as an apex bank. Since all commercial banks have accounts with central banks, it is often called the bankers bank.
Sveriges Riksbank in Sweden was the first central bank in the world, established in 1668.
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