Central Bank

A financial institution that has been given the right to control the production and distribution of money or credit

Author: Adam Bridges
Adam Bridges
Adam Bridges
Reviewed By: Ayah Murshidi
Ayah Murshidi
Ayah Murshidi
An Economics degree holder currently employed in the Banking sector within the Merchant Acquiring department. Skilled in data analysis, strategic planning, and ensuring regulatory adherence. Leveraging academic knowledge to enhance backend operations, guaranteeing effectiveness and bolstering growth within the sector.
Last Updated:March 8, 2024

What Is a Central Bank?

A central bank is a financial institution that has been given the right to control the production and distribution of money or credit. In modern economies, these banks are responsible for creating monetary policy and regulating member banks. 

Generally, these banks are intended to be apolitical and non-competitive, operating independently from the market. However, while most central banks are not nationalized or government-affiliated, they are typically legally protected.

A significant difference between central and member banks is that central banks can issue banknotes and cash, unlike member banks, which can only issue demand liabilities such as checking deposits, savings bank deposits, or cash certificates.

Some of their responsibilities include formulating monetary policies tailored to their nations' economic conditions, controlling the money supply, regulating credit availability, and managing the associated costs. These policies are formulated based on economic performance indicators.

These banks are important because they significantly create and maintain financial and economic stability in their nations. Their policies can help maintain price levels, ensure price stability, and control inflation.

Key Takeaways

  • A central bank controls money production and distribution, regulates monetary policy, and oversees member banks, aiming for economic stability and independence.
  • Originating with the Bank of England, central banks emerged globally to stabilize currencies and address economic challenges, evolving from mere funders of governments to key economic regulators.
  • Central banks manage money distribution, control interest rates, report economic data, and make decisions autonomously, influencing macroeconomic conditions and acting as lenders of last resort.
  • Central banks are vital for economic stability, central banks maintain low inflation, support businesses, manage interest rates, and navigate economic downturns, playing crucial roles in national financial systems.

History Of Central Banks

The first well-known central banking system was the Bank of England, which was used to buy government debt. Inspired by the Bank of England's model, other nations established central banks to address similar economic challenges, with some grappling with monetary disarray.

In 1800, Napoleon established the Banque de France to stabilize their currency and get a grip on the extreme inflation that occurred during the French Revolution. Many of these banks' primary purpose was to help fund the government, but they also dealt with other banks. 

As private entities, these banking systems engaged in typical banking activities, serving as intermediaries for other banks, facilitating transactions, and acting as repositories due to their extensive resources and networks.

Like most central banks, the Bank of England functioned as the lender of last resort during financial crises. However, initially, it refused cash withdrawals for individuals and businesses. Later, it adopted a policy of lending freely against acceptable collateral.

The First Bank of the United States operated from 1791 to 1811. The Second Bank of the United States was established from 1816 to 1836. Both banks ended because they failed to renew their charters due to extensive distrust of the government's handling of financial issues.

Due to the bank's charters not being renewed, there was an eighty-year financial instability. Then, the crisis of 1907 led to the creation of the Federal Reserve in 1913 to administer a uniform and elastic currency and act as the lender of last resort.

After the Great Depression, the Fed started to focus less on inflation and more on higher employment. As a result, significant inflation led into the 1960s and 1970s.

Note

Many world currencies were backed by gold during the gold standard era from 1870 to 1914. During this time, the bank's primary responsibility was to control inflation, which was relatively easy because the amount of gold was limited. They were also responsible for the convertibility from currency to gold. 

What Are the Modern Responsibilities of the Central Bank?

A significant responsibility is serving as the lender of last resort, ensuring the economy can access funds during financial stress to prevent systemic failure. Thus, the bank keeps the economy from failing. 

Central banking systems worldwide are responsible for the following:

Money Distribution and Interest Rate Control

They control the distribution of money, meaning they control how much money is printed in their nations. They also control the federal funds rate, which controls the interest rates and the cost of credit. 

Economic Reporting and Decision Making

Central banking systems typically release quarterly GDP results, forecasts, inflation data, and inflation forecasts. For example, the United States releases a dot plot showing where it believes interest rates are headed. 

Central banks often perform more effectively when operating independently of direct government fiscal policy and political influence. That said, the bank should also interact in the same way with the concerns of commercial banks. 

Influence on Macroeconomic Conditions

Inflation and interest rates are among the largest influences the Federal Reserve has on the macroeconomic condition of the nation. The Fed can take action by performing open market operations (OMO), injecting liquidity, or absorbing extra funds. 

The transactions performed by the Fed can be permanent (long-term) or short-term. The permanent purchases of securities push the growth of the currency already in circulation. They can also do this to put descending pressure on interest rates. Short-term buying is similar.

Note

Short-term transactions typically aim to influence the federal funds rate, set by the Federal Open Markets Committee (FOMC), while long-term transactions target long-term interest rates. Long-term transactions are meant to handle long-term interest rates.

Microeconomic Impact

Central banks also have a microeconomic impact. Since they act as lenders of last resort, they can turn to the Federal Reserve to borrow more if commercial banks cannot lend any more money to their customers.

Central banks typically refrain from favoring specific commercial banks. That said, they typically keep a commercial bank reserve based on the ratio of commercial bank deposits. Some banks will also require a specific reserve/deposit ratio. 

For example, the United Kingdom does not require a reserve/deposit ratio, but the United States does. This practice can help control the money supply in the market, thus controlling inflation.

Note

Low inflation often corresponds to low-interest rates, which can benefit businesses, but the relationship between inflation, interest rates, and business conditions is complex.

Importance Of Central Bank

Central banking systems are imperative to a nation's economic success. As stated earlier, they play a crucial role in achieving financial and economic stability through low inflation and high employment rates. Some of the importance include:

Role in Maintaining Low Inflation

Since the 1980s, keeping inflation low and stable has been one of the most crucial responsibilities of most banking systems. Households may not notice how vital maintaining low inflation is until it gets too high because high inflation affects ordinary families. 

For instance, if inflation consistently ranges between five and eight percent, a family's ability to maintain or improve their living standard diminishes. Parents and guardians may struggle to cope with rising prices, leading to reduced savings and investment. 

Impact on Businesses and Economy

For businesses, keeping track of inflation is very important. Inflation can tell a company how much they need to increase their prices due to the upcharges in the resource market. If inflation rises, then they are expected to pay their employees more.

Central banking systems are vital for maintaining a strong economy and play a significant role during economic downturns. Usually, when the economy is in a downturn, central banks will implement policies to help lift it out of its downtrend.

Influence on Interest Rates and Economic Downturns

During periods of economic instability and downturns, central banks may raise interest rates in response to uncontrollable inflation. Increasing interest rates will slow down the economy until the bank sees that things are under control. 

Raising interest rates is the primary way banking systems slow down the economy to slow inflation. Policies that raise rates affect people, families, and businesses in many ways. While raising interest rates can help curb inflation, excessive actions in this regard can potentially trigger a recession.

For example, young families looking to settle down and buy a house will either have to pay the higher interest rate on a home mortgage or wait until interest rates lower. The housing market usually falls when interest rates rise, hurting families and residential real estate investors.

Note

Higher interest rates don't benefit businesses since borrowing money from banks and investors becomes more expensive. Additionally, it makes it more pricey for them to start and finish projects; thus, they will not be able to grow as quickly as investors would like.

Example Of Central Bank: The Federal Reserve

The Federal Reserve is an example of a central banking system. The Fed operates as the central bank of the United States, with a primary mandate to create and maintain financial and economic stability within the nation.

It is the most powerful economic institution in the United States. The Federal Reserve maintains economic stability by creating monetary policy to maximize employment and stabilize prices.

The policies they create determine the amount of money in circulation and the cost of that money. 

For example, in September 2022, the U.S. reached a record of $2,279.998 billion in money in circulation. During and following the COVID-19 pandemic, there were releases of stimulus packages for families and businesses to help them get through a hard time.

Note

While the stimulus packages provided short-term relief to families, their long-term impact on the economy is subject to debate. Due to the increasing amount of monetary system in the economy and low interest rates following the pandemic, the country saw a significant rise in inflation. 

Organizational Structure and Decision-Making

The Federal Reserve has twelve regional bank locations that are responsible for their geographic regions. The bank locations are New York, Chicago, Richmond, Kansas City, Atlanta, Cleveland, St. Louis, Boston, Philadelphia, Minneapolis, Dallas, and San Francisco. 

The Fed's policy originates from its decision-making body, the Federal Open Market Committee (FOMC). The FOMC holds eight meetings annually to discuss and review current economic conditions, determine policies, and analyze long-term effects. 

Revenue Generation and Responsibilities

A significant source of income for the Federal Reserve is its open market operations (OMO), through which it purchases government securities. The Fed also earns money through investments such as foreign currencies or interest paid on loans from other banking institutions. 

The Federal Reserves' responsibilities can be grouped into four points:

  1. Creating and maintaining national monetary policy to ensure economic stability, including managing the cost of credit for businesses and individuals to promote high employment and low inflation
  2. Managing member banks to ensure safe practices and protect the stability of the U.S. banking and financial systems, as well as safeguarding consumer credit rights
  3. Creating and maintaining economic stability while minimizing non-diversifiable or systemic risks
  4. Providing financial services, such as playing a crucial role in the nation's payment and banking systems and domestic and foreign governments

Conclusion

Central banking systems are designed to keep economies stable and advancing. They can fulfill their responsibilities by creating and maintaining policies that promote high employment rates and low inflation. 

The history of large banking systems dates back to the 1700s and 1800s. Their primary responsibility then, which remains relevant today, was funding governments by purchasing their debt through government securities.

Some modern responsibilities include regulating the amount of money in circulation and the cost of credit. When the economy is booming, unemployment and inflation are low, and the banks can cruise, but a lot of work is needed when the economy is in a downtrend. 

Central banking systems are primarily funded through various means, including revenue from open market operations and interest earned on loans to depository institutions. Central banks can influence interest rates through their operations in the open market.

The Federal Reserve in the United States meets eight times a year to discuss current economic and financial conditions in the U.S. and worldwide. During these meetings, they may discuss policies, discuss the risks and long-term effects, and determine whether they are to implement them. 

In general, these banking systems serve as lenders of last resort. Member banks can borrow from the central bank as a last resort if they cannot raise enough capital to lend, helping to prevent economic collapse in times of crisis.

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