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17/09/2020 08:59:23 PM

CENTRAL BANKS AND THEIR ROLES

Central banks began as large private banks founded by monarchs to finance wars, and over the years added various other functions. While only a few central banks (18 countries had) existed in 1900, now nearly every country in the world has one, and they have become one of the most important institutions in government. A modern central bank not only manages the government’s finances but provides an array of services to commercial banks. Central banks control the availability of money and credit to ensure low inflation, high growth, and the stability of the financial system.

The government’s Bank

Governments have financial needs of their own. Some rulers, like King William of Orange, created the central bank to finance wars. Other, like Napoléon Bonaparte, did it in an effort to stabilize their country’s economic and financial system. As the importance of the government and the financial system grew, the need for a central bank grew along with it.

As the government’s bank, the central bank occupies a privileged position: it has a monopoly on the issuance of currency. The central bank creates money. Historically, central bank money has been seen as more trustworthy than that issued by kings, queens, or emperors. Rulers have had a tendency to default on their debts, rendering their currencies worthless. By contrast, early central banks kept sufficient reserves to redeem their notes in gold. People must have faith in money if they are to use it, and experience tells us that this type of institutional arrangement creates that faith.

The ability to print currency means that the central bank can control the availability of money and credit in a country’s economy. Most central banks go about this by adjusting short-term interest rates. This activity is what we usually refer to as monetary policy. Central banks use monetary policy to stabilize economic growth and inflation. An expansionary or accommodative policy, through lower interest rates, raises both growth and inflation over the short run, while tighter or restrictive policy reduces them.

Why a country would want to have its own monetary policy? At its most basic level, printing paper money is a very profitable business.  A $100 bill costs only a few cents to print, but it can be exchanged for $100 worth of goods and services. It is logical that governments would want to maintain a monopoly on printing paper money and to use the revenue it generates to benefit the general public.

Government officials also know that losing the control of the printing presses means losing control of inflation. A high rate of money growth creates a high inflation rate

The primary reason for a country to creating its own central bank is to ensure control over its currency. Giving the currency-printing monopoly to someone else can be disastrous, resulting in high inflation and damage to the economy’s ability to function smoothly

The bankers’ bank

The political backing of the government, together with their sizable gold reserves made early central banks the biggest and most reliable banks around. The notes issued by the central bank were viewed as safer than those of smaller banks, making it easier for holders to convert their deposits into cash. This safety and convenience quickly persuaded most other banks to hold deposits at the central bank as well

The important day-to-day jobs of the central bank are:

  • Provide loans during times of financial stress: The central bank’s ability to create money means that it can make loan even when no one else can, including during a crisis. They can lend reserves or currency to sound banks; they are the “lender of last resort”. By ensuring that sound banks and financial institutions can continue to operate, the central bank makes the whole financial system more stable
  • Manage the payments system. Every country needs a secure and efficient payments system. People require ways to pay each other, and financial institutions need a cheap and reliable way to transfer funds to one another. The fact that all banks have accounts there (reserves account) makes the central bank the natural place for these interbank payments to be settled
  • Oversee commercial banks and the financial system. Someone has to watch over commercial banks and nonbank financial institutions so that savers and investors can be confident they are sound. Those who monitor the financial system must have sensitive information and not make any harm to other institutions. Government examiners and supervisors are the only ones who can handle such information without conflict of interest. In some countries they are housed in the central bank, while in others they work in separate agencies