Last Updated on: 19th February 2021, 08:54 am
Central banks, also called reserve banks, came into being because their absence in the past had resulted in booms and busts in financial services involving bank failures that wiped out people’s savings.
The main objective of many central banks is price stability. In some countries, central banks are also required by law to act in support of full employment.
The critical feature of a central bank is its legal monopoly status, which gives it the privilege to issue banknotes and cash. Most central banks are not government agencies and are perceived to be politically independent.
A central bank is not a commercial bank.
An individual can’t open an account at a central bank and deposit money or ask it for a loan.
What central banks do is conduct monetary policy, using various tools to influence the amount of money circulating in an economy, interest rates charged on loans, and the rate of inflation.
Inflation occurs when prices continue to rise, meaning a country’s currency is worth less than it was before because it can’t buy as much (also known as a decline in purchasing power).
Inflation is a sign that the economy is growing. But high inflation is a problem because it discourages investment and lending and wipes out people’s savings as it erodes the value of money.
A central bank does act as a bank for commercial banks and this is how it influences the flow of money and credit in the economy to achieve stable prices.
Because commercial banks might lend long-term against short-term deposits, they can face “liquidity” problems.
This is a situation where they have the money to repay a debt but not the ability to turn it into cash quickly.
This is where a central bank can step in as a “lender of last resort.”
This helps keep the financial system stable.
Central banks can have a wide range of tasks besides monetary policy. They usually issue banknotes and coins, often ensure the smooth functioning of payment systems for banks and traded financial instruments, manage foreign reserves, and play a role in informing the public about the economy.
Many central banks also contribute to the stability of the financial system by supervising the commercial banks to make sure the lenders are not taking too many risks.
What Does a Central Bank Do?
As the organization that controls a nation’s monetary policy, central banks have the ability to both grow and slow the growth of the economy.
That’s because central banks have a reserve of cash that commercial banks can draw from to give out loans, the cost of which is determined by national interest rates.
If inflation is increasing, the central bank can raise interest rates, which makes it more expensive for an individual to take out a loan from her bank.
The central bank might stop producing money or compel commercial banks to buy financial instruments like treasury bills or foreign currency, which reduces the supply of money in an economy. This is called contractionary money policy.
On the other hand, if the economy is slowing, the central bank can lower interest rates, giving commercial banks cheaper access to funds that therefore let individuals and businesses borrow more. The central bank might start printing money again. This is called expansionary money policy.
Most central banks set a reserve requirement for commercial banks, meaning that they must retain a specified percentage in cash of what they owe to account holders, which makes sure banks don’t run out of money.
Countries that don’t set a reserve requirement, like the U.K., often have capital requirements instead, which are determined by the ratio of a bank’s capital to its risk.
Central Banks and Interest Rates
Central banks don’t directly set the interest you’ll receive in your savings account. Instead, they set an underlying interest rate.
A central bank either sets the “base rate” which is either:
- The amount that commercial banks are charged to borrow from each other (like in the U.S., where the Fed sets the “federal funds rate”).
- The amount that commercial banks are charged to borrow from the central bank (like in the U.K., where the Bank of England sets the “Bank Rate”).
Why does the central bank change the interest rate?
A central bank lowers interest rates when it is trying to stimulate the economy and increases interest rates when it is trying to contain inflation caused by an economy that’s “overheating” (or growing too fast).
Lower interest rates stimulate an economy in a few ways:
- Businesses can borrow money and invest in projects that will receive more than the risk borrowing rate.
- When interest rates are lower the stock market is discounted at a lower rate, leading to an appreciation in stock market values which causes a wealth effect.
- People invest their money into the economy (stocks and other assets) because they can earn more in these assets than at currently low-interest rates.
If economic growth is too fast, inflation might become too high and unstable.
This makes it difficult for households and businesses to plan for the future because prices are hard to predict with confidence. This can hinder spending and slow growth.
To prevent this scenario, a central bank might raise interest rates to try and slow the rate of growth in spending, and bring inflation back under control.
Central Banks and the Forex Market
Central banks play a key role in the currency markets because of their power over monetary policy.
They have a direct influence over the money supply, which in turn affects the demand and price of the currency.
Through the use of different policies, central banks can try to manipulate the markets so that they can keep their currency at specific levels.
Some countries and their central banks try to peg their currency to that of another currency or basket of currencies.
For example, China and Hong Kong “peg” their currencies to the U.S. dollar.
The central bank can participate in the forex market by buying and selling their currency at the spot market in order to keep it from changing too much.
Another motivation for central banks is to keep the local currency at a specific price in order to make their local economy more attractive for international trade.
Vincent Nyagaka is a Professional Trader, Analyst & Author. He has been actively engaged in market analysis for the past 7 years. He has a monthly readership of 100,000+ traders and has taught over 1,000 students since 2014. Vincent is also an experienced instructor and public speaker. Check out Vincent’s Professional Trading Course here.