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Functions of Central Banks

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Functions of Central Banks

You may not ever interact directly with a central bank in your life. However, the central bank indirectly plays a crucial role in your day-to-day life. By lowering interest rates to stimulate the economy, the central bank may result in a higher level of inflation and cause you to pay more for the goods and services you consume. Eager to learn more about the importance of a central bank? Read on!

The role of the central bank

You can find a central bank in almost every country. The European Central Bank, the Federal Reserve, the Bank of Japan, and the Bank of England are globally the most well-known central banks. In every circumstance, the goal that drives the institution’s activities is the key differentiator between a private bank and a central bank.

Private banks are for-profit enterprises that provide financial services to corporations and individuals.

Central banks operate to affect the behaviour of other financial institutions such as banks and intermediaries. Although central banks produce profits, profits are not the driving force behind their operations.

Several central banks were initially for-profit businesses that began to function to support financial market stability; for example, the Bank of England, founded in 1694, was made public in 1946. Also, in the United States of America, the Federal Reserve name of the central bank was created in 1913. Their commercial focus changed to include an unofficial role in what is now recognised as monetary policy. Central banking institutions were founded in nations where none previously existed as governments got more engaged in monetary policy.

Central banks are state-owned entities tasked with formulating monetary policy, acting as banks to the Government and other Bankers, serving as the Lender of Last Resort, and overseeing the domestic banking system with financial supply and rate of interest.

The five functions of a central bank are: maintaining macroeconomic stability, lender of the last resort for financial stability, being a bank to the government, implementing the monetary policy, and regulating the financial sector.

Functions of Central Banks Seat of the European Central Bank in Frankfurt StudySmarter

Seat of the European Central Bank in Frankfurt, Pixabay

The function of the central bank in macroeconomics: maintaining macroeconomic stability

In terms of macroeconomic stability, the Bank of England’s mandate is to maintain price stability while supporting the government’s economic goals, such as growth and employment. The government’s inflation objective, presently 2% on the consumer price index, is used to establish the price stability mandate rather than zero inflation (CPI). The importance of price stability in setting macroeconomic stability and creating the optimal circumstances for long-term growth in production and employment is emphasised in the mandate.

It is essential to consider the concept of macroeconomic stability and the notion of a related phrase, macroeconomic performance. Stable growth, employment, a sound price level, and steadiness in the current balance of payments account are all examples of macroeconomic stability. The degree to which these desirable aims are being met can evaluate macroeconomic performance.

To learn more about the various measures of macroeconomic performance, check our article on Economic Performance.

Functions of central banks: lender of the last resort (for financial stability)

Financial stability can be achieved by having the central bank act as lender of last resort to the banking system and by having the central bank supervise and regulate the financial system. The lender of last resort function is a common feature of central banks worldwide.

It is typically characterised as the central bank’s willingness to offer loans to solvent banks with short-term liquidity issues. The central bank’s goal in providing this money, although at a cost, is to safeguard depositors and, in the worst-case scenario, to avoid a systemic financial collapse.

The Federal Reserve issued several short-term emergency loans to keep the financial system running during the 1987 stock market crash panic when US stock prices dropped significantly on a given day. The Fed’s readiness to make short-term credit accessible as needed in a period when the banking and financial systems were under stress is an example of the role of the central bank serving as the lender of the last resort for financial stability.

Secondary functions

Regulating the note issue, functioning as the bankers’ bank, operating as even the government’s bank, selling and purchasing currencies to affect the exchange rate, and interfacing with foreign central banks and international organisations are secondary functions of central banks.

Bank to the government

Banks, like individuals, retain balances with the central bank. The central bank functions as the governments’ bank. The government of a country, such as England, has an opened bank account with the Bank of England.

The bank’s position as a banker to the government, on the other hand, has been severely diminished. The Debt Management Office (DMO) has been issuing debt on behalf of the Treasury since 1998. In 2000, it took over responsibility for giving Treasury bills and handling the government’s short-term liquidity needs.

Functions of Central Banks Bank of England StudySmarter

Bank of England, Pixabay

Implementation of the monetary policy

The essential job of central banks is to formulate monetary policy, which entails engaging in actions (like controlling interest rates and conditions of credit) to impact the amount of money supply in the economy. The policy ensures price stability, protect the value of the native currency, maximise employment, and establish a long-term growth environment.

To implement monetary policy in the economy, a central bank has three basic methods:

  • Altering reserve requirements

  • Adjusting the bank rate

  • Open market operations

Altering reserve requirements

The central bank can use the reserve requirement to raise or lower the money supply. The reserve requirement is the ratio of a bank’s deposits mandated by law to keep in cash or on deposit with the central bank. Banks will have less money available to lend if they are compelled to retain more reserves. If banks are permitted to keep less cash in addition, they will have more money to give out.

The Federal Reserve ordered banks to retain reserves equivalent to zero per cent of the first $14.5 million in deposits: after that, three per cent of deposits up to $103.6 million. Finally, ten portions of any amount beyond $103.6 million, beginning in early 2015.

Adjusting the bank rate

The Bank rate is the Central bank’s rate to commercial banks when they acquire reserves from the central bank.

Different central banks utilise the bank rate in various ways. The use of fluctuations in the rate as a signal of monetary policy changes has a long history. A decrease in the bank rate indicates that the central bank intends to expand its economic base. A spike in the bank rate suggests that monetary conditions are becoming tighter.

Borrowing from other banks with unanticipated extra reserves is one approach for an individual bank to offset a reserve deficiency. A bank short on accounts takes from the central bank when no bank within the system has surplus reserves to lend. This generates a monetary base market. The interest rate charged set by the central bank is higher than the inter-commercial lending rate to entice banks to take and offer reserves in the market.

Open market operations

The central bank buys or sells government assets in the open financial market, known as open market operations. They are the primary tool that central banks use to control the size of the monetary base. Central banks use open market operations to supply the financial foundation required to maintain the demand for money, and the sales surge as the economy expands. They provide the necessary monetary base to fulfil money demand at the central bank’s predetermined interest rate. An open market sale adds to the central bank’s capital and currency supply permanently.

Regulation of the financial sector

The role of a central bank is to guarantee that financial institutions perform their operations ethically. The central bank must perform specific regulatory tasks to do so.

  • Central bankers guarantee financial institutions deposits up to a limit. Because the central bank ensures the stakes, it keeps tabs on how the proceeds limit their liability.

  • The central banks have a responsibility to keep an eye on the risks. As a result, perform audits regularly. Commercial banks must guarantee that their level of risk stays within the restrictions the central banks set.

  • Central banks also enforce anti-discrimination regulations to guarantee that communal or racist motivations do not hamper the availability of bank credit.

    For example, inside the United States, there were accusations that banks were redlining certain areas because Hispanics and Black People made up the bulk of the people in these areas.

  • The central bank keeps a check on financial institutions’ activity and looks for any conflicts of interest. If top executives on commercial bank advisory boards are issuing bonds to themselves and other businesses managed by them, the central bank could and should intervene to prevent theft.

To learn more about the various measures of financial regulation by the Central Bank check our article on Regulation of Financial System.

Government’s control over the central bank

The government owns and controls every central bank. The central bank oversees all government banking operations. It has sole authority to carry out all banking duties on the government’s behalf. As a result, the central bank serves as the government’s banker, adviser, and agent. However, whiles some central banks are fully state-controlled, others have independence in certain aspects of their roles.

Independent central banks

Several nations have chosen to make central banks self-contained. The economic argument for central bank independence is that the outcome will not reflect the politicians’ objectives after governments outsource monetary policy to an independent central bank rather than national leaders. In terms of central bank functions, there are certain areas of independence from the government:

  • Legal

  • Financial

  • Personal

  • Goal

  • Institutional

  • Operational

State-controlled central banks

The central bank should be the regulator and authority in the banking and monetary systems to maintain currency stability. Government-owned and state-controlled central banks exist today, and they are not distinct from their country’s finance ministry or department. However, the economic justification for a state-controlled central bank is that national leaders, rather than an independent central bank, oversee monetary policy.

Comparison of independent and state-controlled central banks

A comparison between Independent and State-Controlled Central Banks can best be presented based on the six aspects of independence.

ASPECTS

Independent Central Banks

State-Controlled Central Banks

Legal

Central banks get their separate rights, allowing them to join international accords without the government’s permission.

The government has to approve the legal issues.

Financial

Central banks have complete budget independence, and some are even forbidden from lending to governments.

Government can borrow money anytime.

Personal

Central bank governors can serve extended terms of office, at least for as long as the political cycle.

Central bank governors change with change in the political cycle.

Goal

The central bank has the authority to determine its own policy goal.

The state sets goals.

Institutional

The law guarantees the central bank’s independence, protecting it from political meddling.

No need for laws against political meddling.

Operational

The central bank has the authority to choose the optimal method for attaining its policy objectives, such as the instruments employed and when they are utilised.

The state chooses the optimal method to serve its interest.

Functions of Central Banks - Key takeaways

  • Central banks can be defined as state-owned entities tasked with formulating monetary policy, acting as banks to the Government and other Bankers, serving as the Lender of Last Resort, and overseeing the domestic banking system with financial supply and rate of interest.
  • The core roles of central banks are to assist the government in maintaining macroeconomic stability and encouraging financial stability in the monetary system.
  • Regulating the note issue, functioning as the bankers’ bank, operating as even the government’s bank, selling and purchasing currencies to affect the exchange rate, and interfacing with foreign central banks and international organisations are other roles that central banks do.
  • To implement monetary policy in the economy, a central bank has three basic methods.
    • Altering reserve requirements
    • Adjusting the bank rate

    • Open market operations

  • There are varying degrees of the Government’s Control over Central Bank.
  • A central bank plays a vital role in the regulation of the financial sector.

Frequently Asked Questions about Functions of Central Banks

The central banks are to assist the government in maintaining macroeconomic stability and to ensure financial stability in the monetary system.

Central banks are state-owned entities tasked with formulating monetary policy, acting as banks to the Government and other Bankers, serving as the Lender of Last Resort, and overseeing the domestic banking system with financial supply and rate of interest.

  • Maintain macroeconomic stability.
  • Lender of the last resort for financial stability.
  • Bank to the government.
  • Implementation of the monetary policy.
  • Regulation of the financial sector.

Final Functions of Central Banks Quiz

Question

What is the lender of last resort?

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Answer

It is typically characterised as the central bank’s willingness to offer loans to solvent banks with short-term liquidity issues.

Show question

Question

List the three classic tools a central bank uses to manage the money supply.

Show answer

Answer

  • Altering reserve requirements.
  • Adjusting the discount rate.
  • Open market operations.

Show question

Question

Describe how an open market operation may be used to control the money supply.

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Answer

The central bank buys or sells government assets in the open financial market to control the size of the monetary base.

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Question

Describe how the discount rate may be used to increase the money supply.

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Answer

The central bank uses a discount rate to charge commercial banks when they acquire reserves from the central bank. It compels banks to retain more reserves due to less money available to lend. 

Show question

Question

Central banks were founded as for-profit organisations with the goal of promoting financial market stability. True or false?

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Answer

True.

Show question

Question

What are the main functions of the central bank?

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Answer

The main functions of the central bank are to assist the government in maintaining macroeconomic stability and to ensure financial stability in the monetary system.

Show question

Question

What is a central bank?

Show answer

Answer

Central banks can then be defined as state-owned entities tasked with formulating monetary policy, acting as Bank to the government and other bankers, serving as the lender of last resort, and overseeing the domestic banking system with financial supply and rate of interest.

Show question

Question

What are the secondary functions of the central bank?

Show answer

Answer

Bank to the government.

Show question

Question

Independent central banks get their own separate rights, allowing them to join international accords without the permission of the government. True or false?

Show answer

Answer

True.

Show question

Question

What is macroeconomic stability?

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Answer

The characteristics of macroeconomic stability are stable growth, employment, a stable price level, and consistency in the current balance of payments account.

Show question

Question

Name two indicators of macroeconomic stability.

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Answer

Stable growth.

Show question

Question

___________ are state-owned entities tasked with formulating monetary policy.


Show answer

Answer

Central banks

Show question

Question

Which function of the central blank maintains price stability while supporting the government's economic goals?

Show answer

Answer

maintaining macroeconomic stability

Show question

Question

To implement monetary policy in the economy, a central bank has three basic methods:

  • Altering ___________

  • Adjusting ___________

  • Open market operations

Show answer

Answer

  • Altering reserve requirements

  • Adjusting the bank rate

Show question

Question

The central bank can use the reserve requirement to raise or lower the ___________

Show answer

Answer

money supply.

Show question

Question

___________ is the Central bank’s rate to commercial banks when they acquire reserves from the central bank.

Show answer

Answer

The Bank rate

Show question

Question

Open market operations are the primary tool that central banks use to control the size of the monetary base.


Show answer

Answer

True

Show question

Question

The central bank that is the regulator and authority in the banking and monetary systems of an economy is ___________

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Answer

an independent central bank


Show question

Question

Which function of the central bank guarantees that financial institutions perform their operations ethically?


Show answer

Answer

Regulation of the financial sector

Show question

Question

The government owns and controls every central bank.

Show answer

Answer

True

Show question

Question

The essential job of central banks is to formulate ___________, which entails engaging in actions like controlling interest rates and conditions of credit.


Show answer

Answer

monetary policy

Show question

Question

Stable growth, employment, a sound price level, and steadiness in the current balance of payments account are all examples of ___________. 


Show answer

Answer

macroeconomic stability

Show question

Question

Borrowing from other banks with unanticipated extra reserves is one approach for an individual bank to offset a reserve deficiency.

Show answer

Answer

True

Show question

Question

With an independent central bank, the government can borrow money anytime.

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Answer

True

Show question

Question

___________ central bank has the authority to determine its own policy goal.

Show answer

Answer

Independent

Show question

Question

___________ central bank governors change with change in the political cycle.

Show answer

Answer

State-Controlled

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