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

What is 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.

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.

Five functions of central bank

The five functions of a central bank are:

1. maintaining macroeconomic stability;
2. lender of the last resort for financial stability;
3. being a bank to the government;
4. implementing monetary policy;
5. regulating the financial sector.

Functions of central bank: maintaining macroeconomic stability

One of the functions of central banks is maintaining 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 bank: lender of the last resort

Another function of central banks is being the lender of last resort. 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 of central bank

Secondary functions of central banks are:

• regulating the note issue;
• functioning as the bankers’ bank;
• operating as the government’s bank;
• selling and purchasing currencies to affect the exchange rate;
• interfacing with foreign central banks and international organisations.

Secondary functions of central bank: 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.

Secondary functions of central bank: Implementation of 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.

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.

Secondary functions of central bank: 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:

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.