What is a central bank? What do central banks do?

A central bank, also known as a reserve bank, is a bank in charge of how money operates in a country (or group of countries).

Central banks are the ‘lenders of last resort’ – they are responsible for making sure there are enough funds in the economy when commercial banks are unable to cover a money-supply shortage.

They essentially prevent a nation’s banking system from failing.

Central banks have a number of different responsibilities: they are in charge of a country’s currency, money supply, and interest rates. In addition, they have the power to ensure that private financial institutions do not engage in illegal or fraudulent activities. 

They are also the ‘lender of last resort’ – supplying funds to desperate banks in an emergency; the aim being to prevent a bank run or bank failure.

Through controlling the money supply, central banks aim to meet a government’s economic goals.

Central bankOver the years, central banks’ role in banking and the economy has expanded considerably.

For example, when economies are in trouble central banks are at the forefront of making monetary changes to help the economy recover.

Money is a scarce resource and a limited money supply can have a direct impact on employment rates and market growth.

At times of economic unease, central banks usually step in and inject more money into an economy (increasing the money supply).

The chief executive of a central bank is usually known as the Governor, President or Chairman.

The missions of a central bank

According to the Board of Governors of the Federal Reserve System of the United States, its missions include:

“Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.”

“Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets. Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.”

According to the Bank of England:

“The Bank’s monetary policy objective is to deliver price stability and, subject to that, to support the Government’s economic objectives including those for growth and employment. Monetary stability means stable prices and confidence in the currency.”

“Stable prices are defined by the Government’s inflation target, which the Bank seeks to meet through the decisions delegated to the Monetary Policy Committee, explaining those decisions transparently and implementing them effectively in the money markets.”

The Bank of England was established in 1694.

How does a central bank control money supply?

The tools that central banks use to control money supply are: reserve requirements, open market operations, and discount rate.

Reserve requirements – this influences how much money the banking system can create with each dollar of reserve. An increase in reserve requirements means that banks must hold more reserves and can loan out less of each dollar that is desposited (this decreases the money supply in the economy).

On the other hand, if the central banks decrease the reserve requirement then banks can loan out more money per dollar (increasing the money supply).

Open market operations – through buying back government securities, central banks increase the total money that banks have (increasing money circulation).

Conversely, by selling government securities central banks decrease the money supply – banks reduce the amount of lending as a result.

Discount rate – interest rates on loans made to banks. When central banks lower discount rates the banking system borrows more from the central bank and there is more money in circulation. Central banks can influence the money supply by manipulating the discount rate.

Federal Reserve SystemThe Eccles Building in Washington, D.C., which serves as the United States’ Federal Reserve System’s headquarters.

Do governments control central banks?

Over recent years there has been less political control over the operations of central banks. This increasing trend of giving central banks more independence stems from the belief that too much political pressure may be responsible causing economic cycles (boom and bust cycles).

Politicians often want to boost economic activity in advance of an election without fully-understanding or caring about the long-term effects it may have on the economy.

As far as the law is concerned, central banks in developed nations and many others are independent. However, in democratic countries central banks are accountable at some level to government officials and or elected representatives.

The central bank has the right to set its own targets and goals; it might focus on inflation, controlling the money supply, or maintaining the value of the country’s currency. However, most of them prefer to announce their policy targets together with the relevant government departments, as it makes the policy setting process seem more transparent, thus increasing the credibility of the goals.

In advanced economies, central banks determine how to achieve their policy goals independently. They also have the authority to appoint staff, set budgets, etc.