Central banks are very important to the economy of a country. A central bank is commonly seen as a “lender of last resort”. There are many different types of banks. from commercial banks to industrial banks and to central banks.
As we can see, central banks are usually the most important. Often controlled by the government, they have the power to lend loans to commercial banks, which then lend loans to us as individuals and businesses.
What Are Central Banks?
Central banks have an important job. Their job is to regulate the economy of a country and hand out loans to commercial banks. How does it work? Well, central banks are controlled by the government. When it is needed, they will give loans to commercial banks to help them give out loans to individuals and corporates.
These people will then build homes, invest that money back into the community, and give more taxes to the government. Businesses will use that money to hire more people, create more products, and boost the economy of a country.
So, as we can see, central banks are important and much needed for a country to run more smoothly. They also have direct access to inflation and manage it through the loans that they give to commercial banks. In times when inflation is high, there is less money being given to commercial banks, thus balancing the economy.
(The definition of a central banks. Source: Investopedia)
Central banks are the supervisors for the banking sector. Though that is not for every country, some countries have independent government sectors that deal with the monitoring. They make sure that everything in the banking sector runs smoothly and, most importantly, how those banks treat individuals and customers.
Except its job of giving out loans and monitoring the banking system, central banks have other responsibilities. One of those responsibilities is handing out coins and banknotes, foreign currencies, and more. Thus, sometimes they are named the “bank of banks”.
History of Central Banks
We are not sure when central banks were first introduced, but it is agreed and believed that it happened in the 20th century. This is mainly because that’s when commercial banks started having issues.
Before that and up until 1914, the main standard for world currencies was gold. This period was easy to control by the banks. Inflation was not a big problem at the time because governments could not rule in new laws for “printing out more money”.
At the same time, gold was rare, so expanding monetarily was a big problem. The central bank had the job of converting the gold to currencies through the country’s reserve of gold.
The main reason for the main standard for the world’s currency to change was that during World War One, countries realised that they didn’t have enough resources to wage war. This made them understand that they could not just multiply the amount of gold they had.
This made it possible for some of the biggest countries in the world to change their currency into money and bank notes. This then helps because, in dire need, governments can make a new rule to just print more money.
With this all happening, these countries realized how much they really needed central banks. They would regulate the economy and maintain the printing and handing out of money. By doing so, they would also keep track of inflation and never let it get bigger than it should.
After the Great Depression and World War 2, which both ended up leaving countries involved with major issues, countries decided that it would be best for central banks to be controlled by the government. After that situation, and forward, we have had the same system of central banks.
What Are the Main Functions of a Central Bank?
Up until now, we have talked about what central banks are, how they work, and their history. We can safely say that we somewhat understand the general idea of a central bank. But what are their function? Here we have a list of the main functions of central banks.
Keeping the Money Supply Regulated
Central banks, with the order of the government, are required to keep the money supply regulated. What does this mean? It means setting up everything from interest rates and all the way to managing the country’s national wealth.
See Central banks set interest rates. What are the interest rates? Interest rates are the percentage at which commercial banks have to pay back central banks for the loans they take for any time frame.
See loans work the same for commercial banks as they work for individuals and businesses. Commercial banks take loans from central banks and pay them back with time. Although the interest rate that commercial banks pay back central banks is much lower than what we pay commercial banks.
Why? Well, the main reason is so that commercial banks can have enough money to manage themselves and maintain their banks. Central banks use this interest rate to then regulate inflation by making commercial banks pay more interest.
This makes commercial banks ask for higher interest from individuals, thus making them take loans less frequently and regulating inflation.
Managing Foreign Exchange and Gold
Central banks have an important job of managing the foreign exchange market. The foreign exchange reserves of a country are very important for trading the home currency with other currencies and vice versa.
It also has the important job of buying and holding more of its home currency and then selling it again when it is going higher compared to the USD. This grows the home country’s economy and helps boost its economic status.
Lenders of Last Resort
We explained earlier how central banks give out loans to commercial banks in order to help them give loans to individuals. That is an important job that they have.
What does “lender of last resort” mean? Well, in a lot of cases, commercial banks will have problems with payments by customers and will see bankruptcy. For the people and for the country, this is very negative. So, in that case, central banks make sure that they give loans to these commercial banks to save them from bankruptcy.
Managing Credit
Central banks control credit costs by setting the prime lending rate, or PLR, and getting involved in the open market to absorb excess liquidity. The major tools at the their disposal are interest rates, which are made up of the main lending rate or prime lending rate as it is termed in different nations.
Because this influences bank loan rates, any decrease in the prime lending rate would imply that commercial banks would similarly lower their loan rates, making credit availability and access more affordable.
How Does a Central Bank Influence the Economy?
Central banks have a major influence on the economy. It is said that they only have two functions in influencing the economy.
- Macroeconomics; this mainly happens when they regulate inflation and/or price stability.
- Microeconomics mainly occurs when lending or when acting in the name of “lenders of last resort”.
Central Banks Influence in Macroeconomics
Central banks need to regulate prices and maintain price stability. It is one of their most important jobs, so in order to regulate and keep inflation in tact, they will need to stabilize it and work on it. How do they do that?
They make open market transactions with which they can get extra funds or find different ways in order to maintain the economy of the country. One way of doing so is by “injecting” the market with liquidity.
Government bonds, bills, or other notes are also an important asset for central banks. They only buy them when necessary. This is done when there is not enough fluctuation in the market and not enough loans being sent out and borrowed.
By buying these government bonds, they allow the market and commercial banks to get more loans and more money in loans. This then makes the inflation higher, so there is one downside to it. But anytime they see that inflation is rising, they can sell the government bonds to the open market and control inflation again.
Central Banks Influence in Microeconomics
They are important as last resorts for commercial banks. This title has made them less dependent on commercial banks. The bond between commercial banks and the central ones is almost the same as that of a business owner with a commercial bank.
Commercial banks give loans to customers based on a first-come, first-serve basis. This means that commercial banks do not have reserves based on the number of customers or an average of loans to consumers.
In reality, an individual could ask for a loan from a commercial bank and the bank could not have enough to give to that individual. In these situations, commercial banks turn to central banks and ask for a loan big enough to fill the customer’s needs or to have more for other customers.
Of course, these loans are given by the central bank but with an interest rate towards the commercial bank. Depending on the percentage of the interest rate given to the commercial bank, the commercial bank can decide on what interest rate to give to the customer so they can repay the central bank.
For this reason, and because commercial banks do not hold reserves for costumer loans and ask the central banks when needed, the central banks have opened deposits and reserves just for commercial bank loans.
Some central banks that have opened these reserves require commercial banks to put money in the reserves. This is so they can control the economy even more and the fluctuation of the market. Although this is not something that happens in all countries. For example, the UK doesn’t do it while the US does.
It’s been suggested that the rate of return should keep banks from continuous borrowing, which would destabilize the market’s monetary base as well as the central bank’s monetary policy. But what is the monetary policy?
What is The Monetary Policy?
Central banks play an important role in monetary policy, which helps to maintain price stability and control economic swings. The policy frameworks under which they operate have seen significant modifications in recent decades.
Monetary policy is implemented by central banks by altering the supply of money, typically through open market operations. For example, may lower the amount of money by selling government bonds under a “sale and repurchase” deal, therefore receiving funds from commercial banks.
Following the global financial crisis, central banks in industrialized economies loosened monetary policy by lowering interest rates until short-term rates approached zero, limiting the ability to lower policy rates further.
Takeaways
- A central bank is commonly seen as a “lender of last resort”.
- Their job is to regulate the economy of a country and hand out loans to commercial banks.
- They make sure that everything in the banking sector runs smoothly and, most importantly, how those banks treat individuals and customers.
- Before that and up until 1914, the main standard for world currencies was gold.
- One reason for the main standard for the world’s currency to change was that during World War One, countries realised that they didn’t have enough resources to wage war.
