Central Banks

Notes

Central Banks

Central banks are bankers’ banks.

They guarantee stable monetary and financial policy from country to country and play an important role in the economy of the country. 

Typical functions include:

  • Implementing monetary policy

  • Managing foreign exchange and gold reserves

  • Making decisions regarding official interest rates

  • Acting as banker to the government and other banks

  • Regulating and supervising the banking industry.

Role of central banks

A central bank is a bank which acts on behalf of the government. 

The central bank for the UK is the Bank of England, and in Europe it is the European Central Bank (ECB). 

The main functions of a central bank are:

1) Setting interest rates

The level of interest rates can be influenced by the central bank

To support interest rate policy, the central bank may use open market operations. 

This involves the central bank supplying cash to the banking system on days when the banks have a cash shortage by buying (for example) 'bills' in exchange for cash.

When bills are sold, they are traded at a discount to their face value, and there is an implied interest rate in the rate of discount obtained.

Illustration

A 170-day Treasury Bill is sold for an average price of $9,800 per $10,000 face value. 

Assuming a 360-day year, this creates a yield of:

(10,000 - 9,800) / 9,800] x 360 / 170 x 100 =  4.3%

2) Regulating the banking sector

Central banks will monitor the general stability of the financial system and, where necessary, introduce regulations to reduce the risk of financial crisis.

3) Maintaining financial stability

Apart from regulation, the central bank will also act as a 'lender of last resort' when the banking system is short of money, ie the central bank will provide the money the banks need — at a suitable rate of interest.

Even if the banking system is not short of money the central bank may inject liquidity (ie cash) into the banking system by buying assets from commercial banks. 

The surplus cash that commercial banks will then be holding will be lent out to firms and will hopefully stimulate the economy through the process of credit creation covered earlier. 

This is sometimes called 'quantitative easing', and has been used by central banks in Europe, the UK, the USA and Japan in the aftermath of the economic crisis of 2008.

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