Explainer: The purpose of central banks

Explainer: The purpose of central banks

A central bank is a government institution responsible for managing the currency, monetary base or money supply, and interest rates within a country or state. Depending on the jurisdiction, central banks are also called reserve banks or monetary authority.

Developed countries or states have institutionalized central banks to be independent of political interference. Some governments have maintained a limited control as part of their overall mandate to manage macroeconomic affairs, but governments under an authoritarian leadership, such as in the case of hyperinflation in Venezuela and hyperinflation in Zimbabwe, tend to exert extensive control over their monetary authorities.

The central bank of the United States is called the U.S. Federal Reserve while in the Eurozone of the European Union, it is called the European Central Bank. The United Kingdom has the Bank of England while China has the People’s Bank of China. Saudi Arabia calls its central bank as the Saudi Arabian Monetary Authority.

Purpose of Central Banks: Two Primary Roles and Responsibilities

Most central banks have two general or primary roles and responsibilities. The first is to regulate and manage the commercial banks and the banking sector of a particular country or state. A specific central bank does this by ensuring that these commercial banks have enough money in their reserves to avoid bank runs or in other words, by ensuring that these banks remain liquid.

However, it is worth mentioning that different countries have different ways of managing their banking sector. In the United Kingdom, the U.K. Treasury supervises commercial banks while the U.K. Financial Conduct Authority examines the balance sheets, financial activities, and market behavior of these banks.

The second primary purpose of central banks is to define and implement monetary policies with the specific goal of either increasing or decreasing the money supply to either speed up or slow down the overall economy. A central bank does this using either one or all of the three primary tools of monetary policy.

Governments that adhere to Keynesian economics use their central banks to intervene in their economies. For example, during an economic recession, central banks implement specific monetary policies to lower down the interest rates, encourage lending and borrowing activities, and thus, promote consumption and business investment activities.

More Specific Roles and Responsibilities of Central Banks

Below are more specific roles and responsibilities of central banks:

• Issuance of Bank Notes: The central bank of a particular nation or state holds the exclusive rights to authorize the issuance of bank notes or printing of currencies. It also plays a central role in deciding what form of currency a country should have.

• Money Supply Control: Another responsibility of a central bank is to control the money supply or affect the quantity of cash in circulation by buying or selling government securities such as bonds and treasury bills through open market operations.

• Reserve Requirements: One of the ways a central bank oversees commercial bank is through reserve requirements. The reserve requirement is a mandate developed and implemented by the central bank that tells how much money commercial banks are allowed to keep.

• Influence Interest Rates: Most central banks do not have direct control over the interest rates of commercial banks. However, they can significantly influence these rates using established monetary policy tools such as reserve requirements, discount rates, and open markets operations.

• Expand or Contract the Economy: Most central banks through their monetary policies have been used as a collective macroeconomic tool for managing the economy. By influencing interest rates, a particular central bank can either encourage or discourage borrowing-lending activities that in turn, can promote or reduce consumption and investment activities.

• Control Inflation and Exchange Rate: By influencing interest rates or in other cases, by setting an official interest rate, as well as due to its influence in expanding or contracting the economy, a central bank also manages inflation and the currency exchange rate of a particular country.

• Lender of Last Resort: Another key function of central banks is to be a lender of last resort for financial institutions to provide them with liquidity. Take note that this function stems from the general purpose of ensuring liquidity in the banking sector and overall financial markets. Note that central banks are the banker of banks.