💾 Archived View for gmi.noulin.net › mobileNews › 3875.gmi captured on 2023-06-14 at 16:12:29. Gemini links have been rewritten to link to archived content
⬅️ Previous capture (2023-01-29)
-=-=-=-=-=-=-
2012-03-13 07:02:18
June 05 2010 | Filed Under Banking , Economics
The central bank has been described as "the lender of last resort", which means
that it is responsible for providing its economy with funds when commercial
banks cannot cover a supply shortage. In other words, the central bank prevents
the country's banking system from failing. However, the primary goal of central
banks is to provide their countries' currencies with price stability by
controlling inflation. A central bank also acts as the regulatory authority of
a country's monetary policy and is the sole provider and printer of notes and
coins in circulation. Time has proved that the central bank can best function
in these capacities by remaining independent from government fiscal policy and
therefore uninfluenced by the political concerns of any regime. The central
bank should also be completely divested of any commercial banking interests.
The Rise of the Central Bank
Today the central bank is government owned but separate from the country's
ministry of finance. Although the central bank is frequently termed the
"government's bank" because it handles the buying and selling of government
bonds and other instruments, political decisions should not influence central
bank operations. Of course, the nature of the relationship between the central
bank and the ruling regime varies from country to country and continues to
evolve with time. To ensure the stability of a country's currency, the central
bank should be the regulator and authority in the banking and monetary systems.
Historically, the role of the central bank has been growing, some may argue,
since the establishment of the Bank of England in 1694. It is, however,
generally agreed upon that the concept of the modern central bank did not
appear until the 20th century as problems developed in the commercial banking
system. Thus, the central bank's modern function emerged in response to an
already present commercial banking structure.
Between 1870 and 1914, when world currencies were pegged to the gold standard
(GS), maintaining price stability was a lot easier because the amount of gold
available was limited. Consequently, monetary expansion could not occur simply
from a political decision to print more money, so inflation was easier to
control. The central bank at that time was primarily responsible for
maintaining the convertibility of gold into currency; it issued notes based on
a country's reserves of gold. (For more insight, read The Gold Standard
Revisited.)
At the outbreak of WWI, the GS was abandoned, and it came apparent that, in
times of crisis, governments, facing budget deficits (because it costs money to
wage war) and needing greater resources, will order the printing of more money.
As governments did so, they encountered inflation. After WWI, many governments
opted to go back to the GS to try to stabilize their economies. With this rose
the awareness of the importance of the central bank's independence from the
political machine.
During the unsettling times of the Great Depression and the aftermath of WWII,
world governments predominantly favored a return to a central bank dependent on
the political decision making process. This view emerged mostly from the need
to establish control over war-shattered economies; furthermore, countries with
newly-acquired independence opted to keep control over all aspects of their
countries - a backlash against colonialism. The rise of managed economies in
the Eastern Bloc was also responsible for increased government interference in
the macroeconomy. Soon after the effects of WWII, however, the independence of
the central bank from the government came back into fashion in Western
economies and has prevailed as the optimal way to achieve a liberal and stable
economic regime.
How the Bank Influences an Economy
A central bank can be said to have two main kinds of functions: (1)
macroeconomic when regulating inflation and price stability and (2)
microeconomic when functioning as a lender of last resort. (For background
reading on macroeconomics, see Macroeconomic Analysis.)
Macroeconomic Influences
As it is responsible for price stability, the central bank must regulate the
level of inflation by controlling money supplies by means of monetary policy.
The central bank performs open market transactions that either inject the
market with liquidity or absorb extra funds, directly affecting the level of
inflation. To increase the amount of money in circulation and decrease the
interest rate (cost) for borrowing, the central bank can buy government bonds,
bills, or other government-issued notes. This buying can, however, also lead to
higher inflation. When it needs to absorb money to reduce inflation, the
central bank will sell government bonds on the open market, which increases the
interest rate and discourages borrowing. Open market operations are the key
means by which a central bank controls inflation, money supply, and price
stability. If you'd like to learn more about this subject, see this The Federal
Reserve (the Fed) Tutorial.
Microeconomic Influences
The establishment of central banks as lender of last resort has pushed the need
for their freedom from commercial banking. A commercial bank offers funds to
clients on a first come, first serve basis. If the commercial bank does not
have enough liquidity to meet its clients' demands (commercial banks typically
do not hold reserves equal to the needs of the entire market), the commercial
bank can turn to the central bank to borrow additional funds. This provides the
system with stability in an objective way; central banks cannot favor any
particular commercial bank. As such, many central banks will hold
commercial-bank reserves that are based on a ratio of each commercial bank's
deposits. Thus, a central bank may require all commercial banks to keep, for
example, a 1:10 reserve/deposit ratio. Enforcing a policy of commercial bank
reserves functions as another means to control money supply in the market. Not
all central banks, however, require commercial banks to deposit reserves. The
United Kingdom, for example, does not have this policy while the United States
does.
The rate at which commercial banks and other lending facilities can borrow
short-term funds from the central bank is called the discount rate (which is
set by the central bank and provides a base rate for interest rates). It has
been argued that, for open market transactions to become more efficient, the
discount rate should keep the banks from perpetual borrowing, which would
disrupt the market's money supply and the central bank's monetary policy. By
borrowing too much, the commercial bank will be circulating more money in the
system. Use of the discount rate can be restricted by making it unattractive
when used repeatedly. (To learn more, read Understanding Microeconomics.)
Transitional Economies
Today developing economies are faced with issues such as the transition from
managed to free market economies. The main concern is often controlling
inflation. This can lead to the creation of an independent central bank but can
take some time, given that many developing nations maintain control over their
economies in an effort to retain control of their power. But government
intervention, whether direct or indirect through fiscal policy, can stunt
central bank development. Unfortunately, many developing nations are faced with
civil disorder or war, which can force a government to divert funds away from
the development of the economy as a whole. Nonetheless, one factor that seems
to be confirmed is that, for a market economy to develop, a stable currency
(whether achieved through a fixed or floating exchange rate) is needed.
However, the central banks in both industrial and emerging economies are
dynamic because there is no guaranteed way to run an economy regardless of its
stage of development.
Conclusion
Central banks are responsible for overseeing the monetary system for a nation
(or group of nations), along with a wide range of other responsibilities, from
overseeing monetary policy to implementing specific goals such as currency
stability, low inflation and full employment. The role of the central bank has
grown in importance over time, but in U.S., its activities continue to evolve.
by Reem Heakal