Functions of Central Banks: Introduction & Importance (2024)

You may not ever interact directly with a central bank in your life. However, the central bank indirectly plays a crucial role in your day-to-day life. By lowering interest rates to stimulate the economy, the central bank may result in a higher level of inflation and cause you to pay more for the goods and services you consume. Eager to learn more about the importance of a central bank? Read on!

The role of the central bank

What is the role of the central bank? You can find a central bank in almost every country. The European Central Bank, the Federal Reserve, the Bank of Japan, and the Bank of England are globally the most well-known central banks. In every circ*mstance, the goal that drives the institution’s activities is the key differentiator between a private bank and a central bank.

Private banks are for-profit enterprises that provide financial services to corporations and individuals.

Central banks operate to affect the behaviour of other financial institutions such as banks and intermediaries. Although central banks produce profits, profits are not the driving force behind their operations.

Several central banks were initially for-profit businesses that began to function to support financial market stability; for example, the Bank of England, founded in 1694, was made public in 1946. Also, in the United States of America, the Federal Reserve name of the central bank was created in 1913. Their commercial focus changed to include an unofficial role in what is now recognised as monetary policy. Central banking institutions were founded in nations where none previously existed as governments got more engaged in monetary policy.

Central banks are state-owned entities tasked with formulating monetary policy, acting as banks to the Government and other Bankers, serving as the Lender of Last Resort, and overseeing the domestic banking system with financial supply and rate of interest.

Five functions of central bank

The five functions of a central bank are:

  1. maintaining macroeconomic stability;
  2. lender of the last resort for financial stability;
  3. being a bank to the government;
  4. implementing monetary policy;
  5. regulating the financial sector.

Functions of Central Banks: Introduction & Importance (1)

Seat of the European Central Bank in Frankfurt, Pixabay

Functions of central bank: maintaining macroeconomic stability

One of the functions of central banks is maintaining macroeconomic stability. The Bank of England’s mandate is to maintain price stability while supporting the government’s economic goals, such as growth and employment. The government’s inflation objective, presently 2% on the consumer price index, is used to establish the price stability mandate rather than zero inflation (CPI). The importance of price stability in setting macroeconomic stability and creating the optimal circ*mstances for long-term growth in production and employment is emphasised in the mandate.

It is essential to consider the concept of macroeconomic stability and the notion of a related phrase, macroeconomic performance. Stable growth, employment, a sound price level, and steadiness in the current balance of payments account are all examples of macroeconomic stability. The degree to which these desirable aims are being met can evaluate macroeconomic performance.

To learn more about the various measures of macroeconomic performance, check our article on Economic Performance.

Functions of central bank: lender of the last resort

Another function of central banks is being the lender of last resort. Financial stability can be achieved by having the central bank act as lender of last resort to the banking system and by having the central bank supervise and regulate the financial system. The lender of last resort function is a common feature of central banks worldwide.

It is typically characterised as the central bank’s willingness to offer loans to solvent banks with short-term liquidity issues. The central bank’s goal in providing this money, although at a cost, is to safeguard depositors and, in the worst-case scenario, to avoid a systemic financial collapse.

The Federal Reserve issued several short-term emergency loans to keep the financial system running during the 1987 stock market crash panic when US stock prices dropped significantly on a given day. The Fed’s readiness to make short-term credit accessible as needed in a period when the banking and financial systems were under stress is an example of the role of the central bank serving as the lender of the last resort for financial stability.

Secondary functions of central bank

Secondary functions of central banks are:

  • regulating the note issue;
  • functioning as the bankers’ bank;
  • operating as the government’s bank;
  • selling and purchasing currencies to affect the exchange rate;
  • interfacing with foreign central banks and international organisations.

Secondary functions of central bank: Bank to the government

Banks, like individuals, retain balances with the central bank. The central bank functions as the governments’ bank. The government of a country, such as England, has an opened bank account with the Bank of England.

The bank’s position as a banker to the government, on the other hand, has been severely diminished. The Debt Management Office (DMO) has been issuing debt on behalf of the Treasury since 1998. In 2000, it took over responsibility for giving Treasury bills and handling the government’s short-term liquidity needs.

Functions of Central Banks: Introduction & Importance (2)

Bank of England, Pixabay

Secondary functions of central bank: Implementation of monetary policy

The essential job of central banks is to formulate monetary policy, which entails engaging in actions (like controlling interest rates and conditions of credit) to impact the amount of money supply in the economy. The policy ensures price stability, protect the value of the native currency, maximise employment, and establish a long-term growth environment.

To implement monetary policy in the economy, a central bank has three basic methods:

  • Altering reserve requirements

  • Adjusting the bank rate

  • Open market operations

Altering reserve requirements

The central bank can use the reserve requirement to raise or lower the money supply. The reserve requirement is the ratio of a bank’s deposits mandated by law to keep in cash or on deposit with the central bank. Banks will have less money available to lend if they are compelled to retain more reserves. If banks are permitted to keep less cash in addition, they will have more money to give out.

The Federal Reserve ordered banks to retain reserves equivalent to zero per cent of the first $14.5 million in deposits: after that, three per cent of deposits up to $103.6 million. Finally, ten portions of any amount beyond $103.6 million, beginning in early 2015.

Adjusting the bank rate

The Bank rate is the Central bank’s rate to commercial banks when they acquire reserves from the central bank.

Different central banks utilise the bank rate in various ways. The use of fluctuations in the rate as a signal of monetary policy changes has a long history. A decrease in the bank rate indicates that the central bank intends to expand its economic base. A spike in the bank rate suggests that monetary conditions are becoming tighter.

Borrowing from other banks with unanticipated extra reserves is one approach for an individual bank to offset a reserve deficiency. A bank short on accounts takes from the central bank when no bank within the system has surplus reserves to lend. This generates a monetary base market. The interest rate charged set by the central bank is higher than the inter-commercial lending rate to entice banks to take and offer reserves in the market.

Open market operations

The central bank buys or sells government assets in the open financial market, known as open market operations. They are the primary tool that central banks use to control the size of the monetary base. Central banks use open market operations to supply the financial foundation required to maintain the demand for money, and the sales surge as the economy expands. They provide the necessary monetary base to fulfil money demand at the central bank’s predetermined interest rate. An open market sale adds to the central bank’s capital and currency supply permanently.

Secondary functions of central bank: Regulation of the financial sector

The role of a central bank is to guarantee that financial institutions perform their operations ethically. The central bank must perform specific regulatory tasks to do so.

  • Central bankers guarantee financial institutions deposits up to a limit. Because the central bank ensures the stakes, it keeps tabs on how the proceeds limit their liability.

  • The central banks have a responsibility to keep an eye on the risks. As a result, perform audits regularly. Commercial banks must guarantee that their level of risk stays within the restrictions the central banks set.

  • Central banks also enforce anti-discrimination regulations to guarantee that communal or racist motivations do not hamper the availability of bank credit.

    For example, inside the United States, there were accusations that banks were redlining certain areas because Hispanics and Black People made up the bulk of the people in these areas.

  • The central bank keeps a check on financial institutions’ activity and looks for any conflicts of interest. If top executives on commercial bank advisory boards are issuing bonds to themselves and other businesses managed by them, the central bank could and should intervene to prevent theft.

To learn more about the various measures of financial regulation by the Central Bank check our article on Regulation of Financial System.

Government’s control over the central bank

The government owns and controls every central bank. The central bank oversees all government banking operations. It has sole authority to carry out all banking duties on the government’s behalf. As a result, the central bank serves as the government’s banker, adviser, and agent. However, whiles some central banks are fully state-controlled, others have independence in certain aspects of their roles.

Independent central banks

Several nations have chosen to make central banks self-contained. The economic argument for central bank independence is that the outcome will not reflect the politicians’ objectives after governments outsource monetary policy to an independent central bank rather than national leaders. In terms of central bank functions, there are certain areas of independence from the government:

  • Legal

  • Financial

  • Personal

  • Goal

  • Institutional

  • Operational

State-controlled central banks

The central bank should be the regulator and authority in the banking and monetary systems to maintain currency stability. Government-owned and state-controlled central banks exist today, and they are not distinct from their country’s finance ministry or department. However, the economic justification for a state-controlled central bank is that national leaders, rather than an independent central bank, oversee monetary policy.

Comparison of independent and state-controlled central banks

A comparison between Independent and State-Controlled Central Banks can best be presented based on the six aspects of independence.

ASPECTS

Independent Central Banks

State-Controlled Central Banks

Legal

Central banks get their separate rights, allowing them to join international accords without the government’s permission.

The government has to approve the legal issues.

Financial

Central banks have complete budget independence, and some are even forbidden from lending to governments.

Government can borrow money anytime.

Personal

Central bank governors can serve extended terms of office, at least for as long as the political cycle.

Central bank governors change with change in the political cycle.

Goal

The central bank has the authority to determine its own policy goal.

The state sets goals.

Institutional

The law guarantees the central bank’s independence, protecting it from political meddling.

No need for laws against political meddling.

Operational

The central bank has the authority to choose the optimal method for attaining its policy objectives, such as the instruments employed and when they are utilised.

The state chooses the optimal method to serve its interest.

Functions of Central Banks - Key takeaways

  • Central banks can be defined as state-owned entities tasked with formulating monetary policy, acting as banks to the Government and other Bankers, serving as the Lender of Last Resort, and overseeing the domestic banking system with financial supply and rate of interest.
  • The core roles of central banks are to assist the government in maintaining macroeconomic stability and encouraging financial stability in the monetary system.
  • Regulating the note issue, functioning as the bankers’ bank, operating as even the government’s bank, selling and purchasing currencies to affect the exchange rate, and interfacing with foreign central banks and international organisations are other roles that central banks do.
  • To implement monetary policy in the economy, a central bank has three basic methods.
    • Altering reserve requirements
    • Adjusting the bank rate

    • Open market operations

  • There are varying degrees of the Government’s Control over Central Bank.
  • A central bank plays a vital role in the regulation of the financial sector.
Functions of Central Banks: Introduction & Importance (2024)

FAQs

Functions of Central Banks: Introduction & Importance? ›

The essential roles of a central bank are to affect monetary policy, be the lender of last resort, and oversee the banking system. Central banks set interest rates, lend money to other banks, and control the money supply.

What are the main functions of the central bank? ›

Functions of the Central Bank
  • Currency regulator or bank of issue.
  • Bank to the government.
  • Custodian of Cash reserves.
  • Custodian of International currency.
  • Lender of last resort.
  • Clearing house for transfer and settlement.
  • Controller of credit.
  • Protecting depositors interests.
May 31, 2021

What are central banks and why are they important? ›

A central bank is a public institution that is responsible for implementing monetary policy, managing the currency of a country, or group of countries, and controlling the money supply.

What are the main functions of a central bank Quizlet? ›

The central bank keeps a record of the government's financial activities and maintains the government's accounts. The central bank acts as an economic agent for the government. The government uses the central bank to carry out its monetary policies which include controlling money supply and interest rates.

What are the three main functions a central bank performs in its role as a banker's bank? ›

What are the three main functions a central bank performs in its role as a banker's bank? The three functions are: provide loans during times of financial stress; manage the payments system; and oversee commercial banks and the financial system.

What is a bank and its functions? ›

A bank is a financial institution licensed to receive deposits and make loans. There are several types of banks including retail, commercial, and investment banks. In most countries, banks are regulated by the national government or central bank.

What are the objectives of a central bank? ›

The main objective of a central bank is to maintain price stability. Depending on the country, central banks might have other objectives, such as controlling inflation, unemployment, interest rates, or exchange rates. However, all these objectives align with the primary objective of ensuring financial stability.

What is the most important feature of a central bank? ›

Answer. Option d), the most important feature of a central bank is its independence from the government, allowing it to manage the money supply, control interest rates, and provide financial stability without political interference.

What impact do central banks have? ›

By altering national money stocks, central banks indirectly influence rates of spending and inflation and, to a far more limited extent, rates of employment and the production of goods and services.

What are the three common duties that all central banks perform? ›

A central bank is a financial institution that is responsible for overseeing the monetary system and policy of a nation or group of nations, regulating its money supply, and setting interest rates.

What are two things that keep the banking system healthy? ›

Two things keep a banking system healthy: confidence and liquidity.

What is the central bank of the United States and what functions does it perform? ›

The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.

What factors reduce the money creating abilities of the banking system? ›

A tightening of monetary policy leads to a rise in interest rates and thus dampens the demand for loans. Moreover, rising interest rates cause the economy to slow, which further reduces demand for loans. Higher interest rates also have a negative impact on the banks' credit supply.

What are the most important functions of the central bank? ›

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.

How does a bank create money? ›

Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it.

How do central banks work? ›

Central banks conduct monetary policy by adjusting the supply of money, usually through buying or selling securities in the open market. Open market operations affect short-term interest rates, which in turn influence longer-term rates and economic activity.

What are the 5 functions of a commercial bank? ›

Commercial banks perform various functions that are as follows:
  • Accepting deposits. The basic function of commercial banks is to accept deposits of the customers. ...
  • Granting loans and advances. ...
  • Agency functions. ...
  • Discounting bills of exchange. ...
  • Credit creation. ...
  • Other functions.

What is the main goal of central banks when setting interest rates? ›

The first and most important is price stability or stability in the value of money. Today this means maintaining a sustained low rate of inflation. The second goal is a stable real economy, often interpreted as high employment and high and sustainable economic growth.

How does the central bank control credit? ›

A rise in the bank rate will increase the cost of borrowing from the central bank then causes the commercial banks to increase the interest rates at which they lend. This will discourage businessmen and others from taking loans. Thus reduces the volume of credit and vice versa.

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