Understanding Central Banks
Everybody, establishments, or institutions have to earn money by engaging in different activities such as the offering of goods and services. This is the norm, but there exist institutions that have the legal authority to print money whenever they feel the need. These institutions are called central banks. In this post, we will explore central banks, their history, the different types, their functions, and how they carry out these functions.
What are Central Banks?
According to Wikipedia, a Central Bank is an institution that manages the currency and monetary policy of a state/country and overseas its commercial banking system. The central bank has control over the production and distribution of money and credit for a nation or group of nations. While central banks play roles that will be discussed later on, all their functions can be divided into three focus areas; central banks regulate money supply which is done to manage inflation, unemployment, and consumer spending, central banks regulate member banks through capital and reserve requirements whilst providing loans and managing foreign exchange reserves, and thirdly, they act as an emergency lender to distressed commercial institutions and sometimes even the government.
The major defining/distinguishing feature of a central bank is that it has the authority to issue banknotes. This helps in the discharge of its duties. Most central banks also have regulatory powers over member institutions i.e. commercial banks, they prevent bank runs and also discourage reckless behavior by member banks. A lot of developed nations’ central banks operate independently of political influence however the rights of the central bank are established and protected by law.
Independence of Central Banks
Central Banks are mostly independent of political influence. This independence can manifest in a number of ways such as institutional independence, independence of goal, and financial independence. Institutional independence refers to the provisions made for the central bank in the law that insulates it from political interference. Independence of goal refers to the ability of central banks to set their own policy goals. Other forms of independence include functional and operational independence, personal independence, and legal independence.
Functional and operational independence means that the central bank has the right to determine the best way of achieving its goals and in essence, the bank retains authority to run its own operations. Personal independence gives the head of the central bank independence in governance that is made evident in long tenures and a certain degree of legal protection. This is because if a government can appoint and replace the head of the central bank frequently (at will), then it has the ability to micromanage and interfere in the operations of the bank.
Financial independence refers to the banks having full control over their own budget while legal independence means central banks have a legal personality. This allows them to ratify international agreements without the approval of a government and also to be able to go to court.
History of Central Banks
There were no institutions that could be likened to the present-day central banks until Sweden created the Riksbank (Sveriges Riksbank) in 1668. However, Riksbank created in Sweden followed the model of the Bank of Amsterdam (Amsterdamsche Wisselbank) which was created back in 1609. The creation of the Bank of Amsterdam laid the foundations for the development of the central banking system as we now know it. Although the two banks did not have the monopoly of issuing banknotes, they both performed the functions of a central banking system through a network of banks.
The oldest establishment which is most similar to modern central banks was devised by Charles Montagu, 1st Earl of Halifax, in 1694. This establishment is the Bank of England. At the time the bank was privately held and it was given exclusive possession of the government’s balances and was the only limited-liability corporation allowed to issue banknotes. The establishment of this bank allowed England to prosecute the war against France by borrowing money from the public. Half of which was used to rebuild the navy. After multiple reforms caused by a series of crises, the issuance of notes and the role of lender of last resort was eventually granted to the Bank of England which at the time had become institutionalized.
In 1800 Napoleon created the Bank of France in order to be able to finance his wars and after that many other banks were created across Europe.
In the US a central bank did not appear until 1863 when the National banking act created a network of national banks and a single US currency with New York as the central reserve city. Banking in America also experienced turbulence until eventually in 1913 the US Congress established the Federal Reserve system and regional Federal Reserve banks throughout the country to stabilize financial activity and banking operations. This new bank helped finance World War 1 and World War 2 by issuing treasury bonds.
In the 19th century and early 20th centuries, the central banks created used the international gold standard which made it easy for the value of the currency to be regulated. 1920 saw the establishment of Australia’s first Central Bank, in 1922 Peru established its central Bank, Colombia followed in 1923 with Mexico and Chile in 1925, and Canada, India, and New Zealand established theirs in the aftermath of the Great Depression in 1934. Brazil developed a precursor to its central bank in April 1945 and in 1965 the Central Bank of Brazil was established.
Reserve Bank of India which an established under British colonial rule as a private company was nationalized in 1949. In China, the People’s Bank of China was established in 1948 and by 1979 began to evolve its role with the introduction of market reforms, and that increased in 1989 when the country adopted a generally capitalist approach to its export economy. By 2000 the People’s Bank of China had become a modern Central Bank. The establishment of the European Central Bank in 1998 saw the replacement of all the Independent central banks of the eurozone countries.
Types of Central Banks
There are different types of central banks with almost every country having its own. In this post, we will discuss the central banks of the most traded currencies in the world.
- The Federal Reserve (United States of America – Dollar)
- The European Central Bank (Eurozone – Euro)
- The Bank of Japan (Japan – Yen)
- The Bank of England (United Kingdom – Pound Sterling)
- The Swiss National Bank (Switzerland – Franc)
- The Bank of Canada (Canada – Canadian Dollar)
- The Reserve Bank of Australia (Australia – Australian Dollar)
- The Reserve Bank of New Zealand (New Zealand – New Zealand Dollar)
The Federal Reserve (Fed)
The Federal Reserve is the Central Bank of the United States. Rather than being a single entity, it is more of a system this includes the Federal Reserve itself and 12 other district reserve banks.
The European Central Bank (ECB)
Central Bank was established in 1999 and governed by the council which consists of 6 members of the executive board and governors of all the national Central banks from the 12 Eurozone countries. European Central Bank makes policy decisions 11 times a year these meetings are usually accompanied by press conferences.
The Bank of England (BoE)
The Monetary Policy Committee is responsible for directing the effects of the Bank of England and consists of nine members which include a governor and two deputy governors. The Bank of England meets on a monthly basis.
The Bank of Japan (BoJ)
The Bank of Japan’s monetary policy committee comprises the BoJ governor, two deputy governors, and six other members. Because Japan is very dependent on exports, the BoJ has an even more active interest than the ECB does in preventing an excessively strong currency. The central bank has been known to come into the open market to artificially weaken its currency by selling it against U.S. dollars and euros. The BoJ is also extremely vocal when it feels concerned about excess currency volatility and strength. The economic committee meets once or twice a month.
The Swiss National Bank (SNB)
The Swiss National Bank has a three-person committee that makes decisions on interest rates. Unlike most other central banks, the SNB determines the interest rate band rather than a specific target rate. Switzerland is very export-dependent like Japan and the eurozone, which means that the SNB also is not interested in its currency becoming too strong. Therefore, it (SNB) exhibits conservative bias towards an increase in interest rates. The committee meets quarterly.
The Bank of Canada
Monetary policy decisions within the Bank of Canada are made by a consensus vote by the Governing Council, which consists of the Bank of Canada governor, the senior deputy governor, and four deputy governors. The governing council meets eight times a year.
The Reserve Bank of Australia
The Reserve Bank of Australia’s monetary policy committee consists of the central bank governor, the deputy governor, the secretary to the treasurer, and six independent members appointed by the government. The committee meets eleven times a year.
The Reserve Bank of New Zealand
Unlike other central banks, the decision-making power on monetary policy ultimately rests with the central bank governor. Meetings occur eight times a year.
Functions of Central Banks
The major functions of central banks are as follows:
- Bank of issue
- Custodian of cash reserves
- Manager of foreign reserves
- Lender of last resort
- Controller of credit
- Regulator of commercial banks
Bank of issue
Central Banks today how to exercise the monopoly of issuance of banknotes. The notes issued by the central bank are the legal tender throughout the country and no other bank has the authority to issue banknotes. This function is needed to be able to exercise monetary policy and discharge the duties of the central bank.
Custodian of cash reserves
All commercial banks are expected to keep a part of their cash balances with the central bank. This is often termed the reserve requirement for commercial banks.
Manager of foreign reserves
The next function of central banks is that the manage foreign reserves of the country. Usually, central banks keep a reserve of gold and foreign currency options with other countries. This is important in that it helps to maintain the exchange rate fixed by the government.
Central banks act as a lender of last resort. This means they provide funds to banks and other institutions in times of economic instability. This is to try to restore stability to the economy.
As a clearinghouse
Central banks also act as a clearinghouse. As commercial banks trade between themselves, the transactions are usually not settled immediately, the statement or calls are settled at a later date. Since central banks serve as the holder of the cash balances of commercial banks they become the agents through which these differences are cleared.
Controller of credit
The central bank serves as the controller of credit. This control of credit is often exercised in the monetary policy of the central bank. When commercial banks create credit there is a tendency for them to issue too much credit which can result in inflation. To manage this, the central bank stands as a regulatory body that monitors and takes the proper steps which involve controlling the amount of credit that can be issued by a commercial bank based on their reserves.
Regulators of commercial banks
Finally, central banks act as regulators of commercial banks. Apart from serving as a lender of last resort, a clearinghouse, and a controller of credit, the central bank also acts as a regulator protecting the interest of the depositors.
This is because with no oversight there is a tendency for fraudulent institutions or individuals to enter into the system with the mission to defraud unsuspecting people, hence, the need for regulation.
Central bank policies
The Monetary Policy
The central banks have tools to achieve and accomplish the functions stated in the previous section. These tools are collectively referred to as monetary policy. The central agenda/mission of the central bank is to affect economic growth by controlling the liquidity of the financial system (cash flow).
These monetary tools are:
- setting reserve requirements,
- performing open market operations which includes buying and selling securities from member banks, and
- setting the target interest rate.
As explained in the previous section, the reserve requirement is the minimum amount of cash that each member bank must have with the central bank. This amount is used to determine how much a bank can lend.
Central banks also use open market operations to buy and sell securities from member banks. This is done so as to stabilize the banking system as was seen during the 2008 financial crisis when banks bought government bonds and mortgage-backed securities to stabilize the economy.
Central banks are the primary lenders. They often lend to commercial banks, hence, the interest rate charged by central banks affects the interest rates banks are able to offer. Raising interest rates which are often described as the hawkish sentiment slows down growth and prevents inflation. This is because it leads to a contraction of the money supply and is referred to as a contractionary monetary policy. On the other hand, lower interest rates stimulate growth and can be used to prevent or shorten a recession. It (low-interest rates) causes the economy to expand due to increased cash flow. This is also known as expansionary monetary policy.
Usually, a change in monetary policy takes about six months for the effects to become visible. The downside to lowering interest rates too much is that it can cause inflation. You can read more about inflation in this post.
During desperate times when changes to interest rates become ineffective central banks can be forced to use some unconventional forms of monetary policy examples of which are quantitative easing and forward guidance policy.
Quantitative easing involves the purchase of long-term securities from the open market by the central bank in order to increase the money supply and encourage investments. Also, the direct purchase of securities from the open market by the central bank injects new money into the economy and serves as a way to lower interest rates through the building of fixed-income securities. As stated earlier, quantitative easing is one of the tools used during times of economic crisis how to boost economic activity
Quantitative easing has its downsides as it can lead to what is called stagflation. This phenomenon occurs when there is a stagnation in economic growth but there is also inflation due to an increase in the money supply. Another possible disadvantage of quantitative easing is that can lead to the devaluation of the domestic currency while this can help the export market in that the goods are cheaper to the international community, it also increases the cost of imports
Forward guidance refers to an attempt by a central bank to influence the decisions of business owners investors and individuals by presenting their future plans concerning monetary policy.
If investors and individuals are aware of what’s going to be happening in the economy in the future they can then make appropriate decisions to that effect which can, in turn, have a positive effect on the economy.
If the deployment of monetary policy adjustments fails to revive an economy in crisis, the leadership of the nation can then turn to the use of fiscal policy to try to revive the economy.
Monetary Policy vs Fiscal Policy
Fiscal policy is the use of government revenue collection and expenditure to manage the country’s economy. Whilst the monetary policy is the go-to policy for regulating the economy and fiscal policy is disadvantaged due to political influence, fiscal policy can also be deployed to reduce inflation and consequently manage the economy. Examples of ways in which this can be done include the increase of taxes which leads to the lowering of spending. Government spending can also be used to kick-start the economy in times of deep recession.
In practice, fiscal policy shows greater effects in the long term while monetary policy shows more effect in the short term
Fiscal policy can also be divided into expansionary fiscal policy, contractionary fiscal policy, and neutral fiscal policy. Expansionary fiscal policy as the name suggests is deployed when the economy is in recession. Economic expansion during times of recession is done by increasing government spending on public works and giving residents tax cuts to allow higher purchasing power.
Contractionary fiscal policy is used during times of economic expansion to curb economic growth which has resulted in inflation. It is usually done by increasing tax rates and decreasing government spending.
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