Central Bank

What is the Central Bank?

A central bank is an institution that provides a range of services to help ensure the banking and financial systems of a country or region run effectively.

These tasks involve managing overall monetary policy, which includes setting the level of interest rates to keep inflation under control.

Techopedia Explains the Central Bank Meaning

The clearest central bank definition is that it’s a national institution that provides services to help a country’s financial system.

Unlike commercial banks, a central bank won’t offer accounts – or lend money – to either individuals or businesses.

According to the International Monetary Fund (IMF), central banks “play a crucial role” in ensuring economic and financial stability.

History of Central Banks

The concept of central banks can be traced back to the seventeenth century and the founding of the Swedish Riksbank, according to the Federal Reserve Bank of Cleveland.

“A few decades later (1694), the most famous central bank of the era, the Bank of England, was founded also as a joint stock company to purchase government debt,” it stated.

Other central banks were set up later in Europe for similar purposes, though some were established to deal with monetary disarray.

“For example, the Banque de France was established by Napoleon in 1800 to stabilize the currency after the hyperinflation of paper money during the French Revolution, as well as to aid in government finance,” it added.

How the Central Bank Influences an Economy

Central banks use monetary policy to manage economic fluctuations in an economy and achieve price stability, according to the International Monetary Fund.

“Central banks in many advanced economies set explicit inflation targets,” it stated. “Many developing countries also are moving to inflation targeting.”

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,” stated the IMF. “When central banks lower interest rates, monetary policy is easing. When they raise interest rates, monetary policy is tightening.”

Functions of Central Bank

Central banks may differ from each other in terms of their focus and how they operate. However, they will all share some similar functions.

Let’s take the example of the US Federal Reserve (Fed) System. The central bank of the US is tasked with providing a stable financial and banking system.

These are five of its main functions:

Central Banks and Inflation

A key role of any central bank is keeping inflation under control. This refers to the amount by which goods and services increase in price every year.

For example, the Bank of England has been tasked by the UK Government with the target of keeping inflation at 2%. “Low and stable inflation is good for the UK’s economy and it is our main monetary policy aim,” it has stated.

The Bank also supports the Government’s other economic aims for growth and employment, which is set out by the Chancellor of the Exchequer in what is known as a remit letter.

In recent years, the Bank of England has been under pressure as the inflation rate in the UK soared to a 41 year high of 11.1% in October 2022. To help combat rising living costs, it gradually increased interest rates from 0.1% to 5.25%, as of early May 2024. It seems to be working as inflation is now down to 3.2%.

Central Banks and Deflation

Central banks may also have to help tackle periods of deflation. This is when prices are continually falling, and it can be just as damaging to an economy.

According to the Bank of England, when prices begin to fall, people expect them to continue going down. “This expectation results in people spending less today, in the hope of buying at a cheaper price tomorrow,” it stated. “This is bad for businesses.”

To tackle such a scenario, a central bank may choose to lower interest rates or increase the money supply. The aim of both approaches will be to encourage people to spend more money, which will have the positive effect of pushing up prices.

Central Bank Examples

There are many central banks across the world. These include the Bank of England, the US Federal Reserve System, and the Bank of Japan.

According to Britannica Money, central banks have become varied in authority, autonomy, functions, and instruments of action. “Central banks are operated for the public welfare and not for maximum profit,” it stated.

The Bank of Japan, for example, began operating back in the late 1880s. Its stated purpose includes issuing banknotes and exercising monetary control.

It also ensures the smooth settlement of funds among banks and other institutions, which contributes to the “maintenance of stability” of the financial system.

Central Bank Pros and Cons

The Bottom Line

Central banks perform vital roles within economies. Their actions are required to ensure economic stability, even though this can sometimes be frustrating. For example, borrowers on variable rate mortgages will end up paying more each month when interest rates start to rise.

Conversely, when interest rates fall it means savers will receive less from the money they’ve tucked away in their bank accounts. The fact is that there will always be people benefiting from a central bank’s decisions and those that are adversely affected.

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