Good Key Roles Of The Central Bank In An Economy Essay Example
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Central bank is the backbone of a nation’s economy. As the name suggests, it is central to the banking system of a country. It prevents the banking system of a nation to collapse. It has major role to play in all phases of economy, including recessionary phase, stable phase and expansionary phase. As the markets are becoming more mature, the roles and responsibilities of the central banks are increasing.
The objective of this paper is to discuss the key roles of the central bank in an economy. The paper is divided into five sections. The first section provides definition and historical background of central banks. The second section discusses the key roles of the central bank in an economy. The third section argues why the lender of the last resort function controversial. The fourth section deliberates on the emerging roles of central banks with increasing dynamism in the economic environment. The fifth section concludes the paper.
Central Bank: Definition and History
Definition of Central Bank
Central bank is the backbone of the banking system of any economy. It plays an important role in providing stability to economy. According to Amadeo (2015), central bank is a semi-independent government authority responsible for monitoring the money supply in the market, regulating banks and financial institutions, and providing necessary support, financial, transactional and knowledge support. There are five important aspects of this definition that are discussed here.
First, the central banks are separate, independent entities. The reason that central banks are kept as a separate entity, and not government owned, is to provide in the independence to function in an environment that is free from political influence. As such, the central banks are nation-owned, but not government-owned. Second, the central banks are not fully, but partially, independent. It works in accordance with the existing legislations and policies, and any policy modifications brought about by the government. In this respect, they need to work in close coordination with the government. Third, as they manage the money supply in the market, they are responsible to control liquidity in an economy and help moderate inflation and keep a check on a nation’s currency price. Fourth, the central banks are regulatory bodies that provide operating guidelines to the commercial banks. Fifth, the central banks indulge in economic research and provide knowledge assistance to the banking system. They work as a bridge between commercial banks to offer them transactional ease. If need arises, they also provide financial assistance to other banks to ensure economic health of a nation.
Historical Overview of Central Banks
It is essential to understand the historical background of central banks to appreciate its significance and role in the economy. The model of central banking can be traced back to 1401 when Municipal Bank of Deposit in Barcelona was expected to fund the nation’s military expenses (Wilson, 2013). However, it was only in the 17th century when an effective concept of central bank was witnessed. The Bank of Amsterdam is considered to be pioneer in bringing about the central banking concept. The bank was responsible for maintaining reserves to fully cover the currencies outstanding in the market. The bank was, thus, successful in absorbing the shock of currency devaluation due external invasion.
The Bank of England is accredited with bringing about the modern prototype of central banking in the world (Selgin, 2010). The bank was institutionalised in the year 1694 to finance war against France (Wilson, 2013). Though its origin was modest, the bank later became the most powerful element in the banking system of England. By the beginning of the 19th century, Bank of England was endowed with the responsibility of securing the integrity of the nation’s money supply and its banking system. During this time, the bank was also awarded with the right to be the only bank to issue banknotes in the country.
The concept of central banks, then, spread across the world during the 19th century. In many European countries, it was established to finance the Second World War. In the United States as well, the history of a central bank dates back to the time of Second World War. The first bank was established to refinance the war debts and helped unify the banking system. However, it was a private entity with foreigners holding the majority ownership. It was only in the early 20th century that the concept of a federal system of banking was established in the United States (Federal Reserve Bank of Philadelphia, 2015). It was known as the Federal Reserve System and operated as banker’s bank (Federal Reserve Bank of Philadelphia, 2015). It had the features of the modern central banking system in true sense.
Later, the central banking systems were formed in nations across the world. The central banks of Colombia, Mexico and Canada were formed in the 1920s. The central banking system of India was established in 1935, during the British rule and was fully nationalised in 1949 (Reserve Bank of India, n.d.). It is fully owned by the Government of India. In 1979, the People’s Bank of China took over the role of central bank in the nation (Bank of China, n.d.).
There are two important points to note here. First, most of the central banks were initially conceptualised to conduct a core banking job, like financing a debt or mobilizing deposits. The fact that these banks has the potential to stabilize the national economies were later realised and these banks were transformed into central banks to oversee the entire banking system. Second, the need for a central bank was felt in the early 20th century when problems began to crop up in the already existing commercial banking system.
Key Roles of Central Banks in an Economy
There are four key roles performed by central banks in an economy: to implement monetary policy of the nation, to ensure the stability of the nation’s financial system, to be the custodian of the nation’s currency and disseminate information on economic wellbeing for public awareness (Oanda Corporation, 2015).
This is the key role of a central bank. The concept of having a central bank was formulated to ensure implementation of a sound monetary policy in the country that provides stable growth and employment opportunities to the citizens. The monetary policies of central banks help manage the money supply in the market, thereby controlling the extent of liquidity in the nation’s financial market. The central banks use three main tools in formulating a monetary policy, that guides the lending interest rates in the economy.
First, the central banks have the authority to decide the reserves that the commercial banks to keep at any given point of time as a percentage of the deposits and notes collected from customers. Using this tool, the central banks can control the amount of funds available with the banks for lending purpose.
Open Market Transactions
Second, the central banks can operate in the open market to transact in securities from member banks (Amadeo, 2015). If the securities are bought, cash is paid by the central bank and money supply in the financial system increases, and vice versa. This tool is used in crisis situations where money in circulation has to be controlled quickly.
Supplying Short-Term Capital to Commercial Banks
Third, the central bank is responsible for supplying operational capital to commercial banks, usually on an overnight basis (Oanda Corporation, 2015). It provides short-term loans to the member commercial banks. Based on the lending rate of central bank to member banks, the lending rate of commercial banks to institutions and retail consumers is guided.
Using all the three tools, banks can guide the lending interest rate in the economy. These tools are used differently in different phases of economic growth. During recessionary phase, the central bank lowers the lending rates using one or more of these tools. As the lending rates reduce, companies borrow more to invest in their businesses leading to economic growth. Individuals also tend to indulge more in creating assets when lending rates are low. This helps boost demand and lead to economic growth. Thus, lowering the lending interest rates helps boost growth in recessionary phase of economy and bringing stability. During expansionary phase, the interest rates are increased to reduce money supply in the market and contain inflation. Overall, the most powerful tool that the central bank has to implement monetary policy is by changing the lending interest rates. Over the years, central banks have been mainly using interest rates to contain inflation and bring about price stability.
Maintaining financial stability is a key role of central banks. This role of central bank is closely linked to its function of implementing effective monetary policy. Central banks attempt to achieve financial stability by regulating banks, intermediating between member banks and provide financial services, as deemed necessary from time to time.
Regulating the Banking System
The central bank is responsible of regulating the banking system of nations. The bank regulates the banking system by preparing norms that ensure the banks maintain enough reserves to take care of any potential loan default risk. Since the loans are funded by consumer’s deposits, it is essential for the central bank to safeguard their interests. The central bank also ensures that the member banks do not own risky products in their portfolio like hedge funds.
Intermediating between Commercial Banks
The central banks intermediate between member banks to ensure smooth financial transactions take place. For example, gross settlements of inter-bank transfers made by consumers are taken care of by the central bank in many countries. Check processing is another transaction that involves central banks involvement. Such intermediation helps to carry out financial transactions in a seamless manner and enhances the stability in financial system.
Lender of the Last Resort
The central bank also provides financial assistance to the commercial banks, as deemed necessary from time to time. This is an important function of central bank in promoting financial stability in a recessionary scenario. In a shrunken economy, when organisations and banks are on verge of collapse, the central banks come forward as a last resort to them. Funding in such crisis situation and absorbing recessionary shocks is one of the key roles of the federal banks. However, this function of apex banks is fraught with controversy, which will be discussed in the subsequent section.
Custodian of Nation’s Currency
The central bank is responsible for issuing currency notes, storing them and managing its value in the international markets. The federal banks are endowed with the responsibility of issuing the currency notes. Not only that, they are also responsible for storing them and maintaining its value. The value of a currency is a factor of its global demand and supply. The central banks can manage the value of the nation’s currency by altering its supply. If the currency has to be devalued, more currency can be pumped into the market by liquidating the reserves. To appreciate the value of currency, the money supply in the market can be reduced by increasing the reserves.
The central banks can also improve the value of the nation’s currency by creating a positive trade balance. If exports of a country are more than its imports, a positive trade balance can be created and currency value appreciates. Central banks can encourage firms to indulge in export-oriented businesses to boost trade surplus.
The reserve banks are also responsible for conducting research and disseminating information for public awareness. They are responsible to publish information on economic wellbeing of a nation. In addition to this, the central banks also conduct research on the present and future of financial and banking system of the world, analysis of world economy and similar studies to help them decide on their future strategies and provide a guideline to companies and consumers.
Controversy behind the Lender of the Last Resort Function of Central Banks
There are three main controversies related to the lender of the last resort role of the federal banks: risk of inflation, moral hazard and risk of financing an insolvent firm.
Risk of Inflation
One of the biggest controversies with the lender of the last resort concept is the risk of inflation. The stimulus funding to collapsing institutions in a slowdown economy boosts the money supply in the financial system. This can cause risk of price stability and inflation. However, researches show that this fear of inflation risk may not hold water. According to Ludwig-Maximillans-Universtat Munchen (n.d.), if the crisis funding is quickly rolled back by the central bank, it will not cause risk of inflation. Grauwe (2011) also concluded in his paper that the lender of the last resort funding revives the economy from slowdown and may not cause inflation risk.
The concept of lender of the last resort is considered flawed as it may lead to crisis funding for short-term to illiquid banks and institution can cause a severe blow to sound banking in future (Moore, 1999). The institutions that appear to suffer most due to recession are bailed first. Also, by providing the lender of the last resort option, the governments are encouraged to issue more debts for bail out, which can cause a moral hazard problem. The best way to contain this problem is to set strict lending guidelines during the recessionary phase of economy.
Risk of Financing an Insolvent Entity
In the financial crisis situations, it is difficult to differentiate between an insolvent and an illiquid firm. While an illiquid firm faces temporary cash crunches, an insolvent firm is financially broke. According to Klein (2014), insolvent means that the firm owes more than it owns and illiquid means a firm that has difficulty in meeting its current obligations. By financing an insolvent form, the lender is increasing the fragility of the financial system and also causing moral hazard. According to Cecchetti and Schoenholtz (2014), lending to an insolvent institution by itself does not put an end to its fragility. Hence, the final lender should be careful to differentiate between these two types of entities.
Emerging Roles of Central Banks in the Dynamic Environment
The world economy is becoming more dynamic due to technological advancements, knowledge enhancements and trade liberalisations. As more complex financial products are launched in the market, the vulnerability of economy is also on the rise. Recent financial crisis of 2008 is one such lesson that also reshapes the role of central banks in the economy and makes it more integral to the economy.
There are four emerging roles of central bank in the changing environment. First, as the economies across the globe are getting more integrated, it is essential to have the central banks of these nations were more closely to each other. Also, these banks should be made more robust to handle crisis situations (Guidotti, 2015). Second, more focus needs to be done to bring strengthen the soundness of the world economy. The soundness in the banking system will be ensured by fighting short-termism and impose transparency (Trichet, 2009). Thus, central banks should promote attempts of process improvements and information symmetry in the financial sector to bring about more transparency in the system. Third, central banks will need to be more active in defining liquidity (Guidotti, 2015). Most of these banks have been using interest rates as the only tool to improve liquidity in the system. However, they will need to use tools like quantitative easing and foreign exchange intervention to support their economies at the time of distress (Guidotti, 2015). Fourth, the emerging markets are expected to drive the world economy in future. The real growth drivers in the emerging markets are the small and medium enterprises (Gupta, 2013). The central banks need to leverage on their growth drivers to boost their economy.
Central banks have a great role to play in a nation’s economy. They are responsible for implementing efficient monetary policies, ensuring financial stability, maintaining value of nation’s currency and indulging in economic research. The central banks have also been assigned the role of the lender of last resort. This role is fraught with controversy as it may lead to moral hazard, price instability and funding to insolvent firms. However, there are measures that central banks can take at the time of crisis lending to resolve these issues. The recent financial crisis has posed greater challenge on the role of central banks. These apex banks will need to use tools like quantitative using and foreign exchange intervention, in addition to changes in lending interest rate, to improve liquidity. These banks will need to play an important role in promoting the potential sectors of the economy and integrating their economies with the global economy to boost their nation’s growth.
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