A central bank is the main financial institution of the country that controls its monetary policy and has a list of mandates to follow as well as to set up rules and regulation for the commercial banks (the other banks situated all over the country). Typically monetary policy of central bank has been defined in economics as the ‘lender of the last resort’ i.e. it makes available lending opportunities for all other banks.
The functions of central banks come under two broad headings.
Macroeconomics: This is actually the working of monetary policy whereby banks manage market price levels to bring economic stability. This monetary policy is run by issuing currency, maintaining the FOREX reserves as well as gold reserves of the country, controlling money supply and setting the discount rate for the cost of credit. This controls the economic activity by facilitating economic growth, avoiding recession, and controlling inflation.
Open market operations are shown by purchase or selling of government securities to control money circulation i.e. the sum total of all money circulating in the economy. Central bank makes transactions in open market by injecting liquidity into the market or absorbing funds when open market transactions are made to affect inflation. To increase money circulation and decrease interest rate, central bank chooses to buy bills, bonds, and notes issued by government itself. The increased money supply may induce inflation. In the other scenario increased inflation may be reduced by absorbing extra money from the open market, by selling government bonds. Finally, the shrinking money stream makes a rise in interest rates, making it unfeasible for banks to borrow.
Microeconomics: Commercial banks borrow from the central bank so that they can give out money to common people. The rate at which commercial banks and other financial lending institutions borrow from central bank is called the ‘discount rate’. This is a very useful tactic that increases the central bank’s authority over the economy. As soon as interest rates are lowered, businesses and public are lured to borrow and invest so that the economy receives boost. If there’s high inflation, interest rates are increased which makes it difficult for business to borrow and run for long and hence they ‘downsize’ or close down giving way to recession.
Economists are of the view that central banks should make fair deal by restricting banks from borrowing continually so that more money is in supply. However, this policy alone receives criticism from economists for enriching the financially elite class at the expense of general public.
Some popular banks of the world include: the US Federal Reserve, Bank of Canada, Bank of England, Reserve Bank of Australia and the European Central Bank. Some banks like Bank of Canada manage only one country’s monetary policy while other banks regulate monetary policies across a group of banks in different countries, like the European Central Bank. Governments usually do not have full control of the central bank. However, even independent central banks do come under pressure by government to change their policies.
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