What Is a Central Bank?

A central bank is a financial institution given privileged control over the

production and distribution of money and credit for a nation or a group of
nations. In modern economies, the central bank is usually responsible for the
formulation of monetary policy and the regulation of member banks.

Central banks are inherently non-market-based or even anti-competitive

institutions. Although some are nationalized, many central banks are not
government agencies, and so are often touted as being politically
independent. However, even if a central bank is not legally owned by the
government, its privileges are established and protected by law.

The critical feature of a central bank—distinguishing it from other banks—is

its legal monopoly status, which gives it the privilege to issue banknotes and
cash. Private commercial banks are only permitted to issue demand liabilities,
such as checking deposits.

Understanding Central Banks

Although their responsibilities range widely, depending on their country,
central banks' duties (and the justification for their existence) usually fall into
three areas.

First, central banks control and manipulate the national money supply.
They influence the sentiment of markets as they issue currency and set
interest rates on loans and bonds. Typically, central banks raise interest rates
to slow growth and avoid inflation; they lower them to spur growth, industrial
activity, and consumer spending. In this way, they manage monetary policy to
guide the country's economy and achieve economic goals, such as full
employment.

Second, they regulate member banks through capital requirements, reserve

requirements (which dictate how much banks can lend to customers, and
how much cash they must keep on hand), and deposit guarantees, among
other tools. They also provide loans and services for a nation’s banks and its
government and manage foreign exchange reserves.

Finally, a central bank also acts as an emergency lender to distressed

commercial banks and other institutions, and sometimes even a government.
By purchasing government debt obligations, for example, the central bank
provides a politically attractive alternative to taxation when a government
needs to increase revenue.

A Brief History of Central Banks

The first prototypes for modern central banks were the Bank of England and
the Swedish Riksbank, which date back to the 17 th century. The Bank of
England was the first to acknowledge the role of lender of last resort. Other
early central banks, notably Napoleon’s Bank of France and Germany's
Reichsbank, were established to finance expensive government military
operations.

It was principally because European central banks made it easier for federal
governments to grow, wage war, and enrich special interests that many of
United States' founding fathers—most passionately Thomas Jefferson—
opposed establishing such an entity in their new country. Despite these
objections, the young country did have both official national banks and
numerous state-chartered banks for the first decades of its existence, until a
“free-banking period” was established between 1837 and 1863.

The National Banking Act of 1863 created a network of national banks and a
single U.S. currency, with New York as the central reserve city. The United
States subsequently experienced a series of bank panics in 1873, 1884,
1893, and 1907. In response, in 1913 the U.S. Congress established
the Federal Reserve System and 12 regional Federal Reserve
Banks throughout the country to stabilize financial activity and banking
operations. The new Fed helped finance World War I and World War II by
issuing Treasury bonds.

Between 1870 and 1914, when world currencies were pegged to the gold
standard, maintaining price stability was a lot easier because the amount of
gold available was limited. Consequently, monetary expansion could not
occur simply from a political decision to print more money, so inflation was
easier to control. The central bank at that time was primarily responsible for
maintaining the convertibility of gold into currency; it issued notes based on a
country's reserves of gold.

At the outbreak of World War I, the gold standard was abandoned, and it
became apparent that, in times of crisis, governments facing budget
deficits (because it costs money to wage war) and needing greater resources
would order the printing of more money. As governments did so, they
encountered inflation. After the war, many governments opted to go back to
the gold standard to try to stabilize their economies. With this rose the
awareness of the importance of the central bank's independence from any
political party or administration.

During the unsettling times of the Great Depression in the 1930s and the
aftermath of World War II, world governments predominantly favored a return
to a central bank dependent on the political decision-making process. This
view emerged mostly from the need to establish control over war-shattered
economies; furthermore, newly independent nations opted to keep control
over all aspects of their countries—a backlash against colonialism. The rise
of managed economies in the Eastern Bloc was also responsible for
increased government interference in the macro-economy.
Eventually, however, the independence of the central bank from the
government came back into fashion in Western economies and has prevailed
as the optimal way to achieve a liberal and stable economic regime.

RESPONSIBILITIES OF CENTRAL BANK

What are central banks and why are they so important?

When you think about a bank, perhaps the first thing that pops into your mind
is the place where you manage your finances through services and products
like deposits and loans. However, there is a financial institution that doesn't
have a commercial focus but that plays a key role in the economy and that is
also called a bank: a central bank.

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.
Some of the main responsibilities central banks have are:

 Defining monetary policy – central banks set macroeconomic objectives such as to

ensure price stability and economic growth. To do this, financial authorities have tools
like setting official interest rates, which have an impact on the cost of money. Based on
the economic situation, central banks will opt to either increase official interest rates
(to control inflation, for example) or decrease them (to encourage consumption and
 boost economic growth).

 Regulating money in circulation – they are the authority for issuing coins and notes,
the money supply, and for regulating how much money is in circulation. Central banks
do this to inject liquidity into the economy so that different economic agents (families,
companies and States) can use it in their transactions. With regard to currencies,
central banks are also responsible for carrying out operations to ensure that exchange
rates remain stable, as well for owning and controlling their official reserves.

 Overseeing the inter-bank market – they ensure that the relevant financial laws are
respected and they monitor national payment systems to make sure that they are
working properly.
 Loaning liquidity to commercial banks if necessary for solvency issues – aside from
the loans made between institutions in the inter-bank market, as mentioned in the
previous bullet point, commercial banks can also receive liquidity from central banks in
exchange for collateral, such as guaranteed public bonds. This means that, if required,
commercial banking institutions can cover what they need in the short-term, while the
central banks try and ensure price stability by mediating in credit fluctuations.

 Taking on an advisory role – they regularly produce studies and reports that are useful
for governments or private organizations, for example.

Central banks do all of this independently of the political group in power in any given country, as
they aim to ensure the stability of the financial system. Their decisions are directly dependent on
the supervisory body that composes the financial institution.

Functions of the Central Bank

Central bank is regarded as an apex financial institution in the banking system. It is considered as an integral
part of the economic and financial system of a nation. The central bank functions as an independent authority
and is responsible for controlling, regulating and stabilizing the monetary and banking structure of the country.

In India, the Reserve Bank of India is regarded as the central bank. It was set up in 1935. Central banks are
responsible for maintaining the financial stability and economic sovereignty of the country.

The functions of a central bank can be discussed as follows:

1. Currency regulator or bank of issue

2. Bank to the government

3. Custodian of Cash reserves

4. Custodian of International currency

5. Lender of last resort

6. Clearing house for transfer and settlement

7. Controller of credit

8. Protecting depositors interests

The above mentioned functions will be discussed in detail in the following lines.

Currency regulator or bank of issue: Central banks possess the exclusive right to manufacture notes in an
economy. All the central banks across the world are involved in issuing notes to the economy.

This is one of the most important functions of the central bank in an economy and due to this the central bank
is also known as the bank of issue.

Earlier all the banks were allowed to publish their own notes which resulted in a disorganised economy. To
avoid this situation the government around the world authorised the central banks to function as the issuer of
currency, which resulted in uniformity in circulation and balanced supply of money in the economy.

Bank to the government: One of the important functions of the central bank is to act as the bank to the
government. The central bank accepts deposits and issues funds to the government. It is also involved in
making and receiving payments for the government. Central banks also offer short term loans to the
government in order to recover from bad phases in the economy.

In addition to being the bank to the government, it acts as an advisor and agent of the government by providing
advice to the government in areas of economic policy, capital market, money market and loans from the
government.

In addition to that, the central bank is instrumental in formulation of monetary and fiscal policies that help in
regulation of money in the market and controlling inflation.

Custodian of Cash reserves: It is a practice of the commercial banks of a country to keep a part of their cash
balances in the form of deposits with the central bank. The commercial banks can draw that balance when the
requirement for cash is high and pay back the same when there is less requirement of cash.
It is for this reason that the central bank is regarded as the banker’s bank. Central bank also plays an important
role in the credit creation policy of commercial banks.

Custodian of International currency: An important function of the central bank is to maintain a minimum
balance of foreign currency. The purpose of maintaining such a balance is to manage sudden or emergency
requirements of foreign reserves and also to overcome any adverse deficits of balance of payments.

Lender of last resort: The central bank acts as a lender of last resort by providing money to its member banks
in times of cash crunch. It performs this function by providing loans against securities, treasury bills and also
by rediscounting bills.

This is regarded as one of the most crucial functions of the central bank wherein it helps in protecting the
financial structure of the economy from collapsing.

Clearing house for transfer and settlement: Central bank acts as a clearing house of the commercial banks
and helps in settling of mutual indebtedness of the commercial banks. In a clearing house, the representatives
of different banks meet and settle the inter bank payments.

Lender of last resort: The central bank acts as a lender of last resort by providing money to its member banks
in times of cash crunch. It performs this function by providing loans against securities, treasury bills and also
by rediscounting bills.

This is regarded as one of the most crucial functions of the central bank wherein it helps in protecting the
financial structure of the economy from collapsing.

Clearing house for transfer and settlement: Central bank acts as a clearing house of the commercial banks
and helps in settling of mutual indebtedness of the commercial banks. In a clearing house, the representatives
of different banks meet and settle the inter bank payments.

Controller of credit: Central banks also function as the controller of credit in the economy. It happens that
commercial banks create a lot of credit in the economy that increases the inflation.

The central bank controls the way credit creation by commercial banks is done by engaging in open market
operations or bringing about a change in the CRR to control the process of credit creation by commercial
banks.

Protecting depositors interests: Central bank also needs to keep an eye on the functioning of the commercial
banks in order to protect the interests of depositors.
How do central banks control the money supply?
Central banks control the amount of money circulating in the economy by using
various tools, such as open market operations, reserve requirements, and interest rate
adjustments.

Open market operations

This is the process of buying or selling government securities (such as bonds or
treasury bills) in the open market. When the central bank buys securities, it pays with
new money, increasing the money supply. When it sells securities, it takes money out
of circulation, decreasing the money supply.

Reserve requirements
This is the percentage of deposits that commercial banks have to keep as reserves. The
higher the reserve requirement, the less money banks can lend out, reducing the
money supply. The lower the reserve requirement, the more money banks can lend
out, increasing the money supply.

Interest rate adjustments

This is the rate at which the central bank lends money to commercial banks. The
higher the interest rate, the more expensive it is for banks to borrow money. This
discourages lending and reduces the money supply. The lower the interest rate, the
cheaper it is for banks to borrow money. Thus, encouraging lending and increasing
the money supply.

How do central banks influence the economy?

Central banks influence the economy by affecting the cost and availability of money
and credit. In turn affecting the spending and investment decisions of businesses and
consumers. By controlling the money supply and interest rates, central banks can
influence the rate of inflation, the level of economic activity, and the exchange rate of
the currency.
Inflation
This is the general increase in the prices of goods and services over time. Central
banks aim to keep inflation low and stable. High and volatile inflation can erode the
purchasing power of money, distort economic signals, and create uncertainty and
instability. Central banks use monetary policy to manage inflation, by adjusting the
money supply and interest rates. When inflation is above the target, the central bank
tightens monetary policy. This is done by reducing the money supply and raising
interest rates. When inflation is below the target, the central bank eases monetary
policy. This makes borrowing and spending cheaper, stimulating the economy and
raising inflation.

Economic activity
This is the level of production, consumption, and trade in the economy, measured by
indicators such as gross domestic product (GDP), unemployment, and industrial
output. Central banks aim to support economic growth and employment. They also
use monetary policy to influence economic activity, by affecting the demand and
supply of money and credit. When economic growth is strong, the central bank
tightens monetary policy, by reducing the money supply and raising interest rates.
This cools down the economy, preventing overheating and high inflation. When
economic growth is weak, the central bank eases monetary policy, by increasing the
money supply and lowering interest rates. This boosts the economy, preventing
deflation and recession.

Exchange rate
This is the price of one currency in terms of another currency, determined by the
supply and demand of currencies in the foreign exchange market. Central banks can
affect the exchange rate of their currency, by changing the money supply and interest
rates. When the central bank increases the money supply and lowers interest rates, the
domestic currency becomes less attractive. This causes the currency to depreciate,
meaning that it becomes cheaper relative to other currencies. The opposite also holds
true. Higher rates often causes the domestic currency to appreciate.
Why do central banks matter for businesses and
consumers?
Central banks matter for businesses and consumers, as their actions have direct and
indirect effects on the economy and the financial system. By influencing the money
supply, interest rates, inflation, economic activity, and exchange rates, central banks
affect the cost and availability of credit, the profitability and competitiveness of
businesses, the income and spending power of consumers, and the stability and
confidence of the economy.

Cost and availability of credit

This is the price and quantity of loans and other forms of borrowing in the economy.
Central banks affect the cost and availability of credit, by changing the interest rate
and the money supply. When the central bank lowers the interest rate and increases
the money supply, credit becomes cheaper and more abundant, making it easier for
businesses and consumers to borrow and spend. This can stimulate economic growth
and investment, but also increase the risk of excessive debt and inflation. When the
central bank raises the interest rate and decreases the money supply, credit becomes
more expensive and scarce, making it harder for businesses and consumers to borrow
and spend. This can slow down economic growth and investment, but also reduce the
risk of overheating and inflation.

Profitability and competitiveness of businesses

This is the ability of businesses to generate revenues and profits. Central banks affect
the profitability and competitiveness of businesses, by affecting the inflation,
economic activity, and exchange rate of the currency. When the central bank keeps
inflation low and stable, businesses can plan and invest with more certainty and
confidence, as they face lower costs and risks. They can also impact businesses by
causing catalysts in the forex market. A stronger currency can make exports more
expensive and imports cheaper, hurting exporters and benefiting importers. A weaker
currency can make exports cheaper and imports more expensive, helping exporters
and hurting importers.

Income and spending power of consumers

This is the amount and value of money that consumers earn and spend in the
economy. Central banks affect the income and spending power of consumers, by
affecting the interest rates, inflation, economic activity, and exchange rate of the
currency. When the central bank lowers interest rates and increases the money supply,
consumers can benefit from lower borrowing costs and higher asset prices, as they can
access cheaper credit and increase their wealth. The central bank keeps inflation low
and stable, consumers can preserve the purchasing power of their money, as they face
lower prices and costs. As they support economic growth and employment, consumers
can enjoy higher income and job security, as they have more opportunities and
confidence to work and earn. When the central bank influences the exchange rate of
the currency, consumers can gain or lose purchasing power, depending on whether the
currency appreciates or depreciates. A stronger currency can make foreign goods and
services cheaper, increasing the purchasing power of consumers. A weaker currency
can make foreign goods and services more expensive, decreasing the purchasing
power of consumers.

Stability and confidence of the economy

This is the degree of certainty and trust that the economy and the financial system are
functioning well and can withstand shocks and crises. Central banks affect the
stability and confidence of the economy, by ensuring the financial stability of the
banking system, implementing credible and transparent monetary policy, and
coordinating with other central banks and authorities. When the central bank ensures
the financial stability of the banking system, it prevents bank failures and systemic
risks, by monitoring and regulating the financial institutions, providing liquidity and
emergency loans, and acting as a lender of last resort. As they implement credible and
transparent monetary policy, they enhance the effectiveness and predictability of their
actions.

Conclusion
Central banks are influential institutions that have a significant impact on the
economy and the financial system. They control the money supply, set interest rates,
ensure financial stability, and implement monetary policy. By doing so, they influence
the inflation, economic activity, and exchange rate of the currency. Their actions
affect the cost and availability of credit, the profitability and competitiveness of
businesses, the income and spending power of consumers, and the stability and
confidence of the economy. Central banks matter for businesses and consumers, as
they shape the economic conditions and environment in which they operate and live.