The Central Bank
Learn about the role of the central bank in the economy
Definition: A central bank, reserve bank, or monetary authority is an institution that manages a state's currency, money supply, and interest rates.
Question: Why do we need a central bank?
A central bank has 2 key roles:
1. A lender of last resort to other banks
2. A banker to the government
[The central bank is like a "banker to the banks"]
Lender of Last Resort
Remember, banks like to hold illiquid assets as they are more profitable. Therefore, banks borrow money in the short term, but then lend money long term. This means banks are often too illiquid and they can run into liquidity problems. In this case, a bank can approach the central bank and ask for a loan to cover its liquidity problems.
However, the bank looking to borrow must be solvent
Assets must cover liabilities!
The central bank has some different schemes to provide liquidity to banks:
1. A predictable and "routine" scheme.
2. An emergency scheme - where the central bank will lend banks money in extreme cases.
The emergency scheme will charge higher interest rates to the banks. Therefore, banks are discouraged to run into liquidity problems because they will face higher costs.
In emergency cases, central banks can also provide assistance to other banks when there is a systemic crisis e.g. when there is a major problem in the entire banking industry, not just 1 bank (think back to 2008).
Emergency Liquidity Assistance can be provided to improve the stability of the banking system.
Debate: Should the Central Bank be a Lender of Last Resort?
Advantages of a Lender of Last Resort
1. Prevents panic and bank runs
2. Lessens the severity of financial instability
Disadvantages of a Lender of Last Resort
1. Banks may feel like they are "insured". Leads to the Moral Hazard Problem - can lead to excessive risk taking behaviour because banks know they have a Plan B
2. Banks may become less liquid as they have the lender of last resort
3. Fairness - why does a central bank save financial firms but not regular firms facing liquidity problems? Is this fair?
Banker to the government
How does the central bank help the government?
1. Helps the government manage the national debt e.g. try to reduce the interest paid
2. Issues government bonds on behalf of the government
3. Financial Advice - they can advise the government on economic matters, help them when it comes to international negotiations.
Monetary Policy
The central bank can also implement monetary policy.
They will:
Manage the money supply
- by influencing interest rates (has an affect on money supply)
- influence the availability of the money supply e.g. quantitative easing
Other jobs of the central bank
Set capital requirements
- laws to the banks to tell them how much capital they must keep in reserve (check out the page on financial regulation for more details)
Influence the exchange rate
- Buy and sell currency
- Change interest rates (increase/decrease demand for the local currency - see below for more details)
Control and issue banknotes and coins
They are responsible for the printing of the currency, security of the currency to protect against counterfeiting.
Impose rules to prevent financial market failure and instability of the financial system.
Question: How does a central bank influence the exchange rate by changing the interest rate?
Interest rate rises -> an increased desirability to save/invest in the UK -> investors from abroad will want to hold their wealth in the UK, because the rewards are greater on their investments -> to do this, they have to get hold of UK pounds -> so they sell their currency, buy UK pounds -> with all this increased demand the FX market moves the price of the UK pound up (demand for the pound shifts right)
The central bank can do all of these things (previously mentioned). However, not all central banks will be held accountable for those tasks. In some countries, the government takes control of some of these tasks, or other organisations.
For example, in the UK's case, it is the Debt Management Office that issues "gilts" (government bonds). This is separate from the Bank of England.
Some central banks have more control than others. Some are independent from the government and some are not.
Bank of England - made independent in 1997 -> complete control of interest rate setting for example.
Somebody in the BoE is appointed by the government to achieve targets e.g. 2% CPI inflation.
Debate: Independent Central Bank vs Government Controlled
Advantages of an independent central bank
- Separates politics with the needs of the economy
- Gives the public confidence - the central bank is built up of economic experts
- Specialisation - gives the government to concentrate on what it's good at e.g. politics, policies
Advantages of a state-controlled central bank
- Economic Objectives - government fully concentrates on government objectives, not the bank's objectives
[This might be good if there is a guarantee of no corruption]
- Coordination - it might be easier to coordinate policies (fiscal and monetary)
- Real World Experience - politicians have "real world" experience -> banks might be built up of academics
- Accountability - people will hold the government accountable for bad financial decision
[as long as the government is democratically elected]
Further evidence
Most major economies have chosen an independent central bank. There is evidence that they achieve lower rates of inflation with greater economic stability.
However, there is a criticism of central banks because they can be deemed to be inflexible.
For example, a central bank which has a target rate of inflation may prioritise this before other economic objectives.
The importance of economic objectives is not static and set in stone....there is no economic objective that is more important than another at all times. Sometimes low inflation will be more important than economic growth for example, but sometimes it won't.
In the UK 2008 recession, inflation was not the most important objective. More important objectives were economic growth and unemployment - economic growth was very low and unemployment very high.
The Bank of England prioritised these objectives over inflation during the crisis.
However, other central banks like the ECB has been criticised for too much focus on inflation.
In summary, we have learned:
The objectives of the central bank
the power of the central bank
Independent vs State-Controlled central banks
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