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A central bank. reserve bank. or monetary authority is an institution that manages a state’s currency. money supply. and interest rates. Central banks also usually oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base in the state, and usually also prints the national currency, [ 1 ] which usually serves as the state’s legal tender. [ 2 ] [ 3 ] Examples include the European Central Bank (ECB), the Bank of England and the Federal Reserve of the United States. [ 4 ]

The primary function of a central bank is to manage the nation’s money supply (monetary policy ), through active duties such as managing interest rates. setting the reserve requirement. and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political interference. [ 5 ] [ 6 ] Still, limited control by the executive and legislative bodies usually exists. [ 7 ] [ 8 ]

§ Bank of England [ edit ]

The Bank of England. established in 1694.

Although some would point to the 1694 establishment Bank of England as the origin of central banking, it did not have the functions as a modern central bank, namely, to regulate the value of the national currency, to finance the government, to be the sole authorised distributor of banknotes, and to function as a ‘lender of last resort’ to banks suffering a liquidity crisis. The modern central bank evolved slowly through the 18th and 19th centuries to reach its current form. [ 15 ]

Henry Thornton. a merchant banker and monetary theorist has been described as the father of the modern central bank. An opponent of the real bills doctrine. he was a defender of the bullionist position and a significant figure in monetary theory. Thornton’s process of monetary expansion anticipated the theories of Knut Wicksell regarding the cumulative process which restates the Quantity Theory in a theoretically coherent form. As a response 1797 currency crisis, Thornton wrote in 1802 An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. in which he argued that the increase in paper credit did not cause the crisis. The book also gives a detailed account of the British monetary system as well as a detailed examination of the ways in which the Bank of England should act to counteract fluctuations in the value of the pound. [ 16 ]

Walter Bagehot. an influential theorist on the economic role of the central bank.

Until the mid-nineteenth century, commercial banks were able to issue their own banknotes, and notes issued by provincial banking companies were commonly in circulation. [ 17 ] Many consider the origins of the central bank to lie with the passage of the Bank Charter Act of 1844. [ 15 ] Under this law, authorisation to issue new banknotes was restricted to the Bank of England. At the same time, the Bank of England was restricted to issue new banknotes only if they were 100% backed by gold or up to £14 million in government debt. The Act served to restrict the supply of new notes reaching circulation, and gave the Bank of England an effective monopoly on the printing of new notes. [ 18 ]

The Bank accepted the role of ‘lender of last resort’ in the 1870s after criticism of its’ lacklustre response to the Overend-Gurney crisis. The journalist Walter Bagehot wrote an influential work on the subject Lombard Street: A Description of the Money Market . in which he advocated for the Bank to officially become a lender of last resort during a credit crunch (sometimes referred to as Bagehot’s dictum). Paul Tucker phrased the dictum as follows: [ 19 ]

to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at ‘high rates’.

§ Spread around the world [ edit ]

Central banks were established in many European countries during the 19th century. The War of the Second Coalition led to the creation of the Banque de France in 1800, in an effort to improve the public financing of the war.

Although central banks today are generally associated with fiat money. the 19th and early 20th centuries central banks in most of Europe and Japan developed under the international gold standard. elsewhere free banking or currency boards were more usual at this time. Problems with collapses of banks during downturns, however, lead to wider support for central banks in those nations which did not as yet possess them, most notably in Australia .

The US Federal Reserve was created by the U.S. Congress through the passing of The Federal Reserve Act in the Senate and its signing by President Woodrow Wilson on the same day, December 23, 1913. Australia established its first central bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New Zealand in the aftermath of the Great Depression in 1934. By 1935, the only significant independent nation that did not possess a central bank was Brazil. which subsequently developed a precursor thereto in 1945 and the present central bank twenty years later. Having gained independence, African and Asian countries also established central banks or monetary unions.

The People’s Bank of China evolved its role as a central bank starting in about 1979 with the introduction of market reforms, which accelerated in 1989 when the country adopted a generally capitalist approach to its export economy. Evolving further partly in response to the European Central Bank. the People’s Bank of China has by 2000 become a modern central bank. The most recent bank model, was introduced together with the euro. involves coordination of the European national banks, which continue to manage their respective economies separately in all respects other than currency exchange and base interest rates.

§ Naming of central banks [ edit ]

There is no standard terminology for the name of a central bank, but many countries use the Bank of Country form—for example: Bank of England (which is in fact the central bank of the United Kingdom as a whole), Bank of Canada. Bank of Mexico. Some are styled national banks, such as the National Bank of Ukraine. although the term national bank is also used for private commercial banks in some countries. In other cases, central banks may incorporate the word Central (for example, European Central Bank. Central Bank of Ireland. Central Bank of Brazil ). The word Reserve is also often included, such as the Reserve Bank of India. Reserve Bank of Australia. Reserve Bank of New Zealand. the South African Reserve Bank. and U.S. Federal Reserve System. Other central banks are known as monetary authorities such as the Monetary Authority of Singapore. Maldives Monetary Authority and Cayman Islands Monetary Authority. Many countries have state-owned banks or other quasi-government entities that have entirely separate functions, such as financing imports and exports.

In some countries, particularly in some Communist countries, the term national bank may be used to indicate both the monetary authority and the leading banking entity, such as the Soviet Union ‘s Gosbank (state bank). In other countries, the term national bank may be used to indicate that the central bank’s goals are broader than monetary stability, such as full employment, industrial development, or other goals. Some state-owned commercial banks have names suggestive of central banks, even if they are not: examples are the Bank of India and the Central Bank of India .

§ Activities and responsibilities [ edit ]

Functions of a central bank may include:

• implementing monetary policies.
• determining Interest rates
• controlling the nation’s entire money supply
• the Government’s banker and the bankers’ bank (lender of last resort )
• managing the country’s foreign exchange and gold reserves and the Government’s stock register
• regulating and supervising the banking industry
• setting the official interest rate – used to manage both inflation and the country’s exchange rate – and ensuring that this rate takes effect via a variety of policy mechanisms

§ Monetary policy [ edit ]

Central banks implement a country’s chosen monetary policy. At the most basic level, this involves establishing what form of currency the country may have, whether a fiat currency. gold-backed currency (disallowed for countries with membership of the International Monetary Fund ), currency board or a currency union. When a country has its own national currency, this involves the issue of some form of standardized currency, which is essentially a form of promissory note. a promise to exchange the note for money under certain circumstances. Historically, this was often a promise to exchange the money for precious metals in some fixed amount. Now, when many currencies are fiat money. the promise to pay consists of the promise to accept that currency to pay for taxes.

A central bank may use another country’s currency either directly (in a currency union), or indirectly (a currency board). In the latter case, exemplified by Bulgaria. Hong Kong and Latvia. the local currency is backed at a fixed rate by the central bank’s holdings of a foreign currency.

The expression monetary policy may also refer more narrowly to the interest-rate targets and other active measures undertaken by the monetary authority.

§ Goals of monetary policy [ edit ]

High employment:

Frictional unemployment is the time period between jobs when a worker is searching for, or transitioning from one job to another. Unemployment beyond frictional unemployment is classified as unintended unemployment.

For example, structural unemployment is a form of unemployment resulting from a mismatch between demand in the labour market and the skills and locations of the workers seeking employment. Macroeconomic policy generally aims to reduce unintended unemployment.

Keynes labeled any jobs that would be created by a rise in wage-goods (i.e. a decrease in real-wages ) as involuntary unemployment :

Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment. —John Maynard Keynes. The General Theory of Employment, Interest and Money p11

Price stability:

Inflation is defined either as the devaluation of a currency or equivalently the rise of prices relative to a currency.

Since inflation lowers real wages. Keynesians view inflation as the solution to involuntary unemployment. However, unanticipated inflation leads to lender losses as the real interest rate will be lower than expected. Thus, Keynesian monetary policy aims for a steady rate of inflation.

Economic growth:

Economic growth can be enhanced by investment in capital. such as more or better machinery. A low interest rate implies that firms can loan money to invest in their capital stock and pay less interest for it. Lowering the interest is therefore considered to encourage economic growth and is often used to alleviate times of low economic growth. On the other hand, raising the interest rate is often used in times of high economic growth as a contra-cyclical device to keep the economy from overheating and avoid market bubbles.

Interest rate stability

Financial market stability

Foreign exchange market stability

Conflicts among goals:

Goals frequently cannot be separated from each other and often conflict. Costs must therefore be carefully weighed before policy implementation.

§ Currency issuance [ edit ]

Similar to commercial banks, central banks hold assets (government bonds, foreign exchange, gold, and other financial assets) and incur liabilities (currency outstanding). Central banks create money by issuing interest-free currency notes and selling them to the public (government) in exchange for interest-bearing assets such as government bonds. When a central bank wishes to purchase more bonds than their respective national governments make available, they may purchase private bonds or assets denominated in foreign currencies.

The European Central Bank remits its interest income to the central banks of the member countries of the European Union. The US Federal Reserve remits all its profits to the U.S. Treasury. This income, derived from the power to issue currency, is referred to as seigniorage. and usually belongs to the national government. The state-sanctioned power to create currency is called the Right of Issuance. Throughout history there have been disagreements over this power, since whoever controls the creation of currency controls the seigniorage income.

§ Interest rate interventions [ edit ]

Typically a central bank controls certain types of short-term interest rates. These influence the stock- and bond markets as well as mortgage and other interest rates. The European Central Bank for example announces its interest rate at the meeting of its Governing Council; in the case of the U.S. Federal Reserve, the Federal Reserve Board of Governors .

Both the Federal Reserve and the ECB are composed of one or more central bodies that are responsible for the main decisions about interest rates and the size and type of open market operations, and several branches to execute its policies. In the case of the Federal Reserve, they are the local Federal Reserve Banks; for the ECB they are the national central banks.

§ Limits on policy effects [ edit ]

Although the perception by the public may be that the central bank controls some or all interest rates and currency rates, economic theory (and substantial empirical evidence) shows that it is impossible to do both at once in an open economy. Robert Mundell ‘s impossible trinity is the most famous formulation of these limited powers, and postulates that it is impossible to target monetary policy (broadly, interest rates), the exchange rate (through a fixed rate) and maintain free capital movement. Since most Western economies are now considered open with free capital movement, this essentially means that central banks may target interest rates or exchange rates with credibility, but not both at once.

In the most famous case of policy failure, Black Wednesday. George Soros arbitraged the pound sterling ‘s relationship to the ECU and (after making $2 billion himself and forcing the UK to spend over $8bn defending the pound) forced it to abandon its policy. Since then he has been a harsh critic of clumsy bank policies and argued that no one should be able to do what he did. [ citation needed ]

The most complex relationships are those between the yuan and the US dollar. and between the euro and its neighbours. The situation in Cuba is so exceptional as to require the Cuban peso to be dealt with simply as an exception, since the United States forbids direct trade with Cuba. US dollars were ubiquitous in Cuba’s economy after its legalization in 1991, but were officially removed from circulation in 2004 and replaced by the convertible peso .

§ Policy instruments [ edit ]