Central bank

The central bank is the entity that has the monopoly of the production and distribution of official money in a nation or block of countries. In turn, it is the institution that dictates monetary policy to regulate the money supply in the economy.

Central bank

In other words, the central bank issues the notes and coins that then reach consumers. In addition, it uses various instruments (which we will explain later) to control the amount of money that circulates in the market.

In general, the central bank is a financial institution that has the responsibility to supervise and control the functioning of the financial system. And, more specifically, regulate the amount of money that exists in circulation.

Central bank characteristics

The main characteristics of the central bank are:

  • It is an entity independent of political power. For that reason, its decisions do not depend directly on the government of the day, but on a board of directors. This body, however, is sometimes appointed by another institution such as parliament, so there is always the possibility of political interference.
  • Follow the mandates of its statutes. For example, keep annual inflation between 1% and 3%. These goals are established by the State, and should last in the long term, even if the authorities in power change.
  • In recent times, they have played a key role in facing economic crises. For example, the Federal Reserve in the United States implemented a quantitative stimulus plan between 2010 and 2011. This consisted of buying government bonds for 600 billion dollars to inject liquidity into the system.

Central bank functions

The functions of a central bank can be summarized in five:

1. Take care of the monetary issue

In reality, the monopoly in money issuance has historically been the function that has originated the emergence of central banks.

Thus, in this function, the central bank becomes the only entity authorized to carry out the monetary issue and put into circulation or withdraw the money called legal tender.

2. Government Banker

On the other hand, the government banker function can be divided into two sub-functions:

to. General banking services

On the one hand, the central bank, in its role as government banker, works like any bank with its account holders, only in this case its only account holder is the Government.

Of course, for this function it can make collections and payments corresponding to the operation of the public administration, and also settle state accounts.

b. Government financial agent

Likewise, in this subdivision, the central bank also grants loans to the Government, that is, internal public debt is generated.

This credit granted to the Government is also a way to carry out monetary expansion, so it could also have an inflationary impact.

3. Lender of Last Resort

Regarding the function of lender of last resort, this occurs when commercial banks face liquidity problems, then they turn to the central bank as the last option to lend them the necessary funds, to solve their financial problems.

4. Custody of fractional reserves and clearing house

As for the clearinghouse, this is a function that consists of settling interbank accounts between all commercial banks in the financial system, through the central bank.

Without a doubt, the central bank becomes the bank of banks, since interbank accounts are settled under its supervision.

5. Custody of foreign exchange reserves

Therefore, in the custody of foreign exchange reserves, the central bank seeks to keep foreign exchange reserves within its vaults, with the purpose of achieving exchange rate stability.

Since, the currency is any foreign currency that is bought and sold in a certain country and the exchange rate is the price that the foreign currency has.

In this way, he tries to keep the exchange rate stable.

Central Bank Definition

Central bank instruments

The main instruments of the central bank are:

  • Reference interest rate: It is the indicator that is taken as the basis for setting the rates of loans between banks. This is then passed on to customers. So, if the central bank lowers its benchmark rate, loans between financial institutions will be cheaper and, therefore, loans to individuals will also charge lower interest.
  • Reserve reserve rate: By law, banks must reserve a reserve reserve, which is a percentage of their deposits. Said capital must be kept in cash in the vaults of the financial institution itself or in an account at the country’s central bank.
  • Open market operations: The monetary authority trades financial instruments with commercial banks. If you buy these papers, you give money to your counterpart, injecting liquidity into the system. On the other hand, if you sell them, you are reducing the money supply.

The central bank uses all these instruments to apply a countercyclical monetary policy. If the growth of the economy slows, it can, for example, lower its benchmark interest rate. As we explained above, this makes credit cheaper for people. Therefore, loans and household consumption will expand, boosting the gross domestic product (GDP).

Another way to implement a countercyclical monetary policy is to reduce the reserve requirement rate. Thus, banks will have more resources available to lend to the public. Consequently, credit granted to individuals will increase and private spending will rise.

A third alternative would be to buy securities, such as repos, in open market operations. Consequently, liquidity in the system will increase, increasing the funds available to lend to consumers.

It should be noted that in the case of repos, at the end of the instrument period, the commercial bank will resell the securities to the monetary authority. Thus, it returns the liquidity received by adding interest.

The above can happen the other way around. In case the economy is expanding too fast, central banks can raise interest rates, or increase the reserve requirement to reduce the money supply in the economy.

Origin of central banks

The first central bank is possibly the Bank of Sweden, founded in 1668. But more emblematic was the Bank of England, established in 1694 by the monarch William III with the aim of providing financial support to the crown. However, it was established as a privately managed entity and remained so until its nationalization in 1946.

It should be noted that several monetary authorities were installed throughout the 19th century. This is the case, for example, of the Bank of France, created in 1800, and the Reichsbank of Germany, established in 1876. The latter entity lasted until its dissolution in 1945, with the end of the Second World War.

On the other hand, the first central bank of the United States functioned between 1791 and 1811, and the second between 1816 and 1836. Both, like the Bank of England, were private entities formed to financially support the government. Thus, after more than seventy years without a governing body of monetary policy, the famous Federal Reserve was born in 1913.

Central bank examples

Some examples of central banks are:

  • Central Bank of Venezuela (BCV)
  • Bank of Mexico (Banxico)
  • European Central Bank (ECB)
  • Federal Reserve System (FED)
  • Bank of Japan (BoJ)
  • Bank of england
  • People’s Bank of China (BPC)