September 8, 2010Central Banksby EW Industries and Business Team

Central Banks

A central bank is an institution that manages a nation's monetary policy to foster economic and currency stability. The Board of Governors typically comes from the banking industry. Duties include the management of gold reserves and foreign exchange notes, mitigating inflation, supervising the banking industry and acting as the official bank of the government.

Examples of central banks include the Reserve Bank of India, Reserve Bank of Australia, the Bank of England, the Bank of Japan and the U.S. Federal Reserve. The first central bank model was the Bank of England in the 1600s. The United States went through several central banking incarnations throughout its history, but the modern one that exists today began in 1913 under President Woodrow Wilson. Today, central banks are common in many countries around the world.

Most central banks are state-owned.  The government oversees operations so they are prone to interference from politicians.  Some ‘independent’ central banks function with the least amount of government interference.

Though many central banks are technically independent, these institutions are still subject to a degree of influence from politicians and special interest groups, and critics argue that central banks are primarily focused on rescuing large banks instead of the economy, as was evident during the 2008 financial meltdown.

Central Bank Criticisms

Central banking opponents argue that power is concentrated in the hands of a few elite bankers, with little to no accountability to the government or the public at large, giving rise to cronyism and corruption. For instance, the U.S. Federal Reserve is an independent institution that is not technically accountable to Congress, and the government must borrow money from the institution with interest. Founding fathers such as Thomas Jefferson were strictly opposed to the concept of a central bank, and those who follow this line of thinking believe monetary policy should lie with the Congress, which is representative of the people.

Critics also note that central banks create economic instability by intervening in the market and adjusting interest rates. However, supporters counter that central banks need to intervene during economic downturns, and these institutions can act as a neutral party that is free of government influence when it comes to managing a nation's fiscal policy.

Importance of Central banks

A primary example of central banking policy is the management of interest rates, which is a crucial measure that influences economic output. If a central bank decides to raise rates, a nation’s output may decline.  Interest rates on mortgages, auto loans and credit cards rise.  However, higher interest rates benefit people who have money in savings accounts because their assets rise in value more quickly.  Lower interest rates, on the other hand, allow investors and businesses to borrow money more cheaply and take advantage of the low interest they would pay over time. A low rate can also decrease the value of a nation’s currency and it can boost the money supply.

Central banks also participate in the marketplace to keep market participants engaged and enhance the money supply. If the Fed wants to increase the money supply, for instance, it would buy security treasures in the form of T-bills and T-bonds. The purchase of these assets gives sellers the money they want, increasing the supply of money on the market. A money supply contraction would mean selling the securities and collecting the funds from the transactions.

Central banks also engage in the marketplace to manage inflation, and the purchase of bonds on the market increases inflation. However, selling assets decreases inflation. Market participation is one of the most vital functions of a central bank, and this policy ensures price stability across the board.

Central banks are also a vital asset to commercial banks.  If a commercial bank does not have enough reserves to meet client demands, the central bank acts as a lender to keep that bank in business. However, there are certain requirements, such as a commercial bank keeping a 1:10 ratio of reserves and deposits. The ratio can change.  The Federal Reserve has this policy, but the Bank of England does not have such a requirement.

International Central Banking

Central banks are in place not only to manage national economies, but the international financial system as a whole. For instance, the U.S. Federal Reserve instituted a policy of quantitative easing, which is an injection of funds to invigorate a stagnant economy when traditional monetary policy has failed. This type of program also keeps investors and traders in the marketplace, sending a ripple effect to other markets overseas. The Fed's QE program is one example of a stimulus policy that has benefitted international markets as well, though many critics beg to differ.

The European Central Bank embarked on a similar policy to help Eurozone nations throughout the European Union. A central bank may also loan money to another bank overseas. The nature of these international transactions are not open to the public, since central banks such as the U.S. Federal Reserve have not been audited on a mass scale, but central banks that embark on these transactions collect interest from the loans.

A central bank also plays a crucial role in developing countries, and it can be instrumental to a nation’s transition from a centrally planned economy to a free market one. The problem is that many of these countries tend to take direct control of a nation's finances as a power grab, or to finance conflicts, which can hamper banking policies.

 

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