What is a Central Bank?

When commercial banks are unable to meet a funding shortfall, the central bank, sometimes known as the "lender of last resort," is in charge of supplying funds to the country's economy. In other words, the central bank guards against the collapse of the nation's banking system.

However, the central bank's main objective is to keep inflation under control in order to maintain the value of the national currencies. The sole provider and printer of notes and coins used in circulation, the central bank also oversees the nation's monetary policy.

Time has shown that the central bank can perform these functions most effectively when it is free from the fiscal policies of the government and, consequently, from the political considerations of any regime. Also, all commercial banking interests should be completely sold off by a central bank.

How the Central Bank Can Influence an Economy

There are essentially two main functions that a central bank performs:

• macroeconomics where it controls inflation and price stability
• microeconomic when acting as a lender of last resort.

Macroeconomic influences

In order to maintain price stability, the central bank must manage the level of inflation by limiting the supply of money through monetary policy. The degree of inflation is directly impacted by the open market operations (OMO) that the central bank conducts. OMOs either add liquidity to the market or absorb surplus funds.

The central bank may purchase government bonds, notes, or other forms of currency in order to boost the quantity of money in use and lower borrowing costs. However, this purchasing may also result in rising inflation. The central bank will sell government bonds on the open market when it needs to absorb funds to lower inflation, which raises interest rates and deters borrowing.

A central bank's primary tools for managing the money supply, prices, and inflation are open market operations.

Microeconomic influences

The need for central banks' independence from commercial banking has been pressed by their establishment as lenders of last resort. Money is made available to customers by a commercial bank on a first-come, first-served basis.

Commercial banks can turn to the central bank to borrow more funds if they do not have enough liquidity to meet their customers' requests (commercial banks often do not keep reserves equal to the needs of the entire market). This provides stability in the system because central banks are unable to favour any one commercial bank. As a result, many central banks will maintain commercial bank reserves that are calculated as a percentage of the deposits of each commercial bank.

Consequently, a central bank may mandate that all commercial banks maintain, for instance, a reserve/deposit ratio of 1:10. Another way to manage the market's money supply is to enforce a policy of commercial bank reserves. However, not all central banks demand reserves from commercial banks.

For instance, the United Kingdom does not, however, the United States has historically done so. Although, the U.S. Central Bank cut its reserve requirements to 0% as of March 26, 2020, during the COVID-19 pandemic.

The rate at which commercial banks and other lending institutions can obtain short-term cash from the central bank is known as the discount rate (which is set by the central bank and provides a base for interest rates).

Summary

Along with a host of other duties, central banks have control over a country's (or a group of countries') monetary system. These duties range from monitoring monetary policy to carrying out particular objectives including achieving currency stability, low inflation, and full employment. Over the past century, the central bank's position has become increasingly significant. The central bank should be the governing body and authority in the banking and monetary systems in order to ensure the stability of a nation's currency.

Although they are controlled by the government, modern central banks are independent of their nation's ministry or department of finance. Despite the fact that the central bank deals with the purchasing and selling of government bonds and other securities, political actions shouldn't have an impact on how the bank conducts its business.

It goes without saying that the nature of the connection between the central bank and the ruling regime differs from nation to nation and changes with time.