What is a Central Bank?

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30th Apr 2020 Business Question Reference this

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Question

What is a central bank? Briefly outline the main functions of a central bank.

Answer

A central bank is a key financial institution involved in setting the monetary framework within which both the economy and financial institutions operate. They are the principal means through which the government implements monetary policy, with the principal objective of keeping a good value of the country’s currency. They also have the responsibility of the note issue of their country and provide facilities and liabilities for the private banks. Among the best-known central banks are the Federal Reserve of the USA, the Bank of England, the Bank of Japan and the Bank of France. Although the degree of independence can be different among the world’s countries, for example with the coming of the European unique currency in January 1999, the European Central Bank is nowadays more significant for a European country like France, whose central bank is less important in the decision since this event.

A Central Bank has several functions, five of them are more important:

Firstly, we can see the function of implementation of monetary and exchange rate policy. They can conduct open market operations with a simply scheme. A central bank can purchase Treasury Bills and other market instruments to the private sector, which will increase the money supply held by the private sector and decrease although the short-term interest rates. In contrary, they can sell those market instruments to decrease the money supply and in this way increase the short-term interest rates. This main control of the monetary policy is make to influence the level of economic activity.

Secondly, the central bank has for function to manage the national debt. The Central Bank act as a referee between the government and holders. As we know, a government to spend have to raise taxation across the country. But is not necessarily sufficient so they borrow money to domestic residents or overseas investors. The Central Bank is at this time responsible for ensuring that holders are repaid. In the most of the cases, governments have to issue a new debt to repay the old one.

We can also study the supervisory function. They will act as a supervisor for private institutions who they want to get a licence of deposit-taking. They will have three main condition to give it. A capital adequacy, to know if the bank has sufficient capital to cover the risks being undertaken in the new bank. A liquidity condition, the new institutions have to get sufficient funds to meet the needs of depositors. They will establish finally a risk profile to know if the bank is engaged in risk-taking that make put them in difficulty the safety of their deposits.

Another function in the acting of the Central Bank to be a banker of the government and commercial banks. It carries out all banking business of the government. Government keeps their cash balances in the current account with the central bank. Similarly, central bank accepts receipts and makes payment on behalf of the governments.

The fifth and the last main function of a Central bank is that it is the lender of last resort. Whenever banks are short of funds, they can take loans from the central bank and get their trade bills discounted. The central bank is a source of great strength to the banking system, it acts as a bank of central clearance, settlements and transfers. Its moral persuasion is usually very effective so far as commercial banks are concerned.

It can be saying as well that a Central Bank as for functions to issue note of countries. The Bank of England have to produce pounds and European Central Bank have to produce Euros. In this way, the Central bank is managing reserves of foreign exchanges.

References

  • Goodhart, C. (1996). The Central Bank and the financial system. Basingstoke [u.a.]: Macmillan.
  • Howells, P. and Bain, K. (2007). Financial markets and institutions (5a. ed.). Harlow: Prentice Hall.
  • Pilbeam, K. (2010). Finance & financial markets. 3rd ed. Basingstoke: Palgrave Macmillan.
  • Dedu, V. and Stoica, T. (2012). Central Bank Independance. Theoretical and Applied Economics, XIX(8), pp.97-102.
  • Eijffinger, S. (1997). Independent central banks and economic performance. Cheltenham, UK: Edward Elgar Pub.
  • Boj.or.jp. (2018). Outline of Monetary Policy : Bank of Japan. [online] Available at: https://www.boj.or.jp/en/mopo/outline/index.htm/ [Accessed 26 Apr. 2018].

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