What is a central bank
Published 05/19/2022 | Last updated on May 19, 2022
This institution has the mission of defining and executing monetary policy within a given area, including issuing its legal tender. This mission is usually associated with maintaining price stability.
Origin of central banks
The first central bank was probably the Bank of Sweden, founded in 1668. But more emblematic was the Bank of England, established in 1694 by monarch William III to provide financial support to the crown. However, it was set up as a privately managed entity until its nationalization in 1946.
It is worth noting 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 German Reichsbank, established in 1876. The latter lasted until its dissolution in 1945, ending World War II.
On the other hand, the first central bank in the United States operated between 1791 and 1811, and the second was between 1816 and 1836. As the Bank of England, both were private entities set up to support the Government financially. Thus, after more than seventy years without a monetary policy governing body, the famous Federal Reserve was born in 1913.
What is a Central Bank?
The central bank is the highest financial entity in a country. It manages a nation's monetary, economic and financial system. It also executes monetary policies, maintains stable reserves, and controls the movement of capital.
It acts as the highest national financial regulator, always seeking to maintain economic stability in the country. In other words, it seeks the best interests that lead to the best economic framework. The central bank operates for and hands in hand with the State and the various banks that operate in a country.
The central bank is the only one legally allowed to issue money. They are in charge of manufacturing the banknotes and coins circulating in a country.
Central Bank Functions
1. In charge of monetary issuance
The monopoly on monetary issuance has historically been the function that has led to the emergence of central banks.
Thus, in this function, the central bank becomes the only entity authorized to issue money and to put it into circulation or withdraw the money known as legal tender.
2. Government Banker
On the other hand, the government banker function can be divided into two sub-functions:
a. General banking services
On the one hand, the central bank, in its role as the Government's banker, functions like any other bank with its account holders, except that in this case, its only account holder is the Government.
Of course, because of this function, it can make collections and payments corresponding to the functioning of the public administration and also settles state accounts.
b. Financial agent of the Government
In this subdivision, the central bank also grants loans to the Government, i.e., domestic public debt is generated.
This credit granted to the Government is also a form of monetary expansion, which could also have an inflationary impact.
3. Lender of last resort
The lender of last resort function occurs when commercial banks face liquidity problems and 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 clearinghouse
The clearinghouse is a function that consists of settling interbank accounts between all commercial banks in the financial system through the central bank.
Undoubtedly, 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 within its vaults of foreign exchange reserves to stabilize the exchange rate.
Since the currency is any foreign currency bought and sold in a specific country, the exchange rate is the foreign currency's price. In this way, it tries to keep the exchange rate stable.
Monetary policy
One of the main functions of a central bank is to conduct monetary policy to achieve price stability (low and stable inflation) and help manage economic fluctuations. The policy framework within which a central bank operates has undergone significant changes in recent decades.
Since the late 1980s, the inflation targeting regime has been the most widely used framework for monetary policy. Central banks in Canada, the euro area, the United Kingdom, and New Zealand, among others, have established explicit inflation targets.
In addition, many low-income countries are abandoning monetary aggregate targeting strategies (a measure of the volume of money in circulation) in favor of an inflation targeting regime. Recently, amid concerns about the loss of policy space and lower equilibrium interest rates, and declining inflation expectations, major central banks have been reviewing monetary policy frameworks.
Central banks conduct monetary policy through adjustments to the money supply, usually in open market operations. For example, they can reduce the volume of money by selling government securities through a "sale and repurchase" agreement, thus taking money from commercial banks. The objective of open market operations is to control short-term interest rates, which influence longer-term rates and economic activity in general. In many countries, especially low-income countries, the monetary policy transmission mechanism is ineffective as in advanced economies. Before moving from monetary targeting to inflation targeting, a country must have developed a framework that allows the central bank to target short-term interest rates.
Following the global financial crisis, central banks in advanced economies loosened monetary policy and lowered interest rates until short-term interest rates were close to zero, precluding further cuts in intervention rates (i.e., limited conventional monetary policy options).
In response to the COVID-19 pandemic, central banks have activated unprecedented measures to ease monetary policy worldwide, provide abundant liquidity to main funding markets and maintain the flow of credit. To alleviate pressure in local bond and foreign exchange markets, central banks in many emerging economies resorted to foreign exchange interventions and asset purchase programs for the first time.
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