A central bank is the heart of a country’s monetary policy and its actions exert considerable influence on every aspect of the national economy. Being an independent authority on conducting monetary policy in most countries, it is also responsible for regulating banks, providing financial services, as well as publishing economic research. Having said that, the central bank is typically free from political influence in its day-to-day operations.. The main goals of this important institution is to stabilize the domestic currency, control inflation, and keep unemployment rates at a targeting bandwidth – all of which serves to promote economic growth (Kimberly Amadeo, 2017).
In most countries, this institution is governed independently by an elected board whose head director is appointed by the country’s chief. The primary purpose of having it as an independent body is to ensure that monetary policy is free from interference from the federal government.
The most established central bank would be the one in the United States, which is The Federal Reserve System (Fed). Being the most powerful institution controlling the U.S. economy, and thus the world, it is said that it is the main controller of the world’s money. The Federal Reserve System is a two-part structure consisting of a central authority known as the Board of Governors in Washington, D.C., followed by a decentralized network of 12 Federal Reserve Banks situated throughout the nation (Federal Reserve, 2017).The monetary policy, one of the most important policy to the U.S. economy, is regulated by the Federal Open Market Committee (FOMC), which includes members of the Board of Governors and presidents of the respective Reserve Banks.
Structure of the Federal Reserve System
Roles of Central Bank
Issue of Currency
The central bank is the only institution that is authorized to issue currency legally. Having said that, it is also bound by a specific set of rules and regulations in order to prevent the excessive creation of currency and credit in a country. One of the main conditions that must be fulfilled before the issuance of a currency is that the particular central bank is required to deposit an equivalent amount of reserves in the form of gold and foreign securities as an exchange (Samiksha S, 2014).
If a market lacks sufficient money supply, the economy might achieve a stagnation as businesses cannot expand their limits with the limited monetary circulation. The conventional way is to print new money. However, this is rarely a viable measure because printing more money will devalue the currency and lead to a higher inflation rate. Money becomes cheaper when the quantity increases. Therefore, consumers would require more money than before to acquire the same amount of goods.
Alternatively, the central bank can control the money circulation through the open market operation process. This refers to the buying and selling of government securities by the central bank. To increase money supply, this institution will purchase the securities from commercial financial institutions. Once it does this, the number of deposits in banks will increase, hence raising the loanable funds for banks. On the other hand, under a contractionary monetary policy, it will sell off the securities on hand to reduce the quantity of money circulating in the market.
Supervising Domestic Banking System
The central bank oversees all sorts of banks in the country. For instance, the Fed supervises roughly 5,000 bank-holding companies, 850 state bank members of the Federal Reserve Banking System, and any foreign banks operating in the United States. In this case, it acts as the regulator and supervisor of these banks to ensure their proper functioning. In most countries, this institution requires its subsidiary banks (which are all other banks) to deposit a minimum amount of cash reserve in it in order to regulate the number of funds available for borrowings. Similar to other commercial banks, this institution also acts as a lender to its subsidiary banks during times of fund shortages.
To spur economic activities, large funds are required for investment purposes. The central bank will reduce the reserve requirement by lowering the cash deposit it requires of its subsidiary banks. In 2016, Bank Negara Malaysia has lowered the statutory reserve requirement rate from 4.00% to 3.50% (Joseph Chin, Jan 2016) so as to increase the liquidity in the domestic financial market. This provided more funds to be lent out by the financial institutions in helping to finance the private sector and boosting economic growth.
Maintaining a Stable Financial System
The financial intermediation process occurs when banks take in funds from a depositor and lend them out to a borrowing. And only financial stability can guarantee that this process operate smoothly with confidence in the operations of key financial institutions and domestic markets. To put it simply, financial stability is crucial to a country as it allows the financial intermediation process to facilitate the flow of funds between investors and borrowers. The ultimate aim of promoting economic growth and development can be achieved by allocating financial resources efficiently.
It is, therefore, the main goal of every central government and the central bank of a country to implement a sound, stable and healthy financial system in order to regulate an efficient resource allocation and distribution of risks across the economy. Working closely with the government’s treasury department, the institution plays a huge role in stabilizing the national financial system. The Fed, for example, worked closely with the Treasury Department of the U.S. to prevent global financial collapse during the financial crisis of2008. During that time, many new tools were created including the Term Auction Facility, the Money Market Investor Lending Facility, and Quantitative Easing.
After the 2008 Financial Crisis, Quantitative Easing (QE) was introduced as a tool to generate money supply electronically (BBC, August 2016). QE refers to the buying and selling of government bonds by central banks. Through the purchasing, the central bank can inject money into the domestic market. Besides improving the circulation in the market, QE acts as a psychological strategy for regaining the confidence of investors and consumers. Through QE, this financial institution can strengthen its confidence and maintain a positive outlook towards the local markets.
An external value of a currency is the purchasing power of one currency over another. Also known as the exchange rate, an external value of a currency is determined by its market forces of demand and supply. The central bank is also responsible for ensuring that the external value of a currency is maintained. The Reserve Bank of India (RBI), for instance, takes several measures to ensure the external value of the rupee. The most common measure used is the exchange rate control system, whereby every citizen of India is required to deposit all foreign currency that is received, and the demand for foreign currency by the citizens has to be applied from the RBI. In this context, the RBI can easily take count and regulate the circulation of domestic and foreign currency inflow and outflow in order to maintain its floating rate.
Intervention in the foreign exchange market is needed if the value of currency is too volatile. To limit the appreciation of currency, central bank will stockpile the foreign exchange reserve, normally in US Dollar. Selling of local currency to buy US Dollars will increase the supply of local currency in the foreign exchange market. Another approach is by lowering the interest rate. When the local market is no longer giving a return more lucrative than its competitors, foreign investors will withdraw from the domestic market and reinvest in other markets with a higher return. The value will depreciate when the supply of local currency is increasing in foreign exchange markets. Depreciation of currency will benefit the exporters, as the exports are cheaper, boosting trade and economic growth.
To mitigate the depreciation, it will either sell off the foreign exchange reserve and buy local currency, or raise the interest rate. Both methods are used to increase the demand for local currency and appreciate its value. With a higher interest rate, the local market seems to offer a higher return for the investors. Therefore, an inflow of capital is expected as it drives the demand higher. The beneficiaries of appreciation are the importers, local tourists to overseas, and student studying abroad as things are getting cheaper. They can enjoy more goods and services for every dollar spent.
Managing Inflation Rate
The central bank manages the largest component of money supply -credit – for it needs to control inflation. The tool used in controlling inflation is adjusting the interest rate. By doing so, it can affect the cost of borrowing which further influence the productivity of an economy (Investopedia, 2015).
To curb inflation, it would implement contractionary monetary policy by raising the interest rate. As a result, credit is said to be more expensive as the cost of borrowing has risen. When credit reduces, the money supply circulating in the market will also reduce, which in turn suppresses the expansion of inflation. This is essential because an increase in money supply over a country’s real output would cause inflation, a general sustained rise in the price levels of goods and services. While a low level of inflation is favorable to promote economic growth, an accelerating rate of inflation will destroy any benefits of growth.
On the contrary, when the risk of inflation is low, this institution lowers interest rate to encourage borrowings in order to boost business growth and money circulation. Cheaper borrowing costs fuels private investment and expansion in an economy. When the economy is growing and businesses are expanding, the rate of unemployment would in turn reduce. This situation is desirable to the central bank as it fulfills its goals of achieving low inflation and unemployment rate. To lower interest rates, an expansionary monetary policy is used by expanding credits and liquidity to boost economic growth and create job opportunities.
Although the central bank in most countries works closely with the government’s treasury department, it is an independent institution that deals with the government under separate legal entities of a banker (the central bank) and client (government) relationship. In most cases, the government deposits their cash balances with the current account in it and it is then authorized to manage the receipts and payments on behalf of the government. Therefore, this institution is often known as the government banker.
That being the case, the central government is authorized to borrow money from the central bank in most countries. For instance, when government expenditure exceeds that of its revenue, the central government of India will borrow from the Reserve Bank of India (RBI). In this case, deficit financing, also known as monetization of debt takes place where the RBI will create new currency notes to buy the Treasury Bill from the government and the government will, in turn, spend this money in the domestic market either for infrastructure or economic development.
As the master player in a country’s finance, the central bank is bestowed with a crucial role to regulate the financial stability of a country. Making use of its influence and authority, it is hoping to keep inflation and unemployment at a healthy rate, as well as promote the favourable economic stability to drive consumptions and investments. All these are essential to achieving its ultimate goal of cultivating sustainable economic growth and development in the country.
Researchers: Chong Ker Sun & Wong Vyleen
Editor: Lim Shu Ni
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Joseph Chin, January 2016, BNM lowers statutory reserve requirement for banks to 3.5%, The Star Online.
Kimberly Amadeo, 9th November 2017, Federal Reserve System: Its 4 Functions and How It Works, The Balance.
Federal Reserve, 3rd March 2017, Structure of the Federal Reserve System, Board of Governors of the Federal Reserve System.
Samiksha S, 2nd May 2014, The Role of Central Bank in a Developing Economy of a Country, Your Article Library.
Central Bank, 8th May 2017, The Function and Role of Central Bank, Centrale Bank van Curaçao en Sint Maarten.
BBC, August 2016, “What is Quantitative Easing?”. http://www.bbc.com/news/business-15198789
5Investopedia, 2015, How do central banks impact interest rates in the economy? https://www.investopedia.com/ask/answers/031115/how-do-central-banks-impact-interest-rates-economy.asp