Central Bank - Definition & Key Highlights

A central bank, monetary authority, or reserve bank is an organization that is in charge of a state's or structured monetary union's monetary system, policy, and commercial financial system.  

Unlike commercial banks, a central bank is the only one that can add to the money supply. Many central banks have the authority to supervise and regulate constituent banks to make sure they are stable, cease bank runs, and dissuade careless or deceitful behavior. 

Most developed countries have central banks that are organizationally separate from politics. But the executive and legislative bodies still have some control. 

What is a Central Bank? Definition, Function, and Role 

This comprehensive article is written to give readers an understanding of what a central bank is and what its functions and roles are. 

Central Bank Definition 

A central bank serves as a financial institution that has special power over how cash and credit are made and given out in a country or group of countries.  

In most advanced economies, it's in charge of setting budgetary policy and making sure that member banks follow the rules. 

Central banks are not based on the market and may even be against the competition. Although certain central banks are owned by the state, most are not.  

This is why they are often said to be independent of the government. So even when the central bank does not owe legal obligations to the government, the law sets out and protects its rights. 

The most important thing about a central bank that sets it apart from other banks is that it has the legal authority to grant currency notes and money. Privately-owned banks are just allowed to give out demand liabilities, like checks. 

Key Highlights 

This is how they use monetary policy to steer the economy and reach economic goals like full employment. 

Many central banks establish rates of interest and make decisions about money today based on an inflation expectations of 2% to 3% per year. 

By buying state liabilities, for instance, a central bank gives governments a politically appealing alternative to raising taxes when they need more money. 

An Example of Central Banks 

In addition to the steps listed above, central banks can also take other steps. In the USA, for instance, the Federal Reserve System, also known as "the Fed," is the nation's central bank.  

The Federal Reserve Board (FRB), which is in charge of the Fed, can change the amount of money in circulation by changing what banks need to keep in reserves.  

When the minimum standards go down, banks offer more cash, and the amount of currency in circulation goes up.  

On the other hand, when reserve requirements go up, the supply of money goes down. The Federal Reserve was set up when the Federal Reserve Act was passed in 1913. 

Whenever the Fed decreases the rates of discount, which banks pay on short-term borrowings, it also makes it easier for banks to get short-term loans.  

Lower rates make more money available, which makes the economy grow. But lowering interest rates can make prices go up, so the Fed has to be careful. 

The Fed can also alter the funds' rate through open market operations. The Fed purchases government bonds from brokers, giving them cash and increasing the amount of money in circulation.  

The Fed sells security resources to get the money from the system and into its own hands. 

The History of Central Banks 

The Bank of England as well as the Swedish Riksbank, which goes back to the 1600s, were the very first examples of what a modern central bank would look like.  

The function of lenders of the last resort was first identified by the Bank of England. Other initial central banks, like Napoleon's Bank of France as well as Germany's Reichsbank, were set up to pay for costly military operations by the government. 

European financial institutions made it possible for governments to grow, go to battle, and enhance special interests.  

This was the main reason why many of the founding members of the US, especially Thomas Jefferson, were against creating one in their new nation.  

In spite of these misgivings, the young nation had both formal national banks and many state-chartered financial institutes during the initial few decades of existence, before a "free-banking period" was set up between 1837 and 1863. 

The National Banking Act of 1863 built a network of banking institutions and a solitary U.S. monetary system, with New York serving as the main reserve city.  

After that, there were bank meltdowns in the United States. In answer, the U.S. Congress set up a Federal Reserve System as well as 12 region-specific Federal Reserve Banks across the country in 1913 to keep the banking and financial operations stable.  

By giving out Treasury bonds, the fresh Fed helped pay for World Wars I and II. When all currencies were tied to the gold standard from 1870 to 1914, it was much easier to keep prices stable because there wasn't much gold around.  

So, the government couldn't just decide to create more money and cause the money supply to grow. This made it easier to control inflation.  

At that time, the main job of the central bank was to make sure that gold could still be used as money. It did this by making notes depending on a nation's gold reserves. 

At the onset of the 1st World War, the gold standard had been thrown out, and it became clear that, in moments of emergency, governments with fiscal deficits and a need for more money might order more cash to be printed.  

When governments did this, it led to inflation. After the conflict, numerous governments decided to try to sustain their economies by returning to the gold standard. This made people realize how important it was for the central bank to be separate from any government or political party. 

During the tough moments of the 1930s Great Depression and following World War II, most governments around the world wanted to go back to a central bank that was controlled by politics.  

This point of view came about mostly because of the need to take control of war-torn economies. Also, newly independent nations chose to keep authority over all parts of their nations as a reaction against colonial rule.  

The emergence of controlled economic systems inside the Eastern Bloc also led to more government involvement in the economy as a whole.  

But eventually, in Western economies, the idea that the central bank should be independent of the government returned to practice and has stayed as the best way to have a free and stable economy. 

How Do Central Bank Policies Affect Interest Rates? 

Most of the time, a central bank can't set the interest rates on loans like mortgages, auto loans, and personal loans directly.  

However central banks do have some ways to move interest rates to where they want to be. For instance, the central bank controls the policy rate, which is the rate at which financial institutions can borrow money from central banks. 

When banks can loan from a central bank at lower rates, they save money and give it to their clients and make loans cheaper.  

When interest rates are lower, people tend to borrow more, which means there is more money circulating. 

Central Bank vs Federal Reserve: What’s the Difference? 

Unlike many central banks, the Federal Reserve is only partly centralized. On the national scale, it is governed by a Board of Governors, which is made up of seven people chosen by the US President and approved by the Senate.  

Appointments take place in 14-year terms, and these are set up because every other even-numbered year, on January 31, a term end.  

The lengthy, spaced terms are meant to protect the Board of Governors from government pressure as much as possible so that legislation decisions are taken predicated only on fiscal merits.  

Also, each participant only needs to serve one term, unless they are filling in for someone whose term hasn't ended yet.  

This keeps politics out of the decision-making process even more. Policy decisions made by the Fed don't need approval from Congress, and the President can't ask a Federal Reserve Governor to quit as he or she can with cabinet members. 

Conclusion 

We hope the above article has given you more clarity about central banks and the way they function. For any suggestions, feel free to leave a comment in the comments section below. 

FAQs

Who owns and controls central banks? 

Most central banks are owned by governments, which are usually in charge of making executive appointments and getting a cut of the profits. The central bank's top policy plus management committees are in charge of running the financial institution day in and day out. 

When does the central bank decide it will sell bonds? 

When you buy bonds, you place cash in the money market, which increases the amount of money available. Whenever the bank needs interest rates to go up, it sells bonds. This takes money off the financial markets and reduces the amount of money in circulation. 

Why do central banks hold gold? 

A gold reserve serves as the gold hosted by a central bank. During the times of the gold standard, this gold was mostly used as a warranty to pay depositors, note owners (like paper currency), or trading colleagues. It was also used as a store of value or to endorse the value of the country's currency. 

How do central banks control money supply in the economy? 

Through a procedure called open market operations (OMO) in which they transact government bonds, central banks can change the monetary supply. When a central bank wants to make more money available, it buys government bonds from commercial banking institutions. 

Do all countries have central banks? 

Nearly all the countries on this planet does have a central bank, especially those that make their own money. Even nations that aren't known by the rest of the world, like Abkhazia, have central banks. Most of the time, central banks work on their own so that politics don't affect what they do and how they make policy decisions. 

Which is the mother of all central banks? 

The Bank for International Settlements, which is the mother of all the Central Banks in the world, said in their 82nd Annual Report that people should lower their standards about the economic system.