Role Of Central Bank In The Economy – A central bank is a financial institution that has privileged control over the production and distribution of money and credit for a nation or group of nations. In modern economies, the central bank is usually responsible for making monetary policy and regulating member banks.

Central banks are inherently non-market or even anti-competitive institutions. Although some are nationalised, many central banks are not government agencies, and are therefore often referred to as politically independent. However, even if a central bank is not legally owned by the government, its privileges are established and protected by law.

Role Of Central Bank In The Economy

The crucial feature of a central bank — distinguishing it from other banks — is its legal monopoly status, which gives it the privilege of issuing paper money and cash. Private commercial banks are only allowed to issue demand obligations, such as checking deposits.

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Although their responsibilities vary widely, depending on their country, the duties of central banks (and the justification for their existence) usually fall into three areas.

First, central banks control and manipulate the national money supply. They influence market sentiment as they issue currencies and set interest rates on loans and bonds. Central banks typically raise interest rates to slow growth and avoid inflation; they lower them to spur growth, industrial activity, and consumer spending. In this way, they manage financial policy to lead the country’s economy and achieve economic goals, such as full employment.

Most central banks today set interest rates and conduct monetary policy using an inflation target of 2-3% for annual inflation.

Second, they regulate member banks through capital requirements, reserve requirements (which determine how much banks can lend to customers, and how much cash they must keep on hand), and deposit guarantees , among other tools. They also provide loans and services for a country’s banks and its government and manage foreign exchange reserves.

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Finally, a central bank also acts as an emergency lender to distressed commercial banks and other institutions, and sometimes even government. By buying government debt obligations, for example, the central bank provides a politically attractive alternative to taxation when a government needs to raise revenue.

Along with the measures mentioned above, central banks have other actions at their disposal. In the United States, for example, the central bank is the Federal Reserve System, aka “the Fed”. The Federal Reserve Board (FRB), the Fed’s governing body, can affect the national money supply by changing reserve requirements. When the minimum requirement falls, banks can lend more money, and the economy’s money supply rises. In contrast, raising reserve requirements reduces the money supply. The Federal Reserve was established with the Federal Reserve Act of 1913.

When the Fed lowers the discount rate that banks pay on short-term loans, it also increases liquidity. Lower rates increase the money supply, which in turn boosts economic activity. But falling interest rates can fuel inflation, so the Fed must be careful.

And the Fed can conduct open market operations to change the federal funds rate. The Fed buys government securities from securities dealers, supplying them with cash, thereby increasing the money supply. The Fed sells securities to move the cash into their pockets and out of the system.

The Important Role Of Central Banks

The first prototypes for modern central banks were the Bank of England and Riksbank Sweden, which date back to the 17th.

Century. The Bank of England was the first to recognize the role of lender of last resort. Other early central banks, notably the French Bank of Napoleon and the German Reichsbank, were established to finance the government’s expensive military operations.

It was mainly because European central banks made it easier for federal governments to grow, wage war, and enrich special interests that many of the founding fathers of the United States – Thomas Jefferson most passionately – opposed the establishment of an entity from the type in their new country. Despite these objections, the young country had official national banks and a number of state chartered banks for the first decades of its existence, until a “free banking period” was established between 1837 and 1863.

The National Banking Act of 1863 created a network of national banks and a single US currency, with New York as the central reserve city. The United States subsequently experienced a series of bank panics in 1873, 1884, 1893, and 1907. In response, in 1913 the US Congress established the Federal Reserve System and 12 regional Federal Reserve Banks across the country to stabilize financial activity and operations banking. The new Fed helped finance World War I and World War II by issuing Treasury bonds.

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Between 1870 and 1914, when the world’s currency was pegged to the gold standard, maintaining price stability was much easier because the amount of gold available was limited. As a result, monetary expansion could not occur simply from a political decision to print more money, it was easier to control inflation. The central bank at the time was mainly responsible for maintaining the convertibility of gold into currency; issued notes based on a gold reserve.

At the start of the First World War, the gold standard was abandoned, and it became clear that, in times of crisis, governments faced budget deficits (as it costs money to pay a war) and would need more of resources orders the printing of more money. As governments did that, they encountered inflation. After the war, many governments chose to go back to the gold standard to try and stabilize their economies. With this awareness arose of the importance of the independence of the central bank from any political party or administration.

During the turbulent times of the Great Depression in the 1930s and after the Second World War, the world’s governments mostly favored a return to central bank reliance on political decision-making. This view emerged mainly from the need to establish control over economies that had been shattered by war; moreover, newly independent nations chose to retain control over all aspects of their countries – a backlash against colonialism. The rise of regulated economies in the Eastern Bloc was also responsible for greater government intervention in the macro economy. Ultimately, however, the independence of the central bank from the government came back into fashion in Western economies and has prevailed as the best way to ensure a liberal and stable economic order.

Over the past quarter of a century, concerns about deflation have increased after major financial crises. Japan has offered a sobering example. After its equities and real estate bubbles burst in 1989-90, causing the Nikkei index to lose a third of its value within a year, deflation became stable. Japan’s economy, which had been one of the fastest growing in the world from the 1960s to the 1980s, slowed dramatically. The 90s became known as Japan’s Lost Decade.

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The Great Recession of 2008-09 sparked fears of a similar period of protracted deflation in the US and elsewhere due to the catastrophic fall in the prices of a wide range of assets. The global financial system was also thrown into turmoil by the bankruptcy of a number of major banks and financial institutions throughout the United States and Europe, exemplified by the collapse of Lehman Brothers in September 2008.

In response, in December 2008, the Federal Open Market Committee (FOMC), the Federal Reserve’s monetary policy body, turned to two main types of unconventional monetary policy tools: (1) forward policy guidance and (2) scaled asset purchases big, aka quantitative easing (QE).

The first involved cutting the federal funds target rate to essentially zero and keeping it there through at least mid-2013. But the other instrument, quantitative easing, has hogged the headlines and become synonymous with the Fed’s easy-money policies. Basically, QE means that a central bank creates new money and uses it to buy securities from the nation’s banks in order to pump liquidity into the economy and lower long-term interest rates. In this case, it allowed the Fed to buy riskier assets, including mortgage-backed securities and other non-government debt.

This increases to other interest rates across the economy and the widespread reduction in interest rates stimulates demand for loans from consumers and businesses. Banks are able to meet this increased demand for loans because of the money they have received from the central bank in exchange for their bond payments.

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In January 2015, the European Central Bank (ECB) embarked on its own version of QE, by pledging to buy at least 1.1 trillion euros of bonds, at a monthly pace of 60 billion euros, until September 2016. The ECB launched its QE program six years after the Federal Reserve did so, in an attempt to support the fragile recovery in Europe and prevent deflation, after its unprecedented move to cut the benchmark lending rate below 0% at the end of 2014, only had limited success.

Although the ECB was the first major central bank to experiment with negative interest rates, several central banks in Europe, including those of Sweden, Denmark, and Switzerland, have pushed their benchmark interest rates below the zero bound.

The measures taken by central banks seem to be winning the fight against deflation, but it is too early to say whether they have won the war. Meanwhile, the collective moves to stave off deflation globally have had some strange results:

In Japan and Europe, the central bank purchases included more than various non-government debt securities. Both banks actively participate in corporate direct purchases

China’s Central Bank Vows Greater Support For Real Economy

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