Central Bank

An organization that manages the currency of a country or group of countries and controls the money supply is known as central bank.
The central bank, also known as the Reserve Bank, were established because of their absence in the past had led to a surge in financial services and included bank failures that drained people's savings.
To keep prices stable is the main purpose of the central bank.
Central banks are also required by law to act in support of full employment in some countries.
A key feature of the central bank is its legal monopoly, which gives it the right to issue banknotes and cash.
Most central banks are not government institutions and are considered politically independent.


Central Bank




A central bank is not a commercial bank.


What central banks do is conduct monetary policy, using various tools to influence the amount of money circulating in an economy, interest rates charged on loans, and the rate of inflation.
Inflation occurs when prices continue to rise, meaning a country’s currency is worth less than it was before because it can’t buy as much (also known as a decline in purchasing power).
No one can open an account in the central bank and deposit money or ask for a loan from it.
The key function of the central bank is to operate the monetary policy, using various tools to influence the money circulating in the economy, interest rates on loans, and inflation.
The continue rise in the prices causes inflation, meaning that a country's currency depreciates because it cannot afford to buy so much (also called a reduction in purchasing power).
Inflation indicates that the economy is rising. But high inflation is a problem because it discourages investment and lending and depletes people's savings as it devalues money.
Deflation is the opposite of inflation. This is when prices fall.
Central banks work hard to control inflation and inflation.
A central bank acts as a bank for commercial banks and thus influences the flow of money and credit into the economy to achieve stable prices.
To fulfill the short term needs, commercial banks can approach the central bank to borrow money.

To get a loan from the central bank they have to provide a guarantee - an asset such as a government bond or a corporate bond that has value and it acts as a guarantee that they will repay the money.
Because commercial banks might lend long-term against short-term deposits, they can face “liquidity” problems.
This is a situation where they have the money to pay off the debt but not the ability to quickly convert it into cash.
This is where a central bank can step in as a “lender of last resort.”
This helps keep the financial system stable.
Central banks can have many things besides monetary policy. They usually issue banknotes and coins, often ensure the smooth functioning of payment systems for banks and commercial financial instruments, manage foreign reserves, and do their part in educating the public about the economy.
Many central banks take part in the stability of the financial system by overseeing commercial banks to ensure that lenders are not taking too much risk.


What Does A Central Bank Do?


Central banks have the ability to accelerate and slow down the growth of the economy, as an organization that controls a country's monetary policy,.
Due to this the central banks have cash reserves which commercial banks can withdraw for lending, the value of which is determined by the national interest rate.
If inflation is increasing, the central bank can raise interest rates, which makes it more expensive for an individual to take out a loan from her bank.
The central bank may stop producing money or force commercial banks to buy financial instruments such as treasury bills or foreign currency, which reduces the money supply in the economy. This is called contractionary money policy.
On the other side, if the economy slows down, the central bank may cut interest rates, giving commercial banks cheaper access to funds, allowing individuals and businesses to borrow more. The central bank may start printing money again. This is called Expansionary Money Policy.
Most central banks set a reserve requirement for commercial banks, which means they must maintain a certain percentage of the amount owed to account holders, ensuring that banks do not run out of money.
Countries that do not specify a reserve requirement, such as the U.K., often have a capital requirement instead, which is determined by the ratio of the bank's capital to its risk.


Central Banks and Interest Rates


The central bank does not directly determine the interest you will receive on your savings account. Instead, they set a basic interest rate.
A central bank sets the "base rate" which is either:


  • The amount that commercial banks are charged to borrow from each other (like in the U.S., where the Fed sets the “federal funds rate”).

  • The amount that commercial banks are charged to borrow from the central bank (like in the U.K., where the Bank of England sets the “Bank Rate”).



Why does the central bank change the interest rate?


A central bank lowers interest rates as it seeks to stimulate the economy and raises interest rates as it seeks to control inflation caused by such an economy. Which is “too hot” (or rising too fast)?
Low interest rates stimulate the economy in a few ways:


  • Businesses can borrow money and invest in projects that will receive more than the risk borrowing rate.

  • When interest rates are lower the stock market is discounted at a lower rate, leading to an appreciation in stock market values which causes a wealth effect.

  • People invest their money into the economy (stocks and other assets) because they can earn more in these assets than at currently low-interest rates.


In the case the economy is growing very fast, inflation might become too high and unstable.
This makes it difficult for families and businesses to plan for the future, as it is difficult to estimate prices with confidence. This can prevent costs and slow growth.
To stave off this scenario, a central bank may raise interest rates in an effort to reduce the rate of increase in spending, and bring inflation back under control.


Central Banks and the Forex Market


Central banks play a key role in currency markets because of their power over monetary policy.
The effect the money supply directly, due to which the demand and value of the currency is effected.
By using different policies, central banks may try to manipulate the markets to keep their currency at a certain level.
The central bank can participate in the forex market by buying and selling their currency at the spot market in order to keep it from changing too much.
Some countries and their central banks try to combine their currency with another currency or currency basket.
For example, China and Hong Kong "peg" their currencies with the US dollar.
by buying and selling its currency in the spot market to prevent it from being drastically changed, the central bank can participate in the forex market.
Another impetus for central banks is to keep the local currency at a certain price to make their local economy more attractive to international trade.

 

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