Central banks are crucial to the functioning of any economy. Virtually every country has one. In 1900, there were 18, but today there are more than 170 central banks throughout the world. The earliest central banks, such as the Bank of England, started as commercial banks that did some business with the government, which, over time, took on more and more functions of a central bank. Other central banks, such as the European Central Bank and the United States Federal Reserve were created as central banks right from the start.
Central banks act as both the government's bank, which was their original purpose, and as the bankers' bank, providing services to commercial banks, such as check clearing, electronic payment systems, and providing liquidity when necessary. However, what distinguishes central banks from other banks is their primary objective of maximizing economic efficiency through monetary policy, by increasing or decreasing the supply money or interest rates and overseeing the financial system to maintain soundness of financial institutions and markets. Central banks are not beholden to owners nor do they seek profits. Any profits made by central banks are generally turned over to their government.
Central banks became necessary to help manage the economy — without interference from politicians — since financial problems can easily destroy the economy and problems in one area or country can easily spread, as demonstrated in the recent Credit Crisis of 2008 – 2009.
Central banks use monetary policy to regulate the economy. Increasing the supply of money promotes both growth and inflation over the short run while decreasing it restricts both. However, central banks do not make fiscal policy, which is the policy to determine how public money will be raised and spent – a purview of the politicians.
One problem that all banks have — except for the central bank — is the potential to collapse if all of its depositors withdraw their money within a short time, which often happens when people become afraid that their bank will go under. To prevent these so-called runs on the bank, the central bank stands ready as a lender of last resort. Because the central bank can create money, it can lend financially stressed banks all the money necessary for them to continue functioning. However, a lender of last resort will only provide liquidity for banks suffering from a liquidity crisis, but not a solvency crisis, though it may be difficult to distinguish the 2, especially during economic downturns. A lender of last resort also creates a moral hazard in that it allows banks to reduce their holdings of lower yielding, low risk assets for higher-yielding, higher risk assets.
Central banks oversee the financial system and may also monitor other banks to ensure that they are financially sound and are following wise management practices, since the collapse of any bank can have serious financial repercussions throughout the economy, especially the local economy.
Central Bank Objectives
The economic objectives of most central banks are to maintain financial stability in the economy, while maximizing growth and employment. Stability is important because financial instability is a systemic risk that affects the economy as a whole and cannot be diversified away. For instance, booms and busts in the past, most often brought about by individual banks, have caused the entire economy to expand and contract. Such events characterized the history of the United States before the creation of the Federal Reserve in 1913.
Consequently, central bank objectives have adopted objectives to accomplish their purpose, including: low and stable inflation, high growth, high employment, and stable financial markets and institutions. These factors must be optimized to achieve maximal effect.
Low, Stable Inflation
When the amount of money increases faster than the economy, then inflation results. That high inflation is bad for growth is evident from history, such as Germany after World War I, the Ukraine in 1983, or Bolivia in 1985. The result of these cases of hyperinflation was economic contraction.
Low stable inflation and price stability are desirable so that money can be useful as a means of exchange, unit of account and as a store of value. If inflation is not stable, then money cannot function as money: the use of barter will increase, and assets will be purchased, even when they are not needed, to preserve value. Neither businesses nor individuals can plan for the future; prices no longer indicate supply and demand of products and services, causing economic inefficiency and stress. Higher inflation also varies more than low inflation, creating greater uncertainty about the future. An uncertain future will cause businesses to be reluctant to undergo long-term projects.
High inflation makes it difficult to plan for retirement. Indeed, it could be almost impossible, since there is no way to know what the purchasing power of any given amount will be 30, 40 or 50 years from now. People on fixed incomes will suffer.
Borrowing and lending will become difficult. Lenders would demand a higher rate of return both because the nominal interest rate generally equals the real interest rate plus expected inflation and because there is a risk premium for uncertainty. Hence, interest rates can never be low when inflation is high.
Greater uncertainty about the future causes both people and businesses to be cautious. They will not borrow money nor invest in long-term projects. Higher interest rates impede the economy, and uncertainty increases interest rates further, since greater risk increases the risk premium demanded by lenders to compensate them for their increased risk. Hence high inflation has the same result as high interest rates — both hinder the economy, causing it to become less efficient. Indeed, the Federal Reserve was created in 1913 because of the numerous financial panics that plagued the United States in the 30 or 40 years before.
Although inflation should be low, it should not be negative because deflation makes loans difficult to repay, which increases the default rate and people would hold on to their money rather than spend it to let it increase in value. The government also profits from the inflation — since the government creates money, it is the 1st to profit from it. Employers can also benefit since wages always lags inflation, allowing them to collect higher revenues for their products or services, thereby earning more profits before they increase wages.
One objective of the central banks is to maintain low interest rates. However, low interest rates are frequently a secondary concern, because the manipulation of interest rates is a main tool that central banks use to moderate the economy. When the economy is running hot, and inflation threatens, the central bank raises the interest rate to decrease demand, and when the economy is sluggish, interest rates are lowered to stimulate the economy.
Growth and Employment
Highest sustainable growth is desirable. When the economy fluctuates too much, the cycles tend to reinforce each other. When the economy contracts, consumers stop spending, thereby causing businesses to restrain their spending, thereby causing the economy to contract even more.
The output of any economy depends on technology, capital, and people. However, these factors of production have to be optimized to lead to the greatest potential output. When the economy reaches its maximum potential output, then unemployment will generally be at its lowest rate, and the benefit of the economy to society will be maximized.
Stable Financial Markets and Institutions
Financial stability is also important because financial intermediation is what brings borrowers and lenders together, or investors and businesses. If financial institutions are not stable, then neither people nor businesses will rely on them, and without them, economic growth and efficiency will decline dramatically.
Exchange Rate Stability
Exchange rate stability facilitates international trade, but is not a main objective of most central banks of developed countries, since domestic goals usually have greater priority. Exchange rates are more important to emerging markets that depend on favorable exchange rates for their export businesses. For instance, the Central Bank of China actively buys United States Treasuries to keep its currency, the yuan, pegged at steep discount to the United States dollar.