Central Banks

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. Central banks are the most powerful financial institutions in the world, because they control the money supply of most modern economies. 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 the 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 2007 – 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 legislative and executive branches of the government.

Policy Rules and Policy Discretion

The decisions of central bankers may be guided by policy rules or policy discretion. A policy rule is a formula for determining the policy instrument and the policy, what reaction should be implemented in response to observed changes in the economic state. The advantages of the policy rule are that it is nondiscriminatory and predictable. Therefore, consumers and businesses can make better plans for the future, which increases economic efficiency.

For instance, there are 2 policy rules that have guided the Federal Reserve in the past: the k-percent rule and the Taylor rule. The k-percent rule, recommended by Milton Friedman, is based on 2 guidelines: that a policy rule should be based on a quantity that the central bank can easily control, such as the growth rate of the money supply, and the rule should prevent sudden policy changes. The Taylor rule bases the federal funds rate to the nominal rate of interest implied by the long-term equilibrium of the economy and the inflation target. The Taylor rule stipulates that the federal funds rate should be increased when the output gap is positive, meaning that the economy is operating above its long-term equilibrium, which leads to competition for scarce resources, resulting in increased inflation. When the output gap is negative, then the economy is operating below equilibrium, resulting in unemployment and underutilization of capital, in which case, the federal funds rate would be decreased. Such was the case during the Great Recession of 2008.

Policy discretion depends on the judgment of central bankers, and, thus, is not bound by policy rules, so a better policy can be implemented for economic situations too complex to be handled by simple rules. However, policy discretion can result in possible discrimination, where one group benefits more than others. Moreover, policy discretion is not nearly as predictable as a policy rule, but even policy discretion is guided by general principles.

Other disadvantages to a policy rule is that the policy rule:

Most central banks combine policy rules with policy discretion, since economies are too complicated to be managed by simple rules, but rules do offer guidelines that may prevent central bankers from making bad decisions.

Central Bank Independence

For a central bank to manage monetary policy effectively, it must have independence from politicians seeking to manipulate monetary policy for their own short-term interest or for the benefit of major donors. Several conditions can help assure central bank independence:

In the United States, the Federal Reserve is largely independent, but the Board of Governors is chosen by the president rather than members of the bank.

The influence of central banks on their economies is limited because fiscal policy also affects the economy, but fiscal policy, especially tax policy, is largely determined by elected politicians, who have an incentive to try to maximize the economy in the short run to increase their prospects of being re-elected.

Monetary Tools to Regulate the Economy

Central banks can change the money supply through open market operations, by buying and selling government securities, and by changing the reserve requirements for banks. To increase the money supply through open market operations, the central bank buys government securities from other banks or dealers and pays for the securities by simply incrementing their accounts at the central bank by the amount of the purchase. When the central bank sells government securities, it lowers the money supply of the buyers of the securities, mostly banks or other dealers, by withdrawing the amount of the purchase from their accounts at the central bank. Central banks could also adjust the reserve requirements, which is the minimum amount of money that the banks must hold as a percentage of their transactions. Therefore, decreasing the reserve requirements increases the amount of money available for lending and other transactions, while increasing the reserve requirements has the opposite effect.

Central banks may also establish credit controls, by stipulating the amount of collateral required for loans. In the United States, for instance, the Federal Reserve sets margin requirements for the purchase of stocks and other securities.

Less-developed economies may have a smaller capital market and its citizens may save less, so central banks in these countries may provide credit that would otherwise be unavailable by lending directly to the government or by extending medium- or long-term loans to commercial banks to finance domestic economic development.

One problem that all banks have — except for the central bank — is the potential to collapse if all its depositors withdraw their money within a short time, which often happens when people fear that their bank will go under. To prevent these 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.

Economic planning is also greatly enhanced if the central bank is transparent in its objectives. Transparency is achieved when the central bank follows specific objectives and communicates its intentions to the public.

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. Hyperinflation makes financial planning much more difficult or even impossible, and the economy becomes less productive because people and businesses obsess about managing the hyperinflation.

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 be lowest, 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.

Central Bank Balance Sheets

The balance sheets of central banks also differ from commercial banks (Bank Balance Sheet: Assets, Liabilities, and Bank Capital). The assets of commercial banks consist largely of:

The liabilities of commercial banks consist of:

The main components of a balance sheet can be illustrated succinctly with T-accounts. A T-account is a pedagogical aid used in accounting that illustrates the use of the double-entry accounting system. The T-account has:

  1. a title, describing the asset, liability, or stockholders equity account, or even an entire business or other organization
  2. a left side listing debits, and
  3. a right side listing credits.

The 2 sides must equal. It is called a T-account because it looks like a capital T. Although counterintuitive, assets are classified as debits under accounting rules, and liabilities, along with stockholders equity, are treated as credits. Therefore, assets are listed on the left side of the T-account, while liabilities and stockholders equity are listed on the right side. Both sides must equal, because the T-account is based on the fundamental accounting equation:

Assets = Liabilities + Stockholders Equity

The difference between assets and liabilities = the bank capital, which is the stockholders equity for banks, and, therefore, is displayed on the right side of the T-account. The primary assets of central banks consist of government securities, gold deposits and loans to other banks, while its liabilities is the currency that it issues. This is summarized by the following T-accounts for commercial banks and central banks:

Simplified T-Account for Commercial Banks
  • Cash and Cash Equivalents
  • Securities
  • Loans to Consumers and Businesses
  • Checkable Deposits
  • Non-Transaction Deposits
  • Borrowings from Other Banks
  • Bank Capital
Simplified T-Account for Central Banks
  • Government Securities
  • Gold Deposits
  • Loans to Other Banks
  • Currency

Central banks also have other assets and liabilities which will vary depending on the country and how the central bank is organized. Here is a more detailed balance sheet for the Federal Reserve:

Simplified T-Account for Federal Reserve
  • Federal Reserve Notes (Currency)
  • Reverse Repurchase Agreements
  • Depository Institution Deposits
  • U.S. Treasury Deposits
  • Foreign Officials Deposits
  • Other Deposits
  • Deferred Availability of Cash Items
  • Other Liabilities

Special Drawing Rights

Special drawing rights (SDRs) were created by the International Monetary Fund (IMF) in 1969 to serve as a unit of account for the IMF and other international organizations and to serve as a unit of exchange between countries, to supplement the reserves of gold and other convertible currencies so as to maintain stability in the foreign exchange market. Central banks can use SDRs instead of gold or currencies to temporarily satisfy trade imbalances. SDRs were used extensively by central banks during the market turmoil of the Great Recession of 2007 - 2009.

The IMF allocates SDRs to each of its member countries in proportion to their gross national product. Each member agrees to back SDRs with the full faith and credit of its government and to accept them in exchange for gold or convertible currencies. Under the old Bretton Woods exchange system, each SDR was based on 0.888671 g of fine gold, equal to 1 US dollar when the value of the dollar was fixed to gold. When the fixed exchange system collapsed in 1973, the value of an SDR was based on a floating rate of a basket of currencies. Currently, the SDR is based on the spot rate of the following basket of currencies: US Dollar, Euro, Chinese Yuan, Japanese Yen, and Pound Sterling. These currencies were selected because of their importance in global transactions, and their proportional weight within the basket is commensurate to their dominance in global trading. Thus, the US dollar had the most weight, followed by the euro. Each SDR nominally equals a fixed number of units of these currencies, but their actual weighting changes with market changes in the cross-currency exchange rates. Every 5 years, the currencies comprising the basket is evaluated to ensure that only currencies with the most global significance comprises the basket, then the number of units of each of those currencies for each SDR is fixed for 5 years.

Because of this equalization with a basket of international currencies, SDR's are often used to denominate values used in international treaties, private contracts, and securities on the Eurobond market.

This is a simplified balance sheet for the Bank of England:

Simplified T-Account for the Bank of England
  • Government Securities
  • Other Securities
  • Advances
  • Bank Premises and Equipment
  • Pound Sterling Notes in Circulation
  • Public Deposits
  • Deposits of Banks
  • Deposits in Reserve Accounts

There are several similarities to the balance sheet of the Federal Reserve, but with some differences, such as: