Key Roles of the Central Bank - Essay Example

College: The Central Bank: Roles, independence and the economy Introduction The economies of different countries are driven by policies, rules and regulation that determine the type of financial standards and playing field given to different economic sectors in the country. The nature of an economy is such that checks and balances at play should be checked and reinforced so as to give equal chances to all stakeholders in the economy. Countries have one chief institution that deals with regulations and flow of money, which is crucial in the economy. Government’s hand in economy is thus felt by the central institution that regulates other smaller financial institutions whose role in the economy is crucial. The institution, which is the chief regulator, is called the central bank. 1.0. Roles of the Central Bank 1.1 Background The 17th century money was dominated by gold and silver, with verbal and written promises also being a form of payment. Paper money and attempts to control money flow were first used in China. European form of central banks came in existence in form of Knights Templar’s promises of payment. The modern precursor of central bank was the bank of Sweden, the Sveriges Riksbank, which acted as the source of funding for government operations and was answerable to the political leadership. Modern central banks operate on the model created by Charles Montagu, which operated in the Bank of England. Montagu’s model operated on the subscription of people to the government’s loan, which would guarantee the subscribers incorporation as attracted certain privileges like banking notes. Central banks evolved with increasing public outlook and monetary functions to be what they are today. Central banks operate on the cumulative process that creates quantity theory. This theory was developed by Henry Thornton, to explain the England’s monetary crisis of 1797, with reference to the bank withholding withdrawal of notes from the bank (Rosaveare 34). The Bank Charter of 1844 gave the Bank of England the monopoly over issuance of banknotes and the reserves which any financial institution should have in the bank before issuing a certain value of banknotes (“The Bank” n.pag).19th century witnessed the spread and growth of central banks spread in many European countries. The Banque de France was established in 1800, the U.S. Federal Reserve in 1923, Australia, Mexico, Chile and Colombia established in 1920, 1925 and 1923 respectively. Prior to the Great Depression, only a few countries like New Zealand, China and Brazil had not established central banks. All central banks are government owned entities. The central banks play crucial roles in the economic growth of countries. 1.1. Roles of the Central Bank before the 1930s The Bank of England and the Baroque de France were some of the oldest banks that were created to control the monetary policies of the countries. Theorists like Henry Thornton and Charles Montagu were the early central bank advocates who theories established the means by which central banks could impact on the financial stability and lending rates of financial institutions. Central banks by then dealt with how to control monetary panic and stress and adherence to the gold standards. Central banks acted as the place where discounts could be turned to bills that could be used in trade. As early as 1797, the Bank of England had established control of money circulating in the economy when it denied bankers to withdraw their money due to panic. This was the first role in ensuring that the central bank maintained reserves. Central banks sold out stocks, bills and other liabilities to the investors. The era also saw the attempts at regulating the financial stability and price stability by introducing discounted bills by the bank (Rosaveare 33-35). As a measure of stabilizing inflation, the central bank also controlled the amount of currency circulating among the people. However, these central bank roles served purposes of providing funds for warfare as well as reducing as managing the countries’ debts created during the wars. The lackluster performance of the central banks paved the way for monetary ignorance that characterized the 1920s and early 1930s. The influence of political power on monetary policies took toll on the roles of central banks, which failed to check the amount of money and regulate the prices and lending rates. With little regulations over the expansion of market economy aided by unregulated monetary policies, the market economy over-extended its boundaries in 1920s. The result was the boom and the crash of the economies in 1929 and the ensuing Great Depression which followed. The central bank gained considerable independence from the political influence (McKinnon 2-4). 1.2. Roles of central banks in 1930s to 1980s The Great Depression and fall of gold standard allowed central banks to take control over lending. Further, central banks played a crucial role in influencing monetary policies through providing advice to government. The evolving nature of central banks’ roles not only influenced the economic growth but also checked and mitigated reoccurrence of depressions. The central bank became the stabilizer of economic growth through directly influencing monetary policies and funding government activities. The Great Depression gave central banks the role to control the flow of money in the economy mainly to control inflation. This allowed the central banks to fight recession by limiting the amount of money thus regulating growth of money surplus, spending of people and reigning on taxation as ways of lifting the economy. Central banks became main tools of fiscal regulations and stabilizers of the economy. They controlled money supply, price and financial stability, lending rates and other important economic functions. Central banks were crucial in reinstating economic growth that had been dealt a blow by the Great Depression of the 1930s (McKinnon 3). The central bank has continued to evolve and enabled economies to retain flexibility and elasticity in reaction to changing economic times. This period was influential in determining the future of central banks and the roles they play in the economy. However, political influence continued to dominate roles of the central banks with dire consequences. Fiscal policies were used to stabilize economic growth and were controlled by the political leaders with the help of the advice of the central bank. In 1960s, high unemployment rates, inflation and huge government deficits weakened the fiscal policy efficiency and with it the control of economy by the political leaders. A change was needed to change the influence of politicians on the economy. The adoption of the monetary policy handed the central banks their main role in directing economic growth. Regulating money supply through issuing of notes, keeping the countries’ reserves, regulating commercial banks, lending and financing governments and regulating lending rates became the roles of the central bank. 1.3. Roles of the central bank from 1980s to present Central banks have continued to perform crucial roles in the economic growth of countries. The roles continue to evolve with time moving from one phase of economic growth to the other and ensuring that countries respond to changing economic times. The current roles were shaped by the shift from fiscal to monetary policies as the major method of regulating economic growth. As time goes by central banks have maintained considerable independence from the political influence that was detrimental in the 1960s. Central banks differ in organizational structure from one country to the other, although the functions are the same. The central bank is the chief issuer of banknotes and thus regulates the amount of currency circulating in a country. The bank has jurisdictional powers to issue a country’s currency notes thus checking the volume of circulating currency and maintaining price stability, inflation level, and value of the domestic currency as compared to other currencies and the external value. The bank’s power to issue notes allows it to regulate the supply of legal tender money, thus influencing the elasticity of the currency system and enabling it to react to other global economies (Evanoff et.al 7-10). The bank’s power over notes issuance enhances public’s trust on the country’s monetary system as well as maintaining a uniform monetary supply throughout the country. The power also enables the central bank to maintain circulation of currency at the optimum level allowing flexibility in reaction to different economic situations. The power also checks on inflation thus maintaining both internal and external value of the country’s currency. The central bank is regulated to issue currency is different systems; fixed and minimum fiduciary systems, and proportional and foreign exchange reserve systems. These systems are used in different times of economic situations. The central bank is the bank of the government. The central bank stores money for the government and lends it to both central and state governments. It is the agent and advisor of the government and stores the government surplus after expenditure. The bank keeps check on the government monetary needs and collection of taxes by bridging the gap through various ways. The government reacts to monetary issues, makes policies and enacts them from the central bank’s advice. The bank is the chief collector of government money, manages government debts and is the financial agent of the country. The central bank is the banker of financial banks in the country. The bank acts as a vault to commercial banks through maintaining certain set reserves of the smaller banks. This function enables the bank to control lending and influence the credit structure, ensure and promote liquidity and avail the reserves quickly for use by banks in times of crisis. The role also strengthens the banking industry of the country. The central bank stores nation’s reserves, which include foreign exchange currency and gold. The currency value depends on the gold or foreign exchange reserves and thus, central bank must maintain a considerable reserve to maintain the currency value. Through this role, the bank manipulates the lending rates. Currently, foreign exchange manipulation is the chief role of central banks. Central bank acts as the last alternative of lending and the chief source of financing. Commercial banks get loans from central banks as the bank of rediscount, which is the conversion of credit in the banks to central bank credit. However, central bank is responsible for lending to insolvent banks (Buiter 10, McKinnon 12-13). The central bank is the chief-auditor and clearing agent of a country’s economy. Commercial banks accounts are inspected by the central bank, which allows it to settle inter-bank indebtness. The central bank settles debts between banks by transferring reserves of one bank to the other. This ensures that banks remain stable and profitable, reduces risks involved in transfer of money using inter-bank cheques, and keeps banks’ reserves at check. This also promotes inter-banks cooperation as the major monetary players in the country. The central bank is the principal source of economic information. The bank maintains records and statistics about the country’s economic activities and releases them to the public in form of publications. It also provides information on government monetary policies. The central bank is the chief determinant of economic growth in a country. The bank finances various profit-oriented projects like banks, agricultural sector developments and other projects. The bank checks inflation, price stability, promotes growth of the banking industry and thwarts trade risks. The central bank also controls the credit creation of commercial banks that influences the rates and thus the accessibility of credit by the public. This is crucial in enhancing development and economic growth of a country. The functions of the central bank continue to expand as economies look for new ways to expand and the globalization of the economy in the world (Buiter 2-4). 1.4. Different roles of central banks in UK, Japan and Germany The Bank of England in UK is the oldest central bank in the world established in the 1694. The bank is owned by the Treasury Solicitor on behalf of the government. The bank has some independence but is under the treasury, which has powers to influence the monetary powers held by the bank’s Monetary Policy Committee (MPC) (“The Bank” n.pag). Major functions of the Bank of England are; monetary stability, financial stability, and assets purchase. The bank maintains monetary stability by stabilizing prices and money supply. Prices are maintained by matching increases with government’s inflation budget, achieved through regulating interest rates. The bank maintains financial stability through offering a buffer to the country’s financial system. The bank surveills and collects intelligence to predict both national and international threats. The threats are used to develop relevant financial buffer processes that enable the country to mitigate the threats (Buiter 3). It achieves through lending, having monopoly over issuance of bank notes, managing foreign and gold reserves, offering banking services for the government, and regulating lending rates. The bank also regulates banking and insurance industries. Since 2009, the bank buys high-quality assets that are financed by treasury bills and Debt Management Office (DMO) cash operations under the Asset Purchase Facility (APF). This is meant to improve liquidity and strengthen the credit markets. The bank also operates the Quantitative easing (QE) funds under MPC. The functions are devolved to the Bank of England ASF Facility Fund Limited (BEAPFF) (“The Bank” n.pag). The Bank of Japan has legal independence. The major roles include financial stability, regulation of monetary policies and advising the private and public sectors. The bank regulates lending and helps financial institutions through wiping out non-performing loans. The bank also facilitates inter-bank cooperation, funds important expansion of financial institutions and monitors government measures in the economy. The bank also supervises the commercial banks through auditing accounts, settling indebtness, providing a common playing field, and lending rates. The bank also regulates inflation through checking money supply regulation and maintaining reserves. The bank also determines the exchange rates of the currency through maintaining reserves in the bank (Evanhoff et.al. 85-92). The Deutsche Bundesbank is the central bank of Germany entrusted with among other roles, note issuing, banking for the banks, clearing house, commercial banks’ supervision, government’s bank, and the national vault. The bank’s roles differs with other central banks in that it does not maintain financial stability nor does it act as the lender of (Rosaveare 34) resort. On note issuing, the bank only provides money for the economy, maintains notes and coins, checks money delivered by banks and security agents and hands it over to the police and provides information via weekly bulletins on security mechanisms for money. The bank banks commercial banks money in the deposit facility and enhances cross-border money transactions. Together with Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), Germany’s financial regulator, the bank supervises commercial banks. The bank provides banking services for the federal government, states, local authorities and statutory social security zones. Non-money securities that include gold reserves, foreign exchange, and foreign bank credits are stored by the bank (BaFin n.pag). 2.0. Central bank relationship with the economy and independence 2.1. The relationship of central bank with other economic systems The central bank is the chief financier of major government activities and facilitates development of profitable private activities. The central bank policies indirectly affect the other economic activities. The central bank has several monetary and fiscal policies that affect the functioning of major financial institutions, which consequently affects the economic activities. The central bank regulates lending rates by financial banks, which facilitates accessibility of loans for funding other economic activities like agriculture and small businesses. Monetary policies affect the employment rates, which also have a direct effect on the buying ability of individuals, thus affecting people’s economic activities (Eijffinger and Haan 15). The central bank monetary policies affect activities like open market operations, which have direct effects on the economy. The central bank plays a significant role in providing funding for both government activities that aim at generating more income for the people and for the growth of the economy. The central bank funds operations like agricultural investments, growth of financial institutions and other relevant infrastructures that affect the economic activities of a country. The central bank also determines the currency exchange value that the home currency trades at. The bank holds reserves that are the determinants of the currency value. The bank holds reserves relative to the value of the currency. Central banks play a crucial role in checking prices and currency flow in the country. Through these measures, the central bank checks inflation and regulates increases in prices relative to the government’s deficit. The central bank regulates the commercial bank operations by requiring them to hold certain amount of reserves that is crucial in ensuring that the public money is not wasted in case of the banks’ failure. The central bank power enables it to enact measures to mitigate the occurrence of economic crisis in a country. The growth and stabilization of the economy plays a major role in enhancing growth of other economic sectors. The central bank is the chief regulator and stabilizer of the growth of the economy (Eijffinger and Haan 4) 2.2. Advantages and disadvantages of central bank independence In many countries, the central bank maintains considerable independence mostly from the political influence. Although, the central bank cannot run in utter independence, most countries have rules to prevent it from political influence. There are numerous benefits of having an independent central bank. Independence enhances development of policies that offer long term benefits to the economy of a country. Economists argue that political interference may cause a boom and bust effects in the economy so as to favor politicians during elections (Eijffinger and Haan 4). The Thatcher government targeted lowering inflation, increasing economic growth, exchange rates and even balance of payments. Using short-term remedies, the government affected the economic badly. In 1980, the government increased interest rates to reduce inflation. In 1987, the move caused the stock market crash, which then led to increase of interest rates to boost economic growth. The central bank independence increase publics’ trust in the economy allowing them to invest more which encourages economic growth. The central bank independence allows for the development and enactment of policies that enable the economy of the country to adjust to different economic periods. The central bank plays a pivotal role in ensuring that a country’s economy is flexible and elastic enough to react to various situations. The bank’s long sightedness enables it to ride over political terms to create policies that affect the future of a county’s economy. Central banks’ independence provides a buffer between the creation and use of money. In politically influenced central banks, the power to create money and spend is unequally balanced. Government may be tempted to create the money they want to spend or spend all the money created. In history, there are numerous episodes where political influence has ruined economies of countries (Eijffinger and Haan 5). There are few disadvantages of central banks’ independence. Many of these disadvantages are rooted in political debates. However, total independence may have consequential effects through abuse by the managing entities. The central bank has several types of independence. They include; functional independence that gives its autonomy over monetary policies, instrumental independence, which gives it power over inflation control and related instruments, financial independence, which gives it power to control its own expenditure (Eijffinger and Haan 1-3). Conclusion The central bank is an important body in the economy of a country. Since the 17th century, central banks have evolved in size, power and functions to what they are today. Despite the different structural forms, central banks in most countries have the same functions. Roles range from regulating money flow, lending rates, checking inflation, stabilizing economic growth to developing policies that have direct influence on the economy. The roles of central banks influence indirectly or directly other economic activities. Its role in economic growth has a direct influence on other economic systems. The influence of politics on the roles of central banks has been detrimental over the years. Thus central banks need to have some forms of independence for them to function effectively. Works cited Evanoff, Douglas, et.al. (Eds.). The Role of Central Banks in Financial Stability. How Has It Changed? World Scientific Studies in International Economics. Singapore: World Scientific Publishing Co. Ltd, 2013. Print. BaFin. Federal Financial Supervisory Authority, 2014. Web. 26 March, 2014. Eijffinger, Sylvester and Haan, Jacob. The Political Economy of Central Bank Independence. Special Papers in International Economics, 19. Princeton, NJ: Princeton University, 1996. Print. The Chancellor of the Exchequer. Bank of England Bill. Order of the Second Reading. The Hansard, Dec. 29, 1945. Web. 26 March, 2014. Bank of England Act 1998. Legislation.gov.uk. 2014. Web. 26 March, 2014. Rosaveare, Henry. Financial Revolution 1660 – 1750, The Seminar Studies. New York: Routledge, 1991. Print. Buiter, Willem. The Role of Central Banks In Financial Stability: How Has It Changed? Discussion Paper Series, 8780. London: Centre for Economic Policy Research, 2012. Print. McKinnon, Ronald. The Role of Central Banks in Fostering Economic Growth. Diss., 2006. Web. 26 March, 2014. Read More