The Key Roles of the Central Bank in an Economy - Literature review Example

The key roles of the central bank in an economy Introduction Although central banks are owned by the governments, they are often treated as separate entities from the ministries of finance. For central banks to function properly, they must be free from political influences. This implies that central banks have legal freedom from the ruling regimes. This is despite the fact that they are mandated the responsibility to transact government financial matters such buying and selling of government bonds. However, this does not suggest that there is a homogenous connection between central banks the respective ruling governments across the globe. Each country has its own unique relationship with its central bank, and such relationship may fifer significantly from one country to another. But there is one thing in common though. All central banks have the responsibility to oversee the operations of both banking and monetary systems across several countries globally. This article seeks to examine how central banks influence the economies of various countries all over the world. The Influence of the Central Bank on the Economy Central banks play two critical roles in shaping the economy of a nation. One of the functions is that it plays the regulatory role to control the inflation and ensure price stability. In this case, the central banks can be viewed as playing the macroeconomic functions. The second role played by the central banks in controlling the economy of a country is that it is a lender of the last resort. This role is defined as the microeconomic function (Cecchetti and Krause 2012). Macroeconomic Function of the Central Banks The baseline function of every central government is to ensure price stability. It is noteworthy to observe that it would deleterious to leave the financial and economic systems to operate on their own terms and rules. To curb down a possible case of extreme eruption of uncontrollable detrimental situation, the government steps in to take control through the central banks. Cecchetti and Krause (2012) explain that the work of a central bank is to ensure that they conduct monetary policies that enhance price stability, encourage sustainability of economic growth and development as well as ensure that the financial systems are stable. The central bankers can achieve their objectives of ensuring price stability by enacting specific objectives which include maintaining low and stable inflation. On this note, Mishkin (2000) argues that low and stable inflation is very helpful to the economy. When the prices of public goods are stable, the investments in the financial sector are significantly reduced or eliminated. In economies with high inflation rates, the investments in the financial sectors play the roles of middlemen to elevate profit margins. As a result, they enable both businesses and individuals to dodge some of the costs associated with inflation. Stable prices reduce the uncertainty that surrounds levels of current and future prices. As a result, the ease of decision making for both companies and individuals is elevated hence improving economic efficiencies (Mishkin 2000). These are clear indications that by maintaining low and stable rates of inflation, the central banks can effectively improve the economy by increasing the levels of resources that are vital for the growth of businesses and individuals. Kibmer and Wagner (1998) suggest that the essence of the independence of central banks is to ensure stability of the financial institutions and market. In this case, the central banks conduct the transactions associated with the open market. Such open market transactions can either absorb surplus funds from circulation or add more liquid cash into the system. In either way, these factors alter the rate of inflation. Subsequently, the central banks can purchase government bills, bonds, and any other government owned notes as a mechanism to increase the level of money that is in circulation or to lower the interest costs for borrowing. In order to reduce the amount of money in circulation, the central banks sell the government bonds in the open market. It is evident that by so doing they can obtain the money that is trapped in circulation. This can also be achieved by increasing the rates of interests, so that the members of the public and companies may be discouraged from borrowing. By controlling inflation, the central banks play a critical ole in shaping the economy. These perspectives indicate that inflation, price stability and controlling the amount of money in circulation are some of the ways through which the central banks can achieve this objective (Kibmer and Wagner 1998). In order to ensure consistency in delivering their mandates with regard to controlling the prices of public goods, most central banks formulate committees that constitute of various stakeholders. The main function of these committees is to ensure financial stability. They are very instrumental when it comes to obtaining information that is critical in making well informed decisions that are likely to lead to financial stability. Maintaining the stability of prices is a crucial mechanism for improving the worthiness of currency either as store of revenue or unit of account (Kibmer and Wagner 1998). The objectives of the central banks are often associated with economic interests. In this case, the central banks are expected to act in the best interest of the government and be congruent with the policies of the central governments that uphold the economic development of a nation. The earliest central banks in history were basically associated with issuance of banknotes and being the banker of governments. The central banks of various nations pioneered the functions of restoring the stability of monetary systems as well as the banknotes credibility past periods of collapse of convertibility or the or overissuance. While pursuing monetary stability and enhancing the credibility of the currency systems, the central banks lay the vital foundation for economic stability. According to Ghan and Segalla (2013), the central banks have played a significant role in keeping up with financial, economic and national debts of various countries over the years. Besides the performing the functionality of mobilizing funds on behalf of the federal the central banks are also known for the purpose of controlling both the internal and external debts. The central banks perform these functions by monitoring the level of internal debts while making sure that the external debts do not escalate by servicing them. In this case, they work hand in hand with the ministry of finance to provide advisory service to the respective central governments. With regard to maintain the internal debts, the central banks offer various significant services such as advising the government to adopt policies that will salvage the nation from chronic debts. Such policies may include advising the ruling regimes to allow the new issues be subscribed by the public through advertisements, advise the central governments on how timing emerging debt avenues, paying principles and interest rates at an apposite time to prevent them from cumulating,. The central banks can also act as the overseers of the government debts by monitoring the maturity of stocks and redeeming those that are due. Another way through which the central banks ensure economic stability of a sovereign state is through effective management of the foreign exchange. Resources designated for foreign exchange can be acquired and issued as a mechanism of minimizing the short term-effects of the flows of capital in an economy. The foreign exchange reserves of central banks of most countries are often limited. The central banks devise the policies that ensure proper employment of the scarce foreign exchange reserves as to streamline the utilization of the resources and their subsequent disbursements with economic goals. In this way, not only to the central banks manage a nation’s external reserves, they also ensure the stability of the local currencies of the respective country (Mishkin 2000). Microeconomic Influences of the Central Banks The central banks are essentially established to be the lenders of the last resort. As a result, this has significantly advocated for their freedom from the influences of the ruling governments. Every nation has a series of commercial banks and other financial institutions that lend money to their clients. In most cases, the clients of commercial banks and financial institutions are served on the facets of first come first serve. It is essential to note that commercial banks and the financial institutions do not always have sufficient monetary reserves that is equivalent to the whole market or it their customer base. As such, in cases where the commercial banks and the financial institutions do not have sufficient liquidity to satisfy the demand of clients, they run to the central banks where they can borrow extra funds to meet their shortages. From a critical perspective, this ensures the stability of the financial system of a nation. This is probably due to the fact the central banks do not act in favour of any particular bank or financial institution, but treats all of them on the basis of the deposits they remit to the central banks. This is also another avenue of controlling the amount of money in circulation in a given economy. However, this does not imply that central banks rely on the reserves of the commercial banks. For instance, in some countries such as The United Kingdom do dot practice such policies while the United States exercise it. Peek, Eric and Geoffrey (2003), argues that the failure of the microeconomic system encouraged by the banks that were basically liaises-faire on how they handle matters associated with financial innovation. According to Ronald (2011), the laissez-fair leadership style that encourages the id3eology that the employees should be granted absolute freedom and to allow them to act on their own course with minimal or no control. In the same way, the banks and other financial institutions were not taking control of their financial innovations. Although for a time this proved to be very profitable, it led to market failure, moral problems and agency problems. The market failures imply that the competitive forces of the have been weakened and have become unreliable with regard to the provision of a standardized system that are in line with stability policies. The central bank plays a key role in this case as the regulators of the activities of commercial banks, and other financial institutions. The central banks set the basic lending rates, which translates to the interest rates. This rate that the commercial banks and other financial institution can obtain from the central banks in the form of loans is referred to as the discount rate (Briault 1995). The discount rates play a critical role in shaping the efficiency of the open market. For instance, the discount rate bars the financial institutions and the commercial banks from consistent borrowing of the funds from the central banks. As a result, the central banks can effectively control the amount of money in circulation. Allowing the commercial banks to borrow too much money infiltrates the system with surplus funds in the system which is likely to lower the monetary value. Therefore, raising the discount rates discourages the commercial banks and other financial institutions from borrowing. In turn, this withdraws the amount of money in circulation (Briault 1995). Controversies Surrounding Lenders of the Last Resort Gnan and Segalla (2013) observe that lender of the last resort is the most controversial role of the central banks. The controversy arises in a twofold aspect whereby on one hand, the primary responsibilities of the central banks are to ensure financial stability of the commercial banks by providing emergency liquidity assistance. The central banks possess the unique ability to develop and hold liquid assets in the central liquid assets. The core responsibility of the central banks in this instance is to position themselves in the payment systems as well as upholding and ensuring the stabilization of the macroeconomic objectives. On the contrary, the central banks, the functionality of the central bank as the lender of the last resort is on the other hand viewed as the most risky role. Gnan and Segalla (2013) argue that lending money to the commercial banks and financial institutions create moral hazards and erode the boundaries associated with fiscal policy. In addition, it is argued that lending money to the commercial banks and the financial institutions, places the commercial banks to a big financial risk. Offering liquid assistance to the individual financial institutions and commercial banks enhances reputations risk. The contemporary financial crisis raises the significance of the central banks as the lender of the last resort in ensuring financial stability. This also raises significant questions over the frameworks of the lender of the last resort the performance of the policies regarding the same. The major challenge is realised when it comes to striking a befitting balance between reducing the risks faced by central banks and ensuring the proper functionality or implementation of the lender of last resort objectives (Goodhart 1998). In addition, whether the central banks should be equivocal concerning the terms and conditions associated with lending liquidity assistance is still not clear. Furthermore, there is no proper or standardized lender of last resort policies as a financial stability strategy across borders. The international debt condition being witnessed also serves as another avenue for the controversies that surrounds the functionality of the central banks as the lenders of the last resort. The economic analysts perceive that there is a possibility the central banks may not be effective as far as controlling the external reserves of sovereign states is concerned. In this perspective, it can be argued that countries are persistently defaulting payments of external debts because of the inefficiency of the policies of the central banks (BIS Papers No 79 2014). Baltensperger (2007) observes that the functions of the lender of last resort are often treated with differing definitions and understanding. For this reason, the discussions’ surrounding this function of the central bank is often clouded by semantic problems. Similarly, the clarifications regarding the lender of the last resort functions of the central banks are characterized by ambiguity. As a result of this lack of clarity in the lender of last resort role of the central bank, there are critical issues that are left undetermined. For instance, it is not properly resolved with lender of last resort role is a financial function or a banking function. This implies that it is not certain whether the central banks’ role of lender of last resort is only limited to individual financial institution and commercial banks or whether it includes the open market in general. Conclusion It is popularly acknowledged that central banks are independent overall financial controller with the core responsibility of ensuring price stability. The major pillars of the central banks lie in their ability to curb inflation, controlling the amount of money in circulation in a particular economy and to manage the foreign reserves. Through these mechanisms, the central banks play a vital role in shaping the economy of a country. For instance, controlling the amount of fund in circulation is important. It ensures that the amount of money flowing within the economy is neither too much nor too little. The Excessive amount of money in circulation dilutes the economic value of a currency. As a result, by withdrawing the surplus money in the flow, the central banks protect the economic values of the currency of a given nation. All theses are performed in pursuit of stabilizing the monetary policies. However, the functionality of the central banks as lender of last resort is surrounded by a number of significant controversies and uncertainties such as like of conventional policies regarding this particular function References Baltensperger, E. 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Goodhart, C.A.E. 1998, ´The two concepts of money: implications for the analysis of optimal currency areas´, European Journal of Political Economy, Vol.14, 407–432. Gnan, E. & Segalla, E. 2013, A Changing Role for Central Banks? Key findings from the 41st OeNB Economics Conference,Vienna, June 10 and 11, Retrieved from < http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&uact =8&ved=0CB4QFjAA&url=http%3A%2F%2Fwww.oenb.at%2Fdms%2Foenb%2FPubli kationen%2FVolkswirtschaft%2FResearch- Update%2Fpublications_of_the_economic_analysis_and_research_department%2FPubli cations%25202014_4_FIN.pdf&ei=- k0mVeKJI4XfauKZgaAB&usg=AFQjCNFHtnwD29PfEvxYIFcJNH1Ymrb3lA&sig2=v nJqWoH9V7Q9QIHBcnwkbA&bvm=bv.90237346,d.d2s> [April 9, 2014]. Kibmer, F. & Wagner,H. 1998, Central Bank Indipendance and Microeconomic Performanec: A Survey of the Evidence, Retrieved from [April 9, 2014]. Mishkin, F.S. 2000,What Should Central Banks Do? Retrieved from < http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&uact =8&ved=0CB4QFjAA&url=http%3A%2F%2Fwww.tek.uni- corvinus.hu%2Ffiles%2Fszovegek%2Fmishkin_what_should_central_banks_do.pdf&ei= mkomVY0vg_Jqq96AeA&usg=AFQjCNElZ6eKJIHk- dcal36ZmADMcCxijQ&sig2=vers6bFrG1Vn4_9Eki883A&bvm=bv.90237346,d.d2s>[A pril 9, 2014]. Peek, Joe, Eric S. R. & Geoffrey M. B. 2003, “Does the Federal Reserve an Exploitable Informational Advantage?” Journal of Monetary Economics, Vol. 50,pp. 817–839. Ronald,G.2004, Laissez-Faire Leadership,Retrieved from http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&uact =8&ved=0CB4QFjAA&url=http%3A%2F%2Fwww.sagepub.com%2Fnorthouseintro2e %2Fstudy%2Fchapter%2Fencyclopedia%2Fencyclopedia3.2.pdf&ei=XzQmVdehC8Xda rHegOAL&usg=AFQjCNGixalMOVOIIvKhjrjTcetF1qMkg&sig2=JGs5EoGsx8pYVfkQ ECtSSQ&bvm=bv.90237346,d.d2s [April 9, 2014]. Read More