What do Central Banks do?

A central bank, also called a reserve bank, is an institution responsible for managing the currency, money supply and interest rates in a country. Central banks also supervise the banking system within a country. Some examples of central banks are Federal Reserve Board in the US, European Central Bank (ECB), People's Bank of China, and Reserve Bank of India (RBI).

In this article we will take a look at the roles and responsibilities, and goals of central banks.

Roles and Responsibilities

The central banks perform several key roles.

  1. Implement monetary policy: The central bank is responsible for managing the monetary policy of the country. This involves controlling the quantity of money supplied in the economy through various actions such as managing interest rates, setting reserve requirements, etc.
  2. Supplier of currency: Central banks are the sole suppliers of currency in a country. Central banks create money by printing and issuing currency notes and selling them to public in exchange for debt instruments such as government bonds.
  3. Determine interest rates: A central bank controls the short-term interest rates, which in turn affects the stock markets, bond markets, and other financial markets.
  4. Manage the country's foreign exchange and gold reserves: The central banks are also the holders or safe keepers of the foreign exchange and gold reserves of the country.
  5. Banker for the Government and other banks: The central banks also act as the banker for the government and other banks. They also supply money to other banks with shortages, to avoid any runs on the banks. This way they keep the banking system from failing and act as the lender of last resort.
  6. Regulate and supervise the banking industry: The central banks regulate the banking system by imposing capital requirements, reserve requirements, and other regulations. They also manage a country's payment system to ensure smooth transactions.

Goals of Central Banks

Central banks have several goals.

  • Control inflation to ensure price stability
  • Stabilize exchange rates
  • Improve employment
  • Achieve sustainable economic growth
  • Moderate long-term interest rates

Most countries try to achieve a target inflation rate of 2-3%. A 0% inflation rate is not desired as it increases the risk of deflation.

Some countries are not able to achieve their goals because of several factors. For example, Japan has had a persistent problem of deflation. India is currently facing a very high inflation rate of 7.2%.

Some developing countries peg their exchange rate of currencies to other countries, mostly the US dollar. This also pegs their inflation rate to the inflation rate of the country to which the exchange rate is pegged.

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