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A central bank, reserve bank, or monetary authority is a banking institution granted the exclusive privilege to lend a government its currency. Like a normal commercial bank, a central bank charges interest on the loans made to borrowers, primarily the government of whichever country the bank exists for, and to other commercial banks, typically as a ‘lender of last resort’. However, a central bank is distinguished from a normal commercial bank because it has a monopoly on creating the currency of that nation, which is loaned to the government in the form of legal tender. It is a bank that can lend money to other banks in times of need. Its primary function is to provide the nation’s money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system). It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.

Most richer countries today have an “independent” central bank, that is, one which operates under rules designed to prevent political interference. Examples include the European Central Bank (ECB) and the Federal Reserve System in the United States. Some central banks are publicly owned, and others are privately owned. For example, the United States Federal Reserve is a quasi-public corporation.

Activities and responsibilities

Functions of a central bank (not all functions are carried out by all banks):

• implementing monetary policy
• determining Interest rates
• controlling the nation’s entire money supply
• the Government’s banker and the bankers’ bank (“lender of last resort”)
• managing the country’s foreign exchange and gold reserves and the Government’s stock register
• regulating and supervising the banking industry
• setting the official interest rate – used to manage both inflation and the country’s exchange rate – and ensuring that this rate takes effect via a variety of policy mechanisms

Monetary policy

Central banks implement a country’s chosen monetary policy. At the most basic level, this involves establishing what form of currency the country may have, whether a fiat currency, gold-backed currency (disallowed for countries with membership of the IMF), currency board or a currency union. When a country has its own national currency, this involves the issue of some form of standardized currency, which is essentially a form of promissory note: a promise to exchange the note for “money” under certain circumstances. Historically, this was often a promise to exchange the money for precious metals in some fixed amount. Now, when many currencies are fiat money, the “promise to pay” consists of nothing more than a promise to pay the same sum in the same currency.

In many countries, the central bank may use another country’s currency either directly (in a currency union), or indirectly, by using a currency board. In the latter case, local currency is directly backed by the central bank’s holdings of a foreign currency in a fixed-ratio; this mechanism is used, notably, in Bulgaria, Hong Kong and Estonia.

In countries with fiat money, monetary policy may be used as a shorthand form for the interest rate targets and other active measures undertaken by the monetary authority.

Goals of Monetary Policy

Price Stability

Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for inflation. Effort successful if monetary policy able to maintain steady rate of inflation.

High Employment

The movement of workers between jobs is referred to as frictional unemployment. All unemployment beyond frictional unemployment is classified as unintended unemployment. Reduction in this area is the target of macroeconomic policy.

Economic Growth

Economic growth is enhanced by investment in technological advances in production. Encouragement of savings supplies funds that can be drawn upon for investment.

Interest Rate Stability

Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected changes that cause damage, making policy formulation difficult.

Financial Market Stability

Foreign Exchange Market Stability

Conflicts Among Goals

Goals frequently cannot be separated from each other and often conflict. Costs must therefore be carefully weighed before policy implementation. To make conflict productive, to turn it into an opportunity for change and progress, Follett advises against domination, manipulation, or compromise. “Just so far as people think that the basis of working together is compromise or concession, just so far they do not understand the first principles of working together. Such people think that when they have reached an appreciation of the necessity of compromise they have reached a high plane of social development . . . But compromise is still on the same plane as fighting. War will continue – between capital and labour, between nation and nation – until we reliquich the ideas of compromise and concession.”

Currency issuance

Many central banks are “banks” in the sense that they hold assets (foreign exchange, gold, and other financial assets) and liabilities. A central bank’s primary liabilities are the currency outstanding, and these liabilities are backed by the assets the bank owns.

Central banks generally earn money by issuing currency notes and “selling” them to the public for interest-bearing assets, such as government bonds. Since currency usually pays no interest, the difference in interest generates income, called seigniorage. In most central banking systems, this income is remitted to the government. The European Central Bank remits its interest income to its owners, the central banks of the member countries of the European Union.

Although central banks generally hold government debt, in some countries the outstanding amount of government debt is smaller than the amount the central bank may wish to hold. In many countries, central banks may hold significant amounts of foreign currency assets, rather than assets in their own national currency, particularly when the national currency is fixed to other currencies.

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