Central Banks - What are they, Definition and function

Central banks are the entities that have a monopoly on the production and distribution of official money in a nation or bloc of countries. In turn, it is the institution that dictates monetary policy to regulate the money supply in the economy.

In other words, the central bank issues the notes and coins that then reach consumers. In addition, it uses various instruments (which we will explain later) to control the amount of money that circulates in the market.

In general, central banks are financial institutions that are responsible for supervising and controlling the functioning of the financial system. And, more specifically, regulate the amount of money that exists in circulation.

Characteristics of central banks

The main characteristics of the central bank are:

It is an entity independent of any political power. For that reason, their decisions do not depend directly on the government in power, but on a directory. This body, however, is sometimes appointed by another institution such as parliament, so there is always the possibility of political interference.
It follows the mandates of their statutes. For example, keep annual inflation between 1% and 3%. These goals are established by the State and should last in the long term, even if the authorities in power change.
In recent times, they have played a key role in dealing with economic crises. For example, the Federal Reserve in the United States implemented between 2010 and 2011 a quantitative stimulus plan. This consisted of buying government bonds for 600 billion dollars to inject liquidity into the system.

Central bank functions

The functions of central banks can be summarized in five:

Take care of the monetary issue

In reality, the monopoly in the monetary issue has historically been the function that has originated the emergence of central banks.

So, in this function, the central bank becomes the only entity authorized to issue money and put into circulation or withdraw the money called legal tender.

Government banker

On the other hand, the government banker function of central banks can be divided into two sub-functions:

a. General banking services

On the one hand, the central bank, in its role as the banker of the Government, works like any bank with its account holders, only in this case its only account holder is the Government.

Of course, for this function, it can make collections and payments corresponding to the operation of the public administration, and also settle state accounts.

b. Government Financial Agent

Likewise, in this subdivision, the central bank also grants loans to the Government, that is, internal public debt is generated.

This credit granted to the Government is also a way of carrying out monetary expansion, so it could also have an inflationary impact.

Lender of last resort

Regarding the lender of last resort function, this occurs when commercial banks face liquidity problems, so they turn to the central bank as the last option to lend them the necessary funds to solve their financial problems.

Custody of fractional reserves and clearinghouse

As for the clearinghouse, this is a function that consists of settling interbank accounts between all the commercial banks of the financial system, through the central bank.

Undoubtedly, the central bank becomes the bank of banks, since interbank accounts are settled under its supervision.

Custody of foreign exchange reserves

Therefore, in the custody of foreign exchange reserves, the central bank seeks to store foreign exchange reserves within its vaults, with the purpose of achieving stability in the exchange rate.

Since the currency is any foreign currency that is bought and sold in a certain country and the exchange rate is the price of the foreign currency.

In this way, it tries to keep the exchange rate stable.

Central bank instruments

The main instruments of the central bank are:

Reference interest rate: It is the indicator that is taken as a basis to set the interest rates of loans between banks. This is then passed on to clients. So, if the central bank lowers its reference rate, loans between financial institutions will be cheaper and, therefore, loans to individuals will also charge lower interest.
Reserve rate: By law, banks must maintain a bank reserve, which is a percentage of their deposits. This capital must be kept in cash in the vaults of the financial institution itself or in an account at the country’s central bank.
Open market operations: The monetary authority trades financial instruments with commercial banks. If the central bank buys these instruments, it delivers money to its counterparty, injecting liquidity into the system. Instead, if the central bank sells them, it is reducing the money supply.

The central bank uses all these instruments to apply a countercyclical monetary policy. If the growth of the economy slows down, it can, for example, lower its reference interest rate. As we explained above, this makes it possible to make credit cheaper for people. Therefore, loans and family consumption will expand, boosting the gross domestic product (GDP).

Another way to implement a countercyclical monetary policy is to reduce the reserve requirement rate. Thus, banks will have more resources available to lend to the public. Consequently, the credit granted to individuals will increase and private spending will rise.

A third alternative would be to buy securities, such as repos, in open market operations. Consequently, liquidity in the system will increase, increasing the funds available to lend to consumers.

It should be noted that in the case of repos, at the end of the instrument period, the commercial bank will resell the titles to the monetary authority. Thus, it returns the liquidity received by adding interest.

The above can happen the other way around. In case the economy is expanding too fast, central banks can raise interest rates, or increase the reserve ratio to reduce the money supply in the economy.

Origin of central banks

The first central bank is possibly the Bank of Sweden, founded in 1668. But more emblematic was the Bank of England, established in 1694 by the monarch William III with the aim of providing financial support to the crown. However, it was established as an entity managed by private parties and remained so until its nationalization in 1946.

It should be noted that throughout the 19th century several monetary authorities were installed. This is the case, for example, of the Bank of France, created in 1800, and the German Reichsbank, established in 1876. The latter entity lasted until its dissolution in 1945, with the end of World War II.

On the other hand, the first central bank of the United States functioned between 1791 and 1811, and the second was between 1816 and 1836. Both, like the Bank of England, were private entities established to financially support the government. Thus, after more than seventy years without a governing body for monetary policy, the famous Federal Reserve was born in 1913.