A central bank is an institution that is mandated by constitutional decree to function along certain principles and entrusted with managing the fiscal side of the countrys economy.
The Fed Reserve and Bank of England are examples of central banks. These banks have many functions, some of which are listed below. The central bank manages the monetary policy and sets interest rates to spur growth and rein in inflation. The role of the central banks has become prominent in these days of globalization and laissez-faire economics since the financial system has become more integrated and needs intervention by the central banks from time to time to keep the system together.
Key functions of Central Bank
The key functions of a central bank are:
Regulating the money supply
This includes regulating the size of the nations money supply and setting the interest rates and other policy instruments to curb inflation and spur growth.
The central banks regulate the money supply by expanding and contracting their assets over a period of time. For e.g. the cash reserve ratio or CRR is used by the central bank to either mop up excess liquidity in the system or inject liquidity in times of low growth. The CRR is the ratio of the reserves that the commercial banks must hold as a proportion of their liabilities. The CRR is a policy instrument that the central bank uses to nudge the commercial banks to maintain a certain amount of liquidity in the system.
Typically the central banks in developed countries do not tinker much with the CRR though this is often a tool for fighting inflation in the developing countries. The example of China and India which use the CRR as part of their monetary policy is illustrative of the central banks intervention in the economy.
Managing the cost of credit and its availability
The central banks manage the cost of credit by using the prime lending rate or PLR and by intervening in the open market to mop up excess liquidity. The main instruments that are available to the central bank are the interest rates that take the form of the main lending rate or prime lending rate as it is known in different countries.
The prime lending rate is the interest rate that the commercial banks would get for short term deposits with the central bank. Since this affects the lending rates of the banks as well, any reduction in the prime lending rate would mean that the commercial banks would also cut their lending rate and this would in turn make the availability of credit and access to credit cheaper.
Managing the foreign exchange reserves
The central bank also intervenes in the foreign exchange market to stabilize the currency in times of foreign exchange turmoil. This takes the form of intervention in the open market to buy and sell the home currency as well the foreign currency. It buys the home currency when the exchange rate relative to the USD is going down and sells home currency when it is appreciating. Though the former option is not used that widely in countries which have export led economies the latter option of selling home currency to keep the exchange rate favorable to the USD is a normal practice in developing countries.
Lender of last resort
The central bank acts as the lender of last resort by loaning funds to the commercial banks that are in a crisis of payments. This has happened recently in the US in the case of the bailout of the investment bank Bear Sterns by the Federal Reserve.
We have seen that the central bank of any country is the key player in deciding the monetary policy of that country. In these times of increased globalization and diverse needs of the investors, keeping the economy afloat is the challenge that faces the central bank of any country.
One of the most keenly watched events these days is when the Fed announces a rate cut or the reverse. The stock markets react immediately as do the other sectors in the economy. The preceding two sections were about how the mortgage rates and the bond prices behave to a cut in the base rate. The monetary policy instruments available to the central bank have to be used diligently and with much thought as far as the outcomes are concerned.
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