Functions of a Central Bank in Modern Economies
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
- Managing the foreign exchange and gold reserves in a country
- Managing the cost of credit and its availability
- Acting as the lender of last resort.
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.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Corporate Finance - Introduction
- Nominal and Real Value of Money
- Fundamental Rules of Corporate Finance
- Present and Future Value of Money
- Net Present Value Calculations
- Compounding Intervals and Interest Rate
- What Are Negative Interest Rates ?
- The Consequences of Negative Interest Rates
- Opportunity Cost of Capital
- Valuing Cash Flows in Different Periods
- What is Perpetuity ?
- Growing Perpetuity
- What is Annuity ?
- Ordinary Annuity vs. Annuity Due
- Types of Annuity Calculations
- What is Bond Valuation ?
- Bond Market Conventions
- How Interest Rates Affect Bonds ?
- Stock Valuation Models
- Discounted Cash Flow Approach
- Assumptions During Stock Valuation
- What is Cost of Equity ?
- What is Payback Period ?
- What is Internal Rate of Return (IRR) ?
- Problems With Using IRR
- Capital Rationing & Profitability Index
- Types of Capital Rationing
- Capital Controls: Meaning, Types, Benefits and Downside
- Estimating Project Cash Flows: Part 1
- Estimating Project Cash Flows: Part 2
- Estimating Project Cash Flows: Part 3
- Capital Budgeting and Inflation
- Capital Budgeting and Depreciation
- Equivalent Annual Costs
- Investing and Financing Decisions
- Getting Creative with Capital Budgeting
- The Fallacy of Creative Destruction
- Companys Risk vs. Project Risk
- How Governments around the World are Bankrupting Future Generations for Present Consumption
- Role of Credit Rating Agencies in Determining Attractiveness of Companies and Countries
- Federal Reserve Announcement to Taper Quantitative Easing
- How Do Funds Transfer Systems Work
- The Importance of KYC (Know Your Customer) Norms and Procedures in Banking
- Difference between Corporate, Retail, Investment Banking, and Private Banking
- Impact of Geography on Banking and its Functions
- Functions of a Central Bank in Modern Economies
- Lease Rental Discounting
- Lending Against Intangible Assets
- Real Reasons behind FDI in Retail in India
- Microfinance: A Cure for Poverty
- Microfinance: Indebting the Poorest in the World
- Behind the Scenes of an Initial Public Offer (IPO)
- Pros and Cons of Going Public
- Snapchat IPO: Is this the New Tech Bubble ?
- Benefits of Delaying Profitability
- Why Do Corporations Get Away With Tax Avoidance ?
- After Effects of the Nirav Modi Scam
- The Panaya Acquisition
- The Flipkart and Wal-Mart Alliance
- The Worlds Largest IPO
- Initial Coin Offerings: A Primer
- The Aftermath of the Qualcomm Deal
- What are Demergers: Its Pros and Cons
- Benefits of a Holding Company
- The Economics of Lawsuits
- Protectionist Sentiment over Flipkart Takeover
- The Impact of Tariffs on the Energy Sector
- Venture Debt A Primer
- Interest Rates and Automobile Sales
- How Should Companies Communicate With Wall Street?
- How an Interest Rate Hike Will Affect the Government of USA
- Is Tesla Close to Bankruptcy?
- Myths Surrounding Toys R Us Bankruptcy
- The Economics of 'Soda Taxes'
- Why Elon Musk's Tesla Should Go Private and Why It Won't?
- Why the Xiaomi IPO Failed?
- How A Whatsapp Message Nearly Took Down A Company
- The Case for Index Funds
- The Sears Bankruptcy
- The Socialization of Losses
- The Sudden Downfall of IL&FS
- Why Healthy Corporate-Regulator Tussle is Good for Free Market Capitalist Economies
- What Happens When Businesses Go Bankrupt? Insolvency, Aftermath, and Recovery
- Alibabas Singles Day
- Ubers New Businesses
- Goldman Sachs and the 1MDB Scandal
- The Amazon Divorce
- Are Index Funds Not A Good Investment In India?
- Can Brick And Mortar Stores Compete With Amazon?
- Why is the Fed Still Raising Interest Rates?
- Problems Related to Facebook, WhatsApp, and Instagram Mega Merger
- The Whatsapp-Facebook-Instagram Merger
- What Is The DHFL Scam?
- Financial Troubles In the Fracking Industry
- Flipkart Circumvents Indias FDI Norms
- Subprime Automobile Loans in America
- The Jaguar Land Rover Debacle
- The Kraft - Heinz Fallout
- Why Uber Should Be Regulated?
- Is Regulation of the Tech Sector Long Overdue with the Tech Giants being Too Big
- The Fall of An Ambani Scion
- Litigation Funding: A Primer
- The Finance behind the Plastic Problem
- The MasterCard Visa Duopoly
- Is the Lyft IPO Overpriced?
- The Alliance between Car Companies and Ride Hailing Apps
- The Amazon Divorce Deal
- The Lawsuit Between Spotify and Apple Corporation
- The Story Behind the L&T- Mindtree Takeover Bid
- Do IPOs Affect Competitive Firms?
- Can Cost Cutting Turn Out To Be Expensive?
- The Economic Impact of Facebook Outage
- The Apple-Qualcomm Legal Battle
- Cross Border Credit Reporting
- The Sudden Deluge of Unicorn IPOs
- The Wow Airline Debacle
- The WeWork Business Model
- Problem with Private Securities Offerings
- The Amazon FedEx Breakup
- The Decline of the Big Corporation
- The Gap-Old Navy Breakup
- Apples Acquisition of Intels Modem Business
- Mergers and Acquisitions: A New Perspective
- The CBS-Viacom Merger
- Why are Sprint Wireless and T-Mobile Funding their own Competition?
- Why are Corporations Hoarding Trillions in Cash?