The key role of a central bank is to conduct monetary policy which involves changes in interest rates and a technique called quantitative easing to control the money flow in the economy. Quantitative easing is the process by which the government creates money and purchases bonds to increase the quantity of money in the economy. This in turn increases the income of individuals and firms and results in increased demand. A prime example is the Bank of England, England’s central bank, which is separate from its government. They have the aim of achieving stable inflation, during economic boom and busts.
The first central banks were established in the 17th century, including the Bank of England and the Riksbank. Other early central banks, including the Bank of Napoleonic France and the Reichsbank of Germany, were primarily intended to finance the military objectives of their governments. The Bank of England was created to finance the war against France, with King William and Queen Mary as the two original shareholders who said the bank was created to promote the common good and benefit society. It started as a private bank and later became a bank connected to the government.
As well as financing the government's debt, these early central banks also engaged in banking activities. They were the money reserves for bankers, providing services such as banking facilities and facilitating transactions between banks because they held deposits of other banks. Because of their large reserves and extensive correspondent banking networks, they were the money reserve for many banks in the banking system. A fiscal crisis entrusted them with the role of lender of last resort and when their correspondents were facing financial difficulties, they were able to provide emergency cash.
In the later stages of their development, these banks were created to provide financial stability and integration of the different tools that people use for managing their money. Gold was used as a measure of the value of money until the gold standard was abolished in 1914. To comply with their charter, central banks held large gold reserves. If their reserves dwindle due to a balance of payments deficit or an unfavourable domestic environment, their discount rate (the rate at which they lend money to other banks) will rise. Such rate hikes would attract foreign investment, which in turn may bring more gold. Banks were constrained by gold reserves, which limited the amount of money they could supply, resulting in the prevailing price level, and since prevailing prices were tied to commodities whose long-run value was determined by market forces, expectations of future prices were also tied to it. Price stability was a key priority for early central banks. Due to their obligation to maintain the gold standard, they were not overly concerned about one of the modern goals of central banking, real economic stability, where the fluctuations in economic performance, output growth and low, stable inflation are present.
The era of free banking from 1836 to the Civil War was marked by little banking regulation. Several bank panics occurred during this period, and many banks failed frequently. With thousands of counterfeit and different-looking government banknotes circulating, the payment system was notoriously inefficient. It made payments more efficient by adopting a single currency based on national paper money during the Civil War. During this period, however, the bank did not provide as a lender of last resort, and a severe banking panic swept the country. The crisis of 1907 led to the creation of the Federal Reserve in 1913, formally adopting the currency and acting as a lender of last resort.
Financial stability had become increasingly important to the central banks. The development of this responsibility is similar in all advanced countries. During the gold standard era, central banks acted as lenders of last resort, but the interwar financial system became unstable due to the widespread banking crises of the early 1920s and 1930s. In times of banking crisis, European governments typically use public funds to bail out troubled banks. After the Great Recession 2008, every country built a financial safety net, including deposit insurance, interest rate caps, and a firewall between the financial and commercial sectors. As a result, no banking crisis occurred anywhere in the developed world between the late 1930s and the mid 1970s.
In the 1970s this changed very quickly. Innovation was spurred by the Great Inflation which undermined interest rate caps and other constraints. As a result, the innovations increased competition in the economy. Due to several financial failures such as the failure of Franklin National Bank in 1974, the failure of Continental Airlines in Illinois in 1984, and the savings and credit crisis of the 1980s, banking turmoil in the United States and abroad resurfaced. The disruptions caused banks, which were too big, to bail out, potentially increasing moral hazard. Many of these issues have been addressed because of the Deposit Deregulation Act and Currency Control Act of 1980.
Asset booms and busts have resurfaced in modern times. Busts often trigger economic downturns, and stock market booms often occur at the peak of the business cycle. Traditionally, central banks have avoided defusing booms before they degenerate into busts by supplying enough liquidity (liquidity is the ease of which an asset can be converted to currency) to protect the payments and banking systems rather than reacting before, they collapse. When the stock market crashed in 1987, Alan Greenspan (Former chairman of the US Federal Reserve Bank) took this approach. After a crisis, policies should remove excess liquidity.
Modern day central banks:
Money supply is controlled by the Monetary Policy Committee (MPC) in the UK. In their monthly meeting, the nine members discuss what rate of interest should be set. These members are independent of the government. By altering borrowing costs and saving rewards, interest rates contribute to price stability.
Interest rates across the economy are controlled by the bank's base interest rate. Total demand (Aggregate Demand) of goods and services will rise if the base rate of interest is lowered. When the base interest rate is reduced, saving is less attractive because the rate of return is reduced. Due to lower costs of borrowing from the banks, individuals are more likely to consume goods and services and investment will increase. Repayments for mortage interest is lower for consumers therefore they have greater disposable income which can be used to consume other goods and/or services.
When interest rates have minimal/no economic effects, money must be injected into the circular flow of income to encourage expenditure, which in turn can result in demand-pull inflation. Where the demand exceeds supply, therefore increasing the value of the good/service(s). The central bank will buy assets in the form of bonds, bought from investors. This allows for more money to be lent out to firms and individuals since the cost of borrowing is reduced. This is supposed to, in turn, encourage spending and investing to result in economic growth, however, with the risk of increased inflation due to increased demand.
Overall, the role of central banks is to manipulate the money supply by setting base interest rates on bonds and loans which allows for economic stability to occur. Usually, base interest rates are increased to slow economic growth and reduce inflation rates, but they are also reduced to encourage growth, business activity and consumer expenditure. This allows the country to push towards achieving full employment. They also act as lenders for the government in emergency situations by reducing the government budget deficit, which involves an increase in the government revenue.
However, there are negatives to the monetary policy and changing the interest rate might not have the intended effect if banks do not pass on the change to consumers. The changes in demand levels may also take an exceptionally long time to emerge. Consumers may not be able to borrow even if borrowing costs are low because banks are unwilling to lend due to lower business confidence. Banks have become more risk averse after the 2008 fiscal crisis. High consumer and business confidence can lead to increased spending and investment. Despite low interest rates, consumers may be less likely to spend if they think the economy is still risky.
