Central Bank – Definition

Cite this article as:"Central Bank – Definition," in The Business Professor, updated September 15, 2019, last accessed October 20, 2020, https://thebusinessprofessor.com/lesson/central-bank-definition/.


Central Bank Definition

A central bank is a financial entity that oversees the production and supply of money in a nation, it regulates how money is produced and circulated in the economy. The central bank is aos responsible for the monetary system of a country, it makes monetary policy and regulates money supply and interest rates in banks across the nation.

A central bank, otherwise called a reserve bank manages the entire commercial banking system of a country. It is the monetary or financial authority responsible for the production and circulation of money in the country, this bank enjoys monopoly a it is the only bank that can issue bank notes and cash in a country.

A Little More on What is the Central Bank

Despite that all central banks have a universal function which is to make monetary policy and control the production and distribution of many (cash and bank notes) in a country, they are slightly different across many countries in terms of responsibilities. In general, there are three core areas why central banks were formed which informs how they work, they are;

  • Control of money supply in a nation: catral banks issue bank notes and cash, they also set interest rates to suit the kind of economy a country has for that moment.
  • Regulation of other banks: central banks regulate other banks present in a country, the regulation is done through capital requirements and reserve requirements. These requirements inform how much loan a bank can issue to customers and how much a bank is expected to have as its holdings.
  • Aid for distressed financial institutions and government: a central bank provides financial support for banks and governments when in distress or in dire need of funding.

The major takeaways of central banks include:

  • A central bank is a financial entity that oversees the monetary system o a nation, it makes monetary policy and regulates the production and supply of money in a nation.
  • Central banks help to regulate the supply of cash and bank notes in such a way that inflation will be hedged and at the same time boost the economy.
  • A central bank oversees other banks in the country, it sets capital requirements and reserve requirements for these banks.
  • A central bank can give bail outs to government and other banks in times of financial distress.

Central Banks and the Economy

Central banks play a vital role in the economy of a nation, through monetary policy and regulations, they ensure inflation is avoided in a country and economic growth is retained. The Federal Reserve System is the central bank in the United States. The central bank has a governing body called the Federal Reserve Board, a board that ensures that the distribution and supply of money in the U.S is adequate. For instance, the Federal Reserve system lowers discount rates or interest rate to increase liquidity in the economy, there are other regulations tailored towards spurring growth in the economy.

History of Central Banks

The origin of central banks can be traced to as far back as the 17th century when early central banks emerged such as the Bank of England. Napoleon’s Bank of France, Riksbank of Sweden and Germany’s Reichsbank. It was also at this period when the concept of “lender of last resort” was identified by the Bank of England. In 1863, a network of national banks was created by the National Banking Act. Furthermore, in the United States, the Federal Reserve System, which is the US central bank was established in 1913, after the congress passed the Federal Reserve Act.

Central Banks and Deflation

Based on historical events, several concerns have been raised on the role central banks play in the economy and how deflation occurs in the economy. For instance, Japan experienced an extremely slow economy from the 1960s to the 1980s. Japan as a nation known for fast economic growth had an entrenchment of deflation after 1989- 1990. This was when the equities and real estate boom dropped, causing a lot of firms to lose their values. Due to this financial crisis, the 1990s was described as a ‘Lost Decade’ for Japan.

A similar trend of deflation occurred during the Great Recession which occurred between 2008 and 2009. The financial system across the globe witnesses a strange collapse that affect the economy adversely, banks and other financial institutions were also affected.

The Federal Reserve’s Approach

In  a bid to combat the effects of the 2008 global financial crisis, two unconventional monetary policy tools were utilised. The policy monetary tools were developed by the Federal Reserve money policy body and the Federal Open Market Committee (FOMC). The tools are;

  • The forward policy guidance: This tool was focused on reducing the target of federal funds to zero and maintain this position through mid-2013.
  • Large-scale asset purchases: This is otherwise called the quantitative easing (QE). This policy entails that the central bank creates new money and purchase new securities from the nation’s bank with it.

These two tools were developed to create more liquidity in the economy which will in turn drive economic growth.

Other Deflation-Fighting Measures

Apart from the metrics and policy tools for combating deflation that are mentioned above, there are other measures deployed by countries in fighting deflation. Quantitative easing (QE) is also used by the European Central Bank (ECB) to fight deflation. In 2015, ECB experimented the negative interest rates in order to aid the recovery of the economy and repel deflation. Other central banks in countries such as Switzerland, Sweden and Denmark also reduced their interest rates to zero.

Central Banks’ Contemporary Problems

In the contemporary world, there are certain problems associated with central banks. Major central banks such as the US Federal Reserve and the European Central Bank are constantly faced with the pressure to reduce balance sheets that experienced increase during recession.

Due to the fact the central banks are the largest buyer and often operate in monopoly, there are fears as to whether central banks can accommodate all the demands. Another problem associated with central banks is the tendency of panic which arises from the likelihood of decline or collapse in prices.

Reference for “Central Bank”

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