Monetary policy, inflation, and interest rates - How are they all tied together by central banks is our topic of interest for this article.
Monetary and fiscal policy are the two essential economic concepts. The first one involves banks managing things such as money supply and interest rates. The second deals with how governments choose to invest money.
In our article here, we will discuss more about banks and less (if not at all) about governments.
What is a central bank, and what does it usually do?
A central bank is responsible for the stability of a country’s financial system. Its role is to keep inflation under control and maintain the unemployment levels as low as possible. How can central banks achieve these objectives? It’s simple, at least in theory: by managing commercial banks and supervising the cash flow in the economy.
Apart from the elements mentioned above, central banks can have a wide range of tasks besides monetary policy, including:
• issuing banknotes and coins
• ensuring the smooth functioning of payment systems for banks
• managing foreign reserves
• informing the public about the economy by holding monetary policy announcements or interest rate decisions.
The world's four major central banks are the Bank of England (BOE), the Bank of Japan (BOJ), the Federal Reserve (USA - FED), and the European Central Bank (ECB).
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Central banks and commercial banks
Central banks function as parents for commercial banks. They influence the money flow, credits, and deposits for commercial banks in their goal to achieve stable prices in the banking sector. Stable prices translate into controlled inflation.
Additionally, commercial banks access funds from central banks whenever they need it. As for guarantees for repaying their debts, commercial banks give collateral similarly to the government or corporate bonds.
Also, central banks maintain the financial system stable and in working order by helping commercial banks with liquidity. This usually occurs when commercial banks can't turn money into cash to pay their debts.
Finally, many central banks supervise commercial banks to make sure the lenders are not taking too much risk.
The Central banks - two main directions
Central banks typically increase the money supply to stimulate a slowing economy and reduce the cash flow to keep inflation in check. When it does these things, central banks operate on a macroeconomic level. Still, they can also work at a microeconomic level by providing commercial banks with loans.
The macroeconomic roles of central banks
As we already mentioned, price stability and inflation are primary goals for the financial system’s watchdogs.
Central banks usually use the open market to place transactions for adding extra liquidity or absorb additional funds.
They buy government bonds or other similar products to help reduce the interest rate costs and inject more funds into the markets. If inflation levels go over the top, banks such as the Fed sell these bonds on the open-market and discourage borrowing as interest rates go up.
The microeconomic functions of central banks
Central banks also supply commercial banks with liquidity on both short and long-term and, as explained earlier. Commercial institutions don't create or hold enough reserves to satisfy the needs of an entire market.
The rate at which commercial banks and other lending facilities can borrow short-term funds from the central bank is called the discount rate. This rate is set by the central bank and provides a base for interest rates. This discount rate should keep the banks from continuous borrowing, which would disrupt the market's money supply and the central bank's monetary policy.
Central banks play a crucial role in achieving the economic growth of a country through the many different measures it can take. Central banks promote economic growth, leading to stability. They work to overcome losses of balance in the financial systems and towards stabilizing exchange rates and inflation levels. Last but not least, they provide much-needed support for commercial banks for safely conducting their businesses and keeping them away from debts or other pressing problems.
Sources: Wikipedia.com, Investopedia.com, cnbc.com
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