Different countries operate their own central bank that controls and monitors operations of commercial banks within their economy; central banks are the custodians of commercial bank. Other than being the sole printer of notes and coins currency of a nation, central banks provide their countries’ currencies with price stability by controlling inflation.
To control and intervene in an economy, central banks use monetary and fiscal policies; the idea of central banks was aimed at creating a bank that controls an economy without political influences, however the separation has been a challenge in many nations. This paper discusses the role played by central bank in an economy.
Custodian of commercial banks
Before commercial banks gets an operating license, it must be cleared and accepted by the central bank, the bank considers issues with security, liquidity and the quality of facilities with the applying bank.
There are some bench marks that need to be fulfilled by a trader before being allocated the license, it’s upon the central bank to ensure that the bank has fulfilled the requirements. After licensing, central banks have the role of controlling, monitoring and ensuring that the bank is not engaging in fraudulent business practices. In case of such a move, the powers with the bank can revoke the operating license.
Banks operate with a loan facility that they are given by the central bank. The central banks in various countries issue the loans to banks at a certain rate if interest. The banks on their side have the objective like any other business has, that is to make profits; the major source of their income is from loans given to their customers. When they are lending to the outside customer, they have to charge an interest that is higher than that that the central bank is offering.
Control of banks interest rates
When commercial banks are offering their lending services, they use finances they have collected from their depositors as well the money lend by central bank; an adjustment of the liquidity fund and the rate of lending the finances means an effect on the interest rates. By liquidity fund we mean that the money that central bank requires a bank to hold at one time; which is a percentage of the bank’s capital.
If the amount is increased, it means that the money available for lending have been reduced and thus the money available can only be lend at a high interest rate. On the other hand, in the case that banks are offering loans at high rates, the central bank can reduce the liquidity performance as well as it bank lending rate to facilitate the reduction of bank lending rates.
Another major determinant of the interest rate that the bank is going to charge a certain loan facility is the level of risk that the loan is likely to have. Other countries central banks has power to set the rate of interest that commercial banks are going to charge; this is a direct control of the banking sector that is not common but it can work. The rate that the central bank authorizes to be charged may be lower than what the banks are willing to sell at; it then settles the deficit.
Management of inflation
In cases of inflation the economy has more funds in circulation than it should be having. This makes the cost of good expensive; this has a negative effect on the growth of the economy and discourages foreign and local investments. There are various reasons that can make the central bank to increase the rate of interest. This use mostly monetary policies and fiscal policies that are used to cure inflation in the country.
Money get into the country through the operating commercial banks and so if borrowing money is made more difficult than the flow of currency in the economy is regulated. For this to happen it is a series of activities where the particular country’s central bank is involved; it thus follows that the rate that central bank offers advances to commercial banks will determine the rate at which commercial banks offers loans to the public.
If central bank offers credit to the banks at a higher rate, then the rate of interest that commercial banks will offer loans to the public will be high; this reduces the attractiveness of the facilities; in its return it reduces the flow of money in the economy. This on the other hand cures inflation. These are short term and medium term policies.
There are long term policies that central bank employs they include; issue of treasury bills and bonds and direct participation in the market. Treasury bills and bonds are offered for the general public and companies to buy. When the rate rises, the loan purchasers’ will be discouraged from buying them and circulate the money in other areas of the economy and thus curing the deficit.
When the circulation of money in the economy is higher than the equilibrium, then central bank can aim to offer attractive interest rates; this makes them attractive and the money holders opt to buy them instead of keeping money. It also stops participating in the market. This will make the rate of interest in the country to increase.
The government’s bank
Central banks are termed as the bank of the government where policies regarding financial operations of the government are operated. To finance different projects, money comes from the central bank to treasury for implementation. On the other hand, monies collected in an economy as taxation or other central government funds are banked with central bank.
Custodian of foreign currency
In modern globalized world, there is increased trade among nations, for trade to prevail; trading partners needs to have the currencies of other partner. Central banks have a store for foreign currency and with the currency; it controls deficiencies and surpluses of the funds. For instance with the foreign reserve, the bank can decide to sell some of the reserve to cure a deficit; alternatively it can decide to buy from the market to cure a surplus.
When the flow of foreign currency is controlled, then a country is able to cure deficits in balance of payment.
Banks are important institutions in every economy. They are the medium through which the government uses to control the financial standing of the country that affect a country. Central bank is a central organ that oversees the activities of commercial banks. It uses both monetary and fiscal policies to influence the interests that prevail in an economy. Its participation in the market, either directly or indirectly is aimed at curbing economic vices existing in an economy.
Sullivan, A & SM Sheffrin, Economics: Principles in Action, Pearson Prentice Hall, New Jersey,2003.
Touffut,J, Central banks as economic institutions, Edward Elgar Publishing, New Jersey, 2008.
- J Touffut, Central banks as economic institutions, Edward Elgar Publishing, New Jersey, 2008.
- A Sullivan & SM Sheffrin, Economics: Principles in Action, Pearson Prentice Hall, New Jersey, 2003.