What is a central bank?

A central bank is a government-owned or government-controlled bank that manages a country’s money supply and monetary policy. Central banks are important financial institutions that play a key role in the economy of most countries. They are different from regular commercial banks that provide banking services directly to the public.

Key Responsibilities

The main responsibilities of central banks usually include some or all of the following:

Issuing the country’s currency (banknotes and coins)
Managing the country’s foreign exchange and gold reserves
Regulating the money supply and availability of credit
Setting reserve requirements for commercial banks
Holding deposits from and lending to commercial banks
Acting as a lender of last resort to the banking system
Managing the government’s stock and bond markets
Advising the government on economic and financial matters

In some countries, the central bank is also tasked with promoting full employment and stable prices. The exact roles and level of independence of central banks vary from country to country.

Monetary policy

One of the most important functions of central banks is conducting monetary policy to achieve the government’s economic objectives, such as controlling inflation, promoting growth, or stabilizing the currency’s value.

Central banks typically conduct monetary policy by:

Changing interest rates at which they lend to commercial banks
Buying or selling government bonds to influence money supply
Adjusting the reserve requirements for commercial banks
Intervening in foreign exchange markets to influence the currency’s value

When a central bank wants to stimulate economic activity, it generally lowers interest rates, buys government bonds, decreases reserve requirements, or lets the currency depreciate in value. These actions increase liquidity and credit in the economy.

Conversely, when a central bank wants to cool down an overheating economy and control inflation, it raises interest rates, sells bonds, increases reserve requirements, or supports the currency’s value. These actions reduce money supply growth.

Regulating commercial banks

Central banks oversee and regulate the banking industry to promote a safe and sound financial system. They license banks, establish regulations and guidelines that banks must follow, and supervise banks’ operations to ensure their compliance and financial health.

Central banks require commercial banks to hold a portion of their deposits as reserves, either in cash or as deposits at the central bank. Reserve requirements provide a cushion to cover withdrawals and a tool for monetary policy. By increasing or decreasing reserve requirements, central banks influence how much money banks can lend out.

Central banks also act as a lender of last resort to commercial banks that are facing liquidity shortages and are unable to borrow elsewhere. By providing emergency loans, central banks help prevent bank failures that could trigger a financial panic. However, central banks must balance this role with the need to avoid encouraging excessive risk-taking by banks.

Issuing currency

Most central banks have the sole right to issue banknotes and coins that serve as the country’s legal tender. When central banks issue currency, they are creating money and increasing the money supply.

Central banks control how much currency to print based on economic conditions and monetary policy goals. They distribute currency to commercial banks, which in turn circulate it to the public through withdrawals and loans. Old and worn-out currency is returned to the central bank for destruction.

While many countries have shifted away from paper money to digital payments, banknotes and coins issued by the central bank still play an important role in most economies as a medium of exchange, a store of value, and a unit of account.

Managing foreign exchange reserves

Central banks also manage their country’s foreign exchange reserves, which are assets held in foreign currencies, gold, and special drawing rights (SDRs). Foreign exchange reserves are used to support the value of the domestic currency, provide liquidity during economic crises, facilitate international trade, and boost confidence in the country’s economy.

Central banks buy and sell foreign currencies in the foreign exchange market to influence the exchange rate of their domestic currency based on monetary policy objectives. For example, a central bank might sell foreign currencies and buy its own currency to prevent it from depreciating too much, or buy foreign currencies to keep its own currency from getting too strong and hurting exports.

Central banks earn interest on their foreign exchange reserves by investing them in safe and liquid financial assets, such as government bonds of reserve currency countries. However, they also face risks, such as fluctuations in exchange rates and interest rates, which can result in losses on their reserve holdings.

Providing economic analysis and data

Central banks employ economists and analysts who study economic and financial conditions, nationally and globally, to guide monetary policymaking. They collect and analyze a wide range of data, such as inflation rates, employment numbers, business and consumer sentiment, credit and monetary aggregates, government finances, exchange rates, commodity prices, and financial market indicators.

Central bank economists use this analysis to make economic forecasts, assess risks, and recommend appropriate monetary policy actions to achieve the central bank’s goals and support the country’s economic health. Central banks also publish their data analysis and research to inform markets, businesses, and the public about economic conditions and policy directions.

Central bank independence

There has been a trend in recent decades towards increasing the independence of central banks from government influence in conducting monetary policy. The idea is that monetary policy works best when it is isolated from political considerations and the pressure to finance government budget deficits.

In an independent central bank, the government sets the monetary policy goals (such as an inflation target), but the central bank has autonomy to run policy and use its tools to achieve those goals as it sees fit. Central bankers have lengthy terms that overlap government administrations and cannot be easily fired for political reasons.

However, even independent central banks are ultimately accountable to the government and the public. They have to clearly communicate their economic assessments and reasoning behind policy decisions. Many are required to testify before national legislatures. Their independence can be reduced if the government changes the law.

Economists generally believe central bank independence improves economic outcomes, resulting in lower inflation, reduced government debt monetization, and smoother business cycles. However, central bank independence needs to be balanced with accountability to ensure policy legitimacy in a democracy. The ideal level of central bank independence remains debated.

Important central banks

Almost every country in the world has a central bank. Notable examples include:

The Federal Reserve System (Fed) in the United States
The European Central Bank (ECB) in the Eurozone
The Bank of England (BoE) in the United Kingdom
The Bank of Japan (BoJ) in Japan
The People’s Bank of China (PBoC) in China
The Swiss National Bank (SNB) in Switzerland

These central banks are very influential in the global economy and financial markets due to the size of their economies and importance of their currencies. Their monetary policy decisions are closely watched internationally.

The Bank for International Settlements (BIS), located in Basel, Switzerland, serves as a central bank for major central banks around the world. It promotes cooperation among central banks and provides banking services to facilitate international financial operations. The BIS also does research and sets international standards on bank capital requirements.