Central Banks

Most of us are aware of what a local or national bank is.

This is the financial institution in which most of us put our savings in, get our salary credited to, business transactions made, get our credit cards from, manage our investments, obtain financial advice and secure our home loan.

While the local and national bank plays a big part in our personal financial world, they are not even close in power and influence to the central banks.

What is a central bank and what do they do exactly?

Central banks are also known under other names like Reserve Banks or Monetary Authorities. This institution has several critical and extremely powerful roles in the country’s financial system. What they do affects the entire economy of the country and in the case of the US Federal Reserve or the People’s Bank of China, what they do have an effect on the global economy and that can have serious ramifications and consequences.

A central bank can also be considered the government’s banker and provide money to the government as needed. It possess the only right and monopoly among all the other banks in that country to print the national currency, which is recognized by government law as the nation’s legal tender. They have full power and authority to set the nation’s interest rates and regulate the money supply.

Central banks often oversee, regulate and supervise the commercial banking system and provide liquidity to the other banks during times of financial crisis. When needed, the commercial banks can borrow from the central bank, but often as a last resort.

As the government’s enforcer, central banks implement the country’s monetary policies. They also manage the country’s foreign exchange and gold or other reserves. Central banks provide economic stabilizers for growth, control of inflation, employment, currency volatility and foreign exchange market stability, among other things.

The Independence of Central Banks

Central banks, in most cases; except for authoritative or oppressive governments, operate independently from direct government intervention even though the Governors of central banks are appointees by the government or parliament or the country.

Advocates of central bank independence like the World Bank and the International Monetary Fund (IMF) argues that direct political pressure or policy direction creates unsustainable boom and bust cycles as politicians are often tempted to provide a stimulus for artificially increasing economic activities and growth, prior to an election. They argue that this hurts the log term health of the economy.

Independence for the central banks comes in many forms.

Legal independence is usually endorsed as government law. Although there is some form of accountability in the actions of central banks to a government minister or department; it is important to have that independence clearly defined.

Goal independence may often differ from the government and central banks have the right to set their own monetary policy. While politicians may want to contain interest rate rises during an election year, the central bank may increase it to stave off inflation or slow the economy from overheating.

Operational independence ensures that central banks are in control of their own policy goals, types of instrument use and timing of implementation. As a self regulating organization, central banks’ management is free to run their own operations, unlike a highly and overly regulated government department.

The primary objective of central bank independence is to prevent short term interferences from politics.

As in all things, total independence is not always possible, even in a democratic society. Governments do have some limited control over the behaviour of central banks and its policies, for example; in the appointments of Governors.

On the other hand, central bank policies like the hated interest rate rises and the withholding of liquidity will cause negative political impact on governments. In some well timed and unpopular central bank policy implementations, the sitting government approval rating may get a trashing or in the more extreme cases, can result in a change of government.

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