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  • 11Sep

    What is the central bank and how does it work?

    The central bank is an institution responsible for management of the state’s currency, money supply, and interest rates. The main goal of the central bank is monetary stability. This impacts the stability of prices and the rate of inflation. The central bank has unique control over the money supply, and decisions made by the governors and the board of the bank will determine the level of money supply. The most well-known central banks are the Federal Reserve System headquartered in Washington, D.C.; European Central Bank in Frankfurt, Germany; and People’s Bank of China located in Beijing, China.

    At the most basic level, the governor and members of the board consider the state of the currency. If the situation on the market shows a great demand for money, the form of currency is fiat (the word is derived from the Latin word fiat – let it be done and fiat money means money that derives its value from law or government regulation). It implies in this case that the central banks have the right to supply the market with practically unlimited amounts of money. Of course that would make no sense, because the money would soon become worthless piece of paper. The amount of money in the system depends on the real needs of the economy and should stimulate output and employment.

    After the 1971, the depreciation of the dollar in relation to gold caused the USA to abandon the gold standard as a form of monetary system that had been established after World War II, and the USA started to use fiat currency. This example was followed by other national economies, so the majority of nations today use fiat money as a form of the currency.

    The central banks have no direct impact on the output of the economy and employment. They are able to influence directly only some nominal variables such as prices and inflation. Monetary policy affects these variables through interest rates, required monetary reserves, and open market operations.

    Nominal interest rate

    European central bank

    After the 1971 it came to depreciation of dollar in relation to gold and USA abandoned the gold standard as a form of monetary system

    Nominal interest rate is a short term instrument of the monetary policy that determines the level of credit activity in the economy. Central banks may lend money to commercial banks, and they are even obliged to do so when commercial banks have liquidity problems. Low interest rates indicate that the cost of money is cheap, so the credit activity is on higher level in the economy. Low interest rates should stimulate consumption and investments that result in an increase of output and employment. On the other hand if the economy is overloaded with credits, the central bank can increase the interest rate and cause contraction of the money supply.

    Monetary policy

    Monetary policy can also be managed by the proportion of assets that commercial banks must hold in reserve at the central bank. Every bank has on reserve to use for immediate withdrawals as needed by its customers. The rest is invested in loans and other liquid assets. By setting the rate of required reserves low, the banks have more fund available to lend or invest, so the credit activity is higher. On the other hand, when the rate of the reserve is high, there are fewer funds available to lend or invest, and the credit activity is lower.

    Open market operations

    Open market operations are another important instrument of monetary policy. Through open market operations, the central bank sells and buys bonds, determining the level of financial assets in central bank’s portfolio. By selling assets, it makes the monetary base (money supply) lower, and by buying assets, the system is supplied with more money.

    Using these instruments and activities, the central banks are managing the money in the economy. If the economy is overloaded and there is more money than needed, the central bank will trigger inflation so the money becomes devalued and prices will go up. It is technically a silent form of taking the money from the people because they can buy less for the same amount. On the other hand, if the monetary supply is too low, such policy will cause recession or deflation, and, as a result, there will be low output and high unemployment.


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