Central banks are one of those things many people know exist, they hear about them in the news, and they can grasp the general idea if mentioned in conversation, but they don’t really understand what they do, or why. But central banks affect everyone, every single day. They are the backbone of our monetary system – how much of it there is, what it’s worth, and how stable it is.
Understanding central bank processes are important to anyone managing their personal finances, loans, or mortgages. Here’s everything you need to know about these economic institutions:
What is a central bank?
A central bank is a financial institution that has exclusive control to produce and distribute money and credit. Central banks generally have three main goals: to maintain low inflation, keep unemployment low, and facilitate economic growth.
Some central banks are nationalized, yet many are not owned by governments – they can be accountable to governments but they are not subject to them. That said, central banks’ legal monopoly status to issue money is dependent on legislation. Besides their legal framework, central banks are politically independent.
Central banks are located around the world and can either work for a single nation or a group of nations. They carry out the monetary policy of that location, meaning the currency, money supply, and interest rates. The Bank of England, established in 1694, is considered to be the model on which other central banks are based.
The Fed was established in 1913 after a series of financial crises, to put in place a central authority that would supervise all banks and help stabilize the economy. It has the largest assets of any central bank in the world, and is a leading figure among central banks in terms of policy and setting global monetary conditions. In the midst of the COVID-19 crisis, the Fed has been heading central bank meetings to determine new policies.
What do central banks do?
Central banks control inflation and influence economic growth by various means. These include ‘printing’ money (or creating credit), and manipulating interest rates (the cost of borrowing and lending money throughout the economy).
Central banks act as banks for commercial banks, and they also regulate them: they oversee how much banks can lend to people, how much cash they should keep, and how much foreign currency they should have available.
Central banks are also an emergency lender for commercial banks and governments, but this is usually a last-resort option.
During times of economic hardship, these economic institutions can also set in motion a process called ‘quantitative easing’ to stimulate the economy. They can do this by creating money to buy large amounts of government debt in the form of bonds. Because these bonds are purchased in bulk, their interest rates are lower. The interest rates of government bonds usually have a knock-on effect on the interest rates in an economy as a whole, so once they drop, overall interest rates do the same.
The idea is that by buying bonds to decrease general interest rates, it will be cheaper for people to borrow money and stimulate economic activity. For example, during the COVID-19 crisis, the Fed announced a $700 billion quantitative easing program.
What risks do central banks pose?
An obstacle for central banks is that they cannot force commercial banks to loan more money, nor can they force people to take out loans and buy more goods. The entire premise of quantitative easing is based on the assumption that lower interest rates stimulate economic growth, which isn’t always the case.
Because money is created from thin air in quantitative easing, it also poses the threat of inflation, where general prices increase and the purchasing power of money decreases. As quantitative easing is not a guaranteed solution, there is a possibility of inflation accompanied by no rise in economic activity – which can lead to a slowdown in production and a surge in unemployment.
Additionally, quantitative easing can lower the value of the national currency relative to other currencies, which can make imports more expensive, lower wages, and deter potential foreign investment.
Central banks have absolute power when it comes to money – what they say is cash, is cash. But while in the past, central banks have helped restore economies after financial crises, in some cases they have also taken irresponsible actions. In the wake of the housing crash in 2008, the Fed spent more than $1.75 trillion in quantitative easing, which led to one of the worst economic recoveries in U.S. history.
This reliance on predictive behavior can make central banks unreliable. Today, there’s a growing belief that alternative systems could be more democratic and effective than these traditional, monolithic institutions.