Central banks are not the same as other banks. Their main responsibility is to manage the financial system’s stability. This means they must keep the price from going up or down too quickly. Central banks are usually concerned about the overall state of the economy and want to keep unemployment low and growth high. They achieve this via managing the private banks and controlling how much money is in the economy.
What is a central bank?
The central bank controls the money supply and how it reaches users. It can not only produce and add money to the market but also control the allocation of its commercial banks.
The central bank regulates economic policy such as power over price increases, exchange rates, and money allocation. It has many tools it uses to control such things. For example, you can set interest rates to curb inflation, buy foreign currencies to weaken your domestic currency, or buy assets from financial institutions to operate open markets.
Central bank history
Sweden established the first central bank in 1668 called Sveriges Riksbank. Its establishment stems from the bankruptcy of Sweden’s first bank, Stockholm Bank, in 1656.
Banknotes were primarily very popular because they take place of the heavy and unmanageable coins. Still, in the years that followed, Stockholm Bank issued more banknotes than could cover the deposit. As a result, consumers have become wary of increasing numbers of banknotes in circulation, resulting in demand for the original coins.
What happened in the 1660s was what we called a “run on the bank” I went bankrupt because I didn’t have enough coins to fulfill my obligations. The result is banknotes of no value to consumers. This subsequently led to the Swedish aristocrats taking over the bank and creating the Swedish National Bank.
The main purpose of central bank
The purpose of central banks has changed significantly over the years due to disastrous economic events. For example, in the 1970s, the central bank’s main goal was to secure full employment. But when we focused on employment, central banks could no longer pay attention to inflation. Instead of keeping prices stable, central banks invest money in the economy to make sure people are employed. But this came at the expense of inflation.
- Keep the Prices stable
Price stability is probably one of the central bank’s main objectives. After the high levels of inflation in the 1970s and 1980s and the Great Depression of 1929, price control has become an important element of central bank policy.
Currently, in most developed countries, the target inflation rate is 2 percent. The reason for this is that it is high enough to drive consumption, but not too high to trigger a panic buy, creating a larger cycle of inflation. Still, it’s not low enough to cause excessive savings.
- Full employment
Looking back on history, full employment was one of the central bank’s main objectives. However, as the welfare state expanded and the understanding of monetary policy deepened, it receded.
Nevertheless, full employment remains a relatively important goal. Most central banks will act when employment begins to catch up. This is usually done by lowering interest rates and promoting cheaper credit to businesses. Companies then use cheap credit to invest and expand their businesses, thereby stimulating work in the process.
- Economic stability
Central banks often act as lenders of last options to retain economic stability. For example, most commercial banks need short-term loans to be able to adjust their assets and liabilities.
In some cases, commercial banks may have to pay loans to another financial institution, but their assets are tied to long-term loans and other illiquid assets. As a result, they need some short-term liquidity to meet their obligations, which is where central banks come into play.
This is very important in the private sector as some short-term payment mistakes can have serious consequences. One small short-term default could cause other institutions to stop trading with them and customers to start going elsewhere. It can destroy a company’s reputation and therefore its credibility as an organization. Therefore, central banks play an important role in maintaining the trust and stabilizing banks.
- Financial growing
Financial growth is important for central banks as it usually means more jobs and better living conditions. When there is economic growth, it is often associated with increased business investment, improved employment, and increased demand.
Economic growth is now a central bank goal, but not necessarily its main goal. Controlling inflation and prices may be more beneficial than stimulating the economy, so they often must weigh the pros and cons. Nevertheless, central banks often try to support the economy if they can, while maintaining price stability.
- Keep Exchange rate stable
For several reasons, a country can face a currency shock with a quickly declining demand for its own currency. This may be due to domestic political outcomes or a financial crisis. Second, this creates instability in the market, which central banks try to avoid.
Unstable exchange rates can reduce a company’s credibility by not properly planning investments and business strategies. This is an even more important factor in today’s interconnected economies, which rely heavily on international supply chains.
If the exchange rate drops significantly, central banks may try to buy domestic currencies from the foreign exchange market to increase supply and demand. This helps create market stability and can have a significant impact on importers, supply chains, and exporters as well.