Central bank

Definition

A central bank is a national institution responsible for managing a country's monetary policy, regulating its currency, and overseeing the banking system. Central banks play a crucial role in stabilizing the economy, controlling inflation, and maintaining financial stability through the implementation of interest rate adjustments and other monetary tools. They also act as a lender of last resort during financial crises and manage foreign exchange reserves.

5 Must Know Facts For Your Next Test

1. Central banks typically have the authority to issue national currency, allowing them to control money supply and influence inflation rates.
2. They often set benchmark interest rates, which guide the lending rates for commercial banks and affect borrowing costs for consumers and businesses.
3. Central banks also monitor and regulate commercial banks to ensure the stability of the banking system and protect depositors' interests.
4. In times of economic downturn or crisis, central banks can implement quantitative easing by purchasing government securities to inject liquidity into the economy.
5. Foreign exchange interventions may occur when central banks buy or sell their own currency in the foreign exchange market to stabilize or influence its value.

Review Questions

• How does a central bank use monetary policy to influence economic activity?
  • A central bank uses monetary policy to influence economic activity primarily through adjusting interest rates and controlling the money supply. By lowering interest rates, they encourage borrowing and spending, which can stimulate economic growth. Conversely, raising interest rates can help cool down an overheated economy and control inflation. These decisions are based on various economic indicators, making central banks key players in managing economic health.
• What are the key functions of a central bank in maintaining financial stability?
  • Central banks maintain financial stability through several key functions, including regulating commercial banks, serving as a lender of last resort during crises, and implementing monetary policy to control inflation. By monitoring banking practices and ensuring that financial institutions adhere to sound risk management principles, central banks can prevent systemic failures. Additionally, during times of financial distress, they provide liquidity to banks to keep them solvent and protect the broader economy.
• Evaluate the impact of central bank actions on foreign exchange markets and global trade.
  • Central bank actions have significant impacts on foreign exchange markets and global trade by influencing currency values through interest rate changes and foreign exchange interventions. When a central bank raises interest rates, it often leads to an appreciation of the national currency as higher rates attract foreign capital. Conversely, lowering interest rates can result in currency depreciation. These fluctuations affect global trade competitiveness; for example, a stronger currency can make exports more expensive for foreign buyers while cheaper imports benefit consumers domestically.

Related terms

monetary policy:

The process by which a central bank manages the supply of money and interest rates to achieve specific economic goals.

interest rates:

The amount charged by lenders to borrowers for the use of money, usually expressed as a percentage, which can be influenced by central banks to control economic activity.

reserve requirements: The minimum amount of reserves that banks must hold against deposits, which can be adjusted by central banks to influence lending and liquidity in the economy.