IGCSE Economics 0455

Topic: Microeconomic decision-makers - Money and banking

Objective: Role and importance of central banks

Central banks are crucial institutions in modern economies. They play a vital role in managing the money supply, controlling inflation, and maintaining financial stability. This section will explore the functions and importance of central banks.

What is a Central Bank?

A central bank is a public or private institution responsible for issuing currency, controlling the money supply, and supervising banks. It acts as a lender of last resort and manages a country's monetary policy.

Key Functions of a Central Bank

• Issuing Currency: Central banks have the exclusive right to issue banknotes and coins. This ensures a reliable and regulated currency in circulation.
• Controlling the Money Supply: Central banks use various tools to influence the amount of money available in the economy.
• Setting Interest Rates: Central banks often set a benchmark interest rate, which influences the interest rates charged by commercial banks.
• Banker to the Government: Central banks act as the fiscal agent for the government, holding government accounts and managing government debt.
• Banker to Banks: Central banks provide banking services to commercial banks, including holding their reserves and providing loans.
• Lender of Last Resort: Central banks can provide emergency loans to commercial banks facing liquidity problems, preventing financial crises.
• Supervising and Regulating Banks: Central banks oversee the banking system to ensure its stability and protect depositors.
• Managing Foreign Exchange Reserves: Central banks hold and manage a country's foreign exchange reserves, which are used to influence the exchange rate.

Tools Used by Central Banks

Tool	Description
Reserve Requirements	The fraction of deposits that banks are required to hold in reserve. Increasing reserve requirements reduces the amount of money banks can lend.
Discount Rate	The interest rate at which commercial banks can borrow money directly from the central bank. A lower discount rate encourages borrowing.
Open Market Operations (OMO)	The buying and selling of government securities (bonds) by the central bank. Buying bonds injects money into the economy, while selling bonds withdraws money.
Interest on Reserves (IOR)	The interest rate paid by the central bank on reserves held by commercial banks. This influences the incentive for banks to lend money.
Quantitative Easing (QE)	A more unconventional tool where a central bank purchases longer-term government bonds or other assets to increase the money supply and lower interest rates.

Importance of Central Banks

Central banks are vital for a healthy economy. Their role is crucial for:

• Controlling Inflation: By managing the money supply and interest rates, central banks can help keep inflation at a stable and desirable level.
• Maintaining Economic Stability: Central banks can act as a lender of last resort to prevent financial crises and maintain confidence in the banking system.
• Promoting Economic Growth: By setting appropriate interest rates, central banks can encourage investment and economic growth.
• Managing Exchange Rates: Central banks can intervene in foreign exchange markets to influence the value of their currency.
• Protecting Depositors: Through bank supervision and regulation, central banks help protect depositors' money.

The independence of central banks from political influence is generally considered important for effective monetary policy. This helps ensure that decisions are based on economic considerations rather than short-term political goals.