What are central banks and what do they do?

A central bank is a financial institution responsible for managing a country or group of countries’ monetary policy. Central banks also oversee the monetary system through supervisory and regulatory powers and ensure financial stability. In most developed countries, they are independent from the government to prevent political interference.

The Bank of England is the UK’s central bank while in the USA, it is the US Federal Reserve, also known as the Fed. One of the key features of a central bank, which distinguishes it from other banks, is its legal monopoly status on issuing coins and banknotes, allowing it to increase the monetary supply.

Central banks’ primary goal is to maintain price stability by targeting a specific level of inflation over the medium term (2% in most developed countries). Sometimes, central banks also have a goal to maximise employment and act as a lender of last resort to distressed banks or financial institutions.

Central banks have three monetary policy tools to achieve these goals.

Firstly, they can increase or decrease short-term interest rates to either slow down or stimulate economic activity by making borrowing more or less expensive. When inflation is caused by excess demand, this tool can be effective at bringing inflation levels lower.

Secondly, they control money supply by buying and selling various financial instruments such as government and corporate bonds or foreign currencies. For example, an expansionary or ‘supportive’ policy means a central bank increases the amount of money in circulation by purchasing government debt – this is also known as ‘quantitative easing’.

Finally, they set reserve requirements, which stipulate how much money commercial banks need to have available for immediate withdrawal. Lowering the reserve requirements frees up some funds and allows banks to increase lending, which in turn should support economic activity.