What is a central bank?
|Central bank explained|
|Central bank's goals and duties|
|Central bank and economy|
|Monetary policy and interest rate|
|Modern central banks tools, QE and QT|
|Central banks and financial crisis|
Banks are one of the cornerstones of our society. They have been around for centuries and play a pivotal role in our lives. Whether we want to purchase a house, pay our bills, receive our wages or set up a business. We need a bank account to do any of these things. They also provide a host of other services, which include:
- Credit cards
- Investment strategies
- Foreign currency exchanges
- Savings accounts
However, it is important to note that the banks we use are known as commercial banks, and central banks work differently.
Central bank explained
It is difficult to state just how integral they are to modern society. A central bank will manage the flow of cash into a country's economy in an attempt to achieve several things. This includes controlling the stability of the currency and levels of inflation.
They also offer services that measure economic growth, inflation rates and employment levels. In addition, they ensure that commercial banks operate within the rules and regulations of the territories within which they operate. Examples of central banks include:
- The Federal Reserve (USA)
- European Central Bank (Europe)
- Bank of England
Central bank's goals and duties
Ensuring a country remains financially stable and economically healthy are the two integral goals of a central bank. It is an incredibly difficult balancing act where a number of variables must be considered before they act on their decisions. One wrong move could jeopardize their whole country's economy and currency.
Their duty is to provide care to the citizens of that country from a purely economical perspective. Their main goal is achieved as long as they do their utmost to ensure the currency remains as strong as possible. They do this by ensuring inflation is manageable, and interest rates are also within a steady range. If required, they will amend interest rates or print more money to stabilize the economy as much as possible.
Central bank and economy
An effective central bank is one of the key factors for any country with a strong currency and solid growth. The measures taken by a central bank can also result in strong future economic projections.
They can operate in the limelight and quietly in the background when required. In times of crisis, a central bank will often intervene and ensure that the economy is stabilized, so it becomes a calming voice during times of distress and panic.
The central bank and the economy are so intertwined that they co-exist. One would struggle immensely without the other and vice versa. The two main tools they have at their disposal are controlling monetary policy and the interest rate.
Monetary policy and interest rate
The actions of the central bank have a direct effect on the economy of the nation. If they rise interest rates too high, this can weaken the currency on an international scale. This results in less spending power abroad and can lead to an imbalance in imports and exports.
On the contrary, if they print more money, also known as quantitive easing, this can cause the inflation rate to spiral out of control. Extreme examples of both have resulted in the complete collapse of certain currencies. Notable examples include Zimbabwe and Venezuela.
Modern central banks tools, QE and QT
Quantitative easing (QE) is one of the most effective tools a central bank can implement. It is usually applied when interest rates are low, and the economy is stagnant. As interest rates are already low, central banks must implement a mechanism encouraging spending to ignite economic growth. However, it must remain within the confines of a manageable level.
The two highest-profile examples of QE were the 2008 financial crisis and the 2020 COVID pandemic. The most important objective is to lower interest rates and stimulate growth.
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QE can result in high levels of inflation and a currency that becomes less powerful in international markets. Therefore, it is a fine balancing act to ensure centralized banks get it right. These two strategies are widely considered the most effective way to steady the economy without causing wild fluctuations in the currency or economic outlook.
Quantitative Tightening is the opposite of quantitative easing. Any financial instruments the central banks have purchased, like government bonds, are allowed to mature instead of being superseded. This includes other types of assets purchased through the quantitative easing policy.
The aim of this is to keep the economy operating within optimum margins. Research has suggested QT doesn't cause inflation or liquidity issues, so it is an efficient tool in times of uncertainty.
Central banks and financial crisis
Whilst central banks will operate throughout the fiscal year, with varying levels of intervention, they’re especially required during a financial crisis. The Quantitative easing employed by the Bank of England in 2008 was considered the pivotal decision that stopped the collapse of the banking system in the United Kingdom.
Similarly, the same intervention during the first wave of the coronavirus pandemic stopped the economy from completely grinding to a halt. That isn't to say that this didn't come with negatives, though. This large injection of cash into the UK economy, and similarly the US economy and many in the Eurozone, has put central governments in a fiscal deficit.
There have been talks of austerity to balance the books, which results in rises in poverty and unemployment. However, without this intervention, the economic consequences may have been disastrous and incomprehensible.
This is why we say that any decisions made by any central bank have knock-on effects that can result in stabilization or destabilization based on whether the decision was correct. Ensuring these decisions are on point during a financial crisis is critical to the health of a nation's economy.