Roles and Objectives of Central Banks

Objectives of Central Banks

The main objective of a central bank is to maintain price stability. Depending on the country, central banks might have other objectives, such as controlling inflation, unemployment, interest rates, or exchange rates. However, all these objectives align with the primary objective of ensuring financial stability.

Roles of Central Banks

Central banks are crucial in today’s economies, performing various vital functions for maintaining economic stability and promoting growth. Below is a discussion of the different roles of central banks.

Monopoly Supplier of the Currency

Central banks are the exclusive institutions authorized by law to supply domestic currency, replacing the earlier system where money was exchanged for precious commodities like gold by many private banks.

Money in all major economies today is known as fiat money, which implies that it is not convertible into any other commodity. Moreover, it is deemed as legal tender, which means it must be accepted for goods, services, and debt repayment.

Central banks play a vital role as the suppliers and protectors of the value of fiat currencies, and are charged with the role of maintaining confidence in their currencies.

Banker to the Government and the Bankers’ Bank

Central banks serve as the principal bankers to the government and other banks, ensuring they have the necessary liquidity to operate smoothly. This role is particularly crucial during crises when banks may face liquidity challenges, thereby preventing bank runs and maintaining stability in the financial system.

Lender of Last Resort

Central banks act as the ultimate source of funds for banks facing a liquidity crisis. The knowledge that the central bank stands ready to provide the required liquidity and the trust in government bank deposit insurance helps prevent bank runs. However, as observed in recent financial crises, this central bank’s role alone may not always be sufficient to avert a bank run.

Regulator and Supervisor of the Payments System

Central banks often oversee, regulate, and establish standards for a country’s payment system to ensure its robustness and standardization. This role includes overseeing the payments system, introducing new processes, and coordinating payment systems internationally with other central banks.

Supervisor of the Banking System

Central banks are charged with supervising the banking system. This role may be undertaken by a separate authority or jointly with the central bank in some countries.

Manager of Foreign Currency and Gold Reserves

Central banks manage their countries’ foreign currency reserves and gold reserves. Despite countries abandoning the gold standard in the twentieth century, central banks still hold large quantities of gold.

Conductor of Monetary Policy

This is arguably the most important role of central banks. Since they are the exclusive issuers of national currency, central banks are perfectly situated to formulate and execute monetary policy.

Question

Which of the following is least likely a function of central banks?

1. Lender of last resort.
2. Conductor of fiscal policy.
3. Banker to the bankers’ bank.

Solution

The correct answer is B.

The government, not the central bank, conducts fiscal policy. The central bank conducts monetary policy.

Functions of the central bank.

1. Monopoly supplier of the currency.
2. Banker to the government and the bankers’ bank.
3. Lender of last resort.
4. Regulator and supervisor of the payment system.
5. Supervisor of the banking system.
6. Manager of foreign currency and gold reserves.
7. Conductor of monetary policy.