CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions

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Management of Financial Institutions - MGT 604

Lecture # 3

CENTRAL BANK

A central bank, reserve bank or monetary authority, is an entity responsible for the

monetary policy of its country or of a group of member states, such as the European Central

Bank (ECB) in the European Union or the Federal Reserve System in the United States of

America. Its primary responsibility is to maintain the stability of the national currency and

money supply, but more active duties include controlling subsidized-loan interest rates, and

acting as a "bailout" lender of last resort to the banking sector during times of financial

crisis (private banks often being integral to the national financial system).

It may also have supervisory powers, to ensure that banks and other financial institutions do

not behave recklessly or fraudulently. A central bank is usually headed by a governor, but

the titles are president, chief executive, and managing director respectively for the European

Central Bank the Hong Kong Monetary Authority and the Monetary Authority of

Singapore.

In most countries the central bank is state owned and has a minimal degree of autonomy,

which allows for the possibility of government intervening in monetary policy. An

"Independent central bank" is one which operates under rules designed to prevent

political interference; examples include the US Federal Reserve, the Bank of England (since

1997), and the Bank of Canada, the Reserve Bank of Australia, the Banco de la República

de Colombia, and the European Central Bank.

Activities and responsibilities

Functions of a central bank (not all functions are carried out by all banks):

Implementing the basis of monetary policy

Monopoly on the issue of banknotes

Controls the nation's entire money supply

The Government's banker and the bankers' bank ("Lender of Last Resort")

Manages the country's foreign exchange and gold reserves and the Government's

stock register

Regulation and supervision of the banking industry

Setting the official interest rate - used to manage both inflation and the country's

exchange rate - and ensuring that this rate takes effect via a variety of policy mechanisms.

Monetary Policy

Central banks implement a country's chosen monetary policy. At the most basic level, this

involves establishing what form of currency the country may have, whether a fiat currency,

gold-backed currency, currency board or a currency union. When a country has its own

national currency, this involves the issue of some form of standardized currency, which is

essentially a form of promissory note: a promise to exchange the note for "money" under

certain circumstances. Historically, this was often a promise to exchange the money for

precious metals in some fixed amount. Now, when many currencies are fiat money, the

"promise to pay" consists of nothing more than a promise to pay the same sum in the same

currency.

Many central banks are "banks" in the sense that they hold assets (foreign exchange, gold,

and other financial assets) and liabilities. A central bank's primary liabilities are the

currency outstanding, and these liabilities are backed by the assets the bank owns.

Management of Financial Institutions - MGT 604

Unusually, however, central banks in jurisdictions with fiat currencies may "create" new

money to back its own liabilities, to theoretically unlimited amounts.

In many countries, the central bank may use another country's currency either directly (in a

currency union), or indirectly, by using a currency board. In the latter case, local currency is

directly backed by the central bank's holdings of a foreign currency in a fixed-ratio; this

mechanism is used, notably, in Hong Kong and Estonia.

In countries with fiat money, monetary policy may be used as a shorthand form for the

interest rate targets and other active measures undertaken by the monetary authority.

Central or National

There is no standard terminology for the name of a central bank, but many countries use the

"Bank of Country" form (e.g., Bank of England, Bank of Canada, Bank of Russia). Some

are styled national banks, such as the National Bank of Ukraine. In other cases they may

incorporate the word "Central" (e.g. European Central Bank, Central Bank of Ireland). In

many countries, there may be private banks that incorporate the term national. Many

countries have state-owned banks or other quasi-government entities that have entirely

separate functions, such as financing imports and exports.

In some countries, particularly in some Communist countries, the term national bank may

be used to indicate both the monetary authority and the leading banking entity, such as the

USSR's Gosbank (state bank). In other countries, the term national bank may be used to

indicate that the central bank's goals are broader than monetary stability, such as full

employment, industrial development, or other goals.

Interest Rate Interventions

Typically a central bank controls certain types of short-term interest rates. These influence

the stock- and bond markets as well as mortgage and other interest rates. The European

Central Bank for example announces its interest rate at the meeting of its Governing

Council (in the case of the Federal Reserve, the Board of Governors).

Both the Federal Reserve and the ECB are composed of one or more central bodies that are

responsible for the main decisions about interest rates and the size and type of open market

operations, and several branches to execute its policies. In the case of the Fed, they are the

local Federal Reserve Banks, for the ECB they are the national central banks.

Interest rate interventions are the most common and are dealt with in more detail below.

Limits of Enforcement Power

Contrary to popular perception, central banks are not all-powerful and have limited powers

to put their policies into effect. Most importantly, although the perception by the public may

be that the "Central bank" controls some or all interest rates and currency rates, economic

theory, (and substantial empirical evidence) shows that it is impossible to do both at once in

an open economy. Robert Mundell's "Impossible Trinity" is the most famous formulation of

these limited powers, and postulates that it is impossible to target monetary policy (broadly,

interest rates), the exchange rate (through a fixed rate) and maintain free capital movement.

Since most Western economies are now considered "Open" with free capital movement, this

essentially means that central banks may target interest rates or exchange rates with

credibility, but not both at once.

Management of Financial Institutions - MGT 604

Even when targeting interest rates, most central banks have limited ability to influence the

rates actually paid by private individuals and companies.

Even the US must engage in buying and selling to meet its targets. In the most famous case

of policy failure, George Soros arbitraged the pound sterling's relationship to the ECU and

(after making $2B himself and forcing the UK to spend over $8B defending the pound)

forced it to abandon its policy. Since then he has been a harsh critic of clumsy bank policies

and argued that no one should be able to do what he in fact did.

The most complex relationships are those between the yuan and the US dollar, and between

the Euro and its neighbors. The situation in Cuba is so exceptional as to require the Cuban

peso to be dealt with simply as an exception, since the US forbids direct trade with Cuba.

US dollars were ubiquitous in Cuba's economy after its legalization in 1991, but were

officially removed from circulation in 2004 and replaced by the Convertible peso.

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