The Central Bank, It's Functions And The Influence It Has On Other Banks

WHAT IS A CENTRAL BANK

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The central bank is a key institution in the finance sector of any nation because it is response for the issuance and supply of currency and holds the interest rates of the country within a stable range. The central bank unlike the commercial banks does not interact with the public directly rather it acts as the banker for the state and other authorities within the economy. It is equally important in upholding macro economic stability of a nation and fostering growth that is sustainable in nature. The central bank’s role in implementing the nation’s monetary policy allows it to determine popularity of various goods, defend the currency’s value, and assist in improving the state’s economy.

A central bank tends to diminish the degree of political interference in the realm by being autonomous in nature. This autonomy helps the CB to lead policies that focus on the nation’s economics in the long run rather than short pursuits of the political agenda. In many nations, the duties of determining and defining the agenda of the macroeconomic policy, including setting the discount rate and controlling money circulation extend to the central bank. For example, the central would rest with the
US Federal Reserve, European Central Bank and the Bank of England.

Central banks are important for the management of the economy as well as for any potential responses to economic downturns or excessive growth cycles. Among the strategies employed to achieve these objectives are variations in the interest or rates and open market operations. Moreover, through the supervision of economic performance, including inflation and employment, central banks fine-tune their policies to ensure economic growth and stability in the long run.

FUNCTIONS OF THE CENTRAL BANK

The central bank performs certain crucial activities which help it in performing its duty as the pillar of the financial system of a country. These activities assist is preserving financial stability, promoting soundness of banks, and facilitating economic advancement. Stated below are the central bank's core functions:

• PROMULGATION AND MANAGEMENT OF MONETARY POLICY:

The control of money supply with the interest rates is another of the primary duties of the central bank as it forms and implements the monetary policy. Variation of these results into the variation of unemployment, inflation as well as the output of the economy. The policies that the central bank has in place have great relation to the prevailing rates of inflation. For instance, when inflation rates are too high, the central bank will raise the rates of interest so as to reduce the level of expenditure hence controlling inflation. However, in an economic depression, borrowers may gain, in that a lower rate of interest will induce more borrowing therefore increased business activities.

• ISSUING CURRENCY

There is a limitation on the issuance of currency notes and coins to the sole issuer, the central bank. This function ensures standardized currency all over the economy that reduces friction during trading or conducting commerce activities. The central bank can also manage the amount of currency in circulation so as to avoid situations such as hyperinflation, which results from an excessive supply of money in the economy. The power of the central bank to be the only issuer further solidifies its authority as the main financial institution in the country.

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• ACTING AS THE GOVERNMENT’S BANK:

The Government has entrusted a portion of its business to the central bank, which provides numerous services such as the maintenance of government’s accounts, making payments on the Government’s behalf, and giving out loans at times. Through this connection, the Government is able to meet its financial operations such as the collection of taxes as well as the provision of funds for determination. In addition, fiscal policy advice can also be extended by the central bank to the government concerning economic structure, economic situations, and national debts.

• REGULATION AND CONTROL OF COMMERCIAL BANKS:

The authority of the central bank has a direct impact on the functioning of the commercial banking sector which benefits from its oversight, legal clarity and encouragement to operate on the book. Reserve requirements are established by law to determine the level of funds that commercial banks must maintain and are not permitted to lend. Such regulation acts as safeguard against bank runs/ failures in the sense that sufficient amount of funds are set aside to cater for meeting obligations of depositors by the banks. Periodic audits and inspections may also be applied in a bid to protect the interoperability of the financial system while concurrently preventing unscrupulous behaviors in the banking sector.

• CONTROLLING FOREIGN ASSETS AND FOREIGN CURRENCY AND GOLD BULLION:

For purposes of stabilizing the national currency and enhancing foreign trade, foreign central banks hold currency and gold assets. A uniform rate of the national currency is maintained since the central bank can buy or sell foreign exchange so as to control the exchange rate. This is paramount to countries that are engaged in high levels of foreign trade, a strong currency is strategic in ensuring that engagement with foreign countries is smooth.

• LAST RESORT LENDING:

Last resort emergency facilities are provided by central banks to commercial banks and other financial institutions during their time of need. If a bank is illiquid and unable to meet its liabilities, it has the option to obtain advances from the central bank to avert a bankruptcy situation. This function is critical in averting a bank run and sustaining trust in the banking system. The central bank is able to avert systemic failures, which may have serious economic effects, by extending emergency credit during crises in the financial sector.

HOW THE CENTRAL BANK CONTROLS CASH FLOW

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Maintaining political stability, which is also one of the most crucial functions of the central bank, includes managing the rate of cash movement. Cash flow in this situation is used to mean money supply available in the economy. In order to manage cash flow and ensure that such cash is supported by economic objectives, strategies would be employed by the central bank. Some of the measures include interest, open market facility, reserve ratios, and the discount rate.

• CHANGING THE INTEREST RATES:

The cash flow in the economy is managed through the interest rate which is referred to as the benchmark, policy or discount rate. This rate also affects the rates of other loans and savings offered by commercial banks and the government.

If the central bank places high interest rates, the cost of borrowing rises leading to reduced spending and investment. In other words, the cash flow of money gets reduced, leading to the control of inflation. On the contrary, when interest rates are lowered, it becomes less expensive to borrow and thus both investment and spending rise resulting in higher cash flow and swift growth in the economy.

It is appropriate to argue that rate of interest modification is one of the most effective weapons that can be employed by the central bank which relate to inflation rate and rate of employment in the country.

• OPEN MARKET OPERATIONS (OMOs):

According to Economics, open market operations in currency refer to the central bank buying and selling state securities in the open market. Central bank buyouts of government securities however also imply an increase in the monetary supply thus increasing the level of government expenditures.

This creates a cost of borrowing and investing, which can enhance economic growth. The situation is however reversed when the central bank sells government securities as it now takes out money from the economy which reduces cash flow.

OMOs are a broad and efficient technique that the Central Bank uses to control the money supply in relation to the current stage of economic development.

• DRAWING UP THE RESERVE REQUIREMENTS:

Reserve requirements are the minimum funds that commercial banks are allowed to keep sealed and not lend out. Such reserves play a very important role in the economy. A central bank, through a change in these requirements can definitely control the lending capacity of the reserve banks in the country.

If more funds are kept in reserves, the amount of funds available for loaning out will decrease and smoothening of the cash flow will take longer. On the other hand, a decrease in the reserve requirements will lead to the availability of more funds for loaning purposes thereby increasing cash flows.

Reserve ratio is not used frequently like interest rates and OMOs but in a situation of distress it can be useful for altering the money supply by a major degree.

• DISCOUNT RATES AND COMMERCIAL – BANK LOANS:

The central bank, however, has the ability to control the cash flow by setting the discount rate, which is the interest that is charged to other commercial banks which seek the central banks for borrowing.

Higher discount rates tend to act as disincentives to borrowing among the commercial banks which in turn, may limit how much money is available in the economy for lending and may also be helpful in the fight against inflation.

On the other hand, more banks will tend to borrow funds if the discount rate is low thereby increasing money supply and cash flow. Also, in times of financial distress, the central bank may also lend funds to commercial banks but at a lower interest rate to ensure stability in the overall financial system.

This kind of control with regard to cash flow ensures that banks are able to function uninterrupted even in harsh economic conditions.

CONCLUSION

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Like any other modern economy, a central bank controls the implementation of modern monetary policy in a country. Its main functions include the issuance of the national currency, control over the banking system, and regulation of money supply.

Historic events have demonstrated that the main benefit of a central bank to the economy is its independence, which allows it to make long-term welfare-maximizing decisions without interference from the political arena.

The cash flow management of the central bank is achieved by the use of interest rates, open market operations, reserve requirements and discount rates which in turn helps in the growth of the economy, management of inflation and response to economic crises.

Through such cash flow operations, the Central Bank usually has the power to regulate consumers’ and companies’ demand and the economies’ performance in general and such situations as gorge or recession are avoided.

Central banks and their structural investments have become crucial in shaping economic variables and both aspects have become instrumental in enhancing both economic stability and growth.