How can you explain central bank functions?

Central banks are powerful institutions that play a crucial role in the economy. They are responsible for managing the money supply, setting interest rates, and overseeing the financial system. But how do they do it? And what are the benefits and challenges of their actions? In this article, you will learn about the main functions of central banks and how they affect the economy.

1 Money creation

One of the most important functions of central banks is to create money. Money is not only the physical cash and coins that you use to pay for goods and services, but also the electronic deposits that you have in your bank account. Central banks can create money by buying government bonds or other assets from commercial banks or the public. This increases the amount of money in circulation and lowers the interest rate, which stimulates spending and borrowing. Central banks can also destroy money by selling assets, which reduces the money supply and raises the interest rate, which slows down the economy.

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Mattia Mucci

Treasury & Finance Manager
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The money creation (or destruction) process can affects financial management policy both for leveraged and unleveraged companies. In leveraged companies this process can change the amount of interest expenses that it has to pay. If it has a loan with a variable rate it is exposed to this risk and it could be useful to consider that risk in your risk management process (always when you have to find a new way of financing). It may seem that for unleveraged companies it cannot have problems but it isn't. During period 2020-2022 ECB set interest rates below 0% and some banks created a new fee (Exhange Liquidity Fee) that increased costs for companies with a lot of liquidity.

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2 Monetary policy

Another key function of central banks is to conduct monetary policy. Monetary policy is the use of money creation and interest rates to influence the level of economic activity, inflation, and exchange rates. Central banks usually have a target for inflation, which is the general increase in prices over time. If inflation is too high, central banks can tighten monetary policy by reducing the money supply and raising the interest rate, which makes borrowing more expensive and reduces demand. If inflation is too low, central banks can loosen monetary policy by increasing the money supply and lowering the interest rate, which makes borrowing cheaper and boosts demand.

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Mohammad Jasim Uddin

Chief Investment Officer | MBA | MPF | University of Dhaka |
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In order to have Macroeconomic Stability, Central Bank try to maintain low and stable inflation, stable growth in output and employment. In addition, one of the task of monetary policies, which is very crucial, is to promote maximum employment and price stability.

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3 Financial stability

A third major function of central banks is to ensure financial stability. Financial stability means that the financial system can function smoothly and efficiently, without disruptions or crises. Central banks can promote financial stability by acting as a lender of last resort, which means that they can provide emergency loans to commercial banks or other financial institutions that face liquidity problems. Central banks can also regulate and supervise the financial system, by setting rules and standards for banks and other financial intermediaries, and by monitoring their activities and risks.

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Mohammad Jasim Uddin

Chief Investment Officer | MBA | MPF | University of Dhaka |
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As for financial stability, Central Bank has to minimize and contain systemic risks through active monitoring and engagement at home and abroad.

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4 Currency management

A fourth essential function of central banks is to manage the currency. Currency is the legal tender that is used as a medium of exchange, a unit of account, and a store of value. Central banks can issue and withdraw currency, and control its quality and security. Central banks can also influence the exchange rate, which is the price of one currency in terms of another. Central banks can intervene in the foreign exchange market by buying or selling foreign currencies, which affects the demand and supply of their own currency.

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5 Economic research and advice

A fifth important function of central banks is to conduct economic research and provide advice. Economic research is the analysis of economic data, trends, and issues, using various methods and models. Central banks can use economic research to inform their decisions on monetary policy, financial stability, and currency management. Central banks can also provide advice to the government, the public, and other stakeholders on economic matters, such as fiscal policy, trade policy, and development policy.

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6 International cooperation

A sixth vital function of central banks is to cooperate with other central banks and international organizations. International cooperation is the coordination and collaboration of policies and actions across countries and regions, to achieve common goals and address shared challenges. Central banks can cooperate with other central banks by exchanging information, coordinating monetary policy, and providing mutual assistance. Central banks can also cooperate with international organizations, such as the International Monetary Fund, the World Bank, and the Bank for International Settlements, by participating in their activities, contributing to their resources, and following their standards and guidelines.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Mohammad Jasim Uddin

Chief Investment Officer | MBA | MPF | University of Dhaka |
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Financial system works better when there is utmost trust in governance of the financial system, which has to be ensured by the Central Bank. It will help to avoid bank run and proper utilizing of surplus fund to role the economic activities. Monitoring, Supervision won't work fully when there is lack of governance in the system as a whole and weak legal system in country.

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How can you explain central bank functions?

1

2

3

4

5

6

7

1 Money creation

2 Monetary policy

3 Financial stability

4 Currency management

5 Economic research and advice

6 International cooperation

7 Here’s what else to consider

Economics

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How can you explain central bank functions?

1

2

3

4

5

6

7

1 Money creation

2 Monetary policy

3 Financial stability

4 Currency management

5 Economic research and advice

6 International cooperation

7 Here’s what else to consider

Economics

Rate this article

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