Central bank

Family IX · Macro

Not to be confused with monetary policy, interest rate decision, fomc meeting.

Central bank is the public authority responsible for a country's monetary system. It issues the legal-tender currency, sets the policy interest rate, and acts as lender of last resort to commercial banks. Its mandate, independence, and policy tools differ by jurisdiction and are defined in national law.^[1]

Core functions

Most central banks perform a common set of functions, though the legal details vary by country:

Currency issuance — supplying banknotes and reserves, and often coins.
Monetary policy — setting the policy rate or reserve requirements to influence inflation, employment, or exchange-rate targets.
Lender of last resort — providing liquidity to solvent banks during stress.
Payment-system oversight — operating or supervising interbank settlement systems.
Bank supervision — in some jurisdictions, prudential regulation is assigned to a separate agency.

Mandates range from a single inflation target to dual mandates that include maximum employment, and the degree of political independence is set by statute.

Worked example: policy rate and money supply

Suppose a central bank sets a reserve requirement of 10% and buys 1,000,000 in government bonds from a commercial bank. The bank's reserves rise by 1,000,000; with a 10% reserve ratio, the simple money multiplier is 1 / 0.10 = 10.

Simple deposit expansion

Reserve injection1,000,0001,000,000

Reserve ratio10%0.10

Money multiplier1 / 0.1010

Maximum new deposits1,000,000 × 1010,000,000

Actual expansion is smaller because banks hold excess reserves and the public holds currency. The central bank's policy rate influences the cost of reserves and therefore lending and deposit rates across the economy.

Policy transmission

Changes in the policy rate pass through to money-market rates, bank lending rates, asset prices, and the exchange rate. The speed and strength of transmission depend on the financial system's structure, the share of fixed-rate borrowing, and expectations. Central banks also use forward guidance, asset purchases, and reserve remuneration when the policy rate is near its effective lower bound.

Often confused with

monetary policy: Monetary policy is the set of actions a central bank takes to manage the money supply and short-term interest rates in order to influence inflation, employment and economic activity.
interest rate decision: An interest rate decision is the formal announcement by a central bank's policy committee of the target level for its policy interest rate, or of a change to that level, following a scheduled or ad hoc policy meeting.
fomc meeting: The FOMC meeting is a scheduled gathering of the Federal Open Market Committee, the Federal Reserve body that sets US monetary policy, including the target range for the federal funds rate.

References

↑ Policy rate publications of the relevant central banks. Overnight financing follows the interest-rate differential between the two currencies, plus the broker's own markup, so the figure is not fixed.

Family: IX · Macro · Index A–Z