Central bank

Central bank

Overview
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

, and controls the interest rates in a country. Central banks often also oversee the commercial banking system
Commercial bank
After the implementation of the Glass–Steagall Act, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S...

 of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on printing the national currency, which usually serves as the nation's legal tender
Legal tender
Legal tender is a medium of payment allowed by law or recognized by a legal system to be valid for meeting a financial obligation. Paper currency is a common form of legal tender in many countries....

.
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Encyclopedia
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

, and controls the interest rates in a country. Central banks often also oversee the commercial banking system
Commercial bank
After the implementation of the Glass–Steagall Act, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S...

 of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on printing the national currency, which usually serves as the nation's legal tender
Legal tender
Legal tender is a medium of payment allowed by law or recognized by a legal system to be valid for meeting a financial obligation. Paper currency is a common form of legal tender in many countries....

. Examples include the European Central Bank
European Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

 (ECB), the Federal Reserve of the United States, and the People's Bank of China
People's Bank of China
The People's Bank of China is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China...

.

The primary function of a central bank is to provide the nation's money supply, but more active duties include controlling interest rates (monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

), and acting as a lender of last resort
Lender of last resort
A lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to...

 to the banking sector
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...

 during times of financial crisis. It may also have supervisory powers, intended to prevent banks and other financial institutions from reckless or fraudulent behaviour. Central banks in most developed nations are independent in that they operate under rules designed to render them free from political interference.

History



In Europe prior to the 17th century most money was commodity money
Commodity money
Commodity money is money whose value comes from a commodity out of which it is made. It is objects that have value in themselves as well as for use as money....

, typically gold
Gold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...

 or silver. However, promises to pay were widely circulated and accepted as value at least five hundred years earlier in both Europe and Asia. The Song Dynasty
Song Dynasty
The Song Dynasty was a ruling dynasty in China between 960 and 1279; it succeeded the Five Dynasties and Ten Kingdoms Period, and was followed by the Yuan Dynasty. It was the first government in world history to issue banknotes or paper money, and the first Chinese government to establish a...

 was the first to issue generally circulating paper currency, while the Yuan Dynasty
Yuan Dynasty
The Yuan Dynasty , or Great Yuan Empire was a ruling dynasty founded by the Mongol leader Kublai Khan, who ruled most of present-day China, all of modern Mongolia and its surrounding areas, lasting officially from 1271 to 1368. It is considered both as a division of the Mongol Empire and as an...

 was the first to use notes as the predominant circulating medium. In 1455, in an effort to control inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

, the succeeding Ming Dynasty
Ming Dynasty
The Ming Dynasty, also Empire of the Great Ming, was the ruling dynasty of China from 1368 to 1644, following the collapse of the Mongol-led Yuan Dynasty. The Ming, "one of the greatest eras of orderly government and social stability in human history", was the last dynasty in China ruled by ethnic...

 ended the use of paper money and closed much of Chinese trade. The medieval European Knights Templar
Knights Templar
The Poor Fellow-Soldiers of Christ and of the Temple of Solomon , commonly known as the Knights Templar, the Order of the Temple or simply as Templars, were among the most famous of the Western Christian military orders...

 ran an early prototype of a central banking system, as their promises to pay were widely respected, and many regard their activities as having laid the basis for the modern banking system.

As the first public bank to "offer accounts not directly convertible to coin", the Bank of Amsterdam established in 1609 is considered to be the precursor to modern central banks. The central bank of Sweden ("Sveriges Riksbank
Sveriges Riksbank
Sveriges Riksbank, or simply Riksbanken, is the central bank of Sweden and the world's oldest central bank. It is sometimes called the Swedish National Bank or the Bank of Sweden .-History:...

" or simply "Riksbanken") was founded in Stockholm in 1664 and answered to the parliament ("Riksdag of the Estates
Riksdag of the Estates
The Riksdag of the Estates , was the name used for the Estates of the Swedish realm when they were assembled. Until its dissolution in 1866, the institution was the highest authority in Sweden next to the King...

") thus making it the oldest central bank still operating today. One role of the Swedish central bank was lending to the government, which was likewise true of the Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...

, created in 1694 by Scottish businessman William Paterson
William Paterson (banker)
Sir William Paterson was a Scottish trader and banker.- Early life :...

 in the City of London
City of London
The City of London is a small area within Greater London, England. It is the historic core of London around which the modern conurbation grew and has held city status since time immemorial. The City’s boundaries have remained almost unchanged since the Middle Ages, and it is now only a tiny part of...

 at the request of the English
Kingdom of England
The Kingdom of England was, from 927 to 1707, a sovereign state to the northwest of continental Europe. At its height, the Kingdom of England spanned the southern two-thirds of the island of Great Britain and several smaller outlying islands; what today comprises the legal jurisdiction of England...

 government to help pay for a war. The War of the Second Coalition
War of the Second Coalition
The "Second Coalition" was the second attempt by European monarchs, led by the Habsburg Monarchy of Austria and the Russian Empire, to contain or eliminate Revolutionary France. They formed a new alliance and attempted to roll back France's previous military conquests...

 led to the creation of the Banque de France
Banque de France
The Banque de France is the central bank of France; it is linked to the European Central Bank . Its main charge is to implement the interest rate policy of the European System of Central Banks...

 in 1800.

Although central banks today are generally associated with fiat money
Fiat money
Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...

, the 19th and early 20th centuries central banks in most of Europe and Japan
Bank of Japan
is the central bank of Japan. The Bank is often called for short. It has its headquarters in Chuo, Tokyo.-History:Like most modern Japanese institutions, the Bank of Japan was founded after the Meiji Restoration...

 developed under the international gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...

, elsewhere free banking
Free banking
Free banking refers to a monetary arrangement in which banks are subject to no special regulations beyond those applicable to most enterprises, and in which they also are free to issue their own paper currency...

 or currency board
Currency board
A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target....

s were more usual at this time. Problems with collapses of banks during downturns, however, was leading to wider support for central banks in those nations which did not as yet possess them, most notably in Australia
Australia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...

.

The US Federal Reserve was created by the U.S. Congress through the passing of The Federal Reserve Act in the Senate and its signing by President Woodrow Wilson
Woodrow Wilson
Thomas Woodrow Wilson was the 28th President of the United States, from 1913 to 1921. A leader of the Progressive Movement, he served as President of Princeton University from 1902 to 1910, and then as the Governor of New Jersey from 1911 to 1913...

 on the same day, December 23, 1913. Australia established its first central bank in 1920, Colombia
Colombia
Colombia, officially the Republic of Colombia , is a unitary constitutional republic comprising thirty-two departments. The country is located in northwestern South America, bordered to the east by Venezuela and Brazil; to the south by Ecuador and Peru; to the north by the Caribbean Sea; to the...

 in 1923, Mexico
Mexico
The United Mexican States , commonly known as Mexico , is a federal constitutional republic in North America. It is bordered on the north by the United States; on the south and west by the Pacific Ocean; on the southeast by Guatemala, Belize, and the Caribbean Sea; and on the east by the Gulf of...

 and Chile
Chile
Chile ,officially the Republic of Chile , is a country in South America occupying a long, narrow coastal strip between the Andes mountains to the east and the Pacific Ocean to the west. It borders Peru to the north, Bolivia to the northeast, Argentina to the east, and the Drake Passage in the far...

 in 1925 and Canada
Canada
Canada is a North American country consisting of ten provinces and three territories. Located in the northern part of the continent, it extends from the Atlantic Ocean in the east to the Pacific Ocean in the west, and northward into the Arctic Ocean...

 and New Zealand
New Zealand
New Zealand is an island country in the south-western Pacific Ocean comprising two main landmasses and numerous smaller islands. The country is situated some east of Australia across the Tasman Sea, and roughly south of the Pacific island nations of New Caledonia, Fiji, and Tonga...

 in the aftermath of the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

 in 1934. By 1935, the only significant independent nation that did not possess a central bank was Brazil
Brazil
Brazil , officially the Federative Republic of Brazil , is the largest country in South America. It is the world's fifth largest country, both by geographical area and by population with over 192 million people...

, which subsequently developed a precursor thereto in 1945 and the present central bank twenty years later. Having gained independence, African and Asian countries also established central banks or monetary unions.

The People's Bank of China
People's Bank of China
The People's Bank of China is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China...

 evolved its role as a central bank starting in about 1979 with the introduction of market reforms, which accelerated in 1989 when the country adopted a generally capitalist approach to its export economy. Evolving further partly in response to the European Central Bank
European Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

, the People's Bank of China has by 2000 become a modern central bank. The most recent bank model, was introduced together with the euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...

, involves coordination of the European national banks, which continue to manage their respective economies separately in all respects other than currency exchange and base interest rates.

Activities and responsibilities



Functions of a central bank may include:
  • implementing monetary policies.
  • determining Interest rates
  • controlling the nation's entire money supply
  • the Government's banker and the bankers' bank ("lender of last resort")
  • managing the country's foreign exchange
    Foreign exchange market
    The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...

     and gold reserves and the Government's stock register
  • regulating and supervising the banking industry
  • setting the official interest rate – used to manage both inflation
    Inflation
    In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

     and the country's exchange rate
    Exchange rate
    In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

     – and ensuring that this rate takes effect via a variety of policy mechanisms

Monetary policy


Central banks implement a country's chosen monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

. At the most basic level, this involves establishing what form of currency the country may have, whether a fiat currency, gold-backed currency
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...

 (disallowed for countries with membership of the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

), currency board
Currency board
A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target....

 or a currency union
Currency union
A currency union is where two or more states share the same currency, though without there necessarily having any further integration such as an Economic and Monetary Union, which has in addition a customs union and a single market.There are three types of currency unions:#Informal - unilateral...

. 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
Promissory note
A promissory note is a negotiable instrument, wherein one party makes an unconditional promise in writing to pay a determinate sum of money to the other , either at a fixed or determinable future time or on demand of the payee, under specific terms.Referred to as a note payable in accounting, or...

: 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
Fiat money
Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...

, the "promise to pay" consists of the promise to accept that currency to pay for taxes.

A central bank may use another country's currency either directly (in a currency union), or indirectly (a currency board). In the latter case, exemplified by Bulgaria
Bulgaria
Bulgaria , officially the Republic of Bulgaria , is a parliamentary democracy within a unitary constitutional republic in Southeast Europe. The country borders Romania to the north, Serbia and Macedonia to the west, Greece and Turkey to the south, as well as the Black Sea to the east...

, Hong Kong
Hong Kong
Hong Kong is one of two Special Administrative Regions of the People's Republic of China , the other being Macau. A city-state situated on China's south coast and enclosed by the Pearl River Delta and South China Sea, it is renowned for its expansive skyline and deep natural harbour...

 and Latvia
Latvia
Latvia , officially the Republic of Latvia , is a country in the Baltic region of Northern Europe. It is bordered to the north by Estonia , to the south by Lithuania , to the east by the Russian Federation , to the southeast by Belarus and shares maritime borders to the west with Sweden...

, the local currency is backed at a fixed rate by the central bank's holdings of a foreign currency.

In countries with fiat money, the expression "monetary policy" may refer more narrowly to the interest-rate targets and other active measures undertaken by the monetary authority.

Goals of monetary policy


High employment:

Frictional unemployment
Frictional unemployment
Frictional unemployment is the time period between jobs when a worker is searching for, or transitioning from one job to another. It is sometimes called search unemployment and can be voluntary based on the circumstances of the unemployed individual....

 is the time period between jobs when a worker is searching for, or transitioning from one job to another. Unemployment beyond frictional unemployment is classified as unintended unemployment.

For example, structural unemployment
Structural unemployment
Structural unemployment is a form of unemployment resulting from a mismatch between demand in the labour market and the skills and locations of the workers seeking employment...

 is a form of unemployment resulting from a mismatch between demand in the labour market and the skills and locations of the workers seeking employment. Macroeconomic policy generally aims to reduce unintended unemployment.

Keynes labeled any jobs that would be created by a rise in wage-goods (i.e., a decrease in real-wages
Real wage
The term real wages refers to wages that have been adjusted for inflation. This term is used in contrast to nominal wages or unadjusted wages. Real wages provide a clearer representation of an individual's wages....

) as involuntary unemployment:


Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.


John Maynard Keynes

John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

, The General Theory of Employment, Interest and Money p11




Price stability;

Inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 is defined either as the devaluation of a currency or equivalently the rise of prices relative to a currency.

Since inflation lowers real wage
Real wage
The term real wages refers to wages that have been adjusted for inflation. This term is used in contrast to nominal wages or unadjusted wages. Real wages provide a clearer representation of an individual's wages....

s, Keynesians
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 view inflation as the solution to involuntary unemployment. However, "unanticipated" inflation leads to lender losses . Thus, Keynesian monetary policy aims for a steady rate of inflation.

In opposition to Keynes, the Austrian School of economics views inflation simply as a transfer of wealth from currency holders to those who inflate the currency.

Economic growth:

Economic growth is enhanced by investment in technological advances in production. Savings can supply funds for investment. However, low interest rates and concomitant high inflation typically provide a disincentive for saving .

Interest rate stability:

Free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...

s can sometimes include volatile interest rates. This volatility can generate costs to lenders and borrowers . So, central banks set interest rates in order to control the price of money.

Financial market stability:

Foreign exchange market stability:

Conflicts among goals:

Goals frequently cannot be separated from each other and often conflict. Costs must therefore be carefully weighed before policy implementation.

Currency issuance


In similarity with commercial banks, central banks hold assets (foreign exchange, gold, and other financial assets) and incur liabilities (currency outstanding).

Central banks create money by issuing zero interest currency notes and selling them to the public in exchange for interest-bearing assets such as government bonds. When a central bank wishes to purchase more bonds than their respective national governments make available, they purchase assets denominated in foreign currencies. Income from the interest paid by governments on those bonds is referred to as seigniorage
Seigniorage
Seigniorage can have the following two meanings:* Seigniorage derived from specie—metal coins, is a tax, added to the total price of a coin , that a customer of the mint had to pay to the mint, and that was sent to the sovereign of the political area.* Seigniorage derived from notes is more...

.

The European Central Bank
European Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

 remits its interest income to the central banks of the member countries of the European Union.

The state-sanctioned power to create currency is called the Right of Issuance. Throughout history there have been great disagreements over this power, since whoever controls the creation of currency ultimately controls the entire economy.

Naming of central banks


There is no standard terminology for the name of a central bank, but many countries use the "Bank of Country" form (for example: Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...

, Bank of Canada
Bank of Canada
The Bank of Canada is Canada's central bank and "lender of last resort". The Bank was created by an Act of Parliament on July 3, 1934 as a privately owned corporation. In 1938, the Bank became a Crown corporation belonging to the Government of Canada...

, Bank of Russia). Some are styled "national" banks, such as the National Bank of Ukraine
National Bank of Ukraine
National Bank of Ukraine is the central bank of Ukraine. Its headquarters building, constructed between 1902 and 1934, is located at no. 9 Institutska St., in Kiev-History:...

; but the term "national bank
National bank
In banking, the term national bank carries several meanings:* especially in developing countries, a bank owned by the state* an ordinary private bank which operates nationally...

" is more often used by privately-owned commercial banks, especially in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

. In other cases, central banks may incorporate the word "Central" (for example, European Central Bank, Central Bank of Ireland); but the Central Bank of India
Central Bank of India
Central Bank of India , a government-owned bank, is one of the oldest and largest commercial banks in India. It is based in Mumbai...

 is a (government-owned) commercial bank and not a central bank. The word "Reserve" is also often included, such as the Reserve Bank of India
Reserve Bank of India
The Reserve Bank of India is the central banking institution of India and controls the monetary policy of the rupee as well as US$300.21 billion of currency reserves. The institution was established on 1 April 1935 during the British Raj in accordance with the provisions of the Reserve Bank of...

, Reserve Bank of Australia
Reserve Bank of Australia
The Reserve Bank of Australia came into being on 14 January 1960 as Australia's central bank and banknote issuing authority, when the Reserve Bank Act 1959 removed the central banking functions from the Commonwealth Bank to it....

, Reserve Bank of New Zealand
Reserve Bank of New Zealand
The Reserve Bank of New Zealand is the central bank of New Zealand and is constituted under the Reserve Bank of New Zealand Act 1989. The Governor of the Reserve Bank is responsible for New Zealand's currency and operating monetary policy. The Bank's current Governor is Dr. Alan Bollard...

, the South African Reserve Bank
South African Reserve Bank
The South African Reserve Bank is the central bank of South Africa. It was established in 1921 after Parliament passed an act, the "Currency and Bank Act of 10 August 1920," as a direct result of the abnormal monetary and financial conditions which World War I had brought...

, and U.S. Federal Reserve System
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...

. 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 Soviet Union
Soviet Union
The Soviet Union , officially the Union of Soviet Socialist Republics , was a constitutionally socialist state that existed in Eurasia between 1922 and 1991....

's Gosbank
Gosbank
Gosbank was the central bank of the Soviet Union and the only bank whatsoever in the entire Union from the 1930s until the year 1987. Gosbank was one of the three Soviet economic authorities, the other two being "Gosplan" and "Gossnab"...

 (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 rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s. These influence the stock-
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...

 and bond market
Bond market
The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a mechanism for long term funding of public and...

s as well as mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...

 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 U.S. Federal Reserve, the Board of Governors
Board of governors
Board of governors is a term sometimes applied to the board of directors of a public entity or non-profit organization.Many public institutions, such as public universities, are government-owned corporations. The British Broadcasting Corporation was managed by a board of governors, though this role...

.

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

Limits


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
Robert Mundell
Robert Mundell, CC is a Nobel Prize-winning Canadian economist. Currently, Mundell is a professor of economics at Columbia University and the Chinese University of Hong Kong....

's "impossible trinity
Impossible trinity
The Impossible Trinity is a trilemma in international economics suggesting it is impossible to have all three of the following at the same time:...

" 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.

Even when targeting interest rates, most central banks have limited ability to influence the rates actually paid by private individuals and companies. In the most famous case of policy failure, Black Wednesday
Black Wednesday
In politics and economics, Black Wednesday refers to the events of 16 September 1992 when the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism after they were unable to keep it above its agreed lower limit...

, George Soros
George Soros
George Soros is a Hungarian-American business magnate, investor, philosopher, and philanthropist. He is the chairman of Soros Fund Management. Soros supports progressive-liberal causes...

 arbitraged the pound sterling
Pound sterling
The pound sterling , commonly called the pound, is the official currency of the United Kingdom, its Crown Dependencies and the British Overseas Territories of South Georgia and the South Sandwich Islands, British Antarctic Territory and Tristan da Cunha. It is subdivided into 100 pence...

's relationship to the ECU
European Currency Unit
The European Currency Unit was a basket of the currencies of the European Community member states, used as the unit of account of the European Community before being replaced by the euro on 1 January 1999, at parity. The ECU itself replaced the European Unit of Account, also at parity, on 13...

 and (after making $2 billion himself and forcing the UK to spend over $8bn 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 did.

The most complex relationships are those between the yuan
Renminbi
The Renminbi is the official currency of the People's Republic of China . Renminbi is legal tender in mainland China, but not in Hong Kong or Macau. It is issued by the People's Bank of China, the monetary authority of the PRC...

 and the US dollar, and between the euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...

 and its neighbours. The situation in Cuba
Cuba
The Republic of Cuba is an island nation in the Caribbean. The nation of Cuba consists of the main island of Cuba, the Isla de la Juventud, and several archipelagos. Havana is the largest city in Cuba and the country's capital. Santiago de Cuba is the second largest city...

 is so exceptional as to require the Cuban peso
Cuban peso
The peso is one of two official currencies in use in Cuba, the other being the convertible peso...

 to be dealt with simply as an exception, since the United States 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
Cuban convertible peso
The convertible peso , is one of two official currencies in Cuba, the other being the peso. It has been in limited use since 1994, when it was treated as equivalent to the U.S. dollar: its value was officially US$1.00. On November 8, 2004, the U.S...

.

Policy instruments



The main monetary policy instruments
Macroeconomic policy instruments
Macroeconomic policy instruments refer to macroeconomic quantities that can be directly controlled by an economic policy maker. Instruments can be divided into two subsets: a) Monetary policy instruments and b) Fiscal policy instruments. Monetary policy is conducted by the Federal Reserve or the...

 available to central banks are open market operation
Open market operation
Open market operations is the buying and selling of government bonds on the open market by a central bank. It is the primary means of implementing monetary policy by a central bank. The usual aim of open market operations is to control the short term interest rate and the supply of base money in...

, bank reserve requirement
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...

, interest rate policy, re-lending and re-discount (including using the term repurchase market), and credit policy (often coordinated with trade policy). While capital adequacy is important, it is defined and regulated by the Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...

, and central banks in practice generally do not apply stricter rules.

To enable open market operations, a central bank must hold foreign exchange reserves
Foreign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...

 (usually in the form of government bond
Government bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...

s) and official gold reserves
Official gold reserves
A gold reserve is the gold held by a central bank or nation intended as a store of value and as a guarantee to redeem promises to pay depositors, note holders , or trading peers, or to secure a currency....

. It will often have some influence over any official or mandated exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

s: Some exchange rates are managed, some are market based (free float) and many are somewhere in between ("managed float" or "dirty float").

Interest rates


By far the most visible and obvious power of many modern central banks is to influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. Although the mechanism differs from country to country, most use a similar mechanism based on a central bank's ability to create as much fiat money
Fiat money
Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...

 as required.

The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from (taking deposits from) a limited number of qualified banks, or by purchasing and selling bonds. As an example of how this functions, the Bank of Canada
Bank of Canada
The Bank of Canada is Canada's central bank and "lender of last resort". The Bank was created by an Act of Parliament on July 3, 1934 as a privately owned corporation. In 1938, the Bank became a Crown corporation belonging to the Government of Canada...

 sets a target overnight rate
Overnight rate
The overnight rate is generally the rate that large banks use to borrow and lend from one another on the overnight market. In some countries , the overnight rate may be the rate targeted by the central bank to influence monetary policy...

, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited. Other central banks use similar mechanisms.

It is also notable that the target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity and other factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, even below the short-term rate. Many central banks have one primary "headline" rate that is quoted as the "central bank rate". In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced.

"The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines." – Henry C.K. Liu. Liu explains further that "the U.S. central-bank lending rate is known as the Fed funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...

. The Fed sets a target for the Fed funds rate, which its Open Market Committee
Federal Open Market Committee
The Federal Open Market Committee , a committee within the Federal Reserve System, is charged under United States law with overseeing the nation's open market operations . It is the Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money...

 tries to match by lending or borrowing in the money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...

 ... a fiat money system set by command of the central bank. The Fed is the head of the central-bank because the U.S. dollar is the key reserve currency for international trade. The global money market is a USA dollar market. All other currencies markets revolve around the U.S. dollar market." Accordingly the U.S. situation is not typical of central banks in general.

A typical central bank has several interest rates or monetary policy tools it can set to influence markets.
  • Marginal lending rate
    Discount window
    The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions...

     (currently 2.00% in the Eurozone) – a fixed rate for institutions to borrow money from the central bank. (In the USA this is called the discount rate
    Discount rate
    The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....

    ).
  • Main refinancing rate (1.25% in the Eurozone) – the publicly visible interest rate the central bank announces. It is also known as minimum bid rate and serves as a bidding floor for refinancing loans. (In the USA this is called the federal funds rate
    Federal funds rate
    In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...

    ).
  • Deposit rate (0.50% in the Eurozone) – the rate parties receive for deposits at the central bank.


These rates directly affect the rates in the money market, the market for short term loans.

Open market operations


Through open market operation
Open market operation
Open market operations is the buying and selling of government bonds on the open market by a central bank. It is the primary means of implementing monetary policy by a central bank. The usual aim of open market operations is to control the short term interest rate and the supply of base money in...

s, a central bank influences the money supply in an economy directly. Each time it buys securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...

, exchanging money for the security, it raises the money supply. Conversely, selling of securities lowers the money supply. Buying of securities thus amounts to printing new money while lowering supply of the specific security.

The main open market operations are:
  • Temporary lending of money for collateral
    Collateral (finance)
    In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...

     securities ("Reverse Operations" or "repurchase operations
    Repurchase agreement
    A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...

    ", otherwise known as the "repo" market). These operations are carried out on a regular basis, where fixed maturity
    Maturity (finance)
    In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....

     loans (of one week and one month for the ECB) are auctioned off.
  • Buying or selling securities ("direct operations
    Direct operations
    Direct operations is the term for when a central bank purchases bonds directly from its government.Direct operations work as follows: Governments typically sell bonds when their expenditures exceed revenue from taxes...

    ") on ad-hoc basis.
  • Foreign exchange
    Foreign exchange market
    The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...

     operations such as forex swap
    Forex swap
    In finance, a forex swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates .; see Foreign exchange derivative.-Structure:...

    s.


All of these interventions can also influence the foreign exchange market
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...

 and thus the exchange rate. For example the People's Bank of China
People's Bank of China
The People's Bank of China is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China...

 and the Bank of Japan
Bank of Japan
is the central bank of Japan. The Bank is often called for short. It has its headquarters in Chuo, Tokyo.-History:Like most modern Japanese institutions, the Bank of Japan was founded after the Meiji Restoration...

 have on occasion bought several hundred billions of U.S. Treasuries
Treasury security
A United States Treasury security is government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States federal government, and they are often referred to simply as Treasuries...

, presumably in order to stop the decline of the U.S. dollar
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....

 versus the renminbi
Renminbi
The Renminbi is the official currency of the People's Republic of China . Renminbi is legal tender in mainland China, but not in Hong Kong or Macau. It is issued by the People's Bank of China, the monetary authority of the PRC...

 and the yen.

Capital requirements


All banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the central bank or the banking supervisor. For international banks, including the 55 member central banks of the Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...

, the threshold is 8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain assets (such as government bonds) are considered to have lower risk and are either partially or fully excluded from total assets for the purposes of calculating capital adequacy. Partly due to concerns about asset inflation and repurchase agreements, capital requirements may be considered more effective than reserve requirements in preventing indefinite lending: when at the threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet.

Reserve requirements


Historically, bank reserves
Bank reserves
Bank reserves are banks' holdings of deposits in accounts with their central bank , plus currency that is physically held in the bank's vault . The central banks of some nations set minimum reserve requirements...

 have formed only a small fraction of deposits, a system called fractional reserve banking. Banks would hold only a small percentage of their assets in the form of cash reserves
Bank reserves
Bank reserves are banks' holdings of deposits in accounts with their central bank , plus currency that is physically held in the bank's vault . The central banks of some nations set minimum reserve requirements...

 as insurance against bank runs. Over time this process has been regulated and insured by central banks. Such legal reserve requirement
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...

s were introduced in the 19th century as an attempt to reduce the risk of banks overextending themselves and suffering from bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...

s, as this could lead to knock-on effects on other overextended banks. See also money multiplier
Money multiplier
In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money...

.


As the early 20th century gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...

 was undermined by inflation and the late 20th century fiat dollar hegemony
Dollar hegemony
Dollar hegemony is the hypothesized monetary hegemony of the US dollar in the global economy. Henry C.K. Liu popularized the term in the article "Dollar Hegemony has to go" in Asia Times, April 11, 2002...

 evolved, and as banks proliferated and engaged in more complex transactions and were able to profit from dealings globally on a moment's notice, these practices became mandatory, if only to ensure that there was some limit on the ballooning of money supply. Such limits have become harder to enforce. The People's Bank of China
People's Bank of China
The People's Bank of China is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China...

 retains (and uses) more powers over reserves because the yuan
Renminbi
The Renminbi is the official currency of the People's Republic of China . Renminbi is legal tender in mainland China, but not in Hong Kong or Macau. It is issued by the People's Bank of China, the monetary authority of the PRC...

 that it manages is a non-convertible currency.

Loan activity by banks plays a fundamental role in determining the money supply. The central-bank money after aggregate settlement – "final money" – can take only one of two forms:
  • physical cash, which is rarely used in wholesale financial markets,
  • central-bank money which is rarely used by the people

The currency component of the money supply is far smaller than the deposit component. Currency, bank reserves and institutional loan agreements together make up the monetary base, called M1, M2 and M3
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

. The Federal Reserve Bank stopped publishing M3 and counting it as part of the money supply in 2006.

Exchange requirements


To influence the money supply, some central banks may require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally used in countries with non-convertible currencies or partially-convertible currencies. The recipient of the local currency may be allowed to freely dispose of the funds, required to hold the funds with the central bank for some period of time, or allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be otherwise limited.

In this method, money supply is increased by the central bank when it purchases the foreign currency by issuing (selling) the local currency. The central bank may subsequently reduce the money supply by various means, including selling bonds or foreign exchange interventions.

Margin requirements and other tools


In some countries, central banks may have other tools that work indirectly to limit lending practices and otherwise restrict or regulate capital markets. For example, a central bank may regulate margin lending, whereby individuals or companies may borrow against pledged securities. The margin requirement establishes a minimum ratio of the value of the securities to the amount borrowed.

Central banks often have requirements for the quality of assets that may be held by financial institutions; these requirements may act as a limit on the amount of risk and leverage created by the financial system. These requirements may be direct, such as requiring certain assets to bear certain minimum credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...

s, or indirect, by the central bank lending to counterparties only when security of a certain quality is pledged as collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...

.

Examples of use


The People's Bank of China
People's Bank of China
The People's Bank of China is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China...

 has been forced into particularly aggressive and differentiating tactics by the extreme complexity and rapid expansion of the economy it manages. It imposed some absolute restrictions on lending to specific industries in 2003, and continues to require between 1% and 3% more reserves from large urban banks (typically focusing on export) than rural ones. This is not by any means an unusual situation. The USA historically had very wide ranges of reserve requirements between its dozen branches. Domestic development is thought to be optimized mostly by reserve requirements rather than by capital adequacy methods, since they can be more finely tuned and regionally varied.

Banking supervision and other activities


In some countries a central bank through its subsidiaries controls and monitors the banking sector. In other countries banking supervision is carried out by a government department such as the UK Treasury, or an independent government agency (for example, UK's Financial Services Authority
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...

). It examines the banks' balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...

s and behaviour and policies toward consumers. Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes and coins or foreign currency. Thus it is often described as the "bank of banks".

Many countries such as the United States will monitor and control the banking sector through different agencies and for different purposes, although there is usually significant cooperation between the agencies. For example, money center banks, deposit-taking institutions, and other types of financial institutions may be subject to different (and occasionally overlapping) regulation. Some types of banking regulation may be delegated to other levels of government, such as state or provincial governments.

Any cartel of banks is particularly closely watched and controlled. Most countries control bank mergers and are wary of concentration in this industry due to the danger of groupthink and runaway lending bubbles based on a single point of failure
Single point of failure
A single point of failure is a part of a system that, if it fails, will stop the entire system from working. They are undesirable in any system with a goal of high availability or reliability, be it a business practice, software application, or other industrial system.-Overview:Systems can be made...

, the credit culture of the few large banks.

Independence


Over the past decade, there has been a trend towards increasing the independence of central banks as a way of improving long-term economic performance. However, while a large volume of economic research has been done to define the relationship between central bank independence and economic performance, the results are ambiguous.

Advocates of central bank independence argue that a central bank which is too susceptible to political direction or pressure may encourage economic cycles ("boom and bust
Boom and bust
A credit boom-bust cycle is an episode characterized by a sustained increase in several economics indicators followed by a sharp and rapid contraction. Commonly the boom is driven by a rapid expansion of credit to the private sector accompanied with rising prices of commodities and stock market index...

"), as politicians may be tempted to boost economic activity in advance of an election, to the detriment of the long-term health of the economy and the country. In this context, independence is usually defined as the central bank's operational and management independence from the government.

The literature on central bank independence has defined a number of types of independence.

Legal independence: The independence of the central bank is enshrined in law. This type of independence is limited in a democratic state; in almost all cases the central bank is accountable at some level to government officials, either through a government minister or directly to a legislature. Even defining degrees of legal independence has proven to be a challenge since legislation typically provides only a framework within which the government and the central bank work out their relationship.

Goal independence: The central bank has the right to set its own policy goals, whether inflation targeting, control of the money supply, or maintaining a fixed exchange rate. While this type of independence is more common, many central banks prefer to announce their policy goals in partnership with the appropriate government departments. This increases the transparency of the policy setting process and thereby increases the credibility of the goals chosen by providing assurance that they will not be changed without notice. In addition, the setting of common goals by the central bank and the government helps to avoid situations where monetary and fiscal policy are in conflict; a policy combination that is clearly sub-optimal.

Operational independence: The central bank has the independence to determine the best way of achieving its policy goals, including the types of instruments used and the timing of their use. This is the most common form of central bank independence. The granting of independence to the Bank of England in 1997 was, in fact, the granting of operational independence; the inflation target continued to be announced in the Chancellor's annual budget speech to Parliament.

Management independence: The central bank has the authority to run its own operations (appointing staff, setting budgets, and so on.) without excessive involvement of the government. The other forms of independence are not possible unless the central bank has a significant degree of management independence. One of the most common statistical indicators used in the literature as a proxy for central bank independence is the "turn-over-rate" of central bank governors. If a government is in the habit of appointing and replacing the governor frequently, it clearly has the capacity to micro-manage the central bank through its choice of governors.

It is argued that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. Recently, both the Bank of England (1997) and the European Central Bank have been made independent and follow a set of published inflation targets
Inflation targeting
Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or "target", inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.Because interest rates and the...

 so that markets know what to expect. Even the People's Bank of China
People's Bank of China
The People's Bank of China is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China...

 has been accorded great latitude due to the difficulty of problems it faces, though in the People's Republic of China
People's Republic of China
China , officially the People's Republic of China , is the most populous country in the world, with over 1.3 billion citizens. Located in East Asia, the country covers approximately 9.6 million square kilometres...

 the official role of the bank remains that of a national bank
National bank
In banking, the term national bank carries several meanings:* especially in developing countries, a bank owned by the state* an ordinary private bank which operates nationally...

 rather than a central bank, underlined by the official refusal to "unpeg" the yuan or to revalue it "under pressure". The People's Bank of China's independence can thus be read more as independence from the USA which rules the financial markets, than from the Communist Party of China
Communist Party of China
The Communist Party of China , also known as the Chinese Communist Party , is the founding and ruling political party of the People's Republic of China...

 which rules the country. The fact that the Communist Party is not elected also relieves the pressure to please people, increasing its independence.

Governments generally have some degree of influence over even "independent" central banks; the aim of independence is primarily to prevent short-term interference. For example, the chairman of the U.S. Federal Reserve Bank is appointed by the President of the U.S. (all nominees for this post are recommended by the owners of the Federal Reserve, as are all the board members), and his choice must be confirmed by the Congress.

International organizations such as the World Bank
World Bank
The World Bank is an international financial institution that provides loans to developing countries for capital programmes.The World Bank's official goal is the reduction of poverty...

, the Bank for International Settlements
Bank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...

 (BIS) and the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

 (IMF) are strong supporters of central bank independence. This results, in part, from a belief in the intrinsic merits of increased independence. The support for independence from the international organizations also derives partly from the connection between increased independence for the central bank and increased transparency in the policy-making process. The IMF's Financial Services Action Plan
Financial Services Action Plan
The Financial Services Action Plan is a key component of the European Union's attempt to create a single market for financial services. Created in 1999 and to last for a period of six years, it contained 42 articles related to the harmonization of the financial services markets within the European...

 (FSAP) review self-assessment, for example, includes a number of questions about central bank independence in the transparency section. An independent central bank will score higher in the review than one that is not independent.

Criticism


According to the Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

, central banking tends to wreak havoc on an economy by systematically devaluing a currency by over creating this currency against nothing of intrinsic value (such as gold), resulting in never-ending inflation. The main opponents to fractional reserve central banking are the proponents of the Austrian business cycle theory, including Ludwig von Mises
Ludwig von Mises
Ludwig Heinrich Edler von Mises was an Austrian economist, philosopher, and classical liberal who had a significant influence on the modern Libertarian movement and the "Austrian School" of economic thought.-Biography:-Early life:...

, Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...

 and Murray Rothbard
Murray Rothbard
Murray Newton Rothbard was an American author and economist of the Austrian School who helped define capitalist libertarianism and popularized a form of free-market anarchism he termed "anarcho-capitalism." Rothbard wrote over twenty books and is considered a centrally important figure in the...

.

See also

  • Fractional-reserve banking
    Fractional-reserve banking
    Fractional-reserve banking is a form of banking where banks maintain reserves that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction of the quantity of deposits as reserves...

  • List of central banks
  • National bank
    National bank
    In banking, the term national bank carries several meanings:* especially in developing countries, a bank owned by the state* an ordinary private bank which operates nationally...

  • Seigniorage
    Seigniorage
    Seigniorage can have the following two meanings:* Seigniorage derived from specie—metal coins, is a tax, added to the total price of a coin , that a customer of the mint had to pay to the mint, and that was sent to the sovereign of the political area.* Seigniorage derived from notes is more...

  • State bank
    State bank
    A state bank is generally a financial institution that is chartered by a state. It differs from a reserve bank in that it does not necessarily control monetary policy , but instead usually offers only retail and commercial services.A state bank that has been in operation for five years or less is...

  • Interbank lending market
    Interbank lending market
    The interbank lending market is a market in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate...

  • Free banking
    Free banking
    Free banking refers to a monetary arrangement in which banks are subject to no special regulations beyond those applicable to most enterprises, and in which they also are free to issue their own paper currency...


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