Understanding Central Banks: Roles, Objectives, and Desirable Qualities | CFA Level I Economics

Welcome back as we learn the key roles of the central bank, the primary objectives, and some of the desirable qualities of an effective central bank.

Key Roles of Central Banks

Central banks play a crucial role in maintaining the stability and health of an economy. Their key roles include:

• Supplying money: Central banks have the sole authority to supply money, which is typically fiat money. This type of money, not backed by any tangible asset, derives its value from the trust and acceptance of the people using it.
• Providing banking services: Central banks offer banking services to the government and other banks in the economy. They also serve as a lender of last resort, stepping in to provide funds to banks that are short of money. This role helps ensure the security of depositors’ funds and prevents bank runs.
• Regulating and supervising: Central banks are responsible for regulating and supervising the banking and payments systems. They set standards for risk-taking and reserve requirements for banks under their jurisdiction, ensuring financial stability. Central banks also oversee the smooth operation of domestic and international payment systems.
• Holding reserves: Central banks hold a nation’s gold and foreign currency reserves. These reserves play a crucial role in international trade and maintaining the stability of the domestic currency.
• Conducting monetary policy: Central banks use various tools to control or influence the quantity of money supplied and its growth over time. By doing so, they aim to achieve their stated objectives, such as price stability or economic growth.

Primary Objectives of Central Banks

Although central bank objectives can vary across nations, the single most important objective for most central banks is controlling inflation to promote price stability. High inflation and unexpected inflation can be costly to the economy, so central banks strive to keep inflation close to a stated target rate, typically around 2 to 3% for developed countries.

Developed countries generally find monetary policy an effective tool for regulating the money supply and controlling inflation. However, developing nations may face challenges in using monetary policy to control inflation due to factors such as an illiquid government bond market, a rapidly changing economy, a poor track record in controlling inflation, or a lack of genuine independence for the central bank.

Instead of relying solely on monetary policy, some central banks choose to peg their exchange rate against a major currency, primarily the US dollar. This approach involves setting a fixed level or range for the exchange rate against the dollar and supporting the target by buying and selling the domestic currency in foreign exchange markets. By tying their currency to that of an economy with a good track record on inflation, these countries can effectively “import” the inflation experience of the low-inflation economy.

Desirable Qualities of a Central Bank

For a central bank to succeed in controlling inflation and maintaining economic stability, it should possess three essential qualities:

1. Independence: A central bank should be free from political interference to be truly effective. Independence ensures that the central bank can prioritize price stability and make decisions based on economic indicators rather than political pressures. Independence can be evaluated based on both operational independence (the ability to determine the policy rate) and target independence (the ability to set inflation targets and determine how inflation is computed).
2. Credibility: The credibility of a central bank affects how businesses and households perceive its ability to follow through on its stated intentions. A credible central bank’s targets can become self-fulfilling prophecies. For example, if the market believes that a central bank is serious about achieving a target inflation rate of 3%, wages and other nominal contracts will be based on 3% inflation, resulting in actual inflation being close to 3%.
3. Transparency: A transparent central bank regularly discloses the state of the economy by issuing inflation reports and explaining its views on economic indicators. This transparency helps the central bank gain credibility and reputation, making it easier to influence inflation expectations and achieve its goals.

And that concludes this lesson on central banks. In the next lesson, we’ll discuss the monetary policy tools that central banks use to help them meet their objectives.