Role of Central Banks

A central bank underpins the financial system. In the U.K. the central bank is the Bank of England. In the eurozone countries it is the European Central Bank (ECB). In the U.S.A. It is the Federal Reserve Bank, usually referred to as ‘the Fed’. A central bank has a number of responsibilities:

issuing notes and coins
implementation of monetary policy
managing the country’s reserves of gold and foreign currency
managing the exchange rate (if a country is on a fixed exchange rate)
acting as the government’s banker
acting as banker to the commercial banks – the lender of last resort
regulating the financial services industry

The most important responsibilities are described below:

1. Implementation of Monetary Policy

Monetary policy has been delegated by the government to the Bank of England (B of E), the central bank for the UK. This gives the B of E independence from political pressure so it can concentrate on its main task of keeping inflation at the target level set by the government. Other major economies such as the USA and eurozone have also handed control of monetary policy to their central banks. Central banks that are not independent of government may be required to take measures (such as cutting interest rates) to improve the government’s popularity, which may cause problems or the economy later on.

In the U.K. the Monetary Policy Committee (MPC) of the B of E meets once a month to set Base Rate, which is the most important interest rate in the economy. The MPC comprises nine members, five of whom (including the Governor) are from the B of E. The other 4 are independent economists. It is the rate at which the B of E will lend to the major banks in the U.K. The B of E is the lender of last resort, which means that a bank in difficulty can borrow from the B of E to avoid a collapse that would threaten confidence in the entire banking system.

If the B of E raises Base Rate, the commercial banks will protect themselves from the risk of the higher cost of borrowing by raising their own lending rates to borrowers. If they are charging borrowers more, competition between the banks will force them to offer savers higher rates too. Equally, a fall in Base Rate enables them to lower their lending rates in order to attract more customers. The banks will then also have to lower the rates they pay to savers in order to restore their profit margins. (Essentially, banks make a profit by borrowing from savers at a low rate of interest and lending this money to other customers at a higher rate).

It follows from this that interest rates throughout the economy are influenced by changes in Base Rate. Changes in interest rates will affect the overall level of aggregate demand [C+I+G+(X-M)] as all the components of AD are likely to change:

Consumption – A rise in interest rates is likely to cause consumption to fall and vice versa. Higher interest rates increase the cost of borrowing, which is important for ‘big ticket’ items such as cars and furniture. Higher interest rates also make saving more attractive (and therefore make consumption less attractive). Interest rate changes also affect consumption through ‘wealth effects’; lower rates drive up prices of assets such as houses and shares, encouraging more consumption and vice versa.

_Investment _– A fall in rates will encourage investment and vice versa

Net exports (X-M) – A fall in interest rates may cause the exchange rate to fall.This should make exports more competitive and imports less competitive, leading to a rise in net exports.

The B of E is set an inflation target by the government. Since 1997 this target has stayed at 2%. If inflation varies by more than 1% from this target (ie below 1% or above 3%) the Governor of the B of E has to write an open letter to the Chancellor explaining why it has happened and what measures the Bank will take to bring the rate back to target.

If inflation is above target, the B of E can raise interest rates in order to reduce AD. This should then result in a fall in equilibrium output and a fall in the price level; - ie lower inflation. If inflation is too low, the B of E can lower interest rates to stimulate AD and push inflation up.

The MPC of the B of E looks at economic forecasts to try to predict the likely course of inflation in the period ahead. It does not just react to the current rate of inflation when setting base rate. It may raise base rate in an attempt to head off a possible increase in inflation.

Although meeting the inflation target is the B of E’s major responsibility, it is not always the only consideration when setting interest rates, particularly when the economy is facing exceptional circumstances. After the banking crisis of 2007/8, which plunged the economy into a very severe recession, base rate was cut to 0.5% in 2009 (the lowest in the Bank’s 300 year history). Base rate stayed at 0.5% until 2016, when it was lowered even further to 0.25%. For much of the period, inflation was above target (reaching 5% in 2011), but the Bank took the view that the inflationary pressures were temporary, and caused by cost push factors, such as high oil prices, rather than excess demand.

During the banking crisis of 2007/8 and the subsequent deep recession that affected most of the rich countries (especially North America and Europe), central banks all cut interest rates to record lows, close to zero.

The severity of the banking crisis caused a big reduction in banks ability and willingness to lend. This deepened the recession as finance for business investment, mortgages and consumer credit dried up.

The sharp fall in interest rates proved insufficient to stimulate demand, in part because of banks unwillingness to lend. They had become over cautious in lending, whereas previously they had not been cautious enough.

Central banks therefore deployed another policy instrument: - quantitative easing (QE). Central banks have the unique power to ‘print’ money (this means creating deposits, rather than printing bank notes).

The B of E created hundreds of billions of pounds in new money, which it used to buy financial assets from the banks. This injected huge amounts of money into the banking system for the banks to lend out to businesses and households.

The financial assets were mainly bonds. (a form of long term borrowing by the government and large companies). Bonds earn a fixed interest payment. It therefore follows that if the price of the bonds rises, the effective rate of interest, called the yield, goes down. For instance, a fixed interest of £10 on a bond whose market price is £100 gives a yield of 10%. if the price goes up to £200, the yield falls to 5%.

__QE __therefore also contributed to driving down interest rates in the economy, as well as enabling the banks to lend more.

A third effect of __QE __is on the exchange rate; the big increase in the supply of sterling, and the fall in interest rates makes the currency less attractive to investors, so it falls in value against other currencies. This should also help to stimulate AD. However, if all major economies are pursuing __QE __and the supply of all currencies increases, there is not likely to be much effect on exchange rates.

Note that a programme of QE can be reversed by the central bank; it would have to sell the financial assets back to the banks. This would mean the banks use up some of their cash to buy the assets, and will therefore have to reduce the amount they lend out. It would also cause bond prices to fall, so interest rates would rise.

Summary: A fall in base rate or a programme of QE will cause an increase in AD, (a shift of the AD curve to the right), resulting in higher equilibrium output and possibly a rise in the price level (depending on whether a Keynesian or neoclassical LRAS model is used, and whether the economy is already at full employment). This is called expansionary monetary policy (also known as a ___loosening ___of monetary policy.

A rise in base rate or a reversal of QE will have the opposite effect and is called contractionary monetary policy (sometimes called a ___tightening ___of monetary policy).

4. Regulating the Financial Services Industry

There are several reasons why it is important to have effective regulation of the financial services industry. Institutions that break the regulations can be fined or have their licences to operate taken away. The main forms of regulation are as follows:

_Control of interest rates _– For instance, ‘pay day loan’ companies (which make short term loans to very high risk borrowers who can’t get credit elsewhere) have had a cap put on the interest and other charges they make to customers

Control of reserves – If banks make too many bad lending decisions, there is a risk that they will not have sufficient reserves of cash and other assets that can be used to cover their losses. This could cause a crisis if the bank then did not have enough cash to meet customers’ withdrawals and repay savers. In particular banks have to maintain a minimum amount of shareholders’ capital in proportion to the value of their loans. For instance if that ratio is set at 20%, a bank which has loaned out £10 billions would have to have at least £2 billions of shareholders capital. This ratio places a limit on the bank’s ability to lend, so that if some borrowers default, the losses are borne by the shareholders (the capital they invested in the business) rather than by getting a bailout from the government (which is what happened in the financial crash in 2007/8).

Compensation to customers – When banks and other institutions give misleading information and sell financial products that are inappropriate for customers, they can be forced to pay compensation to the customers and may also face large fines.

Explain how a change in Base Rate will affect aggregate demand.: Your answer should include: lender of last resort / consumption / investment / net exports

3. Acting as Banker to the Commercial Banks

The commercial banks all have their own accounts with the central bank. They can then settle their payments to each other by transferring money from their own accounts to those of other banks, in much the same way a bank customer can make a payment to someone else by transferring money from his/her account to someone else’s.

A vital function of the central bank is to act as lender of last resort. To prevent a banking collapse, the central bank is always willing to lend (at base rate) to the commercial banks to make sure they have sufficient liquidity __(ie cash) to meet the needs of customers who want to make withdrawals. This can create a problem of __moral hazard.

2. Acting as the Government’s Banker

Most central banks manage the country’s national debt (the accumulated total of all government borrowing). This includes the sale of new government bonds (loans to the government, usually bought by banks and other financial institutions). Central banks will sometimes lend directly to the government in certain exceptional circumstances (if banks are unwilling to buy government bonds).

The ECB is an exception to this; it does not lend to governments of eurozone countries.