10 July 2015
A central bank is a public institution that manages the currency of a country or group of countries and controls the money supply – literally, the amount of money in circulation. The main objective of many central banks is price stability. In some countries, central banks are also required by law to act in support of full employment.
One of the main tools of any central bank is setting interest rates – the “cost of money” – as part of its monetary policy. A central bank is not a commercial bank. An individual cannot open an account at a central bank or ask it for a loan and, as a public body, it is not motivated by profit.
It does act as a bank for the commercial banks and this is how it influences the flow of money and credit in the economy to achieve stable prices. Commercial banks can turn to a central bank to borrow money, usually to cover very short-term needs. To borrow from the central bank they have to give collateral – an asset like a government bond or a corporate bond that has a value and acts as a guarantee that they will repay the money.
Because commercial banks might lend long-term against short-term deposits, they can face “liquidity” problems – a situation where they have the money to repay a debt but not the ability to turn it into cash quickly. This is where a central bank can step in as a “lender of last resort.” This helps keep the financial system stable. Central banks can have a wide range of tasks besides monetary policy. They usually issue banknotes and coins, often ensure the smooth functioning of payment systems for banks and traded financial instruments, manage foreign reserves, and play a role in informing the public about the economy. Many central banks also contribute to the stability of the financial system by supervising the commercial banks to make sure the lenders are not taking too many risks.