The principles of central banking

The chief feature that distinguishes central banks from commercial banks is their ability to issue irredeemable or “fiat” paper notes, which in most nations are the only available form of paper currency and the only form of money having unlimited legal-tender status. Besides being held by the general public, central bank notes also serve, together with central bank deposit credits, as the cash reserves of commercial banks. It is the central banks’ monopoly of paper currency and bank reserves that allows them to exercise control over the total supply of money (including commercial bank deposits) available in the economies over which their monopoly privileges extend. By altering national money stocks, central banks indirectly influence rates of spending and inflation and, to a far more limited extent, rates of employment and the production of goods and services. Central banks also can influence the fate of individual banks, and indeed the stability of the banking industry as a whole, by granting or refusing emergency assistance in their role as lender of last resort. Finally, central banks typically take part in the regulation of commercial banks. In this capacity they may enforce a variety of rules governing such things as cash reserve ratios, interest rates, investment portfolios, equity capital, and entry into the banking industry.

Central banks can control national money stocks in two ways: directly, by limiting their issues of paper currency, and indirectly, by altering available supplies of bank reserves and thereby influencing the value of the deposit credits that banks are capable of maintaining. Generally speaking, however, control is secured entirely though the market for bank reserves, with currency supplied to banks on demand in exchange for existing reserve credits.

In most industrialized nations the supply of bank reserves is mainly regulated by means of central bank sales and purchases of government securities, foreign exchange, and other assets in secondary or open asset markets. When a central bank purchases assets in the open market, it pays for them with a check drawn upon itself. The seller then deposits the check with a commercial bank, which sends the check to the central bank for settlement in the form of a credit to the bank’s reserve account. Banking system reserves are thus increased by the value of the open-market purchase. Open-market asset sales have the opposite consequence, with the value of checks written by securities dealers being deducted from the reserve accounts of the dealers’ banks. The principal merit of open-market operations as an instrument of monetary control is that such operations allow central banks to exercise full control over outstanding stocks of basic money.

Two other instruments of monetary control of considerable importance are changes in mandated bank reserve requirements (minimum legal ratios of bank cash reserves to deposits of various kinds) and changes in the discount rate (the interest rate a central bank charges on loans made to commercial banks and other financial intermediaries). Changes in reserve requirements work not by altering the total outstanding value of bank reserves but by altering the total value of deposits supported by available cash reserves.

The role of discount-rate changes is frequently misunderstood by the general public. Instead of purchasing assets on the open market, a central bank can purchase assets directly from a commercial bank. Traditionally such direct purchasing was known as “discounting,” because assets were acquired at a discount from their face or maturity value, with the discount rate embodying an implicit rate of interest. Today central bank support to commercial banks often takes the form of outright loans, even in systems (such as that of the United States) in which official central bank lending rates continue to be referred to as “discount” rates.

Confusion arises because it is often the case that, in setting their own discount rates, central banks are able to influence market lending rates. In practice, most central banks supply relatively little base money through their discount windows, often restricting their discount or lending operations mainly to troubled banks but even denying funds to some of those. Consequently, there may be no connection at all between the rates central banks charge commercial banks and other (including commercial-bank) lending rates. Some central banks have contributed to misunderstandings by using changes in their discount rates as a means of signaling their intention either to increase or to reduce the availability of bank reserves, with the actual easing or tightening of bank reserve market conditions being accomplished, more often than not, by means of open market operations.

Although most central banks (at least those not bound by a fixed exchange-rate commitment) continue to pursue a variety of objectives, economists generally believe that their principal aim should be long-term price stability, meaning an annual rate of general price inflation that is within the range of 0 to 3 percent. While other popular monetary policy objectives, including the financing of government expenditures, combating unemployment, and “smoothing” or otherwise regulating interest rates, are not necessarily at loggerheads with this goal, failure to subordinate such objectives to that of price-level stability has often proved to be a recipe for high inflation.

It is sometimes assumed that, by setting their own discount rates, central banks are able to influence, if not completely control, general market lending rates. In truth, most central banks supply relatively little base money in the form of direct loans or discounts to commercial banks. Central banks wield the greatest influence on rates that banks charge each other for short-term, especially overnight, funds. In some countries overnight interbank lending rates (such as the Federal Funds Rate in the United States, the London Interbank Offered Rate, or LIBOR, in England, and the Tokyo Interbank Offered Rate, or TIBOR, in Japan) function as important indirect guides to the central bank’s monetary policy. Yet even in this respect the ability of central banks to influence inflation-adjusted interest rates is very limited, especially in the long term.

In its role as a lender of last resort, a central bank offers financial support to individual banking firms. Central banks perform this role to prevent such banks from failing prematurely and, more important, to prevent a general loss of confidence that could trigger widespread runs on a country’s banks.

Such a banking panic can involve large-scale withdrawals of currency from the banking system, which, by exhausting bank reserves, might cause the banking system to collapse, depriving firms of access to an essential source of funding while making it extremely difficult for the central bank to steer clear of a deflationary crisis. By standing ready to provide aid to troubled banks and thereby assuring depositors that at least some of the economy’s banking firms are in no danger of failing, central banks make the challenge of monetary control easier while maintaining the flow of bank credit.