What Is a Central Bank?

By Triston Martin Updated on Sep 13, 2022
A central bank, reserve bank, or monetary authority is a government agency controlling the currency supply and formulating monetary policy for an entire country or monetary union. In contrast to a commercial bank, a central bank has exclusive power to expand the money supply..


What Is a Central Bank? However, commercial banks like Bank of America, Chase, or TD Bank, where you might deposit your money, are not the same as central banks. Monetary policy refers to the actions central banks take to affect the money supply, interest rates, and inflation in a given economy. When prices keep going up, the currency of the country in question loses purchasing power and, thus, less value (also known as a decline in purchasing power). The presence of inflation indicates economic expansion. However, excessive inflation undermines the currency's purchasing power, which dampens investment and lending activity and causes people to spend their life savings. Central banks exert considerable effort to limit price increases.

The Functioning of Central Banks

Monetary Policy

Central banks can influence their expansion by regulating the flow of money in the economy. They can use three instruments of monetary policy to get there. To begin, they mandated a certain level of reserves. It is the minimum cash balance that each member bank must maintain at all times. It is a tool of the central bank in regulating bank lending.

Bank Regulation

Members of central banks are subject to oversight. The possibility of loan losses necessitates adequate reserves. They have the duty of safeguarding depositors' money and maintaining financial stability.

Providing Financial Services

Private banks and the government rely on the services of central banks. Checks are cashed, and loans are made to members. Foreign exchange reserves are a means by which central banks save and store foreign cash. To affect a shift in exchange rates, they tap into their reserves. They supplement their currency with foreign currency, typically the US dollar or the Euro, to keep prices stable.

Activities Of Central Banks

Standard central bank duties include the setting the official interest rate and managing the money supply is an example of monetary policy; acting as the government's banker and the bankers' bank ("lender of last resort") is an example of financial stability; reserve management is an example of financial stability; banking supervision is an example of banking industry regulation and supervision; payment systems is an example of managing or supervising the means of payment and inter-bank clearing systems, and managing or supervising coins and notes is an example of monetary policy.

Ways By Which Central Banks Typically Alter The Volume Of Their Assets

Purchases and sales of government securities or other qualified paper constitute the bulk of "open-market activities." Still, transactions in bankers' acceptances and other types of paper are also typically permitted. Open-market operations can only be used as an effective tool of monetary policy in countries with robust securities markets.

Rediscounts and discounts are short-term advances on commercial paper or government securities that banks use to cover brief spikes in demand for loanable funds or to replenish cash reserves lost due to a decline in deposits. In many countries, the central bank is the government's only significant source of credit. Direct government lending from central banks is often frowned upon as fostering monetary irresponsibility and is usually subject to statutory limitation, although it is widely utilised.

Central Banks and Deflation

After major financial crises, deflation fears have increased significantly during the previous quarter century. The situation in Japan is a sobering illustration. The Japanese economy, one of the fastest-growing in the world from the 1960s to the 1980s, slowed considerably after its equities and real estate bubbles burst in 1989-90, forcing the Nikkei index to lose one-third of its value within a year.3 Deflation became entrenched. Japan's '90s were dubbed the "Lost Decade."

Objectives of Central Bank

Due to catastrophic economic occurrences, central banks' goals have shifted significantly over time. In the 1970s, for instance, achieving full employment was a top priority for central banks. But policymakers and central bankers lost sight of inflation as they concentrated on the job market. The money would be pumped into the economy not to keep prices stable but to make sure people had jobs. However, inflation was a cost of this.


Central banks are financial institutions that manage the money supply and interest rates for an entire country or international bloc. By expanding or contracting the money supply and access to credit, central banks implement monetary policy to stabilise national economies. The quantity of cash reserves that banks must keep about their deposits is one of the regulations issued by a central bank. When other banks and governments face difficulties, the central bank can step in as a lender of last resort.