4.4.3 - Role of the Central Bank Flashcards
Define Central Bank
the major financial institution in a country, responsible for printing and issuing notes and coins, setting short - term interest rates, controlling monetary policy and issuing government debt
E.g. Bank of England is central Bank for UK
E.g. Federal Reserve Bank is the central bank for the USA
Four Roles of the Central Bank
. Implementation of monetary policy
. Banker to the government
. Banker to other Banks - lender of last resort
. Regulator of the financial system
Explain ‘implementation of monetary policy’
Central bank control monetary policy through interest rates and controlling money supply in order to keep inflation low and stable
Explain ‘ Acting as a Banker to governments’
. Most central banks act as the banker to their government
. They handle the bank accounts of government departments, hold government debt and foreign exchange reserves
Explain ‘ Banker to other Bank - Lender of last resort’
. Commercial and retail bank deposit their money with the central bank in order to balance their accounts
. The role of the central bank is to act as a lender of last resort, which can occur if banks face illiquidity crises. This can happen for two reasons :
1.) A bank can can run out of liquid assets to pay money it owes. For example a bank experience a withdrawal of £50 million more than it expected by its customers. The bank has assets but since they are illiquid, it is difficult to sell immediately, therefore it turns to the central bank as the lender of last resort to borrow £50 million or sell it some illiquid assets
2.) If the bank is on the brink of collapse as its assets have fallen too far in value e.g. the financial crisis of 2007-8, then the bank can lend them money to prevent them from collapsing.
.Banks tend to lend to each other and so the collapse of one bank will lead to the collapse of other banks; this means that this role is important since as it allows the bank to ensure financial stability
However, it may lead to a moral hazard. This is as banks may engage in highly profitable, high - risk activities because they know if they make large losses, the central bank will bail them.
Define ‘Lender of Last Resort’
Function of central bank; it occurs when financial institutions obtain money from the central bank to balance their account when they are able to do this from the financial markets they operate in.
Explain ‘Regulator of the financial system’
Regulation is used to prevent market failure and to prevent the financial system from collapsing. It includes :
1.) Banning market rigging
2.) Preventing the sale of unsuitable products
3.) Increasing interest rates to prevent consumer exploitation
and prevent excessive risky lending. Low interest rates would encourage speculative activity in property and equity markets and can lead to an unsustainable bubble with asset prices rising.
However, increasing interest rates would reduce AD in the long run by reducing consumption and investment.
4.) Deposit insurance to protect consumer deposits
5.) Enforce a higher liquidity ratio, which is the ratio of liquid assets held by a bank to their total assets in order to pay off short - term obligations e.g. consumers taking money out of bank. The higher the ratio, the greater the safety margin of the bank. This would help in future downturns where there are loan defaults and bad debts, which is often borne by tax payers, by increased tax rates
However, increasing the liquidity ratio would limit the amount of lending, which would reduce consumption reducing AD. It also reduce investment for firms, which would reduce LRAS
6.) Providing more licensing to encourage smaller banks to enter the industry. This would therefore reduce the monopoly power by reducing market share in larger bank such as HSBC and Barclays. More competition would lead to improved interest rates for savers (don’t expand further in test) and lower interest rates for lending (expand in detail in test)
However, from behavioural economics we know that switching banks is inconvenient so consumers are less likely to do. This means the smaller banks will find it hard to achieve the economies of scale to compete effectively. Additionally, lowering interest rates would reduce to demand - pull inflation
