The Central Bank (CB) is the main financial institution in the country, which is responsible for issuing licenses, new money emission, regulating the exchange rate, stabilizing the economy and for a number of other components.
The Central Bank is named different in many countries. For example, in Abkhazia, Belarus, Georgia, Moldova, Ukraine and a number of other countries this has a name «The country’s National Bank». In Armenia, Iran, Russia, Turkey it is named «The Central Bank». In Israel, Canada, Latvia, Estonia and many others countries it is called just a Bank. In Bulgaria, China, it is called «The People’s Bank». There are also other names, for example, «The Reserve Bank of Australia», «The US Federal Reserve», etc.
The functions of these structres are similar to each other in spite of the names abundance. I propose to consider the principle of operation of all Central Banks in more detail, by using simple examples.
How does the Central Bank function and why is it important?
Let`s assume that the government has formed a hole in the budget, which needs something to close. The authorities go to The Central Bank and ask for money to fulfill their social obligations, when there is no other way. The Central Bank doesn`t give money like this, but it wants to receive a bond in return, a promissory note, which indicates that over time the government will give money with interest. The State has no choice, because the Central Bank is a monopolist in creating new money, respectively, it is possible to take new bank bills only from it.
However, not only the government needs money, also ordinary citizens want to get loans for their personal purposes. Unfortunately, they cannot come to the Central Bank and ask for money, because this structure doesn`t work with individuals. There are ordinary commercial banks, which are kind of intermediaries between the Central Bank and the citizens.
The central bank also lends money to commercial banks as well as to the government at a certain percentage, which is called « the discount rate». Those give loans to ordinary people at a percentage, which is slightly higher than the discount. It turns out, that the percentage on loans for ordinary citizens is directly dependent on the discount rate. When it smaller, then loans is the cheaper for the population and demand is higher. There is a logical question: «Why don`t make the rate lower, so that citizens have the opportunity to borrow money for business development and thereby stimulate economic development?». The fact is that, when the interest rate decreases, then inflation rate rises because money becomes more in circulation and this depreciate faster. As a result, prices for goods are rising and this is not profitable for the country.
Therefore, the Central Bank changes the discount rate quite rarely and carefully so that there are no disastrous consequences. This is one of the main instruments that the Central Bank can manage for the development of the country’s economy. The discount rate affects the interest on loans and deposits, the level of inflation, it is used in government bonds. All these variables should be considered, when the discount rate is changing. For example, if analysts of the Central Bank fix a high unemployment rate, then a reduction in the discount rate can has a positive effect on the situation. Cheaper loans and mortgages stimulate consumption, people spend money more, refinance previously taken loans, and develop previously unprofitable businesses. If the level of employment is higher than necessary, then the discount rate may be increased for curbing inflation.
The central bank affects the exchange rate by using the same discount rate. For example, with a decrease in this indicator, the yield on government bonds decreases and consequently foreign investors buy this less. In that regard, the international currency market decreases the demand for national currency. An example is the situation in 2007. The US Federal Reserve lowered the discount rate for the first time in 4 years and that this affected to the dollar exchange rate immediately, which collapsed. However, this is only one of the components of the exchange rates formation. In 2003, the Central Bank of Europe lowered the rate by half a percent, but the EUR increased. Therefore, it is important to consider the discount rate during the prediction of currency rates, moreover it is important to pay attention to other aspects.
[Central Bank of Russia]
There is a logical question: «If the discount rate is so close to 0, and the economy is still in a phase of recession or crisis, what should can be done?». There is one more instrument for increasing the economy development- quantitative easing is an additional emission of currency. How does it work? The central bank buys bonds of financial institutions, in exchange for issuing loans at 0% per annum. Money becomes more and the interest rate is a zero (in spite on the official discount rate). The economy is rehabilitated.
What else does the central bank do?
– Licensing of commercial banks and regulation of their activities. Any financial organization must receive a license from the Central Bank for carrying out its activities. For getting it and at don’t losing it at the same time, it is necessary to constantly report on financial flows, comply with laws, implement the KYC system and fulfill a number of other requirements of the Central Bank.
– Monitors the quality of the services provision to people and businesses. As we have already found out, the Central Bank plays the role of a regulator, therefore it also monitors quality customer service from commercial banks and other financial organizations. For example, the transition to remote service, which is currently actively taking place in the territory of the Russian Federation, is an initiative of the Central Bank.
– Increases financial literacy. In 2017, the Bank of Russia launched a large-scale project on financial literacy. It takes part in the development of educational programs for schools and universities, conducts various events, and prepares information materials for the media and so on.
The Central bank is the main instrument in the country`s economic life. It creates money and distributes this according to the needs. It buys government bonds, changes the discount rate, controls inflation, the exchange rate. As a rule, the Central Bank is the main financial institution within its own country, however, the FED can influence not only the economic situation of the United States, but also the entire world.
[The amount of public debt for each citizen of the country]
There arises the main question that many ask. What if only the Central Bank can print money, then how can the state or ordinary citizens return it with a percentage? For example, if you take 100 rubles in debt and you have no more money, then how can you return 110 rubles? The answer is simple – taking another loan. Thus, we conclude that the whole world lives in debt.
The central bank of the country is the main agency, which is responsible for the monetary policy of the state. It seems that it should be completely state-owned and subjects only to the authorities, because there would be raised the financial security question of the whole country, if the central bank belongs to private entities.
In the second part of the article we will take a closer look at who owns the central banks by using the example of the Russian Federation and why they can don`t make contact with the government at all, if they wish.