Lesson 1 of 8 · All lessons in this module
- What central banks do and what they aim for
- The three tools: open market operations, policy rate, reserve requirements
- How a rate change reaches growth, inflation and the currencyVideo lesson
- Effective central banks and inflation targeting
- Exchange rate targeting and policy in developing economies
- Expansionary or contractionary? The neutral rate and the source of shocks
- Limits of monetary policy: weak transmission, deflation and quantitative easingVideo lesson
- How monetary and fiscal policy interact
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Lesson 1 of 8 · 12 min
What central banks do and what they aim for
A central bank issues the country's fiat money and stands behind the banking system, and almost every central bank names one overarching objective for all that work: price stability.
In short
- Modern money is fiat money: not convertible into gold or anything else, but legal tender that must be accepted in payment. Its value rests on trust, so the issuer must guard it.
- Typical roles: monopoly supplier of the currency, banker to the government and the bankers' bank, lender of last resort, regulator and supervisor of the payments system, conductor of monetary policy and supervisor of the banking system.
- Bank supervision is the role central banks are least likely to hold alone: some countries give it to a separate agency or split it among several bodies.
- Most central banks also manage the country's foreign currency and gold reserves.
- Monetary policy means central bank actions aimed at the quantity of money and credit in the economy. Its overarching objective is nearly always price stability, i.e. controlling inflation.
- Tax rates and transfer programmes are fiscal policy, set by the government, not the central bank.
Guardian of fiat money
Early bank notes were promises to pay a fixed amount of a commodity, usually gold. Today no major currency can be swapped by law for anything else. It is fiat money: it has value because the state declares it legal tender and because people accept it for goods, services and debts.
Fiat money only works as a medium of exchange and a unit of account if it holds its value over time. Because a fiat issuer could in principle create unlimited amounts, the institution that supplies it carries a heavy responsibility. In nearly every country that institution is a state-owned central bank, the legal monopoly supplier of the currency.
Sitting at the centre of the money system, the central bank naturally picks up other jobs as well. The next section lists them.
A fiat currency is a promise backed by nothing but confidence. The central bank's whole job can be read as protecting that confidence.
The six usual roles
As banker to the government and the bankers' bank, the central bank holds accounts for the state and for commercial banks, which keep reserves with it and settle payments with each other through it.
As lender of last resort, it can supply cash to a bank that cannot borrow anywhere else, because it can create money. Simply knowing this backstop exists, together with deposit insurance, discourages bank runs. It is not always enough: if depositors panic before help arrives, a run can still start, and a government guarantee may be needed to stop it spreading to other banks.
It also regulates and supervises the payments system, setting standards so that payments are robust, introducing new processes and coordinating with other central banks on cross-border payments. And it is usually the conductor of monetary policy, its highest-profile role.
Banking supervision is the odd one out. Some central banks supervise banks themselves, some share the task with another agency, and in other countries a separate regulator does it. A country can even move the job back and forth over time, for example returning it to the central bank after a crisis exposed gaps.
| Role | What it means in practice |
|---|---|
| Monopoly supplier of the currency | Issues the fiat money and guards its value |
| Banker to government and banks | Holds their accounts and reserves; settles interbank payments |
| Lender of last resort | Lends to banks in a liquidity crisis to prevent runs and contagion |
| Payments system overseer | Sets standards, runs or regulates settlement, coordinates internationally |
| Conductor of monetary policy | Steers money and credit to keep prices stable |
| Banking supervisor | Licenses and supervises deposit takers (not in every country, often shared) |
Reserves and the overarching objective
Most central banks also manage the nation's foreign currency reserves and gold reserves. Central banks as a group still hold so much gold that large sales by them could push the gold price down.
Central bank mandates differ in wording. Some mention financial stability, full employment, sustainable growth or confidence in the financial system. But nearly all name, or rank first, one overarching objective: price stability. A money that keeps a stable value from one period to the next is exactly what fiat money needs.
Some mandates are explicitly dual: for example, a central bank may be told to pursue maximum employment alongside stable prices. Others put price stability first and support other goals only where they do not conflict with it. Either way, controlling inflation is the practical meaning of the price-stability goal.
- Central bank: money, credit, interest rates, lender of last resort, payments, often supervision.
- Government (fiscal policy): tax rates, government spending, transfer payments.
Worked examples
Example 1 Central bank or government?
Classify each action: (1) lending overnight cash to a solvent bank that has lost market funding; (2) raising the tax on interest income; (3) setting technical standards for a new instant-payment system; (4) launching a child-benefit programme.
Example 2 Why a guarantee can stop a run
Mortgage lender Brightwater Bank funded itself mainly in wholesale markets. When those markets froze it asked the central bank for help, the news leaked and depositors withdrew about 6% of deposits in two days. Shares of similar lenders also fell. Why might the government announce a guarantee of all Brightwater deposits, and why did deposits then rise again?
On the exam
Expect 'which role is a central bank least likely to have' (sole bank supervisor, or setting tax rates) and 'what is the overarching objective' (price stability).
- Thinking every central bank supervises its banks alone. Supervision is often separate or shared.
- Choosing 'fast growth' or 'a current account surplus' as the overarching objective. It is price stability.
- Assigning tax changes or transfer programmes to the central bank. Those are fiscal policy.
- Believing fiat money is backed by gold. It is legal tender, not convertible into anything.
Check yourself
Q1A central bank is least likely to be the:
Q2The overarching long-run objective of most central banks is:
Q3Which role is a central bank least likely to hold in every country?
Q4Money that cannot be converted into any commodity but must be accepted in payment is best described as:
Q5The main reason the lender-of-last-resort role helps prevent bank runs is that the central bank:
Answer the 5 questions: +10 XP for each one you get right first time.
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