Topical text B "Central banks"

Instead of taking deposits and making loans as ordinary banks do, a central bank provides financial services to the government and to the banking sector. In most countries, the central bank prints and issues currency – printing banknotes into circulation. It controls economy by increasing or decreasing the country’s supply of money. If there is more money in circulation, demand in the economy increases, but so does inflation. Central banks can act in three main ways:

1. Reserve requirements

Country’s banks have to keep reserves – a certain amount of their deposits – for customers who want to withdraw their money. These are held by the central bank, which can also change the reserve requirements – the minimum percentage of its deposits a bank has to keep in its reserves. When reserve requirements are raised, banks have less money available to make loans and the economy cools.

If one bank goes bankrupt, it can quickly affect the stability of the whole financial system. And if depositors think a bank is unsafe they might all try to withdraw their money. If this happens it’s called a bank run, and the bank will quickly use up its reserves. The central bank can act as lender of last resort, which means lending money to financial institutions in difficulty, to allow them to make payments. But central banks don’t always bail out or rescue banks in difficulty, because this could lead banks to take risks that are too long.

2. Raising and lowering interest rates

The central bank controls the ‘base rate’ (AmE – discount rate) – how much country’s banks have to pay to borrow money from them. This rate is passed on with some additional percentage as profit to any customer who needs a loan. At this point it is referred to as the interest rate. When the central bank decides that the economy is growing too slowly or not growing at all it can reduce the interest rate it charges on the loans to the country’s banks. When banks are allowed to get cheaper money at the central bank, they can make cheaper loans to businesses and consumers, providing an important stimulus to economic growth. Alternatively, if the economy is booming, the central bank raises rates. This makes borrowing more expensive. So businesses borrow less, and the economy slows as companies spend less on labour, plant, equipment, etc.

3. Open-market operations

The central bank buys and sells bonds. To cool the economy it can sell bonds to the public. The money received in payment is no longer in circulation for the purchase of goods and services. To stimulate the economy it buys back bonds from the public, and the money it pays enters circulation.

In addition to coordinating the country’s monetary policy, the central bank supervises the banking system, in most cases acting independently of its government to provide a stabilizing influence on the country’s economy.