Central Banking – Some basic purposes

I have read many an essays and books this month. Yet I shall write on this ever clouding topic.

In Sean Connelly’s Wold Economy explained: Banks and Banking (2010. London. Franklin Watts), the central bank serves to combat inflation. It explains it in an interesting way i.e. ‘trend for money…to lose value.’ Most other definitions would describe it as continually increasing prices.

The way to curb inflation is to sell government bonds with higher interest rates. This forces private banks (banks) to follow or get out of the game. Since it is more costly to borrow now due to the new interest rates, borrowing falls. What is meant by ‘less money’ is probably more appropriately explained by reduced money circulation since money flows out less from banks and so the money multiplier becomes more restricted. (The more direct method though is to raise the base interest rate.) Conversely, central banks could repurchase the bonds and reverse the trend. The eventual ideal is maximised (note not ‘full’ or total) employment with stable prices. You could infer that to mean low or non-inflationary growth.

Another role, a controversial one to say the least, is for central banks to act a lender of last resort. In other words, the financial backer when the banks have no one else to turn to. It happens when banks get depositors withdrawing more than they have in their coffers. Consequently, the central banks loan the banks funds at base rate. Of course, this runs the risk of the moral hazard. Banks can therefore do crazy and mad things while expecting the central bankers to act as their (unfortunately – limited) insurance.

To end, do read Connelly’s book. It is brief and a good appetiser.

Good day!