Role of Central Banks

What is the “Role of Central Banks?”

Central banks are independent state-owned institutions whose role is to formulate monetary policy, act as “Bank to Banks,” be the “Lender of last resort” and regulate the domestic banking system. The formulation of monetary policy is the most important role of central banks. This involves conducting activities to influence the quantity of money and level of credit in the economy, in order to foster price stability, safeguard the value of the domestic currency, promote maximum employment and create an environment that is conducive for long-term growth.

Central Banks – Federal Reserve and the European Central Bank

The Federal Reserve (U.S.) and the European Central Bank (ECB), are the two biggest central banks in the world.

In the U.S., the Federal Reserve has been tasked to promote three economic goals that Congress instructs it to pursue in their conduct of monetary policy which includes, promote maximum employment, stable prices and moderate long-term interest rates.

To achieve these goals, the Fed’s role in monetary policy includes performing open market operations and setting reserve requirements for banks and the discount rate.

The ECB’s role is very similar, however, their stated goal is to maintain price stability, given that it is essential for maintain economic growth and job creation, which are the European Union’s objectives. Maintaining price stability is pivotal to safeguard the value of the currency (euro).

Central Banks – Other Roles

Central banks also play other roles. They act as “Bank to Banks.” Basically, there is “Discount window,” which a central bank offers to banks – for example, in the US, banks can go to the Federal Reserve and borrow funds on a short-term basis which helps to alleviate the liquidity strains or shortages of individual banks or the banking system. The central bank acts as a reliable back-up source of funding for the banks.

The central bank also acts as a “Lender of last resort,” as they have an unlimited capacity to print the local/domestic currency, and can supply adequate funding to the banking system. In some cases, central banks also ensure adequate funding for governments to cover any short-term damaging shortfalls.

Central banks also act as a regulator of the banking system and the payment systems in their respective countries.

Taylor’s Rule

The Taylor’s rule was developed by economist John Taylor. It is a rule that is used by central banks to compute the target short-term interest rate, when the expected growth rate of GDP differs from the long-term growth rate of GDP and expected rate of inflation differs from the target rate of inflation.

This rule provides an indication of where one can expect central banks to set their respective policy rates (for example, the Fed Funds rate in the US).

Given below is the Taylor’s rule formula:

Target Rate: Neutral Rate + 0.5* (GDP (Exp) – GDP(t)) + 0.5*(Inf (Exp) – Inf (Target)

Target Rate = target short-term interest rate

Neutral Rate = the rate that neither stimulates or slows down economic growth (the original Taylor rule takes the neutral rate as 2%).

GDP (EXP) = expected growth rate of GDP

GDP (t) = long-term growth rate of GDP

I (Exp) = expected rate of inflation

I (Target) = target rate of inflation

Role of Central Banks – Taylor’s Rule, An Example

Assume that the US economy was growing at its long-term growth rate of 2.3% and inflation was as at its target rate of 2%. Further, assume that the Federal Reserve had a target short-term interest rate of 3.5%. However, after a few months, the expected inflation rate rises to 3.5% and expected GDP growth (based on annualized GDP growth rate in recent months) is 2.8%.

Based on this information, we want to predict the Federal Reserve’s likely short-term interest rate, which is calculated below using the Taylor’s rule. Here we see that the Federal Reserve will most likely increase short-term interest rate by 1% to the new target of 4.5%.