Question

What are the functions of a central bank? What are the tools of monetary
policy? How does the FED use these tools to perform its functions?

Answer 1

What are the functions of a central bank?

1 # Bank of Issue:

Central bank now-a-days has the monopoly of note-issue in every country. The currency notes printed and issued by the central bank are declared unlimited legal tender throughout the country.

Central bank has been given exclusive monopoly of note-issue in the interest of uniformity, better control, elasticity, supervision, and simplicity. It will also avoid the possibility of over-issue by individual banks.

The central banks, thus, regulate the currency of country and the total money-supply in the economy. The central bank has to keep gold, silver or other securities against the notes issued. The system of note-issue differs from country to country.

The main objects of the system of currency regulation in general are to see that:

(i) People’s confidence in the currency is maintained,

(ii) Its supply is adjusted to demand in the economy.

Thus, keeping in view the aims of uniformity, elasticity, safety and security, the system of note-issue has been varying from time to time.

Function 2 # Banker, Agent and Adviser to the Government:

Central bank, everywhere, performs the functions of banker, agent and adviser to the government.

“The central bank operates as the government’s banker, not only because it is more convenient and economical to the government, but also because of the intimate connection between public finance monetary affairs.”

As banker to the government, it makes and receives payments on behalf of the government. It advances short-term loans to the government to tide over difficulties.

It floats public loans and manages the public debts on behalf of the government. It keeps the banking accounts and balances of the government after making disbursements and remittances. As an adviser to the government it advises the government on all monetary and economic matters. The central bank also acts as an agent to the government where general exchange control is in force.

Function 3 # Custodian of Cash Reserves:

All commercial banks in a country keep a part of their cash balances as deposits with the central bank, may be on account of convention or legal compulsion. They draw during busy seasons and pay back during slack seasons. Part of these balances is used for clearing purposes. Other member banks look to it for guidance, help and direction in time of need.

It affects centralisation of cash reserves of the member banks. “The centralisation of cash reserves in the central bank is a source of great strength to the banking system of any country. Centralised cash reserves can at least serve as the basis of a large and more elastic credit structure than if the same amount were scattered amongst the individual banks.

It is obvious, when bank reserves are pooled in one institution which is, moreover, charged with the responsibility of safeguarding the national economic interest, such reserves can be employed to the fullest extent possible and in the most effective manner during periods of seasonal strain and in financial crises or general emergencies…the centralisation of cash reserves is conducive to economy in their use and to increased elasticity and liquidity of the banking system and of the credit structure as a whole.”

Function 4 # Custodian of Foreign Balances:

Under the gold standard or when the country is on the gold standard, the management of that standard, with a view to securing stability of exchange rate, is left to the central bank.

After World War I, central banks have been keeping gold and foreign currencies as reserve note-issue and also to meet adverse balance of payment, if any, with other countries. It is the function of the central bank to maintain the exchange rate fixed by the government and manage exchange control and other restrictions imposed by the state. Thus, it becomes a custodian of nation’s reserves of international currency or foreign balances.

Function 5 # Lender of Last Resort:

Central bank is the lender of last resort, for it can give cash to the member banks to strengthen their cash reserves position by rediscounting first class bills in case there is a crisis or panic which develops into ‘run’ on banks or when there is a seasonal strain. Member banks can also take advances on approved short-term securities from the central bank to add to their cash resources at the shortest time.

This facility of turning their assets into cash at short notice is of great use to them and promotes in the banking and credit system economy, elasticity and liquidity.

Thus, the central bank by acting as the lender of the last resort assumes the responsibility of meeting all reasonable demands for accommodation by commercial banks in times of difficulties and strains.

De Kock expresses the opinion that the lending of last resort function of the central bank imparts greater liquidity and elasticity to the entire credit structure of the country. According to Hawtrey, the essential duty of the central bank as the lender of last resort is to make good a shortage of cash among the competitive banks.

Function 6 # Clearing House:

Central bank also acts as a clearing house for the settlement of accounts of commercial banks. A clearing house is an organisation where mutual claims of banks on one another are offset, and a settlement is made by the payment of the difference. Central bank being a bankers’ bank keeps the cash balances of commercial banks and as such it becomes easier for the member banks to adjust or settle their claims against one another through the central bank.

Suppose there are two banks, they draw cheques on each other. Suppose bank A has due to it Rs. 3,000 from bank B and has to pay Rs. 4,000 to B. At the clearing house, mutual claims are offset and bank A pays the balance of Rs. 1,000 to B and the account is settled. Clearing house function of the central bank leads to a good deal of economy in the use of cash and much of labour and inconvenience are avoided.

Function 7 # Controller of Credit:

The control or adjustment of credit of commercial banks by the central bank is accepted as its most important function. Commercial banks create lot of credit which sometimes results in inflation.

The expansion or contraction of currency and credit may be said to be the most important causes of business fluctuations. The need for credit control is obvious. It mainly arises from the fact that money and credit play an important role in determining the level of incomes, output and employment.

According to Dr. De Kock, “the control and adjustment of credit is accepted by most economists and bankers as the main function of a central bank. It is the function which embraces the most important questions of central banking policy and the one through which practically all other functions are united and made to serve a common purpose.”

Thus, the control which the central bank exercises over commercial banks as regards their deposits, is called controller of credit.

Function 8 # Protection of Depositors Interests:

The central bank has to supervise the functioning of commercial banks so as to protect the interest of the depositors and ensure development of banking on sound lines.

The business of banking has, therefore, been recognized as a public service necessitating legislative safeguards to prevent bank failures.

Legislation is enacted to enable the central bank to inspect commercial banks in order to maintain a sound banking system, comprising strong individual units with adequate financial resources operating under proper management in conformity with the banking laws and regulations and public and national interests.

What are the tools of monetary policy?

1. Open Market Operations

Open market operations are when central banks buy or sell securities. These are bought from or sold to the country's private banks. When the central bank buys securities, it adds cash to the banks' reserves. That gives them more money to lend. When the central bank sells the securities, it places them on the banks' balance sheets and reduces its cash holdings. The bank now has less to lend. A central bank buys securities when it wants expansionary monetary policy. It sells them when it executes contractionary monetary policy.12

Quantitative easing is open market operations on steroids.3 Before the recession, the U.S. Federal Reserve maintained between $700-$800 billion of Treasury notes on its balance sheet. It added or subtracted to affect policy, but kept it within that range.4 QE almost quintupled holdings of Treasury notes and mortgage-backed securities to more than $4 trillion by 2014.56

2. Reserve Requirement

The reserve requirement refers to the money banks must keep on hand overnight. They can either keep the reserve in their vaults or at the central bank. A low reserve requirement allows banks to lend more of their deposits. It's expansionary because it creates credit.

A high reserve requirement is contractionary. It gives banks less money to lend. It's especially hard for small banks since they don't have as much to lend in the first place. That's why most central banks don't impose a reserve requirement on small banks. Central banks rarely change the reserve requirement because it's difficult for member banks to modify their procedures.

Central banks are more likely to adjust the targeted lending rate than the reserve requirement. It achieves the same result with less disruption.

The fed funds rate is perhaps the most well-known of these tools. Here's how the fed funds rate works. If a bank can't meet the reserve requirement, it borrows from another bank that has excess cash. The interest rate it pays is the fed funds rate. The amount it borrows is called the fed funds.8 The Federal Open Market Committee sets a target for the fed funds rate at its meetings.

Central banks have several tools to make sure the rate meets that target. The Federal Reserve, the Bank of England, and the European Central Bank pay interest on the required reserves and any excess reserves.10 Banks won't lend fed funds for less than the rate they're receiving from the Fed for these reserves.11 Central banks also use open market operations to manage the fed funds rate.

3. Discount Rate

The discount rate is the third tool.13 It's the rate that central banks charge its members to borrow at its discount window.14 Since it's higher than the fed funds rate, banks only use this if they can't borrow funds from other banks.

Using the discount window also has a stigma attached. The financial community assumes that any bank that uses the discount window is in trouble. Only a desperate bank that's been rejected by others would use the discount window.

How does the FED use these tools to perform its functions?

Central bank tools work by increasing or decreasing total liquidity. That’s the amount of capital available to invest or lend. It's also money and credit that consumers spend. It's technically more than the money supply, known as M1 and M2. The M1 symbol denotes currency and check deposits. M2 is money market funds, CDs, and savings accounts. Therefore, when people say that central bank tools affect the money supply, they are understating the impact.

The Federal Reserve currently uses several tools to implement monetary policy in support of its statutory mandate to foster maximum employment and stable prices.

The Federal Reserve conducts open market operations (OMOs) in domestic markets. OMOs can be permanent, including the outright purchase and sale of Treasury securities, government-sponsored enterprise (GSE) debt securities, and federal agency and GSE mortgage-backed securities (MBS); or temporary, including the purchase of these securities under agreements to resell, and the sale of these securities under agreements to repurchase. The authority to conduct OMOs is granted under section 14 of the Federal Reserve Act, and the range of securities that the Federal Reserve is authorized to purchase and sell is relatively limited. OMOs are conducted by the Federal Reserve Bank of New York's (FRBNY's) Trading Desk, which acts as agent for the Federal Open Market Committee (FOMC). The FRBNY's traditional counterparties for OMOs are the primary dealers with which the FRBNY trades U.S. government and select other securities.² Since 2009, the FRBNY has designated other counterparties for certain OMO programs.

OMOs have been used historically to adjust the supply of reserve balances so as to keep the federal funds rate around the target federal funds rate established by the FOMC. In recent years, the Federal Reserve has also developed other tools to strengthen its control of short-term interest rates and to reduce the large quantity of reserves held by the banking system.

The Federal Reserve provides short-term liquidity to domestic banks and other depository institutions through the discount window. In addition, because of the global nature of bank funding markets, the Federal Reserve has established liquidity arrangements with foreign central banks (FCBs) as part of coordinated international efforts.