Question

To what extent is a central bank necessary? Describe the conditions of banking in the United States and other countries when a central bank did not exist. Was the monetary system adequate for the commercial needs of the nation, or did the nation inevitably fall into crisis and instability?

Answer 1

A central bank is the bankers bank which regulates the actions of commercial bank on one hand, and on the other helps in maintaining the demand and supply of currency in any economy. During times of recession or hyperinflation in the economy, the Central Bank which is known as the Federal Reserve in the United States has been of prime importance and has been the pioneer institution in being able to correct the economy.

In the absence of a Central Bank for an example, the United States largely saw investor confidence which was extremely low, and prior to the establishment of the Federal Reserve in the year 1913, bank runs were normal wherein investors would rush over to banks to withdraw their money and this resulted in significant losses for banks. Also, banks had no one to govern them which meant that they would lend on the basis of instinct rather than sound principles which have been established by the Central Banking system over a period of time. This resulted in loss of public money and worsening economic situation for the United States and all other major economies of the world suffered accordingly. A major reason for instability in the economy prior to the creation of the Federal Reserve can be attributed to the nonexistence of it and the resultant inability of the government to control the flow of money in the economy.

The Federal Reserve in the United States has been able to effectively manage trade cycles such as Inflation or Recession without the help of which it would not have been possible to manage the same. For an example, during a recession the flow of money in the economy is extremely low. As a result of this, the demand for goods and services is on the lower side and the producers cut down on production and unemployment in the economy sees a sudden rise. This is corrected by the Central Bank who then steps in to reduce the interest rates or to reduce the minimum amount of money which Commercial Banks must hold with the Central Bank at all times.

The end result is that the flow of money in the economy is extended and the economy returns back to its normal position. In the absence of such practices by the government, is unable to manage the economy and it would take significant time for it to return back to its normal state or position.

We can conclude by saying that a central bank is essential in maintaining the supply and demand for currency in any economy and to ensure that the conduct of any commercial bank is well regulated and accounted for without the help of which the country may see a significant slump or an inflation and correcting the same would be extremely tough and difficult.

Please feel free to ask your doubts in the comments section if any.