Question

What functions do central banks perform in a market-oriented economy? Explain why each function you have listed is important in the functioning of a market-oriented economic system.

Answer 1

Most modern central banks, at least those in major industrialized economies, perform four interrelated functions: (1) Controlling the nation’s money supply; (2) Stabilizing the money and capital markets; (3)Serving as a lender of last resort for financial institutions in need of reserves; and (4) Maintaining the nation’s payments mechanism.Money supply control is important to minimize the dangers of inflation, while market stabilization is critical to assure a smooth and continuous flow of funds from savings into investment to support economic growth. Service as a lender of last resort helps central banks moderate liquidity pressure in the financial system. Support of the payments mechanism assures continuous business activity and trade without interruption or long delays

(1) Controlling the nation’s money supply

If a nation’s economy were a human body, then its heart would be the central bank. And just as the heart works to pump life-giving blood throughout the body, the central bank pumps money into the economy to keep it healthy and growing. Sometimes economies need less money, and sometimes they need more.The methods central banks use to control the quantity of money vary depending on the economic situation and power of the central bank

(2) Stabilizing the money and capital markets

Money market and Capital market are types of financial market. Money markets are used for short-term lending or borrowing usually the assets are held for one year or less whereas, Capital Markets are used for long-term securities they have the direct or indirect impact on the capital. Capital markets include equity market and debt market.

(3) Serving as a lender of last resort for financial institutions in need of reserves

A lender of last resort is an institution which is willing to offer loans as a last resort. Such an institution is usually a country’s central bank. A central bank offers an extension of credit to financial institutions experiencing financial difficulty which are unable to obtain necessary funds elsewhere

(4) Maintaining the nation’s payments mechanism

The balance of payments, also known as balance of international payments and abbreviated B.O.P. or BoP, of a country is the record of all economic transactions between the residents of the country and the rest of the world in a particular period of time (over a quarter of a year or more commonly over a year). The balance of payments is a summary of all monetary transactions between a country and rest of the world. These transactions are made by individuals, firms and government bodies. Thus the balance of payments includes all external visible and non-visible transactions of a country.