Roles and Objectives of Central Banks - AnalystPrep | CFA® Exam Study Notes (2024)

Objectives of Central Banks

The main objective of a central bank is to maintain price stability. Depending on the country, central banks might have other objectives, such as controlling inflation, unemployment, interest rates, or exchange rates. However, all these objectives align with the primary objective of ensuring financial stability.

Roles of Central Banks

Central banks are crucial in today’s economies, performing various vital functions for maintaining economic stability and promoting growth. The following are the different roles of central banks, explained based on the provided information:

Monopoly Supplier of the Currency

Central banks, by law, are the only institutions authorized to issue domestic currency. This replaced the previous system, where private banks could exchange money for precious commodities like gold.

In all major economies today, money is known as fiat money, which implies that it is not convertible into any other commodity. Moreover, it is deemed legal tender, meaning it must be accepted for goods, services, and debt repayment.

Central banks play a vital role as the suppliers and protectors of the value of fiat currencies, thereby maintaining confidence in the currency and preventing its arbitrary expansion.

Banker to the Government and the Bankers’ Bank

Central banks serve as the principal bankers to the government and other banks, ensuring they have the necessary liquidity to operate smoothly. This role is particularly crucial during crises when banks may face liquidity challenges. Being able to print money places central banks in a unique position to supply funds to banks in crisis, thereby preventing bank runs and maintaining stability in the financial system.

Lender of Last Resort

Central banks act as the ultimate source of funds for banks facing a liquidity crisis. The knowledge that the central bank stands ready to provide the required liquidity and the trust in government bank deposit insurance helps prevent bank runs. However, as observed in recent financial crises, this central bank’s role alone may not always be sufficient to avert a bank run.

Regulator and Supervisor of the Payments System

Central banks often oversee, regulate, and establish standards for a country’s payment system to ensure its robustness and standardization. This role includes overseeing the payments system, introducing new processes, and coordinating payment systems internationally with other central banks.

Supervisor of the Banking System

Many central banks supervise the banking system or at least the banks they license to accept deposits. This role may vary from country to country, with some central banks sharing this responsibility with another authority.

Manager of Foreign Currency and Gold Reserves

Even though the gold standard was abandoned in the early twentieth century, central banks still hold substantial quantities of gold and foreign currency reserves. Decisions by central banks to sell significant portions of their gold reserves could potentially affect gold prices.

Conductor of Monetary Policy

This is arguably the most important role of central banks. Central banks are perfectly situated to formulate and execute monetary policy by being the exclusive issuer of the national currency.

Question

Credit control refers to actions undertaken by central banks to:

1. Control inflation.
2. Control imports and exports.
3. Control the money creation of the government.

Solution

The correct answer is A.

The central bank controls the credit creation process by commercial banks to control inflationary and deflationary pressures on the economy.

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