Central Banks

The Heart of a Country's Financial System

Central banks (sometimes called national banks) manage and organise the banking activity in a country, usually on behalf of a government.

In the United States the central bank is called the Federal Reserve, for the Eurozone area it is the European Central Bank and, in the United Kingdom, it is the Bank of England.

The duty of central banks is to ensure monetary and financial stability, otherwise a country's economy will not operate properly. They do this by setting interest rates, regulating the amount of money in circulation, buying and selling currencies and acting as a lender of last resort, should another bank get into trouble and threaten the stability of the banking system in the country.


Main points about Central Banks:

Most countries today have an institution called a central bank sitting at the heart of their financial system. In the UK this is the Bank of England.
Central banks are not like ordinary banks. They have special functions that help to keep the monetary and financial systems stable, which helps maintain a healthy economy.
One of a central bank's main functions is monetary stability (keeping prices stable). To do this the bank needs to control inflation (when the price of goods keeps rising) and deflation (when the price of goods keeps falling). This is critical to the health of an economy.
Inflation rates are currently low but they used to be much higher. If inflation goes up, the value of money declines (we can buy less for the same amount). High inflation is bad for the economy as costs and prices keep rising. In the UK, the government sets an inflation target and it is the bank's job to try and meet this target.
One way it does this is by setting the base interest rate, which affects interest rates paid on loans and savings and, therefore, the cost of borrowing throughout the economy. This influences how much money everyone spends and saves and, in turn, costs and prices.
Higher interest rates are used to reduce inflation by taking money out of the economy, as it is more expensive to borrow. However, if the growth of the money supply is slowed too much, then economic growth may slow also, resulting in companies becoming less profitable, leading to closures and job losses.
Lower interest rates increase the amount of money in the economy and are used to increase spending when inflation looks likely to be below the target.
Central banks can also control the amount of money in the economy (hence interest rates) by buying or selling high quality assets such as treasury bills and short term government bonds in the money markets.
If conventional monetary policies fail, a central bank may use ‘quantitative easing’ to stimulate the national economy. This is when a central bank purchases financial assets from banks and other private sector businesses with new, electronically created, money, to inject a pre-determined amount of money into the economy.
Maintaining public confidence in the currency is a key role of central banks. In most countries, only central banks have the right to print and issue national currencies, so they can regulate and control the money supply.
Central banks are also concerned with financial stability. The different parts of the financial system are all linked together to allow money to flow around the economy. If something goes wrong in one part it can affect all the others.
In the UK, the Bank of England assesses where potential weak spots might lie and works with the Treasury and Financial Services Authority (FSA) to ensure problems occurring in one area do not lead to disruption across the financial system.
The central bank is the 'lender of last resort', which means that it is responsible for providing the banking system with funds, when commercial banks cannot cover a supply shortage, to prevent the country's banking system from failing.
If a bank is about to go bust, a central bank is likely to step in and save it. Banks borrow from each other every day and are completely dependent upon one another. If one goes bust, it can bring down other banks, until the entire banking system is under threat.
Central banks, like the Bank of England, also act as the government's banker. The Bank of England maintains the government's bank account, known as the 'consolidated fund', into which taxes and other revenues are paid.
One final, very important role of central banks is to act as the official custodian of the nation's gold reserves. In fact, the Bank of England also stores the gold reserves of several other countries.

The Bank of England

The Bank of England is the central bank for the whole of the United Kingdom. It was established in 1694, as a private company, to act as the English government's banker. In 1734, the bank moved to new quarters in Threadneedle Street, where it still is.

As government borrowing became so large, the money markets had to accept the interest rate the government was prepared to pay and, from the late 18th century onwards, it gradually became the other bankers' bank.

The Bank of England started issuing bank notes over 300 years ago. Early banknotes were receipts for gold deposited at the Bank. The holder of a banknote could go to the Bank of England and exchange the banknote for gold. This is no longer the case but banknotes still retain the words ‘I promise to pay the bearer on demand’. 

Until the 1930s, other banks were also able to issue their own notes (Scottish and Northern Irish banks still can). However, from the mid-19th century, any bank wishing to issue notes had to deposit gold or silver with the Bank of England to the value of the notes issued.

The Bank is now the only issuer of notes in England and Wales. These notes have special security features to make them hard to copy, so that people can be confident in the currency. There are around £2 billion  banknotes in circulation, worth about £38 billion.

The Bank of England was taken into public ownership by the government in 1946. In 1997 it became a public organisation, still owned by the government, but with independence in setting monetary policy for the UK. The Bank still acts as the banker for HM government. However, the Bank’s original role of regulating banks has been transferred to Financial Services Authority (FSA).

The Bank's main focus is setting interest rates and hence the cost of borrowing throughout the British economy. The Bank's Monetary Policy Committee (MPC) is a panel of nine experts who meet on a monthly basis to set the official Bank interest rate, known as the bank rate.

The Bank has the duty of trying to keep inflation at the government’s target, but its members are independent of any government influence.  If inflation is higher or lower by 1% than the target, then the Governor of the Bank of England has to write to the Chancellor of the Exchequer explaining why this is so, and what he will do about it.

Interest rates can take up to two years to affect inflation. This means today’s bank rate decision is based on where the MPC thinks inflation is heading over the next few years. That is never certain because unexpected things can always happen.

Until recently, the Bank of England's monetary policy focussed almost solely on controlling inflation. However, in June 2011, it was asked to look also at economic policy as a whole. So it set up the Financial Policy Committee. The reason for this was that the country's economy was facing the possibility of the worst slump in its history, and getting the economy moving again had become a much higher priority than controlling inflation.