It is not easy for the layman to understand what the Central Banks do. Nevertheless, Central Banks play a very important role in the Economy and Stock Market’s cycles, so it’s inevitable to understand what they do and how it influences the stock markets. Here at BB-economy, we’re happy to make it very understandable for a broad audience.

Let’s break it down.

The name, definition and origin

A central bank also called a reserve bank or sometimes generalized monetary authority is an institution (authority) that manages the currency and monetary policy of a state or a formal monetary union. Examples for a monetary union is the Eurozone. But what is monetary policy? To keep it simple it’s policy frameworks that affect a country’s supply of money and credit.

If it’s still too abstract, let’s break it down a bit:

Central Banks duties and goals

The most intriguing duty of the central banks is the Monetary Policy already mentioned above.

Monetary policy

There are three key goals of modern monetary policy.

  1. The first and most important is price stability or stability in the value of money. Today this means maintaining a sustained low rate of inflation.
  2. The second is a stable real economy, often interpreted as high employment and high and sustainable economic growth. Another way to put it is to say that monetary policy is expected to smooth the business cycle and offset shocks to the economy.
  3. The third goal is financial stability. This encompasses an efficient and smoothly running payments system and the prevention of financial crises.

The typical tools of the monetary policy are

  • Open market operations
  • Discount window lending
  • Reserve requirements
  • Setting interest rates

those are in use to steer the Monetary Supply. Monetary Supply refers to the total volume of currency held by the public at a particular point in time. The whole topic can become large and confusing so we will shed some light on those aspects one by one.

The only one concept to mention in this article is the distinguishing between Cental Bank Money and Commercial Bank Money.

Central Bank Money vs Commercial Bank Money

  1. central bank money or Monetary Base - obligations of a central bank, including currency and central bank depository accounts.
  2. commercial bank money - obligations of commercial banks, including checking accounts and savings accounts.

A central bank possesses a monopoly on increasing the monetary base, but this money is not directly available to the public (and stock markets) but it indirectly defines Commercial Bank Money, that money fuels the economy at the end.

The commercial bank money is controlled by setting interest rates on loans and bonds. Typically, central banks raise interest rates to slow growth and avoid inflation. They lower them to spur growth, industrial activity, and consumer spending. Also central banks regulate member banks through capital requirements, reserve requirements (which dictate how much banks can lend to customers, and how much cash they must keep on hand), and deposit guarantees, among other tools.

The commercial banks are in constant need of central bank money to meet their minimum reserve requirements, to be able to withdraw cash and to settle cashless payment transactions. They obtain this central bank money, in part, by taking out loans from the central bank. Hence, raising and lowering the interest rate on central bank money serves as an important tool for achieving the objectives like price stability.

Other duties of a Central Bank

Modern central banks do have also other responsibilities that we should mention:

  • Financial stability: acting as a government’s banker and as the bankers’ bank (“lender of last resort”)
  • Reserve management: managing a country’s foreign-exchange and gold reserves and government bonds
  • Banking supervision: regulating and supervising the banking industry
  • Payments system: managing or supervising means of payments and inter-banking clearing systems
  • Others: like coins and notes issuance, statistical collection.

Markets are mostly depending on the Monetary policy function of the central banks, so we look closer on that in this article but we will cover other Central Bank functions in following articles as well.

TOP 10 Central Banks

Top 10 Central Banks ranked by Assets, Year 2020

Rank Central Bank Total Assets
1 Federal Reserve System $8,822,401,000,000
2 Bank of Japan $5,878,875,571,224
3 People’s Bank of China $5,144,760,000,000
4 Deutsche Bundesbank $2,684,748,269,640
5 Bank of France $2,306,543,661,200
6 Bank of Italy $1,552,899,487,941
7 Bank of England $1,291,640,000,000
8 Bank of Spain $1,135,110,000,000
9 Swiss National Bank $1,037,145,564,215
10 Reserve Bank of India $818,333,198,885

Central banks history

Central Banks emerged in the 17th century in Europe with a purpose of lending money to the government. So Central Banks have not always been independent, but over time there has been a clear trend towards separating monetary policy from the direct political influence. Extensive empirical evidence and theoretical analyses have shown that independent central banks are better capable of maintaining low inflation rates.