Central Banks: Why Do They Exist?

A central bank is a government organization, typically independent, that manages a country's monetary policy, ensures financial stability, and promotes economic progress. The main responsibilities of central banks include controlling the money supply, setting interest rates, and managing foreign exchange reserves. They are also authorized to oversee and regulate the banking sector to ensure the safety and efficiency of the financial system.

In this article, we will take a closer look at the functions of central banks, why they exist, and how they operate.

History of Central Banks

Central banks emerged with the development of modern economic systems. The first central bank, considered to be the Sveriges Riksbank of Sweden, was established in 1668. The foundations of modern central banking as we know it today were laid with the establishment of the Bank of England in 1694.

The Industrial Revolution of the 19th century, combined with the rise of international trade and the growing complexity of economic systems, emphasized the importance of central banks. During this time, central banks began to assume responsibilities such as preserving currency stability, managing banking crises, and providing liquidity to commercial banks. For example, the United States Federal Reserve, formed in 1913, was intended to minimize the impacts of banking crises while also supporting the overall health of the economy.

The 20th century witnessed the globalization of central banking. Following World War II, during the reconstruction of the international economic system, central banks became critical actors in managing exchange rates under the Bretton Woods system. This era emphasized the importance of central bank independence and the goal of maintaining economic stability free from political interference.

Central banks now play an important role in both national economies and the global economic system.  During large economic instability, central banks are responsible for supplying liquidity to markets and reducing the effects of crises.

Why Do Central Banks Exist?

Controlling inflation and preserving the value of the currency are essential for long-term economic growth and improving the investment climate. When price stability is not achieved, economic uncertainties increase and investor confidence declines. Central banks use monetary policy tools to prevent such adverse outcomes.

Central banks are also tasked with maintaining the stability of the financial system. By providing credit to commercial banks, they support the banking sector during financial crises and prevent systemic risks from spreading.

The main reasons for the need for central banks can be summarized as follows:

• Preserving the value of the currency and reducing economic uncertainties by keeping inflation in check.
• Providing liquidity to banks during crises to uphold financial stability.
• Controlling interest rates and the money supply to achieve economic growth, employment, and price stability.
• Stabilizing the value of the local currency and ensuring the sustainability of international trade.
• Establishing a stable environment to achieve long-term development goals.

Monetary Policy and Central Banking

Monetary policy encompasses the set of economic tools implemented by central banks to help a country achieve its economic objectives. This policy aims to regulate the money supply and interest rates to control inflation, support economic growth, and increase employment.

The policy can be applied in two different ways, depending on economic conditions:

• Expansionary policy aims to stimulate economic activity during periods of recession by increasing the money supply and lowering interest rates.
• Contractionary policy seeks to reduce the money supply and raise interest rates to control inflation during periods of excessive economic growth.

Central banks use various tools to implement monetary policy. The primary tools include open market operations, reserve requirements, and the policy interest rate:

• Open market operations are used to increase or decrease the money supply by buying or selling government bonds in the market.
• Reserve requirements determine the minimum amount of reserves commercial banks must hold with the central bank, influencing the supply of credit.
• The policy interest rate is the rate applied by central banks during lending or borrowing transactions, directly impacting overall economic activity.

This policy affects economic growth, inflation, and unemployment. Lower interest rates promote spending and investment but may increase inflation, while higher rates control inflation but slow growth. Central banks adjust policies to maintain balance.  

In a globalized world, these decisions also impact international markets. For example, a U.S. Federal Reserve rate hike can shift global capital and affect exchange rates in emerging economies. While central banks focus on national interests, they must also consider global effects.

Central Bank Policy Example

Central bank policies can have a direct impact on financial markets, shaping investors' decisions. Let’s take a look at some historical examples in this context.

Following the 2008 global financial crisis, the Federal Reserve implemented expansionary monetary policies to provide liquidity to the markets. Methods such as lowering interest rates and quantitative easing were adopted during this period.

The Fed reduced its policy rate to near-zero levels. This helped reduce borrowing costs for companies, boost investments, and facilitate the recovery of stock markets.

Additionally, the Fed conducted large-scale bond purchases, injecting trillions of dollars into the markets. This weakened the US dollar, leading other currencies to gain value against it in the Forex market. Forex traders particularly benefited by shifting to alternative currencies to take advantage of the weaker dollar.

Another example is the quantitative easing program implemented by the European Central Bank (ECB) in 2015. To combat economic stagnation and low inflation in the Eurozone, the ECB launched a quantitative easing program in 2015:

The ECB purchased government bonds of Eurozone countries to inject liquidity into the markets. This led to a depreciation of the euro, creating investment opportunities for Forex traders in stronger currencies relative to the euro.

The ECB's liquidity-boosting measures had a positive effect on European stock markets. The financial sector, in particular, benefited from low interest rates and increased liquidity. This provided traders with opportunities to invest in European corporate stocks.

Why are Central Bank Decisions Important for Traders?

• Central bank decisions can create fluctuations in financial markets and directly impact traders' strategies.
• Changes in interest rates affect borrowing costs and asset prices.
• Changes in the money supply determine market liquidity and investor risk appetite.
• Central bank policies directly influence the value of the local currency.
• Bond purchase or sale decisions impact yields and prices.
• Low interest rates can increase corporate profitability and drive up stock prices.
• Decisions aimed at controlling inflation shape economic growth and asset prices.
• Uncertainty before and after decisions can increase market volatility and create opportunities.

FAQ

How do expansionary monetary policies affect stock markets?

Expansionary monetary policies aim to stimulate economic activity by lowering interest rates and increasing the money supply. Lower interest rates reduce borrowing costs for companies, encouraging them to invest more. This increases corporate profitability, leading to a rise in stock prices. Additionally, a low-interest-rate environment pushes traders toward higher-yielding assets like stocks, creating a positive sentiment across the market.

How does the Federal Reserve's interest rate hike decision impact global markets?

The Federal Reserve's decision to raise interest rates typically strengthens the US dollar. This leads to other currencies depreciating against the dollar, causing significant fluctuations in the Forex market. It can also trigger capital outflows from emerging markets, potentially destabilizing their financial systems. In stock markets, higher interest rates increase borrowing costs, which can lower corporate valuations and put downward pressure on stock prices.

How do European Central Bank (ECB) decisions affect the Euro?

The ECB’s monetary policy decisions directly influence the value of the Euro. For example, lowering interest rates or implementing quantitative easing as part of expansionary policies can weaken the Euro. Conversely, contractionary measures such as raising interest rates can lead to the Euro appreciating in value.

How does increasing the money supply by central banks impact commodity prices?

Increasing the money supply generally creates inflationary pressures, which tend to drive commodity prices higher. Greater liquidity in the market often prompts investors to shift toward physical assets like gold and oil. This trend is particularly evident during times of economic uncertainty, as increased money supply adds to volatility in commodity prices.