The Central Bank of a country, such as the US Federal Reserve or the Reserve Bank of India, is one of its most powerful institutions. Since late 20th century onwards, it is the Central Bank of a country that usually decides key aspects of the country’s monetary policy such as level of interest rates, the printing of currency, exchange rate matters and liquidity requirements of banks among other items. Governments in general do not intervene in these important matters. There are reasons why such an institution has been created across countries.

1. Over the course of the 20th century, researchers and economists concluded that to ensure economic growth as well as financial stability, inflation in a country should be low and stable, ideally between 0 and around 2% on an annual basis. Inflation should not become high as it adversely impacts economic decisions of companies, individuals and governments. It also has political repercussions – it is believed that high inflation (a condition called hyperinflation) was a key reason behind political polarization in Germany leading up to World War II. Therefore, when inflation becomes high, monetary policy should be tightened (e.g. interest rates should be increased) so that economic growth reduces, and inflation comes down. Conversely when inflation is very low, monetary policy can be made loose (example, reduction of interest rates) to increase economic growth and hence inflation. Inflation becoming negative, a situation called deflation, is also dangerous as it once again leads to adverse impacts on decision making of corporates, individuals and governments.

Governments on the other hand have a strong incentive to keep interest rates very low as it spurs economic growth even though inflation can increase in future years. Therefore, policy makers have decided to keep monetary policy decision making away from the government and into the hands of economists in an institution structured as the central bank.

On a regular basis we read in the press about tension between governments and central banks on monetary policy. Globally we read about governments insisting on lower interest rates or benign monetary policy. Central Banks, however, are expected to base their interest rate decisions only on the basis of the economic health of the country and not take any political factors into consideration.

2. Central Banks also manipulate interest rates and liquidity through Open Market Operations (OMO). OMO refers to purchase of government bonds by the Central Bank. The Central Bank chooses which particular bond to buy based on the interest rate adjustments it wants to target.

3. One of the main ways in which the Central Bank manages monetary policy is by adjusting key interest rates. Most Central Banks achieve this by purchasing or selling government bonds

4. Another way in which Central Banks manipulate monetary conditions is by changing liquidity requirements of banks. Banks are required to maintain certain amount of liquidity by holding certain financial instruments.

5. A professional central bank has been a key reason for the economic growth in global GDP over the last five decades.                                                                                                                                               

6. The economics of the central bank are similar to a company with an exclusive license over an extremely lucrative business opportunity. Central bank operations often result in very high profits. Central banks keep a vast reserve to address any financial crises and dividend out any additional profits to the Government.                                                 

More details on central banking history was captured very well in the book – ‘Lords of Finance: The Bankers Who Broke the World’ by Liaquat Ahmed. You can buy it here.

 

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