Intro
Central banks are the driving force behind the economy of every country in this world. They play a very important role related to the growth and sustainability of societies and use a variety of tools to keep all broad monetary aspects in check.
Some central banks are more known than others especially as they affect other countries when they use their tools. For example, the Fed, also known as the Federal Reserve, is the central bank of the US while the ECB, also known as the European Central Bank, is the central bank of the entire Euro Zone. Other powerful and well-known central banks include the Swiss National Bank, the Bank of England, The People’s Bank of China, and the Bank of Japan.
Central banks ensure the health of the economy of that country by regulating the amount of money available in circulation. They also change interest rates over time, print money if needed, and set reserve requirements for banks to control the supply of money.
Some other tools that are used by central banks include open market operations and quantitative easing which is the act of buying or selling government bonds and securities.
Why does the amount of money matter?
Money circulating within an economy affects micro-economic and macro-economic trends. Starting with the micro, a large supply of money allows for more spending by people and businesses as well as obtaining loans and securing financing by companies.
Looking at the macro-economic level, the GDP, interest rates, and unemployment rates are all affected by the amount of money circulating.
Central banks control this flowing money to achieve certain objectives and influence monetary policy.
Printing Money
One of the main tools that central banks use to control the amount of money in circulation is printing more if needed. While it’s not the main method or the preferred one, it is still used occasionally to tackle certain scenarios. Printing more money does not exactly affect economic output and causes inflation, so there are consequences to using such a tool.
Reserve requirements
This is a common tool used by all central banks and that is to require commercial banks to maintain a certain amount of money against the deposits of their clients. This money is held in vaults or at the central bank and never moves. Assuming that the central bank has a reserve requirement of 10% and a commercial bank has deposits of $100 million, the bank needs to set aside $10 million as a reserve requirement while being able to circulate the remaining $90 million.
Adjusting the reserve requirement is common practice. When the central banks raise the requirements, they are technically telling banks to circulate less and put aside more. When the central banks drop the requirements, they are allowing banks to circulate and loan more while putting aside less.
Effective January 16, 2020, US banks with up to $16.9 million in deposits are exempt from any reserve requirements while anywhere between $16.9 million and $127.5 million should put aside 3%, and anything above $127.5 million need to have 10% as a reserve requirement. This was quickly changed on March 26, 2020, due to the Covid pandemic by eliminating all reserve requirements.
Interest Rates
While the central bank cannot decide on the rate of personal loans, mortgages, and other commercial borrowing activities, they can adjust the policy rate which is the rate at which commercial banks can borrow money from the Fed. In the US, this is referred to as the “federal discount rate”.
When banks are able to borrow cheaply from the central bank, they are able to pass on those savings to their customers. Furthermore, lower rates fuel an increase in borrowing, leading to an increase in the money supply circulating.
Open Market Operations
Open market operations refer to central banks buying or selling government securities. When central banks are looking to increase the money in circulation, they would buy government securities from banks and institutions. The transaction results in commercial banks having more cash which they can use to loan to their customers. This is usually seen as an expansionary or easing monetary policy, leading to lower interest rates.
Quantitative easing
During difficult economic times, central banks can introduce an upgraded version of the open market operations by launching a quantitative easing program. In this situation, central banks create more money then use it to buy government securities. The newly entered money improves the money supply and allows banks to give out more loans, leading to lower interest rates in the long run and an increase in investments.During difficult economic times, central banks can introduce an upgraded version of the open market operations by launching a quantitative easing program. In this situation, central banks create more money then use it to buy government securities. The newly entered money improves the money supply and allows banks to give out more loans, leading to lower interest rates in the long run and an increase in investments.
After the crisis of 2007, the Bank of England and the Fed launched quantitative easing programs while more recently, the ECB and the Bank of Japan launched similar programs.
Currency intervention
At times, central banks may decide to strengthen or weaken their own currency for different reasons. Two popular examples include the Bank of Japan (Figure 1) and the Swiss National Bank who, over the years have intervened in the markets to weaken their currencies on multiple occasions. The Japanese Yen and the Swiss Franc are considered safe-haven currencies which leads to strong demand especially during times of uncertainty. At this point, the central bank may look to sell their own currency and buy other foreign currencies using very large amounts that could influence the market and change the exchange rate.
Figure 1 – Daily USDJPY chart showing intervention of March 18, 2011 and its results
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There have been other interventions over the years but it’s an extreme measure that is taken only when an exchange rate is reaching dangerous levels in relation to the economic activities of the country.
Final thoughts
Central banks have a sensitive task at their hand at all times yet they have to do what it takes to keep the economy healthy. Using a variety of tools, they are able to control the amount of money circulating but a bit too much or too little of something could have serious consequences. Furthermore, they are often criticized for their decisions where different tools could have better outcomes but the situation is never perfect or 100% scientific and would depend on how an entire nation acts with the money available to them.
The content published above has been prepared by CFI for informational purposes only and should not be considered investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.