Central Bank Functions: Currency, Banking, and Fiscal Roles
Central Bank
1. Legal Currency Provider: The central bank is the sole issuer of a country’s legal currency. While printing may occur at mints or abroad, the central bank controls the process. Damaged notes are typically destroyed in central bank vaults.
2. Bank of Banks: The central bank acts as a lender to other banks facing temporary liquidity issues. With board approval, banks can receive short-term loans, which may be renewed. If a bank’s problems are permanent, the central bank can intervene, appointing a liquidator to manage bankruptcy.
The central bank may also finance specific programs through the banking system, either by directly injecting resources or by rediscounting bills or notes.
3. International Reserves Manager: Central banks manage a country’s foreign currency and gold reserves to meet international obligations. If a country lacks these resources, it may seek loans from the International Monetary Fund, often under conditions outlined in a “Letter of Intent” that may have social costs.
Countries with balance of payments surpluses, like Chile, often invest these reserves in fixed-income instruments such as U.S. Treasury bonds.
4. Fiscal Agent: The central bank represents the state in monetary and financial transactions, especially abroad. For example, the central bank may handle external debt renegotiations and represent the country in international lending agency meetings.
5. Monetary Policy Responsibility: The central bank is responsible for the state’s monetary policy, including exchange rate policy. It does not maintain accounts for individuals or other banks, only for the state. As the sole legal currency dispenser, it can increase or decrease the money supply (M1).
The central bank uses the following mechanisms for credit policy:
A) Interest Rate Policy: The central bank sets interest rates to influence the market. Raising the policy rate increases interest rates and reduces credit, while lowering the rate has the opposite effect.
B) Reserve Rate: The reserve rate regulates credit by restricting the resources banks can lend. Increasing the reserve rate raises interest rates, while decreasing it has the opposite effect.