Central Bank Functions: Monetary Policy, Financial Stability, and Inflation

Posted on Nov 27, 2024 in Economy

Central Banks: Guardians of Economic Stability

Central banks are responsible for two essential elements: financial stability and price stability. Financial institutions play a crucial role in circulating money, acting as intermediaries between savers and borrowers. These entities must be robust, and the public must have confidence in them due to the mismatch between their assets and liabilities. Fear of bank failure can trigger deposit withdrawals, causing liquidity problems even for solvent institutions. Interbank lending crises can create widespread doubts about the entire financial system. Therefore, central banks monitor financial institutions and prevent banking panics through:

  • Bank inspection and supervision
  • Publication of financial health reports
  • Reserve requirements
  • Deposit Guarantee Funds
  • Special liquidity loans

Maintaining Price Stability

Keeping inflation below a certain level is a priority. High inflation can:

  • Reduce export competitiveness
  • Decrease the real value of debt
  • Erode purchasing power, leading to wage increases and an inflationary spiral

Central banks aim for price stability over a two-to-three-year horizon, considering current events and future variables. This complex process involves analyzing money supply and demand.

Money Supply, Demand, and Inflation

The amount of cash and liquid assets in an economy determines its inflation rate. The central bank, as the primary money provider, lends money to banks at an interest rate. Financial institutions borrow from the central bank, providing cash to the interbank market and loans to individuals and businesses.

The central bank controls the money supply through auctions with minimum interest rates. Banks bid for amounts at various rates. The central bank decides the amount and distribution. Money demand depends on credit requests, cash holdings, and economic activity (related to GDP growth). Safety factors also influence money demand: individuals decide whether to spend or save based on future uncertainty and liquidity needs. They also decide how much to hold in liquid assets versus investments, considering risk and uncertainty.

Central banks analyze the money supply and various economic indicators to identify and anticipate inflation.

The European Central Bank (ECB)

Since January 1, 1999, the European Central Bank (ECB) and national central banks, forming the European System of Central Banks (ESCB), manage monetary policy for EU member countries. The ESCB’s primary objective is maintaining price stability. Its basic functions include:

  • Defining and implementing monetary policy in the euro area
  • Conducting foreign exchange operations
  • Holding and managing official currency reserves
  • Promoting smooth payment systems
  • Contributing to the prudential supervision of credit institutions and financial system stability

The Eurosystem aims to control inflation in the euro area, targeting a rate below 2% on average. The ECB’s Governing Council makes monetary policy decisions. The ECB grants loans to financial institutions at various intervals (usually weekly and for three months) at the same interest rate. However, inflation rates differ across countries due to varying production structures. Countries with production focused on services less exposed to competition experience lower price effects from changes in money supply and demand compared to those producing goods more exposed to competition.

Other reasons relate to the transmission mechanism of monetary policy. Banks apply interest rates based on those set by the ECB. The Euribor, the rate at which banks lend in the euro interbank market, serves as a reference for interest rates on savings and loans.