Role and importance of central banks

Published by Patrick Mutisya · 14 days ago

Cambridge IGCSE Economics 0455 – Role and Importance of Central Banks

Microeconomic Decision‑Makers: Money and Banking

Objective

Understand the role and importance of central banks in an economy.

What is a Central Bank?

A central bank is the primary monetary authority of a country. It is responsible for issuing currency, managing the nation’s money supply, and ensuring financial stability.

Main Functions of a Central Bank

  • Issue of legal tender: sole authority to print and mint money.

  • Monetary policy implementation: controls interest rates and the money supply to achieve macro‑economic objectives.

  • Banker’s bank: holds reserves of commercial banks and provides them with short‑term liquidity.

  • Lender of last resort: provides emergency funding to prevent bank failures.

  • Regulation and supervision: oversees the banking sector to maintain confidence.

  • Management of foreign reserves: intervenes in foreign‑exchange markets to stabilise the currency.

Tools of Monetary Policy

The central bank uses both quantitative and qualitative tools to influence the economy.

ToolTypeHow it worksTypical impact on economy
Open Market Operations (OMO)QuantitativeBuying or selling government securities to change bank reserves.Purchases increase money supply → lower interest rates; sales decrease money supply → higher interest rates.
Policy (Bank) RateQuantitativeInterest rate at which commercial banks borrow from the central bank.Lower rate encourages borrowing and spending; higher rate discourages them.
Reserve RequirementsQuantitativePercentage of deposits that banks must hold as reserves.Lower requirement expands credit; higher requirement contracts credit.
Standing Facilities (e.g., discount window)QuantitativeShort‑term lending to banks at a set rate.Provides liquidity, stabilising short‑term interest rates.
Moral suasionQualitativePersuading banks to adopt desired lending behaviour.Influences credit conditions without formal policy changes.
Macro‑prudential regulationsQualitativeRules such as loan‑to‑value caps, counter‑cyclical capital buffers.Reduces systemic risk and dampens credit booms.

Money Multiplier Concept

The money multiplier shows how an initial change in reserves can lead to a larger change in the total money supply.

\$m = \frac{1}{r}\$

where m is the money multiplier and r is the reserve ratio.

Why Central Banks are Important

  1. Price stability: By controlling inflation, central banks protect purchasing power.

  2. Economic growth: Appropriate monetary policy can stimulate investment and consumption.

  3. Financial stability: Lender‑of‑last‑resort facilities and supervision prevent systemic crises.

  4. Confidence in the currency: Managing foreign reserves and exchange rates maintains trust in the national money.

  5. Policy coordination: Central banks work with government fiscal authorities to achieve balanced macro‑economic outcomes.

Illustrative Example: Impact of an Interest‑Rate Cut

Suppose the central bank reduces the policy rate from 5 % to 3 %.

  • Commercial banks can borrow cheaper funds.

  • They lower lending rates for households and firms.

  • Borrowing becomes more attractive → increase in investment (I) and consumption (C).

  • Aggregate demand (AD) shifts right, potentially raising real GDP and, if the economy is near full capacity, putting upward pressure on prices.

Suggested diagram: AD–AS model showing the rightward shift of AD after a central bank cuts interest rates.

Key Take‑aways

  • The central bank is the cornerstone of a country’s monetary system.

  • It uses a mix of quantitative and qualitative tools to influence money supply, interest rates, and credit conditions.

  • Effective central banking promotes price stability, sustainable growth, and financial confidence.