Why Do We Have Central Banks?

Let’s discuss what is arguably the most powerful institution in the world, the central

bank.

Nearly every country in the world has a central bank, or institution that manages the currency

and monetary policy of an entire country.

Unlike a commercial bank, a central bank has a monopoly on how much money can be created

and put in circulation.

That’s quite a power, as historically, countries have risen and fallen due to the value of

their currency.

Because of the powerful nature of central banks, most countries have made theirs institutionally

independent from political interference, meaning that governments can’t use them to control

society.

So why do we let these central banks have so much power?

The simple answer is to prevent economic crashes and keep markets stable, based on all the

devastating recessions throughout history that occurred when we didn’t have central

banks.

Let’s look at an example.

In 1837, a financial panic led to a major depression in the United States.

What caused the panic?

A dramatic drop in cotton and land prices, along with a dramatic drop in lending, which

led investors to attempt to withdraw all their funds from banks.

Due to these panicked withdrawals which caused banks to fail, the crisis became known as

the Panic of 1837, and most economists today argue it could have been avoided had there

been a central bank in place to regulate banking transactions and aid failing banks.

While the role of central banks is constantly debated by politicians, central banks have

many extremely important functions.

First, as we mentioned, they control monetary policy by setting the official interest rate

for lending, and determining how much currency can be created and in circulation.

Second, central banks manage how a country exchanges currency with other countries, as

well as a country’s gold reserves and government bonds.

They use what is known as “open market operations” to buy and sell securities from banks in order

to also influence the money supply.

Third, central banks often regulate the banking industry.

Fourth, and perhaps most importantly, central banks act as a government’s banker, and

as the “bankers’ bank,” or “lender of last resort.”

In other words, the central bank is the provider of liquidity when no other institution is

able to be.

Other functions of central banks that aren’t as common include economic research, statistical

collection, and advising governments regarding financial policy.

The most influential central bank system in the world is likely The Federal Reserve System