The role of central banks in economic policy

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Central banks have a crucial role in economic policy formation and execution. These big players control the money flow. They also help in policy and guideline formation.

This essay is an example of a student's work


This essay has been submitted to us by a student in order to help you with your studies. This is not an example of the work written by our professional essay writers.

The reasons for which central banks control various economic issues are:

1. The major reason behind controlling the flow of money in an economy is to make sure that there is sufficient credit availability for the various categories of consumers in the economy. This will help to ensure economic stability of nation. In the event of excess credit availability, there arises a situation of excess demand. If at all the supply and demand ratio gets imbalanced i.e. the excess demand of the consumers in the country cannot be met by the available supply then the situation of inflation is ought to arise. On the other hand, if the credit available is less then the economic growth will be affected in a negative way. This is because there is a requirement of a fixed value capital or some level of investment to sustain at an assured level of development and growth, in the long-term that will not be attained.

This is one of the many results of controlling credit availability in the nation’s economy. This can also result in development of the overall economy by giving the Government statistics about the sectors that lag behind in the economy. Thereafter the steps of selective credit control by the government policies can ensure development of these segments further.

2. The other way is by bringing the variation in the Bank Rates. These are those rates at which these top Central Banks makes available the loans or lends money to other commercial banks in reservation of securities. To understand the increase or decrease in these rates result in flow of money for commercial purpose in the economy as a whole. In the course of increased rates the rates at which these commercial banks lend money to end customer will also increase and will result in less loans to be taken by people. This will restrict flow of money into market depriving businesses, development and growth in an economy.

3. Now the mention of the statutory cash balances which have to be maintained by these commercial banks. This is the mandatory cash that the commercial banks is required to keep at all times idle at a specific rate made compulsory by the Central Bank. This is termed as the Legal Reserve Ratio. This consists of two components: first is Cash Reserve Ratio (CRR) and the others is Statutory Liquidity Ratio (SLR). Regulation of these rates results in influences on the level of credit availability in the economy. The first component called CRR is maintained as unused cash balance with Central Bank, but the other one called SLR includes idle cash or liquid assets which are maintained with these commercial banks by them. Fluctuation in these too affects credit availability. Increased rates of CRR/SLR tend to decrease the credit availability and that means the flow of money in the economy whereas the reduced CRR/SLR will result in increased flow of money in the economy.

4. In addition to these above mentioned ways there are some other ways too. There are both qualitative and quantitative tools which are used by these central banks to control the money supply.

  1. In order to achieve the objective of credit control of an economy there are so many factors that are to be managed and coordinated with each other. To get a solution to an economic problem there has to be a one-dimensional view of many co-related things and factors.
  2. The other measures that can be named here are Quantitative Easing, Signalling, Credit Easing, and Qualitative Easing. These may be put to use in an economy in the event of failure of execution of conservative monetary reform meant to increase credit availability. QE is meant to be put to use in the course when the viability of the option of purchase of government bonds with short-term interest rates with the near-zero levels which is the part of OMO, comes to an end which also indicates that this particular method to control credit supply is no more practicable.
  3. Signalling means the way in which the statements are issued regarding the future activity of interest rates by a concerned monetary authority of the country which can eventually boost up the behaviour of market.
    There is a differentiation in Credit Easing and QE where credit easing focuses majorly on the asset-side of the balance sheet of the Central Bank. On the other hand QE is focused majorly on the liability-side of the balance sheet.
  4. Other tool called Qualititative Easing is the way in which the risk is taken care of or reduced through involvement of Government policies. This is used currently in China. It relates to replacement of the privately purchased and held risky assets of the Central Bank with the government debt, where there is guarantee of fixed by the taxpayer.
    This differs from Quantitative Easing because QE leads to increase in the monetary liabilities which refer to base money holding the risk of the asset portfolio and liquidity issues constant. The only similarity between the two is that both measures results in the increase in the size of the balance sheet.
  5. The aim of Credit easing is to bring about a change in the shares of different type of assets held by the private sector, with an expected change lead in their relative prices, eventually leading to stimulation of entire economic activity. An act where the central bank lend directly to the market participants could result in reduction of credit market spreads and then lead to improvement in the functionality of private credit markets generally, in the course of breakdown of normal transmission mechanism. Credit easing generally brings an increase in the size of a central bank balance sheet; a change in the ratio of various assets rather than level reserves of bank.
  6. The most significant old policy tools adopted in the eastern countries except Japan involves the act of maintaining a provision of foreign currency liquidity in the central banks through Federal Reserve exchange activities to bring a counterbalance from the shortage of American dollars as a result of capital outflows from the country.
  7. Other old measures include expansion of repo operations of the eligible counterparties with an extension of their term of operations from 30 to 180 days. In this expansion of eligible collateral includes certificates of deposit; and also linking of the interest rates on central bank reserve deposits with that of market rates. These measures seem to have effective influence in reducing the interbank spreads comparative to policy rates by reasonable basis points. The other way the Central banks can attempt to influence market expectations is by announcing the expected probable future monetary policy trend. If at all the central bank is able to persuade to keep its policy rates lower than the market then it could cause in fall of long term rates ultimately stimulating the economy.
  8. Central banks also have macro-prudential powers in order to promote financial stability of an economy by having responsibility for control and supervision of the banking sector. This enables the central banks to bring under control the generation of financial imbalances by use of various tools. These tools can be named in terms of ratios such as debt-service-to-income ratios, loan-to-value ratios, credit exposure limits specific to certain sectors, and limitation drawn on loan growth, etc. Some of these are time-invariant tools whereas others are open to alterations based on discretionary way of assessment of economic and financial issues by the authorities’. Most of these macro-prudential tools are developed for use at a bank level, but can be adapted to macro-financial cycle by specific calibrating processes. Implementation of these tools can be worked out with close association and working of central banks with the supervisory agencies to generate powers. The tools which are restricted to certain specific sectors is to control and restrict the loans and other activities of financial nature during the boom periods. Their main objective and aim is to restrict the arising of tendency for a self-perpetuating cycle generating from asset values and growth of credit which may lead to generation of an unsustainable asset bubble. The list of these measures are to include standards for loan and underwriting processes, ratio of loan-to-value, debt-service-income ratio, credit growth related caps, and exposure limits available.

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