Tuesday, September 22, 2009

The role of central banks in the economy

Control of the money supply
Central banks, including the Federal Reserve System, perform several important functions in a modern economy. The first and most important of their functions is control of the nation's money supply.
What is money? Money is anything which serves as a medium of exchange in the purchase of goods and services. Money as another important function, however-serving as a store of value, for money is a financial asset that may be used to store purchasing power until it is needed by the owner. If we define money exclusively as a medium of exchange , then the sum of all currency and coin held by the public plus the value of all publicly held checking accounts and other deposits against which drafts may be issued (such as NOW accounts) would constitute the nation's money supply. If we define money as a store of value, on the other hand, then time and savings accounts at commercial banks and other nonbank financial intermediaries, such as credit unions and savings banks, would also be considered important components of the money supply. However we define money, the power to regulate its quantity and value was delegated by Congress early in this century to the Federal Reserve System. The Fed has become, not only the principal source of currency and coin (pocket money) used by public, but also the principal government agency responsible for stabilizing the value of the dollar and protecting its integrity in the international financial markets. Why is control of the nation's money supply so important? One reason is that changes in the money supply are closely linked to the changes in economic activity. A number of studies in recent years have found a statistically significant relationship between current and lagged changes in the money supply and movements in the nation's gross national product (GNP). The essential implication of these studies is that, if the central bank carefully controls the rate of growth of money, then it can influence the growth rate of the economy as a whole.
Another important reason for controlling the money supply is that, in the absence of effective controls, money in the form of paper notes or bank deposits could expand virtually without limit. The marginal cost of creating additional units of money is close to zero. Therefore, the banking system, the government, or both are capable of increasing the money supply well beyond the economy's capacity to produce goods and services. Because this action would bring on severe inflation, disrupt the nation's payments mechanism, and eventually bring business activity to a halt, it is not surprising that modern governments have come to rely so heavily upon centrals banks as guardians of the quantity and value of their currencies. The Federal Reserve System operates almost daily in the financial markets in an attempt to control domestic price inflation in order to protect the purchasing power of the dollar at home, while occasionally intervening in foreign currency markets to protect the dollar abroad.
Stabilizing the money and capital markets
A second function of central banking is stabilization of the money and capital markets. The financial system must transmit savings to those who require funds for investment so that the economy can grow. If the system of money and capital markets is to work efficiently, however, the public must have confidence in financial institutions and be willing to commit its savings to tem. If the financial markets are unruly, with extremely volatile fluctuations in interest rates and security prices, or if financial institutions are prone to frequent collapse, the public´ confidence in the financial system might well be lost. The flow of capital funds would dry up, resulting in a drastic slowing in the nation's rate of economic growth and a rise in unemployment. All central banks play a vital role in fostering the mature development of financial markets and in ensuring a stable flow of funds through those markets.
Pursuing this objective, the Federal Reserve System will, from time to time, provide funds to major securities dealers when they have difficulty financing their portfolios so that buyers and sellers may easily acquire or sell securities. When interest rates rise or fall more rapidly than seems consistent with the nation's economic goals, the Fed will again intervene in the financial markets. The central bank may changes the rates it charges banks on direct loans or engage in securities trading in an attempt to moderate rate movements.
Lender of last resort
Another essential function of central banks is to serve as a lender of last resort. This means providing liquid funds to those financial institutions in need, especially when alternative sources of funds have dried up. For example, the Federal Reserve through its discount window will provide funds to selected deposit-type financial institutions, upon their request, to cover short-term cash deficiencies. As we will soon see, before the Fed was created, one of the weaknesses in the early financial system of the United States was the absence of a lender of last resort to aid to aid financial institutions squeezed by severe liquidity pressures.
Maintaining the payments mechanism
Finally, central banks have a role to play in maintaining and improving a nation´ payments mechanism. This involves the clearing checks, providing an adequate supply of currency and coin, and preserving confidence in the value of the fundamental monetary unit. A smoothly functioning and efficient payments mechanism is vital for carrying on business and commerce. If checks cannot be cleared in timely fashion or the public cannot get the currency and coin that it needs to carry out transactions, business activity will be severely curtailed. The result might well be large-scale unemployment and a decline in both capital investment and the nation's rate of economic growth.

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