European Central Bank

Central Bank Instruments and their Impact on Businesses

Central banks play a crucial role in a country’s economy. It plays a massive part in the banking system of a nation, and its role involves setting monetary policies.

The central bank is the one responsible for maintaining and stabilizing financial sovereignty and economy. It’s crucial to underdeveloped countries as it could be the key for them to grow faster.

Other terms for the central bank are the reserve bank and monetary authority. In the United States, the central bank is called the United States Federal Reserve and is one of the most powerful and prominent banks in the globe. While in Singapore, its central bank is called The Monetary Authority of Singapore.

The bank oversees the commercial banking system of a country and is the last resort lender during a financial crisis.

Central banks have several measures and instruments implemented to maintain the financial stability of a country, and here are some:

Discount Rate

Also known as the main monetary policy tool of central banks discount rates or otherwise known as interest rates. The South African Reserve Bank uses a tool similar to it called the repo rate.

The discount rate serves as the main interest of the central bank when lending money to commercial banks. In turn, it also affects how commercial banks lend money to businesses and people. It affects the overall interest rates in the economy.

When central banks adjust their discount rates, they take into account numerous factors and fundamentals; this includes domestic inflation, the country’s credit extension, and local variables. Another factor that contributes to a central bank’s decision is the internal economic conditions or other movements of different central banks.

During the Covid-19 pandemic, central banks from all across the globe have lowered their interest rates to help buoy their respective economies. Due to the paralyzing impact of the virus, central banks were forced to set low rates to cope and help commercial banks fund businesses.

The Reserve Requirement

All commercial banks in the country are under the central bank. By law, this obligates banks to have an account with their respective central banks.

The accounts are known as cash reserve requirement accounts, or simply as CRR accounts. Commercial banks will need to maintain a certain percentage of their deposit at the central bank, and it’s mostly around 6%.

The cash reserve requirement account will help facilitate clearing and settlements of bank transactions like cheque clearing. Aside from that, it also facilities transactions between the commercial bank itself and the central bank.

By increasing or decreasing the minimum requirements of CRR, it affects the banking liquidity in the country and the credit extension. According to a recent study, the CRR also affects the trajectory and effectiveness of inflation measures of a central bank. Higher CRR slows inflation and vice versa.

The Liquidity Requirement

So, after the cash reserve requirements comes the liquidity requirement. Banks will only maintain a certain percentage of the deposits as cash available for withdrawal, therefore the cash reserve requirements.

The rest of the funds ate then invested in liquid assets like treasury bills or bonds. This ration is then called as the LS; it includes both the cash reserve requirement and liquid assets.

The most common ratio given by central banks is 25%, and it automatically changes and affects the availability of lendable funds.

And just like the first two instruments, the liquidity requirement has a significant impact on the direction of the country’s inflation. Every year, a central bank reviews its liquidity requirement to ensure that balance.

Open Market Operations

The Open Market Operation is a tool of a central bank that encompasses and manages the liquidity of the domestic economy. It’s also known as OMO through it; commercial banks can buy and sell securities in the market that will affect the liquidity conditions.

Central banks have a discretionary deposit facility that enables domestic banks to deposit short-term funds; may it be overnight or one month.

This monetary policy instrument influences the liquidity conditions of the country’s banking system and the reach of external capital flows.

Other Instruments Central Bank

Aside from those, central banks are using more instruments like quantitative easing. 

However, central banks do not use every instrument, and typically their application takes place during a crisis or when inflation lags.

The Reserve Bank of Australia launched its quantitative easing program during the coronavirus pandemic to combat the impact on the economy. Aside from the RBA, the United States Federal Reserve also introduced a massive QE program in light of the coronavirus pandemic.

Quantitative easing is an unconventional instrument wherein a central bank purchases long-term securities. This tool increases the supply of money in the financial system and also encourages investing and lending.

Keep in touch with the latest news about central banks and the rest of the financial industry. Finance Brokerage is one of the top news sites that provide all the freshest news, materials, and reviews to help you navigate through the financial sector.

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