What Is a Central Bank?
A central bank is a financial institution that manages the production and distribution of money and credit for a state, or a group of states. Central banks oversee its state’s commercial banks and maintain a monopoly on the money supply of the state.
Central banks are not competitive institutions and many are not government entities. Those that are not government entities are politically independent but are theoretically created and protected by the law of the state in which they operate.
Central Bank vs. Commercial Bank
A central bank is often referred to as a “banker’s bank”, responsible for formulating the monetary policy of an economy. While a commercial bank performs activities for individuals and businesses like accepting deposits, making investments and granting loans with the focus on generating a profit.
Monetary and Fiscal Policy
Macroeconomics, which focuses on the performance of national economies, is divided into two broad categories: fiscal policy and monetary policy.
The Bank of Canada defines fiscal policy as “the set of decisions a government makes with respect to taxation, spending and borrowing.” Whereas monetary policy is “the set of decisions a government makes, usually through its central bank, about the amount of money in circulation in the economy.”
Monetary policy in Canada has three main features:
Monetary policy is operated by the Bank of Canada, a government-owned corporation that operates separately from the government, but is still accountable to Parliament.
Interest rates rise simultaneously across all provinces and territories. The Bank of Canada is the only issuer allowed to distribute Canada’s bank notes.
The Bank of Canada has only one policy instrument.
The one policy instrument the Bank of Canada has is the target it sets for the overnight interest rate. By changing the target for the overnight interest rate, the Bank of Canada can alter the overnight rate at which commercial banks transact.
The Bank of Canada explains that these changes in the overnight interest rate “lie at the heart of how monetary policy affects the economy” and the circulation of money.
History of Central Banks
The first central bank was the Bank of Sweden, which was established in 1668, followed by the Bank of England in 1694. Money at this time was typically in the form of gold or silver.
By the 19th century, many European nations had established a central bank. Napoleon Bonaparte established the Banque de France in 1800. Meanwhile, the People’s Bank of China was founded in 1948 and presently holds the third-highest total assets for a central bank in the world.
The United States Federal Reserve would not be established until 1913, signed by then President Woodrow Wilson.
Bretton Woods: The United Nations Monetary and Financial Conference was held in July of 1944, including 44 nations in Bretton Woods, New Hampshire. These nations established the Bretton Woods Agreement, which created the International Monetary Fund (IMF) and a revamped international monetary system after the end of the Second World War.
Under the Bretton Woods Agreement, gold was held as the basis for the United States Dollar (USD), and other global currencies were pegged to the value of the USD. This system was largely orchestrated by world-renowned economists, John Keynes and Harry White.
Nixon Shock: The Nixon Shock was a set of economic policies enacted by U.S. President Richard Nixon in 1971 which ultimately led to the end of the Bretton Woods system.
The Nixon Shock ended the convertibility of USD into gold and allowed central banks to have more significant control over their own money. This permitted central banks to easily manage interest rates, money supply and velocity.
In essence, the Nixon Shock created fiat currency, the floating rate currency exchange system and the significant devaluation of the USD.
The Nixon shock ended the Bretton Woods system of fixed exchange rates (Photo via Medium).
Reserve Currency
A reserve currency is a large amount of currency held by central banks and major financial institutions to use for international transactions, investments, debt obligations or domestic exchange rates.
The Dutch guilder is known as the first world reserve currency, followed by the rise of the British Empire and the British Pound, then ultimately Bretton Woods established the USD as the world’s leading reserve currency.
Central Bank Responsibilities
The IMF states that the role of central banks is to “conduct monetary policy to achieve price stability (low and stable inflation) and to help manage economic fluctuations.”
To note, central banks figuratively print money by digitally crediting and debiting member banks.
Major Central Banks
Federal Reserve: The Federal Reserve is the central bank of the United States. The “Fed” performs five main functions:
Conducts the nation’s monetary policy
Promotes the stability of the financial system
Promotes the safety and soundness of individual financial institutions
Fosters payment and settlement safety and efficiency
Promotes consumer protection and community development
The Fed is arguably the most powerful economic institution in the world. This is largely due to the size of the bank’s total assets, the size of the United State’s gross domestic product and the status of the USD as the global reserve currency.
Chair of the Fed: The chair of the Board of Governors of the Federal Reserve System, or the “Chair of the Fed” is the head of the Federal Reserve. Presently, Jerome Powell is the Chair of the Fed, presiding over his second term after being nominated to the position by President Donald Trump in 2017.
Fed Chair Jerome Powell (Photo via Barron’s / Getty Images).
European Central Bank: The European Central Bank (ECB) manages the euro. It frames and implements economic and monetary policy for the European Union (EU). Its current President is Christine Lagarde, a politician and lawyer from France. The ECB is located in Frankfurt, Germany.
Bank of England: The Bank of England (BoE) is the central bank for the United Kingdom and is located in London, England on Threadneedle Street. The BoE has presided on Threadneedle Street since 1734. Since its establishment, the BoE is the model on which most modern central banks have been based.
Bank of Canada: The Bank of Canada (BoC) is Canada’s central bank and is currently headed by Governor Tiff Macklem. Macklem was appointed by Prime Minister Justin Trudeau in 2020 for a term of seven years as Canada’s 10th governor of the BoC.
For more information, speak to your Cash Management Group at Canaccord Genuity advisor. Call us on 604.643.0101 or email cashgroup@cgf.com.
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