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Public finance

Sources of government revenue

Tax and non-tax revenue

Government policy

Fiscal · Monetary · Trade · Policy mix

Fiscal policy

Tax policy (see taxation series)

Government revenue · Government debt
Government spending (Deficit spending)
Budget deficit and surplus

Monetary policy

Money supply · Central bank

Gold standard · Fiat currency

Trade policy

Balance of trade · Tariff · Tariff war

Free trade · Trade pact

See also

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A central bank, reserve bank, or monetary authority is a public institution that usually issues the
currency, regulates the money supply, and controls the interest rates in a country. Central banks often also
oversee the commercial banking system within its country's borders. A central bank is distinguished from a
normal commercial bank because it has a monopoly on creating the currency of that nation, which is usually
that nation's legal tender.[1][2]
The primary function of a central bank is to provide the nation's money supply, but more active duties
include controlling interest rates, and acting as a lender of last resort to the banking sector during times of
financial crisis. It may also have supervisory powers, to ensure that banks and other financial institutions do
not behave recklessly or fraudulently.

Most developed nations today have an "independent" central bank, that is one which operates under rules
designed to prevent political interference. Examples include the European Central Bank (ECB) and
the Federal Reserve System in the United States.[3]

Contents
 [hide]

1 History

2 Activities and responsibilities

o 2.1 Monetary policy

3 Goals of monetary policy

o 3.1 Currency issuance

o 3.2 Naming of central banks

o 3.3 Interest rate interventions

o 3.4 Limits of enforcement

power

4 Policy instruments

o 4.1 Interest rates

o 4.2 Open market operations

o 4.3 Capital requirements

o 4.4 Reserve requirements

o 4.5 Exchange requirements

o 4.6 Margin requirements and

other tools

 4.6.1 Examples of

use

5 Banking supervision and other

activities

6 Independence

7 Criticism

o 7.1 Alternatives

8 See also

9 References
 10 External links

[edit]History

The Bank of England, established in 1694.

In Europe prior to the 17th century most money was commodity money, typically gold or silver. However,
promises to pay were widely circulated and accepted as value at least five hundred years earlier in both
Europe and Asia. The Song Dynasty was the first to issue generally circulating paper currency, while
the Yuan Dynasty was the first to use notes as the predominant circulating medium. In 1455, in an effort to
control inflation, the succeeding Ming Dynasty ended the use of paper money and closed much of Chinese
trade. The medieval European Knights Templar ran an early prototype of a central banking system, as their
promises to pay were widely respected, and many regard their activities as having laid the basis for the
modern banking system.

As the first public bank to "offer accounts not directly convertible to coin", the Bank of
Amsterdam established in 1609 is considered to be a precursor to a central bank. [4] In 1664, the central
bank of Sweden—"Sveriges Riksbank" or simply "Riksbanken"—was founded in Stockholm and is by that
the world's oldest central bank (still operating today). [5] This was followed in 1694 by the Bank of England,
created by Scottish businessman William Paterson in the City of London at the request of
the English government to help pay for a war.

Although central banks today are generally associated with fiat money, the nineteenth and early twentieth
centuries central banks in most of Europe andJapan developed under the international gold standard,
elsewhere free banking or currency boards were more usual at this time. Problems with collapses of banks
during downturns, however, was leading to wider support for central banks in those nations which did not as
yet possess them, most notably in Australia.

With the collapse of the gold standard after World War I, central banks became much more widespread.
The US Federal Reserve was created by the U.S. Congress through the passing of the Glass-Owen Bill,
signed by President Woodrow Wilson on December 23, 1913, whilst Australia established its first central
bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New Zealand in the aftermath
of the Great Depression in 1934. By 1935, the only significant independent nation that did not possess a
central bank was Brazil, which developed a precursor thereto in 1945 and created its present central bank
twenty years later. When African and Asian countries gained independence, all of them rapidly established
central banks or monetary unions.

The People's Bank of China evolved its role as a central bank starting in about 1979 with the introduction of
market reforms in that country, and this accelerated in 1989 when the country took a generally capitalist
approach to developing at least its export economy. By 2000 the People's Bank of China was in all senses
a modern central bank, and emerged as such partly in response to theEuropean Central Bank. This is the
most modern bank model and was introduced with the euro to coordinate the European national banks,
which continue to separately manage their respective economies other than currency exchange and base
interest rates.

[edit]Activities and responsibilities

United States Federal Reserve

Functions of a central bank may include:

 implementing monetary policy

 determining Interest rates

 controlling the nation's entire money supply

 the Government's banker and the bankers' bank ("lender of last resort")

 managing the country's foreign exchange and gold reserves and the Government's stock register

 regulating and supervising the banking industry

 setting the official interest rate – used to manage both inflation and the country's exchange rate –
and ensuring that this rate takes effect via a variety of policy mechanisms
[edit]Monetary policy
Central banks implement a country's chosen monetary policy. At the most basic level, this involves
establishing what form of currency the country may have, whether a fiat currency, gold-backed
currency (disallowed for countries with membership of the IMF), currency board or a currency union. When
a country has its own national currency, this involves the issue of some form of standardized currency,
which is essentially a form of promissory note: a promise to exchange the note for "money" under certain
circumstances. Historically, this was often a promise to exchange the money for precious metals in some
fixed amount. Now, when many currencies are fiat money, the "promise to pay" consists of nothing more
than a promise to pay the same sum in the same currency.
In many countries, the central bank may use another country's currency either directly (in a currency union),
or indirectly, by using a currency board. In the latter case, local currency is directly backed by the central
bank's holdings of a foreign currency in a fixed-ratio; this mechanism is used, notably, in Bulgaria, Hong
Kong and Estonia.

In countries with fiat money, monetary policy may be used as a shorthand form for the interest rate targets
and other active measures undertaken by the monetary authority.

[edit]Goals of monetary policy

The ECB building in Frankfurt

Price Stability

Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for inflation.
Effort successful if monetary policy able to maintain steady rate of inflation.

High Employment

The movement of workers between jobs is referred to as frictional unemployment. All

unemployment beyond frictional unemployment is classified as unintended unemployment.
Reduction in this area is the target of macroeconomic policy.

Economic Growth

Economic growth is enhanced by investment in technological advances in production.

Encouragement of savings supplies funds that can be drawn upon for investment.

Interest Rate Stability

Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected
changes that cause damage, making policy formulation difficult.

Financial Market Stability

Foreign Exchange Market Stability

 Conflicts Among Goals

Goals frequently cannot be separated from each other and often conflict. Costs must therefore be
carefully weighed before policy implementation.
[edit]Currency issuance
Many central banks are "banks" in the sense that they hold assets (foreign
exchange, gold, and other financial assets) and liabilities. A central bank's
primary liabilities are the currency outstanding, and these liabilities are backed
by the assets the bank owns.

Central banks generally earn money by issuing currency notes and "selling"
them to the public for interest-bearing assets, such as government bonds.
Since currency usually pays no interest, the difference in interest generates
income, called seigniorage. In most central banking systems, this income is
remitted to the government. The European Central Bank remits its interest
income to its owners, the central banks of the member countries of the
European Union.

Although central banks generally hold government debt, in some countries the
outstanding amount of government debt is smaller than the amount the central
bank may wish to hold. In many countries, central banks may hold significant
amounts of foreign currency assets, rather than assets in their own national
currency, particularly when the national currency is fixed to other currencies.

[edit]Naming of central banks

There is no standard terminology for the name of a central bank, but many
countries use the "Bank of Country" form (e.g., Bank of England, Bank of
Canada, Bank of Russia). Some are styled "national" banks, such as
the National Bank of Ukraine; but the term "national bank" is more often used
by privately-owned commercial banks, especially in the United States. In other
cases, central banks may incorporate the word "Central" (e.g. European
Central Bank, Central Bank of Ireland). The word "Reserve" is also often
included, such as the Reserve Bank of India, Reserve Bank of
Australia, Reserve Bank of New Zealand, the South African Reserve Bank, and
U.S. Federal Reserve System. Many countries have state-owned banks or
other quasi-government entities that have entirely separate functions, such as
financing imports and exports.

In some countries, particularly in some Communist countries, the term national

bank may be used to indicate both the monetary authority and the leading
banking entity, such as the USSR's Gosbank(state bank). In other countries,
the term national bank may be used to indicate that the central bank's goals
are broader than monetary stability, such as full employment, industrial
development, or other goals.

[edit]Interest rate interventions

Typically a central bank controls certain types of short-term interest rates.
These influence the stock- and bond markets as well as mortgage and other
interest rates. The European Central Bank for example announces its interest
rate at the meeting of its Governing Council; in the case of the Federal
Reserve, the Board of Governors.

Both the Federal Reserve and the ECB are composed of one or more central
bodies that are responsible for the main decisions about interest rates and the
size and type of open market operations, and several branches to execute its
policies. In the case of the Fed, they are the local Federal Reserve Banks; for
the ECB they are the national central banks.

[edit]Limits of enforcement power

Contrary to popular perception, central banks are not all-powerful and have
limited powers to put their policies into effect. Most importantly, although the
perception by the public may be that the "central bank" controls some or all
interest rates and currency rates, economic theory (and substantial empirical
evidence) shows that it is impossible to do both at once in an open
economy. Robert Mundell's "impossible trinity" is the most famous formulation
of these limited powers, and postulates that it is impossible to target monetary
policy (broadly, interest rates), the exchange rate (through a fixed rate) and
maintain free capital movement. Since most Western economies are now
considered "open" with free capital movement, this essentially means that
central banks may target interest rates or exchange rates with credibility, but
not both at once.

Even when targeting interest rates, most central banks have limited ability to
influence the rates actually paid by private individuals and companies. In the
most famous case of policy failure, George Soros arbitraged the pound
sterling's relationship to the ECU and (after making $2 billion himself and
forcing the UK to spend over $8bn defending the pound) forced it to abandon
its policy. Since then he has been a harsh critic of clumsy bank policies and
argued that no one should be able to do what he did.

The most complex relationships are those between the yuan and the US dollar,
and between the euro and its neighbours. The situation in Cuba is so
exceptional as to require the Cuban peso to be dealt with simply as an
exception, since the United States forbids direct trade with Cuba. US dollars
were ubiquitous in Cuba's economy after its legalization in 1991, but were
officially removed from circulation in 2004 and replaced by the convertible
peso.

[edit]Policy instruments

The main monetary policy instruments available to central banks are open

market operation, bank reserve requirement, interest rate policy, re-lending and
re-discount (including using the term repurchase market), and credit
policy (often coordinated with trade policy). While capital adequacy is
important, it is defined and regulated by the Bank for International Settlements,
and central banks in practice generally do not apply stricter rules.

To enable open market operations, a central bank must hold foreign exchange

reserves (usually in the form of government bonds) and official gold reserves. It
will often have some influence over any official or mandated exchange rates:
Some exchange rates are managed, some are market based (free float) and
many are somewhere in between ("managed float" or "dirty float").

[edit]Interest rates
By far the most visible and obvious power of many modern central banks is to
influence market interest rates; contrary to popular belief, they rarely "set" rates
to a fixed number. Although the mechanism differs from country to country,
most use a similar mechanism based on a central bank's ability to create as
much fiat money as required.

The mechanism to move the market towards a 'target rate' (whichever specific
rate is used) is generally to lend money or borrow money in theoretically
unlimited quantities, until the targeted market rate is sufficiently close to the
target. Central banks may do so by lending money to and borrowing money
from (taking deposits from) a limited number of qualified banks, or by
purchasing and selling bonds. As an example of how this functions, the Bank of
Canada sets a target overnight rate, and a band of plus or minus 0.25%.
Qualified banks borrow from each other within this band, but never above or
below, because the central bank will always lend to them at the top of the
band, and take deposits at the bottom of the band; in principle, the capacity to
borrow and lend at the extremes of the band are unlimited. [6] Other central
banks use similar mechanisms.
It is also notable that the target rates are generally short-term rates. The actual
rate that borrowers and lenders receive on the market will depend on
(perceived) credit risk, maturity and other factors. For example, a central bank
might set a target rate for overnight lending of 4.5%, but rates for (equivalent
risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves,
even below the short-term rate. Many central banks have one primary
"headline" rate that is quoted as the "central bank rate." In practice, they will
have other tools and rates that are used, but only one that is rigorously
targeted and enforced.

"The rate at which the central bank lends money can indeed be chosen at will
by the central bank; this is the rate that makes the financial headlines." - Henry
C.K. Liu.[7] Liu explains further that "the U.S. central-bank lending rate is known
as the Fed funds rate. The Fed sets a target for the Fed funds rate, which
its Open Market Committee tries to match by lending or borrowing in
the money market ... a fiat money system set by command of the central bank.
The Fed is the head of the central-bank because the U.S. dollar is the key
reserve currency for international trade. The global money market is a USA
dollar market. All other currencies markets revolve around the U.S. dollar
market." Accordingly the U.S. situation is not typical of central banks in general.

A typical central bank has several interest rates or monetary policy tools it can
set to influence markets.

 Marginal lending rate (currently 1.75% in the Eurozone) – a fixed rate for

institutions to borrow money from the central bank. (In the USA this is
called the discount rate).

 Main refinancing rate (1.00% in the Eurozone) – the publicly visible interest

rate the central bank announces. It is also known as minimum bid rate and
serves as a bidding floor for refinancing loans. (In the USA this is called
the federal funds rate).

 Deposit rate (0.25% in the Eurozone) – the rate parties receive for deposits
at the central bank.

These rates directly affect the rates in the money market, the market for short
term loans.

[edit]Open market operations

Through open market operations, a central bank influences the money supply
in an economy directly. Each time it buys securities, exchanging money for the
security, it raises the money supply. Conversely, selling of securities lowers the
money supply. Buying of securities thus amounts to printing new money while
lowering supply of the specific security.

The main open market operations are:

 Temporary lending of money for collateral securities ("Reverse Operations"

or "repurchase operations", otherwise known as the "repo" market). These
operations are carried out on a regular basis, where fixed maturity loans
(of 1 week and 1 month for the ECB) are auctioned off.

 Buying or selling securities ("direct operations") on ad-hoc basis.

 Foreign exchange operations such as forex swaps.

All of these interventions can also influence the foreign exchange market and

thus the exchange rate. For example the People's Bank of China and the Bank
of Japan have on occasion bought several hundred billions of U.S. Treasuries,
presumably in order to stop the decline of the U.S. dollar versus
the renminbi and the yen.

[edit]Capital requirements
All banks are required to hold a certain percentage of their assets as capital, a
rate which may be established by the central bank or the banking supervisor.
For international banks, including the 55 member central banks of the Bank for
International Settlements, the threshold is 8% (see the Basel Capital Accords)
of risk-adjusted assets, whereby certain assets (such as government bonds)
are considered to have lower risk and are either partially or fully excluded from
total assets for the purposes of calculating capital adequacy. Partly due to
concerns about asset inflation and repurchase agreements, capital
requirements may be considered more effective than deposit/reserve
requirements in preventing indefinite lending: when at the threshold, a bank
cannot extend another loan without acquiring further capital on its balance
sheet.

[edit]Reserve requirements
In practice, many banks are required to hold a percentage of their deposits
as reserves. Such legal reserve requirements were introduced in the
nineteenth century to reduce the risk of banks overextending themselves and
suffering from bank runs, as this could lead to knock-on effects on other
banks. See also money multiplier. As the early 20th century gold standard and
late 20th centurydollar hegemony evolved, and as banks proliferated and
engaged in more complex transactions and were able to profit from dealings
globally on a moment's notice, these practices became mandatory, if only to
ensure that there was some limit on the ballooning of money supply. Such
limits have become harder to enforce. The People's Bank of China retains (and
uses) more powers over reserves because the yuan that it manages is a non-
convertible currency.

Even if reserves were not a legal requirement, prudence would ensure that
banks would hold a certain percentage of their assets in the form of cash
reserves. It is common to think of commercial banks as passive receivers of
deposits from their customers and, for many purposes, this is still an accurate
view.

This passive view of bank activity is misleading when it comes to considering

what determines the nation's money supply and credit. Loan activity by banks
plays a fundamental role in determining the money supply. The central-bank
money after aggregate settlement - final money - can take only one of two
forms:

 physical cash, which is rarely used in wholesale financial markets,

 central-bank money.

The currency component of the money supply is far smaller than the deposit
component. Currency and bank reserves together make up the monetary base,
called M1 and M2.

[edit]Exchange requirements
To influence the money supply, some central banks may require that some or
all foreign exchange receipts (generally from exports) be exchanged for the
local currency. The rate that is used to purchase local currency may be market-
based or arbitrarily set by the bank. This tool is generally used in countries with
non-convertible currencies or partially-convertible currencies. The recipient of
the local currency may be allowed to freely dispose of the funds, required to
hold the funds with the central bank for some period of time, or allowed to use
the funds subject to certain restrictions. In other cases, the ability to hold or use
the foreign exchange may be otherwise limited.

In this method, money supply is increased by the central bank when it

purchases the foreign currency by issuing (selling) the local currency. The
central bank may subsequently reduce the money supply by various means,
including selling bonds or foreign exchange interventions.

[edit]Margin requirements and other tools

In some countries, central banks may have other tools that work indirectly to
limit lending practices and otherwise restrict or regulate capital markets. For
example, a central bank may regulate margin lending, whereby individuals or
companies may borrow against pledged securities. The margin requirement
establishes a minimum ratio of the value of the securities to the amount
borrowed.

Central banks often have requirements for the quality of assets that may be
held by financial institutions; these requirements may act as a limit on the
amount of risk and leverage created by the financial system. These
requirements may be direct, such as requiring certain assets to bear certain
minimum credit ratings, or indirect, by the central bank lending to
counterparties only when security of a certain quality is pledged as collateral.

[edit]Examples of use

The People's Bank of China has been forced into particularly aggressive and

differentiating tactics by the extreme complexity and rapid expansion of the
economy it manages. It imposed some absolute restrictions on lending to
specific industries in 2003, and continues to require between 1% and 3% more
reserves[8] from large urban banks (typically focusing on export) than rural
ones. This is not by any means an unusual situation. The USA historically had
very wide ranges of reserve requirements between its dozen branches.
Domestic development is thought to be optimized mostly by reserve
requirements rather than by capital adequacy methods, since they can be more
finely tuned and regionally varied.

[edit]Banking supervision and other activities

Finance

Financial markets[show]

Financial instruments[show]

Corporate finance[show]

Personal finance[show]

Public finance[show]

Banks and banking[show]

 Financial regulation[show]

Standards[show]

Economic history[show]

v · d · e

In some countries a central bank through its subsidiaries controls and monitors
the banking sector. In other countries banking supervision is carried out by a
government department such as the UK Treasury, or an independent
government agency (e.g. UK's Financial Services Authority). It examines the
banks' balance sheets and behaviour and policies toward consumers. Apart
from refinancing, it also provides banks with services such as transfer of
funds, bank notes and coins or foreign currency. Thus it is often described as
the "bank of banks".

Many countries such as the United States will monitor and control the banking
sector through different agencies and for different purposes, although there is
usually significant cooperation between the agencies. For example, money
center banks, deposit-taking institutions, and other types of financial institutions
may be subject to different (and occasionally overlapping) regulation. Some
types of banking regulation may be delegated to other levels of government,
such as state or provincial governments.

Any cartel of banks is particularly closely watched and controlled. Most

countries control bank mergers and are wary of concentration in this industry
due to the danger of groupthink and runaway lending bubbles based on
a single point of failure, the credit culture of the few large banks.

[edit]Independence

This section needs
additional citations for verification.
Please help improve this article by adding reliable references.
Unsourced material may be challenged and removed. (February
2009)

This section may be unbalanced towards certain

viewpoints. Please improve the article by adding
information on neglected viewpoints, or discuss
the issue on the talk page. (February 2009)

Over the past decade, there has been a trend towards increasing the
independence of central banks as a way of improving long-term economic
performance. However, while a large volume of economic research has been
 done to define the relationship between central bank independence and
economic performance, the results are ambiguous.

Advocates of central bank independence argue that a central bank which is too
susceptible to political direction or pressure may encourage economic cycles
("boom and bust"), as politicians may be tempted to boost economic activity in
advance of an election, to the detriment of the long-term health of the economy
and the country. In this context, independence is usually defined as the central
bank's operational and management independence from the government.

The literature on central bank independence has defined a number of types of

independence.

Legal independence

The independence of the central bank is enshrined in law. This type of independence is limited in a
democratic state; in almost all cases the central bank is accountable at some level to government
officials, either through a government minister or directly to a legislature. Even defining degrees of
legal independence has proven to be a challenge since legislation typically provides only a
framework within which the government and the central bank work out their relationship.

Goal independence

The central bank has the right to set its own policy goals, whether inflation targeting, control of the
money supply, or maintaining a fixed exchange rate. While this type of independence is more
common, many central banks prefer to announce their policy goals in partnership with the
appropriate government departments. This increases the transparency of the policy setting process
and thereby increases the credibility of the goals chosen by providing assurance that they will not
be changed without notice. In addition, the setting of common goals by the central bank and the
government helps to avoid situations where monetary and fiscal policy are in conflict; a policy
combination that is clearly sub-optimal.

Operational independence

The central bank has the independence to determine the best way of achieving its policy goals,
including the types of instruments used and the timing of their use. This is the most common form
of central bank independence. The granting of independence to the Bank of England in 1997 was,
in fact, the granting of operational independence; the inflation target continued to be announced in
the Chancellor's annual budget speech to Parliament.

Management independence

The central bank has the authority to run its own operations (appointing staff, setting budgets, etc.)
without excessive involvement of the government. The other forms of independence are not
possible unless the central bank has a significant degree of management independence. One of
the most common statistical indicators used in the literature as a proxy for central bank
independence is the "turn-over-rate" of central bank governors. If a government is in the habit of
appointing and replacing the governor frequently, it clearly has the capacity to micro-manage the
central bank through its choice of governors.

It is argued that an independent central bank can run a

more credible monetary policy, making market
expectations more responsive to signals from the
central bank. Recently, both the Bank of England (1997)
and the European Central Bank have been made
independent and follow a set of published inflation
targets so that markets know what to expect. Even
the People's Bank of China has been accorded great
latitude due to the difficulty of problems it faces, though
in the People's Republic of China the official role of the
bank remains that of a national bank rather than a
central bank, underlined by the official refusal to "unpeg"
the yuan or to revalue it "under pressure". The People's
Bank of China's independence can thus be read more
as independence from the USA which rules the financial
markets, than from the Communist Party of China which
rules the country. The fact that the Communist Party is
not elected also relieves the pressure to please people,
increasing its independence.

Governments generally have some degree of influence

over even "independent" central banks; the aim of
independence is primarily to prevent short-term
interference. For example, the chairman of the U.S.
Federal Reserve Bank is appointed by the President of
the U.S. (all nominees for this post are recommended
by the owners of the Federal Reserve, as are all the
board members), and his choice must be confirmed by
the Congress.

International organizations such as the World Bank,

the BIS and the IMF are strong supporters of central
bank independence. This results, in part, from a belief in
the intrinsic merits of increased independence. The
support for independence from the international
organizations also derives partly from the connection
between increased independence for the central bank
and increased transparency in the policy-making
process. The IMF's FSAP review self-assessment, for
example, includes a number of questions about central
bank independence in the transparency section. An
independent central bank will score higher in the review
than one that is not independent.

[edit]Criticism

According to the Austrian School, central banking tends

to wreak havoc on an economy by systematically
devaluing a currency by over creating this currency
against nothing of intrinsic value (such as gold),
resulting in never-ending inflation. The main opponents
to fractional reserve central banking are the proponents
of the Austrian business cycle theory, including Ludwig
von Mises, Friedrich Hayekand Murray Rothbard,
[9]
 though this economic theory is not generally accepted
by mainstream economists. F. A. Hayek shared a Nobel
Prize in economics (with Stockholm
school economist, Gunnar Myrdal) in 1974 based on
"their pioneering work in the theory of money" among
other contributions.

[edit]Alternatives
This section does
not cite any references or
sources.
Please help improve this article by
adding citations to reliable sources.
Unsourced material may
be challenged and removed. (Novem
ber 2010)

Demurrage currencies provide an alternative and

perhaps complementary means towards central
banking's goal of sustaining economic growth with
different specific characteristics and a mechanism that
follows naturally from the use of commodity currencies,
is more uniform in operation, does not devalue the
currency unit, and is more predictable and potentially
more decentralized in its operation. Historically, the idea
of demurrage influenced Keynes' prescription for net-
inflationary central bank poli