What role do they play? How do they affect exchange rates and what influence do they have on the forex market? Find out everything you need to know about central banks in just five minutes.
As the monetary authority of a country’s economy, central banks are responsible for regulating and monitoring the banking system of the country in question. They are in charge of formulating the country’s monetary policy and although they are politically independent, they have a statutory monopoly status in their country which gives them the power and responsibility to issue money. Described as the “lender of last resort” central banks are responsible for creating sufficient reserves and govern the banking industry by ensuring commercial banks are not facing a supply shortage, as was the case during the 2008 financial crisis.
Central banks typically intervene to prevent excessively large and rapid evolutions in the value of their currencies. This ensures that the latter are neither undervalued nor overvalued for an excessively long period.
Among the main methods of central bank intervention, one may include the issuing and withdrawal of liquidity in the domestic currency or a massive currency swap over a relatively short period of time. To increase a currency’s rate, central bank can lower the supply of their currency which will have the effect of increasing the demand of the currency. Conversely, by selling the domestic currency in exchange for other currencies, this increases the supply of a currency and causes its value to fall. Currency devaluation makes domestic goods cheaper than foreign goods which itself has both positive and negative effects on a country’s currency.
What role do central banks play?
Central banks perform three main functions:
01. Regulating the market
- One of the primary functions of central banks is to regulate economic activity by setting interest rates, typically referred to as the key interest rate.
02. Managing foreign currency reserves
- Another central bank function is the management of foreign exchange reserves.
- Depending on their reserves, central banks may decide to buy foreign currency or sell the local currency in order to influence its value.
- In this way, they try to control the price of their currency in order to avoid either under- or overvaluation.
03. Controlling the supply of money in circulation
- A central bank may decide to issue or withdraw liquidity in the domestic currency to regulate the amount of money in circulation.
- All central banks play an essential role. However, the weight of the currency and the economy they represent gives some of them an international dimension.
The Bank of England found itself unable to stop the devaluation of the pound sterling, while the introduction of the single currency required the stabilisation of European currencies around a specific rate. This foreshadowed the maintenance of the UK’s national currency.
Which central banks are the most important?
The most important central banks include the ECB European Central Bank, the Federal Reserve, the Bank of England, the Bank of Japan, the Swiss National Bank and finally the Bank of Canada. Because of their country and their currency’s weight in the world economy, the influence of these central banks goes beyond their country’s borders.
Foreign exchange market participants pay special attention to the announcements and interventions of these central banks, as their decisions affect the most traded currency pairs and the global economy at large.
The European Central Bank ensures the smooth functioning of the economic and monetary union of all the countries having adopted the single currency.
- It heads the European System of Central Banks (ESCB), which is composed of the central banks of the eurozone, as well as those of the countries that have not yet adopted the single currency within the bloc.
- It acts to ensure price stability and the smooth operation of foreign exchange transactions and payment systems.
- It sets interest rates for countries within the monetary union and lends to commercial banks according to the key interest rate in force, helping to regulate the money in circulation and keep inflation under control.
- The ECB also authorises the issue of euro (EUR) banknotes by eurozone countries.
