4.4.3 - Role of central banks

Implementing Monetary Policy

The best-known role of a central bank is implementing monetary policy. That means using interest rates and other monetary tools to influence spending, inflation, and wider macroeconomic conditions.

In the UK, the Monetary Policy Committee sets Bank Rate. When Bank Rate rises, commercial banks usually raise the interest rates they charge on loans and often the rates they offer to savers. That tends to reduce borrowing and encourage saving, so consumption and investment grow more slowly. If demand in the economy weakens, inflationary pressure is likely to ease.

Interest rate changes also affect the economy through other channels. Higher interest rates can attract foreign funds and strengthen the exchange rate, which makes imports cheaper but can make exports less competitive. They may also reduce house prices and share prices, which can lower household wealth and make spending more cautious. Lower rates tend to work in the opposite direction.

Central banks can also influence monetary conditions through open market operations, by buying or selling government bonds to affect liquidity in the banking system. In more unusual circumstances they may use quantitative easing, creating money to buy financial assets and push down longer-term interest rates. In some countries they can also change reserve requirements, although that is not the main day-to-day instrument used in the UK.

A good UK example is the period after the financial crisis, when the Bank of England combined very low interest rates with asset purchases to support spending and credit conditions.

Banker to the Government

Central banks also act as the government's bank. They hold the government's main accounts, so tax revenue can flow in and public spending can flow out through a secure central institution. This gives the state a reliable place to manage day-to-day payments and cash balances.

They also manage official reserves of gold and foreign currency. Those reserves can help maintain confidence, allow intervention in foreign exchange markets if needed, and support the country's ability to meet international obligations. In a crisis, reserves also provide a financial buffer.

Another part of the role is advice. Because central banks monitor inflation, credit conditions, exchange rates, and financial stress closely, they can advise governments on monetary and financial issues.

Historically, central banks often managed the national debt directly by issuing and repurchasing government bonds. In the UK, routine debt management now sits with the Debt Management Office. Even so, the Bank of England still matters for government financing conditions, especially when monetary policy involves large-scale purchases of government debt.

Banker to Banks and Lender of Last Resort

Commercial banks also keep reserve accounts at the central bank. This matters because banks are constantly making payments to one another as customers transfer money, write cheques, or use cards. At the end of the process, the central bank can settle the net amounts owed by adjusting those reserve accounts. That is why it is often described as the banker's bank.

This everyday role becomes critical in a crisis. A bank can be solvent, meaning its assets are still greater than its liabilities, but illiquid, meaning it does not have enough cash right now to meet withdrawals or other short-term payments. If the interbank market freezes or other banks refuse to lend, the central bank may provide emergency liquidity.