Central Bank System

Over the centuries, central banks have played four broad roles in the economy: fiscal support, financial stability support, monetary support and macroeconomic support.

While the present monetary system, with central banks and a prudential apparatus at its core, can and must be improved, it still provides the best basis to build on. Furthermore, central banks can provide revenue or fiscal support for their government in a variety of ways.

The Financial Stability

The financial stability role evolved slowly both in terms of learning how to be a lender of last resort and in acceptance of the duty of (largely) private institutions to undertake that role. The monetary support role refers to the role of central banks in providing a medium of exchange and a medium for the settlement of interbank balances (or a medium for final payment). These are connected, but not identical, functions, and their relative significance evolved over time.

Monetary Support

Money’s future purchasing power depends on the commitment of the government and the central bank to maintain price stability; the functioning of the transmission mechanism of monetary policy; the fiscal discipline of the government; the stability of the exchange rate; the banking system that creates the bulk the money supply; the effectiveness of regulation and supervision of the banking system; effective lender-of-last-resort and deposit insurance mechanisms and, least visible of all, the payments system.

Our Technology of Money

Central banks have fulfilled a number of mandates providing monetary unification, uniformity and stability, generating fiscal resources, acting as a tool for macroeconomic stability, and enhancing financial stability. In different periods, different motives have taken pride of place. In the early 21st century the financial stability role dominated. The shift away from macroeconomic stability and fiscal contributions of central banks, combined with a belief that the ‘market’ would support illiquid but solvent financial institutions created an environment where central bank independence took pride of place.

The mandates of central banks have evolved in response to three factors: the existence of alternative sources of funds for the sovereign, the prevailing economic theory or broader set of philosophical beliefs, and the technology of money and of financial instruments more broadly. All three factors remain in play, and it is likely that central banks will continue to change their colours as their environments change.