What Is a Central Bank and What Does It Do?

What is a central bank and what does it do?

A central bank is an institution that manages a country’s currency and its money supply. It is now one necessary part in a country’s financial system.

The primary function of a central bank is to keep the financial system stable. In order to fulfill this final goal, it needs to pursue 3 specific objectives. The first one is to maintain price stability, which means to maintain a low and stable inflation as well as a stable exchange rate. The second one is to maintain financial stability, and at the same time, generate financial growth. This objective suggests a stable real growth, a low unemployment, a stable interest rate, together with a stable financial market and institutions. The third one is to support the country at times of crises as “lender of last resort”.

Although Central banks’ objectives are all what people desire, but some of them sometimes are contradictive to each other.

In history, some central banks were established to help provide war finance, like the Bank of England and the Banque de France, as lender of last resort. But in modern times, the existence of central banks, a huge part of the reasons, is to make a balance between financial stability and stable price as to avoid financial crises and generate real growth. Financial systems can provide liquidity and convenience that help us making transactions and producing commodities. And markets convey information to guide people to produce through the change of prices. In many ways, market is a much more efficient distribution method to satisfy needs and demands than rationing. And market can stimulate growth and new production. However, market is fragile because of its uncertainty. When prices don’t convey the real information or when people misinterpret the information, setting a wrong expectation about the future, a small signal will be amplified and sometimes a crisis comes. A stable price sometimes means a low growth rate. And prices can go...