Central banks play a vital role in the economy. They use their central banking power to respond to changes in the domestic money supply or in the interest rates. Central banks control both the volume of currency in circulation and the rate of interest it should be able to offer to individuals and businesses. In fact, central banking plays a key role in the functioning of the economy.
There are two general categories of central banking systems. One is direct central banking. In this system, banks lend their loans directly to borrowers. The second is market-based central banking. In this system, banks make loans only to businesses who put up collateral for the loan. In this system, long-term debts are converted into short-term assets and savings are converted into capital investment.
There are two types of central banking system: traditional central banking and modern central banking. In the traditional system, the central banks print paper currency. Paper currency is backed up by gold and other precious metals. This system has been in place since the inception of the nation states.
Modern central banking systems are composed of a variety of complex financial instruments. A number of these instruments are commonly known as "frictional instruments." Some of these include government bonds, commercial paper currency, foreign exchange market products, and various deposit interest bureaus such as the Federal Reserve.
Many observers believe that modern central banking systems are too intrusive into monetary affairs. For example, some argue that it is not appropriate for central banks to intervene in order to control the price level of interest rates. Others argue that the existence of too many competing currencies weakens the value of the domestic monetary unit. Still others believe that attempts by central banks to manipulate the money supply will result in increased instability and inflationary pressures. To protect the financial system from these problems, the Fed, acting on behalf of the US government, prints a large amount of money to be placed into bank reserves.
In order to monitor bank balances, and to keep a watchful eye on monetary aggregates, central banks employ a wide range of tools including interest rates, exchange rates, and spot exchange rates. In addition, they can use other tools such as asset quality, central bank balance standards, bank policy, and international macroprudential measures. In fact, even money market instruments are subject to central banking influences.
The second bank plays an important role in contemporary monetary systems, serving as an alternative to the central banking system. The role of the second bank is to continue the function of banks previously performed by them. Central banks normally have a controlling interest in foreign trade and foreign investments. They are primarily concerned with inflation, but they do tolerate a healthy financial state in foreign countries so long as their policy aims remain oriented towards inflation. The second bank fulfills this role in relation to the domestic monetary system.
During the World War I, the Federal Reserve System printed U.S. dollars in order to finance the war effort. When peace was declared, the dollar was withdrawn from circulation, and the need for the massive, federally controlled depositories was soon felt. With the end of World War I and the onset of the Great Depression, the government began to look for methods of maintaining the value of the dollar.
At first, most of the early central banks attempted to curb deflation, which is the gradual loss of goods, services, and confidence resulting from a recession. Various policies, such as controls on interest rates, were introduced. However, these measures proved not very effective. Eventually, the last resort to rectifying the situation was to make a large scale purchase of short term assets. These assets, mostly government bonds, later became known as "excess reserves." The purpose of this last resort was to prevent a run on the money supply, which in turn, would lead to hyperinflation.
The early United States experienced four stages of inflation: an early stage of price inflation, called bandaid inflation, which lasted from early in the century until the start of the thirties; a mild inflation that continued into the thirties and continued through the 1950s; a stagflation that began in the early 1960s and continued until the end of the seventies; and a deflation that occurred after the start of the eighties. The current global economic crisis, which has been occurring since last summer, is being exacerbated by widespread deflation. In this sense, the recent bank lending crisis does not seem quite so bad. Even though the banking system may have prevented hyperinflation from happening in the past, current circumstances may have led to its occurrence in the past and may soon happen again. Monetary authorities around the world have an important role to play in ensuring that stable economic conditions are maintained by creating appropriate interest rates, increasing the stability of financial markets, and by facilitating monetary flows and reducing exchange rates.