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What is a central bank, and what is its role?

Heard of it, but not really sure what a central bank is? Find out what role this institution plays, and its influence on a country’s economy.

4 min read

So, what’s a central bank anyway—and what do they do? Nicknamed the “bank of banks”, a central bank is an independent public institution that’s responsible for ensuring the financial stability of a country. Each country has its own central bank, whose shareholder is the state. There’s also one for Europe—the ECB (European Central Bank)—which manages the monetary policy of all 19 countries in the eurozone. 

What role does a central bank have?

A central bank has three main missions:

  • Guaranteeing price stability by minimizing inflation and deflation at around 2%, with central bank policy rates
  • Issuing money by putting coins and banknotes into circulation
  • Lending money to commercial banks

So, central banks control the amount of money in circulation within a country, as well as the cost of money. They set the interest rates on the loans they grant to commercial banks, who then pass them on as loans to households and businesses—thereby influencing the economy. Central banks are also responsible for ensuring sufficient foreign exchange reserves—that is, assets that are held in foreign currency or gold.

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What is the European Central Bank?

The European Central Bank (ECB) was created in 1992 with the Maastricht Treaty—and since 1998, Frankfurt, Germany has been the host city of the ECB. The ECB is responsible for implementing the monetary policy for all member states of the eurozone.

To ensure the viability of the single euro currency, the ECB is always independent from other institutions—including the bodies of the European Union, and its member states. Its directives must be applied by all central banks in the eurozone.

Like any other central bank, the ECB’s main mission is to ensure price stability, growth, and to promote full employment (i.e. to help curb unemployment rates). To do this, the ECB controls the money supply in circulation—and thus limits the risk of excessive inflation or deflation. 

The ECB also sets the mandatory reserve ratio (i.e. the amount of money that national central banks must deposit into their ECB account) in order to maintain the long-term sustainability of the banking system.The ECB also determines the policy rates—the interest rate on loans from the ECB to commercial banks—which in turn, influence the short-term interest rates and the money supply in the economy. 

Speaking of money supply, the ECB is the only European body to authorize the issuance of currency in euros. That means the ECB has a supply role among national banks, which must have the ECB’s agreement before issuing currency.

Who manages the European Central Bank?

Since November 2019, Christine Lagarde has been President of the European Central Bank. She is the first woman to be President of the ECB, and was previously the Minister of Economy in France from 2007 to 2011, and the Managing Director of the International Monetary Fund (IMF) from 2011 to 2019.

The ECB has 3 decision-making bodies: 

  • The Governing Council, which decides on monetary policy
  • The Executive Board, which applies the policies decided by the Governing Council
  • The General Council, which plays an administrative role

What is the Banque de France?

The Banque de France is the French national central bank which is part of the European System of Central Banks (ESCB). It was created by Napoleon Bonaparte in 1800. Along with the ECB and the other national banks in the euro area, the Banque de France is part of the Eurosystem. Its governor is appointed by the French President. Since 2015, François Villeroy de Galhau has been the governor. The Banque de France has a national management committee, as well as departmental branches.

The Banque de France has two main missions:

  • Issuing currency in the country, with the ECB’s authorization
  • Applying the monetary rules decided by the ECB

The Banque de France also ensures the security of payment methods, manages the secretariat of over-indebtedness commissions, provides a reserve of funds for banks, and oversees the financial establishments in France to guarantee financial stability.

How is the central bank financed?

Central banks can inject emergency liquidity into the economy during severe crises, as was the case in 2007 with the subprime mortgage crisis. Central banks can indeed create unlimited money, and grant short-term loans—with an interest rate—to commercial banks. 

But while central banks can inject money into the economy, they must fulfill their first mission of guaranteeing price stability at all costs. If too much money is injected into the economy, there is a risk of inflation, resulting in a decrease in purchasing power. For example, this is what happened in Germany after the First World War. Among other things, the state created too much money in a short period of time, which led to an unprecedented hyperinflation crisis from 1921 to 1924.

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