Essay on Central Bank | Banking

central bank essay

In this essay we will discuss about central bank. After reading this essay you will learn about: 1. Essay on the Definition of a Central Bank 2. Essay on the Functions of a Central Bank 3. Essay on the Objectives of Credit Control by the Central Bank 4. Essay on the Role of Central Bank in a Developing Economy 5. Essay on the Need for Central Bank.

Essay Contents:

  • Essay on the Need for Central Bank

1. Essay on the Definition of a Central Bank:

A central bank has been defined in terms of its functions. According to Vera Smith, “The primary definition of central banking is a banking system in which a single bank has either complete control or a residuary monopoly of note issue.” W.A. Shaw defines a central bank as a bank which control credit. To Hawtrey, a central bank is that which is the lender of the last resort. According to A.C.L. Day, a central bank is “to help control and stabilise the monetary and banking system.”

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According to Sayers, the central bank “is the organ of government that undertakes the major financial operations of the government and by its conduct of these operations and by other means, influences the behaviour of financial institutions so as to support the economic policy of the Government.” Sayers refers only to the nature of the central bank as the government’s bank. All these definitions are narrow because they refer only to one particular function of a central bank.

On the other hand, Samuelson’s definition is wide. According to him, a central bank “is a bank of bankers. Its duty is to control the monetary base…. and through control of this ‘high-powered money’ to control the community’s supply of money.” But the broadest definition has been given by De Kock.

In his words, a central bank is “a bank which constitutes the apex of the monetary and banking structure of its country and which performs as best as it can in the national economic interest, the following functions:

(i) The regulation of currency in accordance with the requirements of business and the general public for which purpose it is granted either the sole right of note issue or at least a partial monopoly thereof,

(ii) The performance of general banking and agency for the state,

(iii) The custody of the cash reserves of the commercial banks,

(iv) The custody and management of the nation’s reserves of international currency,

(v) The granting of accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and dealers, or other financial institutions and the general acceptance of the responsibility of lender of the last resort,

(vi) The settlement of clearance balances between the banks,

(vii) The control of credit in accordance with the needs of business and with a view to carrying out the broad monetary policy adopted by the state.” De Kock’s definition is too long to be called a definition. For, a definition must be brief.

2. Essay on the Functions of Central Bank:

A central bank performs the following functions, as given by De Kock and accepted by the majority of economists:

1. Regulator of currency :

The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the government mint but they are put into circulation through the central bank.

Central banks have been following different methods of note issue in different countries. The centred bank is required by law to keep a certain amount of gold and foreign securities against the issue of notes. In some countries, the amount of gold and foreign securities bears a fixed proportion, between 25 to 40 per cent of the total notes issued.

In other countries, a minimum fixed amount of gold and foreign currencies is required to be kept against note issue by the central bank. This system is operative in India whereby the Reserve Bank of India is required to keep Rs115crores in gold and Rs85crores in foreign securities. There is no limit to the issue of notes after keeping this minimum amount of Rs200crores in gold and foreign securities.

The monopoly of issuing notes vested in the central bank ensures uniformity in the notes issued which helps in facilitating exchange and trade within the country. It brings stability in the monetary system and creates confidence among the public.

The central bank can restrict or expand the supply of cash according to the requirements of the economy. Thus it provides elasticity to the monetary system. By having a monopoly of note issue, the central bank also controls the banking system by being the ultimate source of cash. Last but not the least, by entrusting the monopoly of note issue to the central bank, the government is able to earn profits from printing notes whose cost is very low as compared with their face value.

2. Banker, fiscal agent and adviser to the g overnment :

Central banks everywhere act as bankers, fiscal agents and advisers to their respective governments. As banker to the government, the central bank keeps the deposits of the central and state governments and makes payments on behalf of governments. But it does not pay interest on governments deposits. It buys and sells foreign currencies on behalf of the government., It keeps the stock of gold of the government.

Thus it is the custodian of government money and wealth. As a fiscal agent, the central bank makes short-term loans to the government for a period not exceeding 90 days. It floats loans, pays interest on them, and finally repays them on behalf of the government. Thus it manages the entire public debt.

The central bank also advises the government on such economic and money matters as controlling inflation or deflation, devaluation or revaluation of the currency, deficit financing, balance of payments, etc. As pointed out by De Kock, “Central banks everywhere operate as bankers to the state not only because it may be more convenient and economical to the state, but also because of the intimate connection between public finance and monetary affairs.”

3. Custodian of cash reserves of commercial banks :

Commercial banks are required by law to keep reserves equal to a certain percentage of both time and demand deposits liabilities with the central banks. It is on the basis of these reserves that the central bank transfers funds from one bank to another to facilitate the clearing of cheques. Thus the central bank acts as the custodian of the cash reserves of commercial banks and helps in facilitating their transactions.

There are many advantages of keeping the cash reserves of the commercial banks with the central bank, according to De Kock.

In the first place, the centralisation of cash reserves in the central bank is a source of great strength to the banking system of a country.

Secondly, centralised cash reserves can serve as the basis of a large and more elastic credit structure than if the same amount were scattered among the individual banks.

Thirdly, centralised cash reserves can be utilised fully and most effectively during periods of seasonal strains and in financial crises or emergencies.

Fourthly, by varying these cash reserves the central bank can control the credit creation by commercial banks. Lastly, the central bank can provide additional funds on a temporary and short term basis to commercial banks to overcome their financial difficulties.

4. Custody and management of foreign exchange reserves :

The central bank keeps and manages the foreign exchange reserves of the country. It is an official reservoir of gold and foreign currencies. It sells gold at fixed prices to the monetary authorities of other countries. It also buys and sells foreign currencies at international prices. Further, it fixes the exchange rates of the domestic currency in terms of foreign currencies.

It holds these rates within narrow limits in keeping with its obligations as a member of the International Monetary Fund and tries to bring stability in foreign exchange rates. Further, it manages exchange control operations by supplying foreign currencies to importers and persons visiting foreign countries on business, studies, etc. in keeping with the rules laid down by the government.

5. Lender of the last resort :

De Kock regards this function as a sine qua non of central banking. By granting accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and dealers, or other financial institutions, the central bank acts as the lender of the last resort. The central bank lends to such institutions in order to help them in times of stress so as to save the financial structure of the country from collapse.

It acts as lender of the last resort through discount house on the basis of treasury bills, government securities and bonds at “the front door”. The other method is to give temporary accommodation to the commercial banks or discount houses directly through the “back door”.

The difference between the two methods is that lending at the front door is at the bank rate and in the second case at the market rate. Thus the central bank as lender of the last resort is a big source of cash and also influences prices and market rates,

6. Clearing house for transfer and settlement :

As bankers’ bank, the central bank acts as a clearing house for transfer and settlement of mutual claims of commercial banks. Since the central bank holds reserves of commercial banks, it transfers funds from one bank to other banks to facilitate clearing of cheques.

This is done by making transfer entries in their accounts on the principle of book-keeping. To transfer and settle claims of one bank upon others, the central bank operates a separate department in big cities and trade centres. This department is known as the “clearing house” and it renders the service free to commercial banks.

When the central bank acts as a clearing agency, it is time-saving and convenient for the commercial banks to settle their claims at one place. It also economises the use of money. “It is not only a means of economising cash and capital but is also a means of testing at any time the degree of liquidity which the community is maintaining.”

7. Controller of credit :

The most important function of the central bank is to control the credit creation power of commercial bank in order to control inflationary and deflationary pressures within this economy. For this purpose, it adopts quantitative methods and qualitative methods.

Quantitative methods aim at controlling the cost and quantity of credit by adopting bank rate policy, open market operations, and by variations in reserve ratios of commercial banks. Qualitative methods control the use and direction of credit. These involve selective credit controls and direct action. By adopting such methods, the central bank tries to influence and control credit creation by commercial banks in order to stabilise economic activity in the country.

Besides the above noted functions, the central banks in a number of developing countries have been entrusted with the responsibility of developing a strong banking system to meet the expanding requirements of agriculture, industry, trade and commerce. Accordingly, the central banks possess some additional powers of supervision and control over the commercial banks.

They are the issuing of licences; the regulation of branch expansion; to see that every bank maintains the minimum paid up capital and reserves as provided by law; inspecting or auditing the accounts of banks; to approve the appointment of chairmen and directors of such banks in accordance with the rules and qualifications; to control and recommend merger of weak banks in order to avoid their failures and to protect the interest of depositors; to recommend nationalisation of certain banks to the government in public interest; to publish periodical reports relating to different aspects of monetary and economic policies for the benefit of banks and the public; and to engage in research and train banking personnel etc.

3. Essay on the Objectives of Credit Control by the Central Bank :

Credit control is the means to control the lending policy of commercial banks by the central bank.

The central bank controls credit to achieve the following objectives:

1. To stabilise the internal price level:

One of the objective of controlling credit is to stabilise the price level in the country. Frequent changes in prices adversely affect the economy. Inflationary or deflationary trends need to be prevented. This can be achieved by adopting a judicious policy of credit control.

2. To stabilise the rate of foreign exchange:

With the change in the internal prices level, exports and imports of the country are affected. When prices fall, exports increase and imports decline. Consequently, the demand for domestic currency increases in the foreign market and its exchange rate rises. On the contrary, a rise in domestic prices leads to a decline in exports and an increase in imports.

As a result, the demand for foreign currency increases and that of domestic currency falls, thereby lowering the exchange rate of the domestic currency. Since it is the volume of credit money that affects prices, the central bank can stabilise the rate of foreign exchange by controlling bank credit.

3. To protect the outflow of gold:

The central bank holds the gold reserves of the country in its vaults. Expansion of bank credit leads to rise in prices which reduce exports and increase imports, thereby creating an unfavourable balance of payments. This necessitates the export of gold to other countries. The central bank has to control credit in order to prevent such outflows of gold to other countries.

4. To control business cycles:

Business cycles are a common phenomenon of capitalist countries which lead to periodic fluctuations in production, employment and prices. They are characterised by alternating periods of prosperity and depression. During prosperity, there is large expansion in the volume of credit, and production, employment and prices rise.

During depression, credit contracts, and production, employment and prices fall. The central bank can counteract such cyclical fluctuations through contraction of bank credit during boom periods, and expansion of bank credit during depression.

5. To meet business needs:

According to Burgess, one of the important objectives of credit control is the “adjustment of the volume of credit to the volume of business.” Credit is needed to meet the requirements of trade and industry. As business expands, larger quantity of credit is needed, and when business contracts less credit is needed. Therefore, it is the central bank which can meet the requirements of business by controlling credit.

6. To have growth with stability:

In recent years, the principal objective of credit control is to have growth with stability. The other objectives, such as price stability, foreign exchange rate stability, etc., are regarded as secondary. The aim of credit control is to help in achieving full employment and accelerated growth with stability in the economy without inflationary pressures and balance of payments deficits.

4. Essay on the Role of Central Bank in a Developing Economy :

The central bank in a developing economy performs both traditional and non-traditional functions. The principal traditional functions performed by it are the monopoly of note issue, banker to the government, bankers’ bank, lender of the last resort, controller of credit and maintaining stable exchange rate. But all these functions are related to the foremost function of helping in the economic development of the country.

The central bank in a developing country aims at the promotion and maintenance of a rising level of production, employment and real income in the country. The central banks in the majority of underdeveloped countries have been given wide powers to promote the growth of such economies.

They, therefore, perform the following functions towards this end:

Creation and expansion of financial institutions:

One of the aims of a central bank in an underdeveloped country is to improve its currency and credit system. More banks and financial institutions are required to be set up to provide larger credit facilities and to divert voluntary savings into productive channels. Financial institutions are localised in big cities in underdeveloped countries and provide credit facilities to estates, plantations, big industrial and commercial houses.

In order to remedy this, the central bank should extend branch banking to rural areas to make credit available to peasants, small businessmen and traders. In underdeveloped countries, the commercial banks provide only short-term loans. Credit facilities in rural areas are mostly non-existent.

The only source is the village moneylender who charges exorbitant interest rates. The hold of the village moneylender in rural areas can be slackened if new institutional arrangements are made by the central bank in providing short-term, medium term and long-term credit at lower interest rates to the cultivators.

A network of co-operative credit societies with apex banks financed by the central bank can help solve the problem. Similarly, it can help the establishment of lead banks and through them regional rural banks for providing credit facilities to marginal farmers, landless agricultural workers and other weaker sections.

With the vast resources at its command, the central bank can also help in establishing industrial banks and financial corporations in order to finance large and small industries.

Proper adjustment between demand for and supply of money:

The central bank plays an important role in bringing about a proper adjustment between demand for and supply of money. An imbalance between the two is reflected in the price level. A shortage of money supply will inhibit growth while an excess of it will lead to inflation. As the economy develops, the demand for money is likely to go up due to gradual monetization of the non-monetized sector and the increase in agricultural and industrial production and prices.

The demand for money for transactions and speculative motives will also rise. So the increase in money supply will have to be more than proportionate to the increase in the demand for money in order to avoid inflation. There is, however, the likelihood of increased money supply being used for speculative purposes, thereby inhibiting growth and causing inflation.

The central bank controls the uses of money and credit by an appropriate monetary policy. Thus in an underdeveloped economy, the central bank should control the supply of money in such a way that the price level is prevented from rising without affecting investment and production adversely.

A suitable interest rate policy:

In an underdeveloped country the interest rate structure stands at a very high level. There are also vast disparities between long-term and short-term interest rates and between interest rates in different sectors of the economy. The existence of high interest rates acts as an obstacle to the growth of both private and public investment, in an underdeveloped economy. A low interest rate is, therefore, essential for encouraging private investment in agriculture and industry.

Since in an underdeveloped country businessmen have little savings out of undistributed profits, they have to borrow from the banks or from the capital market for purposes of investment and they would borrow only if the interest rate is low.

A low interest rate policy is also essential for encouraging public investment. A low interest rate policy is a cheap money policy. It makes public borrowing cheap, keeps the cost of servicing public debt low, and thus helps in financing economic development.

In order to discourage the flow of resources into speculative borrowing and investment, the central bank should follow a policy of discriminatory interest rates, charging high rates for non-essential and unproductive loans and low rates for productive loans.

But this does not imply that savings are interest-elastic in an underdeveloped economy. Since the level of income is low in such economies, a high rate of interest is not likely to raise the propensity to save.

In the context of economic growth, as the economy develops, a progressive rise in the price level is inevitable. The value of money falls and the propensity to save declines further. Money conditions become tight and there is a tendency for the rate of interest to rise automatically. This would result in inflation. In such a situation any effort to control inflation by raising the rate of interest would be disastrous. A stable price level is, therefore, essential for the success of a low interest rate policy which can be maintained by following a judicious monetary policy by the central bank.

Debt management:

Debt management is one of the important functions of the central bank in an underdeveloped country. It should aim at proper timing and issuing of government bonds, stabilizing their prices and minimizing the cost of servicing public debt. It is the central bank which undertakes the selling and buying of government bonds and making timely changes in the structure and composition of public debt.

In order to strengthen and stabilize the market for government bonds, the policy of low interest rates is essential. For, a low rate of interest raises the price of government bonds, thereby making them more attractive to the public and giving an impetus to the public borrowing programmes of the government.

The maintenance of structure of low interest rates is also called for minimizing the cost of servicing the national debt. Further, it encourages funding of debt by private firms. However, the success of debt management would depend upon the existence of well-developed money and capital markets in which wide range of securities exist both for short and long periods. It is the central bank which can help in the development of these markets.

Credit control:

Central Bank should also aim at controlling credit in order to influence the patterns of investment and production in a developing economy. Its main objective is to control inflationary pressures arising in the process of development. This requires the use of both quantitative and qualitative methods of credit control.

Open market operations are not successful in controlling inflation in underdeveloped countries because the bill market is small and undeveloped. Commercial banks keep an elastic cash-deposit ratio because the central bank’s control over them is not complete. They are also reluctant to invest in government securities due to their relatively low interest rates.

Moreover, instead of investing in government securities, they prefer to keep their reserves in liquid form such as gold, foreign exchange and cash. Commercial banks are also not in the habit of rediscounting or borrowing from the central bank.

The bank rate policy is also not so effective in controlling credit in LDCs due to:

(a) The lack of bills of discount;

(b) The narrow size of the bill market;

(c) A large non-monetized sector where barter transactions take place;

(d) The existence of a large unorganised money market;

(e) The existence of indigenous banks which do not discount bills with the central banks; and

(f) The habit of commercial banks to keep large cash reserves.

The use of variable reserve ratio as method of credit control is more effective than open market operations and bank rate policy in LDCs. Since the market for securities is very small, open market operations are not successful. But a rise or fall in the reserve ratio by the central bank reduces or increases the cash available with the commercial banks without affecting adversely the prices of securities. Again, the commercial banks keep large cash reserves which cannot be reduced by a raise in the bank rate or sale of securities by the central bank.

But raising the cash-reserve ratio reduces liquidity with the banks. However, the use of variable reserve ratio has certain limitations in LDCs. First, the non-banking financial intermediaries do not keep deposits with the central bank so they are not affected by it. Second, banks which do not maintain excess liquidity are not affected than those who maintain it.

The qualitative credit control measures are, however, more effective than the quantitative measures in influencing the allocation of credit, and thereby the pattern of investment. In underdeveloped countries, there is a strong tendency to invest in gold, jewellery, inventories, real estate, etc., instead of in alternative productive channels available in agriculture, mining, plantations and industry.

The selective credit controls are more appropriate for controlling and limiting credit facilitates for such unproductive purposes. They are beneficial in controlling speculative activities in food grains and raw materials. They prove more useful in controlling ‘sectional inflations’ in the economy. They curtail the demand for imports by making it obligatory on importers to deposit in advance an amount equal to the value of foreign currency.

This has also the effect of reducing the reserves of the banks in so far as their deposits are transferred to the central banks in the process. The selective credit control measures may take the form of changing the margin requirements against certain types of collateral, the regulation of consumer credit and the rationing of credit.

Solving the balance of payments problem:

The central bank should also aim at preventing and solving the balance of payments problem in a developing economy. Such economies face serious balance of payments difficulties to fulfill the targets of development plans. An imbalance is created between imports and exports which continues to widen with development.

The central bank manages and controls the foreign exchange of the country and also acts as the technical adviser to the government on foreign exchange policy. It is the function of the central bank to avoid fluctuations in the foreign exchange rates and to maintain stability. It does so through exchange controls and variations in the bank rate. For instance, if the value of the national currency continues to fall, it may raise the bank rate and thus encourage the inflow of foreign currencies.

5. Essay on the Need for Central Bank:

It is widely recognised that the central bank is a valuable and indispensable institution for the proper functioning of a modern economy. But, there is a difference of opinion regarding the necessity and usefulness of the central bank in economically backward countries having underdeveloped money markets.

Some people argue that the central bank is not necessary in such countries for various reasons: such as the absence of well-organised banking institutions over which the central bank exercises its supervision and control, the absence of short-term money markets and of well-developed bill markets to enable the central bank to perform the rediscounting operations properly, the fear of political pressure of the governments of these countries over the normal working of the central bank, and others. For all these reasons it is argued that the central bank in the under-developed countries cannot execute its monetary policy and control-techniques properly and effectively.

But, the fact remains that the central bank is as indispensable in the underdeveloped countries as it is in the developed countries.

For this reason it is now established that every country, whether developed or underdevel­oped, must set up a central bank for the following reasons:

(a) Economic stability:

The central bank is indispensable for maintaining stability in the economy of a country. It can maintain both price and foreign exchange stability through the exercise of proper and effective control over the country’s total money supply.

Such economic stability is as essential for underdeveloped countries as for developed ones, for promoting rapid economic growth. No other institutions except the central bank is competent enough to maintain this overall economic stability.

(b) Control over bank credit:

The central bank is necessary to exercise a judicious control over bank credit. As bank credit constitutes the most important component of the money supply, its supply is to be properly regulated in time for avoiding instability in the price-level and for regulating its supply in accordance with the country’s requirements.

(c) Control and supervision over the activities of other banks:

The central bank of a country can develop the banking system by exercising proper control and supervision over the operations of other banks. In the absence of the central bank, it becomes a difficult task to bring about proper co-ordination among the banks and to develop these institutions along a sound line.

(d) Proper execution of the monetary policy:

The central bank is the leader of the money market of a country. Therefore, its existence is of utmost importance for pursuing the country’s monetary (credit) policy.

(e) Special role of the central bank in a developing economy:

The central bank has a special role to play in a developing economy in promoting economic growth with stability, in providing special finance for agriculture, industry and other top priority sectors.

(f) Foreign exchange regulations and international dealings:

Every country, whether a developed or an underdeveloped one, must have a monetary institution like the central bank for foreign exchange regulations Sid for dealing with international institutions like the International Mone­tary Fund and the Bank for International Settlements. When the gold standard was in existence, it had some special importance.

(g) Control over the money supply:

The central bank is also necessary for the control over the money supply and for the regulation of the country s interest rates. For this reason the central bank enjoys the monopoly power regarding the issue of paper notes, and its rate of interest (i.e., the bank rate) acts as the pace-setter to other rates such as market rates of interest.

Conclusion:

The above description shows that every country, whether a developed or an underdeveloped one, must set up a Central Bank of its own.

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What Is a Central Bank?

Central Banks Explained

Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest.

central bank essay

Definition and Example of a Central Bank

How central banks work, criticism of central banks, notable happenings, frequently asked questions (faqs).

The Balance / Bailey Mariner

A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services, including economic research. Its goals are to stabilize the nation's currency, keep unemployment low, and prevent inflation.

Learn more about how central banks carry out these goals, their origins, and what critics have to say.

Key Takeaways

  • A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services.
  • Central banks have three monetary policy tools at hand, including reserve requirements, open market operations, and target interest rates.
  • The Consumer Financial Protection Agency was established under the Dodd-Frank Act to give the Fed more regulatory authority.
  • Central banks serve a nation's government and private banks. They also manage exchange rates and foreign currency.
  • Critics of central banks are wary of their power over interest rates and the potential to cause high inflation.

Though they may be established by a governing body, central banks are independent authorities. They have a number of duties related to monetary policy, providing financial services, regulating lower banks, and conducting research. Central banks aim to keep a nation's currency and economy stable.

Most central banks are governed by a board consisting of its member banks. The country's chief elected official appoints the directors. The national legislative body approves them. That keeps the central bank aligned with the nation's long-term policy goals. At the same time, it's free of political influence in its day-to-day operations. The Bank of England first established that model.  The U.S. Federal Reserve is another example.

Monetary Policy

Central banks affect economic growth by controlling the liquidity in the financial system. They have three  monetary policy tools  to achieve this goal.

First, they set a reserve requirement. It's the amount of cash that member banks must have on hand each night. The central bank uses it to control how much banks can lend.

Second, they use open market operations to buy and sell securities from member banks. It changes the amount of cash on hand without changing the reserve requirement. They used this tool during the 2008 financial crisis. Banks bought government bonds and mortgage-backed securities to stabilize the banking system. The Federal Reserve added $4 trillion to its balance sheet with quantitative easing . It began reducing this stockpile in October 2017.

Third, they set targets on interest rates they charge their member banks. That guides rates for loans, mortgages, and bonds.  Raising interest rates slows growth, preventing inflation. That's known as contractionary monetary policy. Lowering rates stimulates growth, preventing or shortening a recession. That's called  expansionary monetary policy . The European Central Bank lowered rates so far that they became negative.

Monetary policy is tricky. It can take over a year for it to have its full effects on the economy.

Banks can misread economic data, as the Fed did in 2006. It thought the subprime mortgage meltdown would only affect housing. It waited to lower the fed funds rate . By the time the Fed lowered rates, it was already too late.

Bank Regulation

Central banks regulate their members. They require enough reserves to cover potential loan losses. They are responsible for ensuring financial stability and protecting depositors' funds.

In 2010, the Dodd-Frank Wall Street Reform Act gave more regulatory authority to the Fed. It created the Consumer Financial Protection Agency. That gave regulators the power to split up large banks, so they don't become "too big to fail." It eliminates loopholes for hedge funds and mortgage brokers. The Volcker Rule prohibits banks from owning hedge funds. It bans them from using investors' money to buy risky derivatives for their own profit.

Dodd-Frank also established the Financial Stability Oversight Council. It warns of risks that affect the entire financial industry. It can also recommend that the Federal Reserve regulate any non-bank financial firms.

Dodd Frank keeps banks, insurance companies, and hedge funds from becoming too big to fail.

Providing Financial Services

Central banks serve as the bank for private banks and the nation's government. They process checks and lend money to their members.

Central banks store currency in their foreign exchange reserves . They use these reserves to change exchange rates. They add foreign currency, usually the dollar or euro, to keep their own currency in alignment. That's called a peg , and it helps exporters keep their prices competitive.

Central banks also regulate exchange rates as a way to control inflation. They buy and sell large quantities of foreign currency to affect supply and demand.

Most central banks produce regular economic statistics to guide fiscal policy decisions. Here are examples of reports provided by the Federal Reserve:

  • Beige Book : A monthly economic status report from regional Federal Reserve banks
  • Monetary Policy Report : A semiannual report to Congress on the national economy
  • Consumer Credit : A monthly report on consumer credit

If central banks stimulate the economy too much, they can trigger inflation. Central banks avoid inflation like the plague. Ongoing inflation destroys any benefits of growth. It raises prices for consumers, increases costs for businesses, and eats up any profits. Central banks must work hard to keep interest rates high enough to prevent it.

Politicians and sometimes the general public are suspicious of central banks. That's because they usually operate independently of elected officials. They often are unpopular in their attempt to heal the economy. For example, Federal Reserve Chairman Paul Volcker (served from 1979 to 1987) sent interest rates skyrocketing. It was the only cure for runaway inflation. Critics lambasted him. Central bank actions are often poorly understood, raising the level of suspicion.

Here are a few of the more notable events in central bank history:

  • Sweden created the world's first central bank, the Riksbank, in 1668.
  • The Bank of England came next in 1694.
  • Napoleon created the Banquet de France in 1800.
  • Congress established the Federal Reserve in 1913.
  • The Bank of Canada began in 1935.
  • The German Bundesbank was re-established after World War II.
  • In 1998, the European Central Bank replaced all the eurozone's central banks.

Where is the central bank of the United States located?

The Federal Reserve's Board of Governors is based in Washington, D.C., but its banks are spread around the country, representing 12 regions. These banks are located in:

  • Kansas City, Missouri
  • Minneapolis
  • Philadelphia
  • Richmond, Virginia
  • San Francisco

How do central banks increase the money supply?

Central banks increase the money supply through various types of monetary policy. In the U.S., that typically involves the Fed buying securities through open market operations , which gives banks more money to lend. It can also change reserve requirements for banks, adjust the rates it pays for excess reserves, and lower the Fed funds rate, which determines how much banks charge each other for overnight lending.

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Federal Reserve Bank of San Francisco. " What Are Some of the Factors That Contribute to a Rise in Inflation? "

White House Archives. " Chairman Paul A. Volcker ."

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About the Fed: An Introduction to the U.S. Central Bank

The Federal Reserve System is the central bank of the United States. As the nation's central bank, it performs five key functions in the public interest to promote the health of the U.S. economy and the stability of the U.S. financial system.

central bank essay

by Federal Reserve Bank of St. Louis staff

The Federal Reserve System (sometimes called "The Fed") is the central bank of the United States.

As the St. Louis Fed's overview " In Plain English " explains it,

A "central bank" is the name given to a country's primary monetary authority. A nation's central bank is usually given a mix of responsibilities including determining the money supply, supervising banks, providing banking services for the government, lending to banks during crises, and promoting consumer protection and community development.

The Fed performs five key functions in the public interest to promote the health of the U.S. economy and the stability of the U.S. financial system: 

  • conducts the nation’s monetary policy ;
  • promotes the stability of the financial system ;
  • promotes the safety and soundness of individual financial institutions;
  • fosters payment and settlement system safety and efficiency; and
  • promotes consumer protection and community development

Instead of a single central bank, the framers of the Federal Reserve Act provided for a central banking “system” with three main features: (1) a central governing Board, (2) a decentralized operating structure of regional reserve banks, and (3) a combination of public and private characteristics. That's why the Federal Reserve System has multiple parts that together serve as the central bank of the United States. This system has three main entities: the Board of Governors, the Reserve Banks, and the Federal Open Market Committee (FOMC). Learn more about the Federal Reserve's structure .

The Federal Reserve is designed to be independent , but also does its work alongside other institutions that have a role in the nation's economy and banking system, like the Treasury , the Department of Labor , the FDIC , and more.

The Fed's structure and responsibilities have shifted over time as the economy—and our understanding of the economy—has changed. But from the original Federal Reserve Act to the Banking Act of 1935 to today, the Fed has worked to promote a healthy economy. Learn more about the Fed's work in The Fed Explained , produced by the Board of Governors, or dig into the explanation " In Plain English " from the St. Louis Fed's economic education team.

Written as of September 13, 2021. See disclaimer .

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  • Overview: The History of the Federal Reserve
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Role of Central Bank Essay

Custodian of commercial banks, control of banks interest rates, management of inflation, the government’s bank, custodian of foreign currency.

Bibliography

Different countries operate their own central bank that controls and monitors operations of commercial banks within their economy; central banks are the custodians of commercial bank. Other than being the sole printer of notes and coins currency of a nation, central banks provide their countries’ currencies with price stability by controlling inflation.

To control and intervene in an economy, central banks use monetary and fiscal policies; the idea of central banks was aimed at creating a bank that controls an economy without political influences, however the separation has been a challenge in many nations. This paper discusses the role played by central bank in an economy.

Before commercial banks gets an operating license, it must be cleared and accepted by the central bank, the bank considers issues with security, liquidity and the quality of facilities with the applying bank.

There are some bench marks that need to be fulfilled by a trader before being allocated the license, it’s upon the central bank to ensure that the bank has fulfilled the requirements. After licensing, central banks have the role of controlling, monitoring and ensuring that the bank is not engaging in fraudulent business practices. In case of such a move, the powers with the bank can revoke the operating license.

Banks operate with a loan facility that they are given by the central bank. The central banks in various countries issue the loans to banks at a certain rate if interest. The banks on their side have the objective like any other business has, that is to make profits; the major source of their income is from loans given to their customers. When they are lending to the outside customer, they have to charge an interest that is higher than that that the central bank is offering.

When commercial banks are offering their lending services, they use finances they have collected from their depositors as well the money lend by central bank; an adjustment of the liquidity fund and the rate of lending the finances means an effect on the interest rates. By liquidity fund we mean that the money that central bank requires a bank to hold at one time; which is a percentage of the bank’s capital.

If the amount is increased, it means that the money available for lending have been reduced and thus the money available can only be lend at a high interest rate. On the other hand, in the case that banks are offering loans at high rates, the central bank can reduce the liquidity performance as well as it bank lending rate to facilitate the reduction of bank lending rates.

Another major determinant of the interest rate that the bank is going to charge a certain loan facility is the level of risk that the loan is likely to have. Other countries central banks has power to set the rate of interest that commercial banks are going to charge; this is a direct control of the banking sector that is not common but it can work. The rate that the central bank authorizes to be charged may be lower than what the banks are willing to sell at; it then settles the deficit.

In cases of inflation the economy has more funds in circulation than it should be having. This makes the cost of good expensive; this has a negative effect on the growth of the economy and discourages foreign and local investments. There are various reasons that can make the central bank to increase the rate of interest. This use mostly monetary policies and fiscal policies that are used to cure inflation in the country.

Money get into the country through the operating commercial banks and so if borrowing money is made more difficult than the flow of currency in the economy is regulated. For this to happen it is a series of activities where the particular country’s central bank is involved; it thus follows that the rate that central bank offers advances to commercial banks will determine the rate at which commercial banks offers loans to the public.

If central bank offers credit to the banks at a higher rate, then the rate of interest that commercial banks will offer loans to the public will be high; this reduces the attractiveness of the facilities; in its return it reduces the flow of money in the economy. This on the other hand cures inflation. These are short term and medium term policies.

There are long term policies that central bank employs they include; issue of treasury bills and bonds and direct participation in the market. Treasury bills and bonds are offered for the general public and companies to buy. When the rate rises, the loan purchasers’ will be discouraged from buying them and circulate the money in other areas of the economy and thus curing the deficit.

When the circulation of money in the economy is higher than the equilibrium, then central bank can aim to offer attractive interest rates; this makes them attractive and the money holders opt to buy them instead of keeping money. It also stops participating in the market. This will make the rate of interest in the country to increase [1] .

Central banks are termed as the bank of the government where policies regarding financial operations of the government are operated. To finance different projects, money comes from the central bank to treasury for implementation. On the other hand, monies collected in an economy as taxation or other central government funds are banked with central bank.

In modern globalized world, there is increased trade among nations, for trade to prevail; trading partners needs to have the currencies of other partner. Central banks have a store for foreign currency and with the currency; it controls deficiencies and surpluses of the funds. For instance with the foreign reserve, the bank can decide to sell some of the reserve to cure a deficit; alternatively it can decide to buy from the market to cure a surplus.

When the flow of foreign currency is controlled, then a country is able to cure deficits in balance of payment [2] .

Banks are important institutions in every economy. They are the medium through which the government uses to control the financial standing of the country that affect a country. Central bank is a central organ that oversees the activities of commercial banks. It uses both monetary and fiscal policies to influence the interests that prevail in an economy. Its participation in the market, either directly or indirectly is aimed at curbing economic vices existing in an economy.

Sullivan, A & SM Sheffrin, Economics: Principles in Action , Pearson Prentice Hall, New Jersey,2003.

Touffut,J, Central banks as economic institutions, Edward Elgar Publishing, New Jersey, 2008.

  • J Touffut, Central banks as economic institutions, Edward Elgar Publishing, New Jersey, 2008.
  • A Sullivan & SM Sheffrin, Economics : Principles in Action , Pearson Prentice Hall, New Jersey, 2003.
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IvyPanda. (2020, January 12). Role of Central Bank. https://ivypanda.com/essays/role-of-central-bank/

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A Brief History of Central Banks

  • Michael D. Bordo

A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. More specifically, a central bank uses its tools of monetary policy—open market operations, discount window lending, changes in reserve requirements—to affect short-term interest rates and the monetary base (currency held by the public plus bank reserves) and to achieve important policy goals.

One of the world’s foremost economic historians explains the forces behind the development of modern central banks, providing insight into their role in the financial system and the economy.

A central bank is the term used to describe the authority responsible for policies that affect a country’s supply of money and credit. More specifically, a central bank uses its tools of monetary policy—open market operations, discount window lending, changes in reserve requirements—to affect short-term interest rates and the monetary base (currency held by the public plus bank reserves) and to achieve important policy goals.

There are three key goals of modern monetary policy. The first and most important is price stability or stability in the value of money. Today this means maintaining a sustained low rate of inflation. The second goal is a stable real economy, often interpreted as high employment and high and sustainable economic growth. Another way to put it is to say that monetary policy is expected to smooth the business cycle and offset shocks to the economy. The third goal is financial stability. This encompasses an efficient and smoothly running payments system and the prevention of financial crises.

The story of central banking goes back at least to the seventeenth century, to the founding of the first institution recognized as a central bank, the Swedish Riksbank. Established in 1668 as a joint stock bank, it was chartered to lend the government funds and to act as a clearing house for commerce. A few decades later (1694), the most famous central bank of the era, the Bank of England, was founded also as a joint stock company to purchase government debt. Other central banks were set up later in Europe for similar purposes, though some were established to deal with monetary disarray. For example, the Banque de France was established by Napoleon in 1800 to stabilize the currency after the hyperinflation of paper money during the French Revolution, as well as to aid in government finance. Early central banks issued private notes which served as currency, and they often had a monopoly over such note issue.

While these early central banks helped fund the government’s debt, they were also private entities that engaged in banking activities. Because they held the deposits of other banks, they came to serve as banks for bankers, facilitating transactions between banks or providing other banking services. They became the repository for most banks in the banking system because of their large reserves and extensive networks of correspondent banks. These factors allowed them to become the lender of last resort in the face of a financial crisis. In other words, they became willing to provide emergency cash to their correspondents in times of financial distress.

The Federal Reserve System belongs to a later wave of central banks, which emerged at the turn of the twentieth century. These banks were created primarily to consolidate the various instruments that people were using for currency and to provide financial stability. Many also were created to manage the gold standard, to which most countries adhered.

The gold standard, which prevailed until 1914, meant that each country defined its currency in terms of a fixed weight of gold. Central banks held large gold reserves to ensure that their notes could be converted into gold, as was required by their charters. When their reserves declined because of a balance of payments deficit or adverse domestic circumstances, they would raise their discount rates (the interest rates at which they would lend money to the other banks). Doing so would raise interest rates more generally, which in turn attracted foreign investment, thereby bringing more gold into the country.

Central banks adhered to the gold standard’s rule of maintaining gold convertibility above all other considerations. Gold convertibility served as the economy’s nominal anchor. That is, the amount of money banks could supply was constrained by the value of the gold they held in reserve, and this in turn determined the prevailing price level. And because the price level was tied to a known commodity whose long-run value was determined by market forces, expectations about the future price level were tied to it as well. In a sense, early central banks were strongly committed to price stability. They did not worry too much about one of the modern goals of central banking—the stability of the real economy—because they were constrained by their obligation to adhere to the gold standard.

Central banks of this era also learned to act as lenders of last resort in times of financial stress—when events like bad harvests, defaults by railroads, or wars precipitated a scramble for liquidity (in which depositors ran to their banks and tried to convert their deposits into cash). The lesson began early in the nineteenth century as a consequence of the Bank of England’s routine response to such panics. At the time, the Bank (and other European central banks) would often protect their own gold reserves first, turning away their correspondents in need. Doing so precipitated major panics in 1825, 1837, 1847, and 1857, and led to severe criticism of the Bank. In response, the Bank adopted the “responsibility doctrine,” proposed by the economic writer Walter Bagehot, which required the Bank to subsume its private interest to the public interest of the banking system as a whole. The Bank began to follow Bagehot’s rule, which was to lend freely on the basis of any sound collateral offered—but at a penalty rate (that is, above market rates) to prevent moral hazard. The bank learned its lesson well. No financial crises occurred in England for nearly 150 years after 1866. It wasn’t until August 2007 that the country experienced its next crisis.

The U.S. experience was most interesting. It had two central banks in the early nineteenth century, the Bank of the United States (1791–1811) and a second Bank of the United States (1816–1836). Both were set up on the model of the Bank of England, but unlike the British, Americans bore a deep-seated distrust of any concentration of financial power in general, and of central banks in particular, so that in each case, the charters were not renewed.

There followed an 80-year period characterized by considerable financial instability. Between 1836 and the onset of the Civil War—a period known as the Free Banking Era—states allowed virtual free entry into banking with minimal regulation. Throughout the period, banks failed frequently, and several banking panics occurred. The payments system was notoriously inefficient, with thousands of dissimilar-looking state bank notes and counterfeits in circulation. In response, the government created the national banking system during the Civil War. While the system improved the efficiency of the payments system by providing a uniform currency based on national bank notes, it still provided no lender of last resort, and the era was rife with severe banking panics.

The crisis of 1907 was the straw that broke the camel’s back. It led to the creation of the Federal Reserve in 1913, which was given the mandate of providing a uniform and elastic currency (that is, one which would accommodate the seasonal, cyclical, and secular movements in the economy) and to serve as a lender of last resort.

The Genesis of Modern Central Banking Goals

Before 1914, central banks didn’t attach great weight to the goal of maintaining the domestic economy’s stability. This changed after World War I, when they began to be concerned about employment, real activity, and the price level. The shift reflected a change in the political economy of many countries—suffrage was expanding, labor movements were rising, and restrictions on migration were being set. In the 1920s, the Fed began focusing on both external stability (which meant keeping an eye on gold reserves, because the U.S. was still on the gold standard) and internal stability (which meant keeping an eye on prices, output, and employment). But as long as the gold standard prevailed, external goals dominated.

Unfortunately, the Fed’s monetary policy led to serious problems in the 1920s and 1930s. When it came to managing the nation’s quantity of money, the Fed followed a principle called the real bills doctrine. The doctrine argued that the quantity of money needed in the economy would naturally be supplied so long as Reserve Banks lent funds only when banks presented eligible self-liquidating commercial paper for collateral. One corollary of the real bills doctrine was that the Fed should not permit bank lending to finance stock market speculation, which explains why it followed a tight policy in 1928 to offset the Wall Street boom. The policy led to the beginning of recession in August 1929 and the crash in October. Then, in the face of a series of banking panics between 1930 and 1933, the Fed failed to act as a lender of last resort. As a result, the money supply collapsed, and massive deflation and depression followed. The Fed erred because the real bills doctrine led it to interpret the prevailing low short-term nominal interest rates as a sign of monetary ease, and they believed no banks needed funds because very few member banks came to the discount window.

After the Great Depression, the Federal Reserve System was reorganized. The Banking Acts of 1933 and 1935 shifted power definitively from the Reserve Banks to the Board of Governors. In addition, the Fed was made subservient to the Treasury. The Fed regained its independence from the Treasury in 1951, whereupon it began following a deliberate countercyclical policy under the directorship of William McChesney Martin. During the 1950s this policy was quite successful in ameliorating several recessions and in maintaining low inflation. At the time, the United States and the other advanced countries were part of the Bretton Woods System, under which the U.S. pegged the dollar to gold at $35 per ounce and the other countries pegged to the dollar. The link to gold may have carried over some of the credibility of a nominal anchor and helped to keep inflation low.

The picture changed dramatically in the 1960s when the Fed began following a more activist stabilization policy. In this decade it shifted its priorities from low inflation toward high employment. Possible reasons include the adoption of Keynesian ideas and the belief in the Phillips curve trade-off between inflation and unemployment. The consequence of the shift in policy was the buildup of inflationary pressures from the late 1960s until the end of the 1970s. The causes of the Great Inflation are still being debated, but the era is renowned as one of the low points in Fed history. The restraining influence of the nominal anchor disappeared, and for the next two decades, inflation expectations took off.

The inflation ended with Paul Volcker’s shock therapy from 1979 to 1982, which involved monetary tightening and the raising of policy interest rates to double digits. The Volcker shock led to a sharp recession, but it was successful in breaking the back of high inflation expectations. In the following decades, inflation declined significantly and has stayed low ever since. Since the early 1990s the Fed has followed a policy of implicit inflation targeting, using the federal funds rate as its policy instrument. In many respects, the policy regime currently followed echoes the convertibility principle of the gold standard, in the sense that the public has come to believe in the credibility of the Fed’s commitment to low inflation.

A key force in the history of central banking has been central bank independence. The original central banks were private and independent. They depended on the government to maintain their charters but were otherwise free to choose their own tools and policies. Their goals were constrained by gold convertibility. In the twentieth century, most of these central banks were nationalized and completely lost their independence. Their policies were dictated by the fiscal authorities. The Fed regained its independence after 1951, but its independence is not absolute. It must report to Congress, which ultimately has the power to change the Federal Reserve Act. Other central banks had to wait until the 1990s to regain their independence.

Financial Stability

An increasingly important role for central banks is financial stability. The evolution of this responsibility has been similar across the advanced countries. In the gold standard era, central banks developed a lender-of-last-resort function, following Bagehot’s rule. But financial systems became unstable between the world wars, as widespread banking crises plagued the early 1920s and the 1930s. The experience of the Fed was the worst. The response to banking crises in Europe at the time was generally to bail out the troubled banks with public funds. This approach was later adopted by the United States with the Reconstruction Finance Corporation, but on a limited scale. After the Depression, every country established a financial safety net, comprising deposit insurance and heavy regulation that included interest rate ceilings and firewalls between financial and commercial institutions. As a result, there were no banking crises from the late 1930s until the mid-1970s anywhere in the advanced world.

This changed dramatically in the 1970s. The Great Inflation undermined interest rate ceilings and inspired financial innovations designed to circumvent the ceilings and other restrictions. These innovations led to deregulation and increased competition. Banking instability reemerged in the United States and abroad, with such examples of large-scale financial disturbances as the failures of Franklin National in 1974 and Continental Illinois in 1984 and the savings and loan crisis in the 1980s. The reaction to these disturbances was to bail out banks considered too big to fail, a reaction which likely increased the possibility of moral hazard. Many of these issues were resolved by the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Basel I Accords, which emphasized the holding of bank capital as a way to encourage prudent behavior.

Another problem that has reemerged in modern times is that of asset booms and busts. Stock market and housing booms are often associated with the business cycle boom phase, and busts often trigger economic downturns. Orthodox central bank policy is to not defuse booms before they turn to busts for fear of triggering a recession but to react after the bust occurs and to supply ample liquidity to protect the payments and banking systems. This was the policy followed by Alan Greenspan after the stock market crash of 1987. It was also the policy followed later in the incipient financial crises of the 1990s and 2000s. Ideally, the policies should remove the excess liquidity once the threat of crisis has passed.

Challenges for the Future

The key challenge I see facing central banks in the future will be to balance their three policy goals. The primary goal of the central bank is to provide price stability (currently viewed as low inflation over a long-run period). This goal requires credibility to work. In other words, people need to believe that the central bank will tighten its policy if inflation threatens. This belief needs to be backed by actions. Such was the case in the mid-1990s when the Fed tightened in response to an inflation scare. Such a strategy can be greatly enhanced by good communication.

The second policy goal is stability and growth of the real economy. Considerable evidence suggests that low inflation is associated with better growth and overall macroeconomic performance. Nevertheless, big shocks still occur, threatening to derail the economy from its growth path. When such situations threaten, research also suggests that the central bank should temporarily depart from its long-run inflation goal and ease monetary policy to offset recessionary forces. Moreover, if market agents believe in the long-run credibility of the central bank’s commitment to low inflation, the cut in policy interest rates will not engender high inflation expectations. Once the recession is avoided or has played its course, the central bank needs to raise rates and return to its low-inflation goal.

The third policy goal is financial stability. Research has shown that it also will be improved in an environment of low inflation, although some economists argue that asset price booms are spawned in such an environment. In the case of an incipient financial crisis such as that just witnessed in August 2007, the current view is that the course of policy should be to provide whatever liquidity is required to allay the fears of the money market. An open discount window and the acceptance of whatever sound collateral is offered are seen as the correct prescription. Moreover, funds should be offered at a penalty rate. The Fed followed these rules in September 2007, although it is unclear whether the funds were provided at a penalty rate. Once the crisis is over, which generally is in a matter of days or weeks, the central bank must remove the excess liquidity and return to its inflation objective.

The Federal Reserve followed this strategy after Y2K. When no financial crisis occurred, it promptly withdrew the massive infusion of liquidity it had provided. By contrast, after providing funds following the attacks of 9/11 and the technology bust of 2001, it permitted the additional funds to remain in the money market once the threat of crisis was over. If the markets had not been infused with so much liquidity for so long, interest rates would not have been as low in recent years as they have been, and the housing boom might not have as expanded as much as it did.

A second challenge related to the first is for the central bank to keep abreast of financial innovations, which can derail financial stability. Innovations in the financial markets are a challenge to deal with, as they represent attempts to circumvent regulation as well as to reduce transactions costs and enhance leverage. The recent subprime crisis exemplifies the danger, as many problems were caused by derivatives created to package mortgages of dubious quality with sounder ones so the instruments could be unloaded off the balance sheets of commercial and investment banks. This strategy, designed to dissipate risk, may have backfired because of the opacity of the new instruments.

A third challenge facing the Federal Reserve in particular is whether to adopt an explicit inflation targeting objective like the Bank of England, the Bank of Canada, and other central banks. The advantages of doing so are that it simplifies policy and makes it more transparent, which eases communication with the public and enhances credibility. However, it might be difficult to combine an explicit target with the Fed’s dual mandate of price stability and high employment.

A fourth challenge for all central banks is to account for globalization and other supply-side developments, such as political instability and oil price and other shocks, which are outside of their control but which may affect global and domestic prices.

The final challenge I wish to mention concerns whether implicit or explicit inflation targeting should be replaced with price-level targeting, whereby inflation would be kept at zero percent. Research has shown that a price level may be the superior target, because it avoids the problem of base drift (where inflation is allowed to cumulate), and it also has less long-run price uncertainty. The disadvantage is that recessionary shocks might cause a deflation, where the price level declines. This possibility should not be a problem if the nominal anchor is credible, because the public would realize that inflationary and deflationary episodes are transitory and prices will always revert to their mean, that is, toward stability.

Such a strategy is not likely to be adopted in the near future because central banks are concerned that deflation might get out of control or be associated with recession on account of nominal rigidities. In addition, the transition would involve reducing inflation expectations from the present plateau of about 2 percent, which would likely involve deliberately engineering a recession—a policy not likely to ever be popular.

The views authors express in Economic Commentary are theirs and not necessarily those of the Federal Reserve Bank of Cleveland or the Board of Governors of the Federal Reserve System. The series editor is Tasia Hane. This work is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License. This paper and its data are subject to revision; please visit clevelandfed.org  for updates.

Suggested Citation

Bordo, Michael D. 2007. “A Brief History of Central Banks.” Federal Reserve Bank of Cleveland,  Economic Commentary  12/1/2007.

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What Is a Central Bank, and Does the U.S. Have One?

central bank essay

What Is a Central Bank?

A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.

Central banks are inherently non-market-based or even anti-competitive institutions. Although some are nationalized, many central banks are not government agencies, and so are often touted as being politically independent. However, even if a central bank is not legally owned by the government, its privileges are established and protected by law.

The critical feature of a central bank—distinguishing it from other banks—is its legal monopoly status, which gives it the privilege to issue banknotes and cash. Private commercial banks are only permitted to issue demand liabilities, such as checking deposits .

Key Takeaways

  • A central bank is a financial institution that is responsible for overseeing the monetary system and policy of a nation or group of nations, regulating its money supply, and setting interest rates.
  • Central banks enact monetary policy, by easing or tightening the money supply and availability of credit, central banks seek to keep a nation's economy on an even keel.
  • A central bank sets requirements for the banking industry, such as the amount of cash reserves banks must maintain vis-à-vis their deposits.
  • A central bank can be a lender of last resort to troubled financial institutions and even governments.

Investopedia / Zoe Hansen

Understanding Central Banks

Although their responsibilities range widely, depending on their country, central banks' duties (and the justification for their existence) usually fall into three areas. 

First, central banks control and manipulate the national money supply. They influence the sentiment of markets as they issue currency and set interest rates on loans and bonds. Typically, central banks raise interest rates to slow growth and avoid inflation; they lower them to spur growth, industrial activity, and consumer spending. In this way, they manage monetary policy to guide the country's economy and achieve economic goals, such as full employment .

Most central banks today set interest rates and conduct monetary policy using an inflation target of 2-3% annual inflation.

Second, they regulate member banks through capital requirements, reserve requirements (which dictate how much banks can lend to customers, and how much cash they must keep on hand), and deposit guarantees, among other tools. They also provide loans and services for a nation’s banks and its government and manage foreign exchange reserves .

Finally, a central bank also acts as an emergency lender to distressed commercial banks and other institutions, and sometimes even a government. By purchasing government debt obligations, for example, the central bank provides a politically attractive alternative to taxation when a government needs to increase revenue.

Example: The Federal Reserve

Along with the measures mentioned above, central banks have other actions at their disposal. In the U.S., for example, the central bank is the Federal Reserve System , aka "the Fed". The Federal Reserve Board (FRB), the governing body of the Fed, can affect the national money supply by changing reserve requirements. When the requirement minimums fall, banks can lend more money, and the economy’s money supply climbs. In contrast, raising reserve requirements decreases the money supply. The Federal Reserve was established with the 1913 Federal Reserve Act.

When the Fed lowers the discount rate that banks pay on short-term loans , it also increases liquidity . Lower rates increase the money supply, which in turn boosts economic activity. But decreasing interest rates can fuel inflation, so the Fed must be careful.

And the Fed can conduct open market operations to change the federal funds rate . The Fed buys government securities from securities dealers, supplying them with cash, thereby increasing the money supply. The Fed sells securities to move the cash into its pockets and out of the system.

A Brief History of Central Banks

The first prototypes for modern central banks were the Bank of England and the Swedish Riksbank, which date back to the 17 th century. The Bank of England was the first to acknowledge the role of lender of last resort . Other early central banks, notably Napoleon’s Bank of France and Germany's Reichsbank, were established to finance expensive government military operations.

It was principally because European central banks made it easier for federal governments to grow, wage war, and enrich special interests that many of United States' founding fathers—most passionately Thomas Jefferson—opposed establishing such an entity in their new country. Despite these objections, the young country did have both official national banks and numerous state-chartered banks for the first decades of its existence, until a “free-banking period” was established between 1837 and 1863.

The National Banking Act of 1863 created a network of national banks and a single U.S. currency , with New York as the central reserve city. The United States subsequently experienced a series of bank panics in 1873, 1884, 1893, and 1907 . In response, in 1913 the U.S. Congress established the Federal Reserve System and 12 regional Federal Reserve Banks throughout the country to stabilize financial activity and banking operations. The new Fed helped finance World War I and World War II by issuing Treasury bonds .

Between 1870 and 1914, when world  currencies  were pegged to the  gold standard , maintaining price stability was a lot easier because the amount of gold available was limited. Consequently, monetary expansion could not occur simply from a political decision to print more money, so  inflation  was easier to control. The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency; it issued notes based on a country's reserves of gold.

At the outbreak of World War I, the gold standard was abandoned, and it became apparent that, in times of crisis, governments facing  budget deficits  (because it costs money to wage war) and needing greater resources would order the printing of more money. As governments did so, they encountered inflation. After the war, many governments opted to go back to the gold standard to try to stabilize their economies. With this rose the awareness of the importance of the central bank's independence from any political party or administration.

During the unsettling times of the  Great Depression  in the 1930s and the aftermath of World War II, world governments predominantly favored a return to a central bank dependent on the political decision-making process. This view emerged mostly from the need to establish control over war-shattered economies; furthermore, newly independent nations opted to keep control over all aspects of their countries—a backlash against colonialism. The rise of managed economies in the Eastern Bloc was also responsible for increased government interference in the macro-economy. Eventually, however, the independence of the central bank from the government came back into fashion in Western economies and has prevailed as the optimal way to achieve a liberal and stable economic regime.

Central Banks and Deflation

Over the past quarter-century, concerns about deflation have spiked after big financial crises. Japan has offered a sobering example. After its equities and real estate bubbles burst in 1989-90, causing the Nikkei index to lose one-third of its value within a year, deflation became entrenched. The Japanese economy, which had been one of the fastest-growing in the world from the 1960s to the 1980s, slowed dramatically. The '90s became known as Japan's Lost Decade .

The Great Recession  of 2008-09 sparked fears of a similar period of prolonged deflation in the United States and elsewhere because of the catastrophic collapse in prices of a wide range of assets. The global financial system was also thrown into turmoil by the insolvency of a number of major banks and financial institutions throughout the United States and Europe, exemplified by the collapse of Lehman Brothers  in September 2008.

The Federal Reserve's Approach

In response, in December 2008, the Federal Open Market Committee (FOMC) , the Federal Reserve's monetary policy body, turned to two main types of unconventional monetary policy tools: (1) forward policy guidance and (2) large-scale asset purchases, aka quantitative easing (QE) .

The former involved cutting the target federal funds rate essentially to zero and keeping it there at least through mid-2013. But it's the other tool, quantitative easing, that has hogged the headlines and become synonymous with the Fed's easy-money policies. QE essentially involves a central bank creating new money and using it to buy securities from the nation's banks so as to pump liquidity into the economy and drive down long-term interest rates. In this case, it allowed the Fed to purchase riskier assets, including mortgage-backed securities and other non-government debt.

This ripples through to other interest rates across the economy and the broad decline in interest rates stimulate demand for loans from consumers and businesses. Banks are able to meet this higher demand for loans because of the funds they have received from the central bank in exchange for their securities holdings.

Other Deflation-Fighting Measures

In January 2015, the European Central Bank (ECB) embarked on its own version of QE, by pledging to buy at least 1.1 trillion euros' worth of bonds, at a monthly pace of 60 billion euros, through to September 2016. The ECB launched its QE program six years after the Federal Reserve did so, in a bid to support the fragile recovery in Europe and ward off deflation, after its unprecedented move to cut the benchmark lending rate below 0% in late-2014 met with only limited success.

While the ECB was the first major central bank to experiment with negative interest rates , a number of central banks in Europe, including those of Sweden, Denmark, and Switzerland, have pushed their benchmark interest rates below the zero bound.

Results of Deflation-Fighting Efforts

The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war. Meanwhile, the concerted moves to fend off deflation globally have had some strange consequences: 

  • QE could lead to a covert currency war: QE programs have led to major currencies plunging across the board against the U.S. dollar. With most nations having exhausted almost all their options to stimulate growth, currency depreciation may be the only tool remaining to boost economic growth, which could lead to a covert currency war .
  • European bond yields have turned negative: More than a quarter of debt issued by European governments, or an estimated $1.5 trillion, currently has negative yields . This may be a result of the ECB's bond-buying program, but it could also be signaling a sharp economic slowdown in the future.
  • Central bank balance sheets are bloating: Large-scale asset purchases by the Federal Reserve, Bank of Japan, and the ECB are swelling balance sheets to record levels. Shrinking these central bank balance sheets may have negative consequences down the road.

In Japan and Europe, the central bank purchases included more than various non-government debt securities. These two banks actively engaged in direct purchases of corporate stock in order to prop up equity markets , making the BoJ the largest equity holder of a number of companies including Kikkoman, the largest soy-sauce producer in the country, indirectly via large positions in exchange-traded funds (ETFs ).

Modern Central Bank Issues

Currently, the Federal Reserve, the European Central Bank, and other major central banks are under pressure to reduce the balance sheets that ballooned during their recessionary buying spree.

Unwinding, or tapering these enormous positions is likely to spook the market since a flood of supply is likely to keep demand at bay. Moreover, in some more illiquid markets, such as the MBS market, central banks became the single largest buyer. In the U.S., for example, with the Fed no longer purchasing and under pressure to sell, it is unclear if there are enough buyers at fair prices to take these assets off the Fed's hands. The fear is that prices will then collapse in these markets, creating more widespread panic. If mortgage bonds fall in value, the other implication is that the interest rates associated with these assets will rise, putting upward pressure on mortgage rates in the market and putting a damper on the long and slow housing recovery.

One strategy that can calm fears is for the central banks to let certain bonds mature and to refrain from buying new ones, rather than outright selling. But even with phasing out purchases, the resilience of markets is unclear, since central banks have been such large and consistent buyers for nearly a decade.

Federal Reserve System. " Federal Reserve Act ."

Federal Reserve System. " Open Market Operations ."

Macrotrends. " Nikkei 225 Index - 67 Year Historical Chart ."

Federal Reserve Bank of St. Louis. " Federal Funds Effective Rate (FEDFUNDS) ."

Federal Reserve System. " Quantitative Easing and the "New Normal" in Monetary Policy ."

European Central Bank. " Annual Report 2016 ."

European Central Bank. " Asset Purchase Programmes ."

European Central Bank. " Going Negative: The ECB’s Experience ."

Bloomberg. " ‘Why Am I Holding This?’ Saying Bye to Europe’s Negative Yields ."

Barron's. " Kikkoman Corp ."

  • The Impact of Interest Rate Changes by the Federal Reserve 1 of 30
  • What Is a Central Bank, and Does the U.S. Have One? 2 of 30
  • Federal Reserve System (FRS): Functions and History 3 of 30
  • U.S. Treasury vs. Federal Reserve: What’s the Difference? 4 of 30
  • Prime Rate vs. Discount Rate: What's the Difference? 5 of 30
  • The Fed's Tools for Influencing the Economy 6 of 30
  • Federal Funds Rate: What It Is, How It's Determined, and Why It's Important 7 of 30
  • Forces That Cause Changes in Interest Rates 8 of 30
  • What Happens If Interest Rates Increase Too Quickly? 9 of 30
  • Do Lower Interest Rates Increase Investment Spending? 10 of 30
  • How Does Money Supply Affect Interest Rates? 11 of 30
  • Interest Rates Explained: Nominal, Real, and Effective 12 of 30
  • How Negative Interest Rates Work 13 of 30
  • Monetary Policy Meaning, Types, and Tools 14 of 30
  • How the Federal Reserve Manages Money Supply 15 of 30
  • What Is Quantitative Easing (QE), and How Does It Work? 16 of 30
  • Fiscal Policy vs. Monetary Policy: Pros and Cons 17 of 30
  • How the Federal Reserve Devises Monetary Policy 18 of 30
  • How to Prepare for Rising Interest Rates 19 of 30
  • How to Invest for Rising Interest Rates 20 of 30
  • How Are Money Market Interest Rates Determined? 21 of 30
  • Open Market Operations vs. Quantitative Easing: What’s the Difference? 22 of 30
  • Interest Rate Risk Between Long-Term and Short-Term Bonds 23 of 30
  • How Higher Interest Rates Impact Your 401(k) 24 of 30
  • How Interest Rates Affect the U.S. Markets 25 of 30
  • Average Credit Card Interest Rates - February 2024: Rates Remain Steady 26 of 30
  • The Most Important Factors Affecting Mortgage Rates 27 of 30
  • How Interest Rates Work on Car Loans 28 of 30
  • These Sectors Benefit From Rising Interest Rates 29 of 30
  • How Banks Set Interest Rates on Your Loans 30 of 30

central bank essay

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This doctoral thesis engages the political economy of central banking and central bank independence (short: CBI) by challenging and qualifying prevalent pre-crisis and post-crisis accounts of CBI as well as existing explanations of the policy-making of major central banks. Central banks have emerged from the economic and financial crises of the late-2000s as one of the key actors in the macroeconomy of advanced political economies. Understanding their actions and motivations, as well as the evolving relationship and communication between central banks and their variegated stakeholders, has thus become a more relevant feat than hardly ever before. The thesis consists of a set of three essays, employing a mixed-methods strategy which combines quantitative text analysis (in the first essay) with élite interviews (in the second and third essays) as well as qualitative document analyses (in all three essays). The first of the three essays revisits the Eurozone's unparalleled monetary-fiscal 'divorce' in light of an equally unparalleled involvement of the ECB in fiscal policy issues throughout the crisis. It argues that a situation best characterized as 'financial dominance' can help explain this puzzling observation, drawing our attention to the ECB's concerns about bearing financial risks on its balance sheet and its desire for fiscal solutions to alleviate these concerns. The second and third essays, in turn, pick up on and dig deeper into this apparent risk aversion on behalf of central banks in the context of unconventional monetary policy, probing into the understudied and perplexing political economy of central bank capital and concerns for central bank solvency. While the thesis as a whole is focused on the case of the Eurozone, it also leverages pertinent comparisons with other advanced political economies, notably the United Kingdom and Japan.

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IMF Working Papers

A new measure of central bank independence.

Author/Editor:

Tobias Adrian ; Ashraf Khan ; Lev Menand

Publication Date:

February 23, 2024

Electronic Access:

Free Download . Use the free Adobe Acrobat Reader to view this PDF file

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

This paper constructs a new index for measuring de jure central bank independence, the first entirely new index in three decades. The index draws on a comprehensive dataset from the IMF’s Central Bank Legislation Database (CBLD) and Monetary Operations and Instruments Database (MOID) and weightings derived from a survey of 87 respondents, mostly consisting of central bank governors and general counsels. It improves upon existing indices including the Cukierman, Webb, and Neyapti (CWN) index, which has been the de facto standard for measuring central bank independence since 1992, as well as recent extensions by Garriga (2016) and Romelli (2022). For example, it includes areas absent from the CWN index, such as board composition, financial independence, and budgetary independence. It treats dimensions such as the status of the chief executive as composite metrics to prevent overstating the independence of statutory schemes. It distills ten key metrics, simplifying current frameworks that now include upwards of forty distinct variables. And it replaces the subjective weighting systems relied on in the existing literature with an empirically grounded alternative. This paper presents the key features of the new index; a companion, forthcoming paper will provide detailed findings by country/region, income level, and exchange rate regime.

Working Paper No. 2024/035

9798400268410/1018-5941

WPIEA2024035

Please address any questions about this title to [email protected]

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Annual Report 2021

Federal Reserve Bank of St. Louis

The Blockchain Revolution: Decoding Digital Currencies

By David Andolfatto and Fernando M. Martin

  • Introduction

Few people took notice of an obscure white paper published in 2009 titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” authored by a pseudonymous Satoshi Nakamoto. The lack of fanfare at the time is hardly surprising given that innovations in the way we make payments are not known to generate tremendous amounts of excitement, let alone inspire visions of a revolution in finance and corporate governance. But just over a decade later, the enthusiasm for cryptocurrencies and decentralized finance spawned by Bitcoin and blockchain technology has grown immensely and shows no signs of abating.

Because cryptocurrencies are money and payments systems, they have naturally drawn the interest of central banks and regulators. The Federal Reserve Bank of St. Louis was the first central banking organization to sponsor a public lecture on the topic: In March 2014, presenters outlined the big picture of cryptocurrencies and the blockchain by discussing its possibilities and pitfalls. Since that time, the Bank’s economists and research associates have published numerous articles and explainers on these topics, all of which are freely available to the general public. This essay represents a continuation of our effort to help educate the public and offer our perspective of the phenomenon as central bankers and economists.

Understanding how cryptocurrencies work “under the hood” is a challenge for most people because the protocols are written in computer code and the data are managed in an esoteric mathematical structure. To be fair, it’s difficult to understand any technical language (e.g., legalese, legislation and regulation). Because we are not technical experts in this space, we spend virtually no time discussing the technology in detail. For an accessible introduction to the technology, see Fabian Schär and Aleksander Berentsen’s “ Bitcoin, Blockchain, and Cryptoassets: A Comprehensive Introduction ,” MIT Press, 2020. What we offer instead is an overview of cryptocurrencies and blockchain technologies, explaining the spirit of the endeavor and how it compares with traditional operations.

In this essay, we explore four key areas:

  • Money, digital money and payments
  • Cryptocurrencies, blockchain and the double-spend problem of digital money
  • Understanding decentralized finance
  • The makeup of a central bank digital currency
  • Money, Digital Money and Payments

It is sometimes said that money is a form of social credit. One can think of this idea in the following way: When people go to work, they are in effect providing services to the community. They are helping to make others’ lives better in some way and, by engaging in this collective effort, make their own lives better as well.

In small communities, individual consumption and production decisions can be debited and credited, respectively, in a sort of communal ledger of action histories. This is because it is relatively easy for everyone to monitor and record individual actions. A person who has produced mightily for the group builds social credit. Large social credit balances can be “spent” later as consumption (favors drawn from other members of the community).

In large communities, individual consumption and production decisions are difficult to monitor. In communities the size of cities, for example, most people are strangers. Social credit based on a communal record-keeping system does not work when people are anonymous. See Narayana Kocherlakota’s “ The Technological Role of Fiat Money ,” Federal Reserve Bank of Minneapolis, Quarterly Review , 1998. Producers are rewarded for their efforts by accumulating money balances in wallets or bank accounts. Accumulated money balances can then be spent to acquire goods and services (or assets) from other members of the community, whose wallets and bank accounts are duly credited in recognition of their contributions. In this manner, money—like social credit—serves to facilitate the exchange of goods and services.

The monetary object representing this social credit may exist in physical or nonphysical form. In the United States, physical cash takes the form of small-denomination Federal Reserve bills and U.S. Treasury coins. Cash payments are made on a peer-to-peer (P2P) basis, for example, between customer and merchant. No intermediary is required for clearing and settling cash payments. As the customer debits his or her wallet, cash is credited to the merchant’s cash register, and the exchange is settled. Hardly any time is spent inspecting goods and money in small-value transactions. Some trust is required, of course, in the authority issuing the cash used in transactions. While that authority is typically the U.S. government, there is no law preventing households and businesses from accepting, say, foreign currency, gold or any other object as payment.

When people hear the word “money,” they often think of cash. But, in fact, most of the U.S. money supply consists of digital dollars held in bank accounts. The digital money supply is created as a byproduct of commercial bank lending operations and central bank open market operations. Digital money is converted into physical form when depositors choose to withdraw cash from their bank accounts. Most people hold both forms of money. The reasons for preferring one medium of exchange over the other are varied and familiar.

Digital dollar deposits in the banking system are widely accessible by households and businesses. This digital money flows in and out of bank accounts in the form of credits and debits whenever a party initiates a purchase. Unlike with cash, making payments with digital money has traditionally required the services of a trusted intermediary. A digital money payment is initiated when a customer sends an encrypted message instructing his or her bank to debit the customer’s account and credit the merchant’s account with an agreed-upon sum. This debit-credit operation is straightforward to execute when both customer and merchant share the same bank. The operation is a little more complicated when the customer and merchant do not share the same bank. In either case, clearing and settling payments boils down to an exercise in secure messaging and honest bookkeeping.

  • Cryptocurrencies, Blockchain and the Double-Spend Problem of Digital Money

One can think of cryptocurrencies as digital information transfer mechanisms. If the information being transferred is used as an everyday payment instrument, it fulfills the role of money. In this case, a cryptocurrency can be thought of as a money and payments system.

Every money and payments system relies on trust. The difference between cryptocurrencies and conventional money and payments systems lies in where this trust is located. In contrast to conventional systems, no delegated legal authority is responsible for managing and processing cryptocurrency information. Instead, the task is decentralized and left open to “volunteers” drawn from the community of users, similar in spirit to how the internet-based encyclopedia Wikipedia is managed. These volunteers—called miners—work to update and maintain a digital ledger called the blockchain. The protocols that govern the read-write privileges associated with the blockchain are enshrined in computer code. Users trust that these rules are not subject to arbitrary changes and that rule changes (if any) will not benefit some individuals at the expense of the broader community. Overall, users must trust the mathematical structure embedded in the database and the computer code that governs its maintenance.

Managing a digital ledger without a delegated accounts manager is not a trivial problem to solve. If just anyone could add entries to a public ledger, the result likely would be chaos. Malevolent actors would be able to debit an account and credit their own at will. Or they could create social credit out of thin air, without having earned it. In the context of money and payments systems, these issues are related to the so-called double-spend problem.

To illustrate the double-spend problem, consider the example of a dollar stored in a personal computer as a digital file. It is easy for a customer to transfer this digital file to a merchant on a P2P basis, say, by email. The merchant is now in possession of a digital dollar. But how can we be sure that the customer did not make a copy of the digital file before spending it? It is, in fact, a simple matter to make multiple copies of a digital file. The same digital file can then be spent twice (hence, a double-spend). The ability to make personal copies of digital money files would effectively grant each person in society his or her own money printing press. A monetary system with this property is not likely to function well.

Physical currency is not immune from the double-spend problem, but paper bills and coins can be designed in a manner to make counterfeiting sufficiently expensive. Because cash is difficult to counterfeit, it can be used more or less worry-free to facilitate P2P payments. The same is not true of digital currency, however. The conventional solution to the double-spend problem for digital money is to delegate a trusted third party (e.g., a bank) to help intermediate the transfer of value across accounts in a ledger. Bitcoin was the first money and payments system to solve the double-spend problem for digital money without the aid of a trusted intermediary. How?

The Digital Village: Communal Record-Keeping

The cryptocurrency model of communal record-keeping resembles the manner in which history has been recorded in small communities, including in networks of family and friends. It is said that there are no secrets in a small village. Each member of the community has a history of behavior, and this history is more or less known by all members of the community—either by direct observation or through communications. The history of a small community can be thought of as a virtual database living in a shared (or distributed) ledger of interconnected brains. No one person is delegated the responsibility of maintaining this database—it is a shared responsibility.

Among other things, such a database contains the contributions that individuals have made to the community. As we described above, the record of these contributions serves as a reputational history on which individuals can draw; the credit they receive from the community can be considered a form of money. There is a clear incentive to fabricate individual histories for personal gain—the ability to do so would come at the expense of the broader community in the same way counterfeiting money would. But open, shared ledgers are very difficult to alter without communal consensus. This is the basic idea behind decentralized finance, or DeFi.

Governance via Computer Code

All social interaction is subject to rules that govern behavior. Behavior in small communities is governed largely by unwritten rules or social norms. In larger communities, rules often take the form of explicit laws and regulations. At the center of the U.S. money and payments system is the Federal Reserve, which was created in 1913 through an act of Congress. The Federal Reserve Act of 1913 specifies the central bank’s mandates and policy tools. There is also a large body of legislation that governs the behavior of U.S. depository institutions. While these laws and regulations create considerable institutional inertia in money and payments, the system is not impervious to change. When there is sufficient political support—feedback from the American people—changes to the Federal Reserve Act can be made. The Humphrey-Hawkins Act of 1978 , for example, provided the Fed with three mandates: stable prices, maximum employment and moderate long-term interest rates. And the Dodd-Frank Act of 2010 imposed stricter regulations on financial firms following the financial crisis in 2007-09.

Because cryptocurrencies are money and payments systems, they too must be subject to a set of rules. In 2009, Satoshi Nakamoto brought forth his aforementioned white paper, which laid out the blueprint for Bitcoin. This blueprint was then operationalized by a set of core developers in the form of an open-source computer program governing monetary policy and payment processing protocols. Adding, removing or modifying these “laws” governing the Bitcoin money and payments system is virtually impossible. Relatively minor patches to the code to fix bugs or otherwise improve performance have been implemented. But certain key parameters, like the one that governs the cap on the supply of bitcoin, are likely impervious to change.

Concerted attempts to change the protocol either fail or result in breakaway communities called “forks” that share a common history with Bitcoin but otherwise go their separate ways. Proponents of Bitcoin laud its regulatory system for its clarity and imperviousness, especially relative to conventional governance systems in which rules are sometimes vague and subject to manipulation.

Timely Topics logo

Bitcoin: Beyond the Basics

Learn about the structure and fundamentals of Bitcoin in this Timely Topics podcast with St. Louis Fed economist David Andolfatto. During the 16-minute episode , Andolfatto examines how distributed ledgers work and explains the mining process. This podcast was released Aug. 27, 2018.

How Blockchain Technology Works

As with any database management system, the centerpiece of operations is the data itself. For cryptocurrencies, this database is called the blockchain. One can loosely think of the blockchain as a ledger of money accounts, in which each account is associated with a unique address. These money accounts are like post office boxes with windows that permit anyone visiting the post office to view the money balances contained in every account. Beyond viewing the balances, one can also view the transaction histories of every monetary unit in the account (i.e., its movement from account to account over time since it was created). These windows are perfectly secured. It is important to note that many cryptocurrency users hold their funds via third parties to whom they relinquish control of their private keys. If an intermediary is hacked and burgled, one’s cryptocurrency holdings may be stolen. This has nothing to do with security flaws in the cryptocurrency itself—but with the security flaws of the intermediary. While anyone can look in, no one can access the money without the correct password. This password is created automatically when the account is opened and known only by the person who created the account (unless it is voluntarily or accidentally disclosed to others). The person’s account name is pseudonymous (unless voluntarily disclosed). These latter two properties imply that cryptocurrencies (and cryptoassets more generally) are digital bearer instruments. That is, ownership control is defined by possession (in this case, of the private password). It is worth noting that large-denomination bearer instruments are now virtually extinct. Today, bearer instruments exist primarily in the form of small-denomination bills and metal coins issued by governments. For this reason, cryptocurrencies are sometimes referred to as “digital cash.”

As with physical cash, no permission is needed to acquire and spend cryptoassets. Nor is it required to disclose any personal information when opening an account. Anyone with access to the internet can download a cryptocurrency wallet—software that is used to communicate with the system’s miners (the aforementioned volunteer accountants). The wallet software simultaneously generates a public address (the “location” of an account) and a private key (password). Once this is done, the front-end experience for consumers to initiate payment requests and manage money balances is very similar to online banking as it exists today. Of course, if a private key is lost or stolen, there is no customer service department to call and no way to recover one’s money.

Cryptocurrencies have become provocative and somewhat glamorous, but their unique and key innovation is how the database works. The management of money accounts is determined by a set of regulations (computer code) that determines who is permitted to write to the database. The protocols also specify how those who expend effort to write to the database—essentially, account managers—are to be rewarded for their efforts. Two of the most common protocols associated with this process are called proof-of-work (PoW) and proof-of-state (PoS). The technical explanation is beyond the scope of this essay. Suffice it to say that some form of gatekeeping is necessary—even if the effort is communal—to prevent garbage from being written to the database. The relevant economic question is whether these protocols, whatever they are, can process payments and manage money accounts more securely, efficiently and cheaply than conventional centralized finance systems.

Native Token

Recording money balances requires a monetary unit. This unit is sometimes referred to as the native token. From an economic perspective, a cryptocurrency’s native token looks like a foreign currency, albeit one whose monetary policy is governed by a computer algorithm rather than the policymakers of that country. Much of the excitement associated with cryptocurrencies seems to stem from the prospect of making money through capital gains via currency appreciation relative to the U.S. dollar (USD). (To see how the prices of bitcoin and ethereum, another cryptocurrency, have changed over the past decade, see the FRED charts below.) It seems to have less to do with the promise of the underlying record-keeping technology stressed by Nakamoto’s white paper. To be sure, the price of a financial security can be related to its underlying fundamentals. It is not, however, entirely clear what these fundamentals are for cryptocurrency or how they might generate continued capital gains for investors beyond the initial rapid adoption phase. Moreover, while the supply of a given cryptocurrency such as Bitcoin may be capped, the supply of close substitutes (from the perspective of investors, not users) is potentially infinite. Thus, while the total market capitalization of cryptocurrencies may continue to grow, this growth may come more from newly created cryptocurrencies and not from growth in the per-unit price of any given cryptocurrency, such as Bitcoin. See David Andolfatto and Andrew Spewak’s “ Whither the Price of Bitcoin? ” Federal Reserve Bank of St. Louis, Economic Synopses , 2019.

central bank essay

SOURCE: Coinbase, retrieved from FRED (Federal Reserve Economic Data).

NOTE: Gray shaded areas indicate U.S. recessions. For more data from Coinbase, see these series .

In any case, conceptually, there is a distinction to be made between the promise of a cryptocurrency’s underlying technology and the market price of its native token. Bitcoin (BTC) as a payments system could, in principle, function just as well at any given BTC/USD exchange rate.

Cryptocurrency Applications

Cryptocurrencies designed to serve as money and payments systems have continued to struggle in their quest for adoption as an everyday medium of exchange. Their main benefit to this point—at least for early adopters—has been as a long-term store of value. But their exchange rate volatility makes them highly unsuitable as domestic payment instruments, given that prices and debt contracts are denominated in units of domestic currency. While year-over-year returns can be extraordinary, it is not uncommon for a cryptocurrency to lose most of its value over a relatively short period of time. How a cryptocurrency might perform as a domestic payments system when it is also the unit of account remains to be seen. El Salvador recently adopted bitcoin as its legal tender, and people will be watching this experiment closely. Legal tender is an object that creditors cannot legally refuse as payment for debt. While deposits are claims to legal tender (they can be converted into cash on demand), they also constitute claims against all bank assets in the event of bankruptcy.

A use case touted early in Bitcoin history was its potential to serve as a vehicle currency for international remittances. One of the attractive attributes of Bitcoin is that anyone with access to the internet can access the Bitcoin payments system freely and without permission. For example, a Salvadoran working in the United States can convert his or her USD into BTC at an online exchange and send BTC to a relative in El Salvador in minutes for (usually) a relatively low fee, compared with sending money through conventional channels.

As with any tool, bitcoin may be used for good or ill purposes. Because BTC is a permissionless bearer instrument (like physical cash), it may become a popular way to finance illegal activities, terrorist organizations and money laundering operations. Recently, it has been used in ransomware attacks, in which nefarious agents blackmail hapless victims and demand payment in bitcoin, thereby bypassing the banking system.

But possibly the most attractive characteristic of Bitcoin is that it operates independently of any government or concentration of power. Bitcoin is a decentralized autonomous organization (DAO). Its laws and regulations exist as open-source computer code living on potentially millions of computers. The blockchain is beyond the (direct) reach of government interference or regulation. There is no physical location for Bitcoin. It is not a registered business. There is no CEO. Bitcoin has no (conventional) employees. The protocol produces a digital asset, the supply of which is, by design, capped at 21 million BTC. Participation is voluntary and permissionless. Large-value payments can be made across accounts quickly and cheaply. It is not too difficult to imagine how these properties can be attractive to many people.

Policy Considerations of Cryptocurrency

To a central bank, a cryptocurrency looks very much like a foreign currency. From this perspective, there is nothing revolutionary here. Foreign currency is sometimes seen as a threat by governments. This is not the case for the United States, since the U.S. dollar remains the world’s reserve currency, but many other countries often take measures to discourage the domestic use of foreign currency. Citizens may be prohibited, for example, from holding foreign currency or opening accounts in foreign banks. Because cryptocurrencies are freely available and permissionless, it would likely be considerably more difficult to enforce cryptocurrency controls. The cryptocurrency option may also serve to constrain domestic monetary and fiscal policies—in particular, by imposing a more stringent limit on the amount of seigniorage (i.e., the “printing” of more money to finance government spending).

A dominant foreign currency may cause another problem: As it turns out, it is often cheaper to issue debt denominated in a dominant foreign currency. The problem with this activity is that when the domestic currency depreciates, debtors may have trouble repaying, and a financial crisis may ensue. When that dominant foreign currency is the U.S. dollar, the central bank of a foreign country can sometimes find relief by borrowing dollars from the Federal Reserve through a currency-swap line. But if debt instruments are denominated in cryptocurrency, there is no negotiating with the DAO of that cryptocurrency. Because this is the case, domestic regulators might want to regulate the practice of issuing cryptocurrency-denominated debt more stringently, if the practice ever became sufficiently widespread to pose significant systemic risk.

  • Understanding Decentralized Finance

Decentralized finance broadly refers to financial activities that are based on a blockchain. Unlike conventional or traditional finance that relies on intermediaries and centralized institutions, DeFi relies on so-called smart contracts. The removal of those intermediaries in transactions between untrusted parties would significantly reduce costs and grant the parties more control over the terms of such agreements. Still, intermediaries oftentimes play meaningful roles beyond verification and enforcement, which means they would not altogether disappear. Here, we examine some of these concepts to explain what DeFi means and implies. For a more extensive review, see Fabian Schär’s “ Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets ,” Federal Reserve Bank of St. Louis, Review , 2021; also see an analysis by Sara Feenan et al. in “ Decentralized Financial Market Infrastructures: Evolution from Intermediated Structures to Decentralized Structures for Financial Agreements ,” The Journal of FinTech , 2021.

What Are the Benefits and Challenges of Decentralized Finance?

DeFi allows parties to engage in financial transactions without the need for intermediaries. In this short video, St. Louis Fed economist Fernando Martin looks at how DeFi works with smart contracts and digital tokens.

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What Are Smart Contracts?

A smart contract is a computer program designed to execute an agreed-upon set of actions. The concept was first introduced in the mid-1990s by Nick Szabo, who proposed vending machines as a primitive example: A vending machine is a mechanism that dispenses a product in exchange for a listed amount of coins (or bills); anyone with a sufficient amount of money can participate in this exchange. See Nick Szabo’s “ Smart Contracts ” (1994) and “ The Idea of Smart Contracts ” (1997). The key idea is that contractual terms, once agreed upon, are not renegotiable and are therefore automatically executed in the future. In economic theory, so-called Arrow-Debreu securities have the same property. Smart contracts allow interested parties to engage in secure financial transactions without the participation of third parties. As we explain below, their application goes beyond conventional financial transactions.

Ethereum is a blockchain with smart contract capability that was released in 2015. In this case, smart contracts are a type of account, with their own balance and the capability to interact with the network. Rather than being controlled by a user, smart contracts run as programmed, with their code and data residing at a specific address on the Ethereum blockchain. Other platforms may implement smart contracts in different ways. For example, Hyperledger allows for confidential transactions, whereas Ethereum, a public network, does not. Bitcoin is also able to handle a variety of smart contracts.

Like cryptocurrencies, smart contracts overcome security and transparency concerns in transactions between untrusted parties, without the need for a trusted third party. In fact, smart contracts aim to do away with intermediaries such as brokers, custodians and clearinghouses.

Consider a collateralized loan as an example. In traditional finance, a borrower seeks a bank to lend funds or a broker to find potential lenders. The parties then agree on the terms of the loan: interest rate, maturity, type and value of collateral, etc. The borrower’s collateral is placed in escrow. If the borrower fulfills the terms of the contract, the collateral is released and full ownership rights are returned. If the borrower defaults, the collateral is used to fulfill the contract (e.g., repay the remaining principal, interest and penalties). There are many parties involved in this transaction: financial intermediaries, appraisers, loan servicers, asset custodians, and others.

In a smart contract, the entire agreement is specified as part of the computer program and is stored on a blockchain. The program contains the terms of the loan, as well as the specific actions it will take based on compliance (e.g., the transfer of collateral ownership in the event of default). Since the blockchain handles the faithful execution of the contract, there is no need to involve any parties beyond the borrower and lender.

Asset Tokenization

The example above illustrates an important wrinkle: It may not be possible for all the elements and actions of a contract to be handled by the blockchain—particularly when it comes to collateral. If collateral is not available as an asset in the native protocol (i.e., the specific blockchain where the smart contracts exist), then, as in traditional finance, the contract necessitates a third party to provide escrow services. Naturally, this exposes the contract to counterparty risk. One solution to this problem is asset tokenization.

Asset tokenization consists of converting the ownership of an asset into digital tokens, each representing a portion of the property. If the asset exists in physical form (e.g., a house), then tokenization allows the asset to exist in a blockchain and be used for various purposes (e.g., as collateral). An important issue is how to enforce property rights stored in the blockchain for assets that exist in the physical world. This is an ongoing challenge for DeFi and one that may never be fully resolved.

Tokens also have a variety of nonfinancial applications. For example, they may grant owners voting rights to an organization. This allows for the decentralized control of institutions within a blockchain, as we describe below. Another popular application is the creation of nonfungible tokens (NFTs), which provide ownership of a digital image created and “signed” by an artist. Although the image could in principle be replicated countless times, there is only one version that is verifiably authentic. The NFT serves as a certificate of authenticity in the same way that artists’ signatures ensure paintings are originals and not copies. The advantage of an NFT is the security provided by the blockchain—signatures can be forged, whereas the authenticity of the NFT is validated by a decentralized communal consensus algorithm.

Decentralized Autonomous Organization

Smart contracts could transform the way we organize and control institutions. Applications may range from investment funds to corporations and perhaps even the provision of public goods and services.

A decentralized autonomous organization, or DAO, is an organization represented by a computer code, with rules and transactions maintained on a blockchain. Therefore, DAOs are governed by smart contracts. A popular example is MakerDAO, the issuer of the stablecoin Dai, whose stakeholders use tokens to help govern decisions over protocol changes.

The concept of governance refers to the rules that balance the interests of different stakeholders of an institution. For example, a corporation’s stakeholders may include shareholders, managers, creditors, customers, employees, the government and the general public, among others. The board of directors typically plays the critical role in corporate governance. One of the main issues corporate governance is designed to mitigate is agency problems: when managers do not act in the best interest of shareholders. But governance extends beyond regulating internal matters and may, for example, manage the role of a corporation inside a community or relative to the environment.

DAOs may be created for ongoing projects, such as a DeFi entity, or for specific and limited purposes, such as public works. Because they offer an alternative governance model by encoding rules in a smart contract, they replace the traditional top-down structure with a decentralized consensus-based model. Two prominent examples—the decentralized exchange Uniswap and the borrowing and lending platform Aave—started out in the traditional way, by having their respective development teams in charge of day-to-day operations and development decisions. They eventually issued their own tokens, which distributed governance to the wider community. With varying details, holders of governance tokens may submit development proposals and vote on them.

Centralized and Decentralized Exchanges

Currently, the most popular way in which cryptoassets are traded is through a centralized exchange (CEX), which works like a traditional bank or a broker: A client opens an account by providing personal identifiable information and depositing funds. With an account, the client can trade cryptoassets at listed prices in the exchange. The client does not own these assets, however, as the exchange acts as a custodian. Hence, clients’ trades are recorded on the exchange’s database rather than on a blockchain. Binance and Coinbase are CEXs that offer accessibility to users. However, since they stand between users and blockchains, they need to overcome the same trust and security issues as traditional intermediaries.

Decentralized exchanges (DEXs), on the other hand, rely on smart contracts to enable trading among individuals on a P2P basis, without intermediaries. Traders using DEXs keep custody of their funds and interact directly with smart contracts on a blockchain.

One way to implement a DEX is to apply the methods from traditional finance and rely on order books. These order books consist of lists of buy and sell orders for a specific security that display the amounts being offered or bid on at each price point. CEXs also work in this way. The difference with DEXs is that the list and transactions are handled by smart contracts. Order books can be “on-chain” or “off-chain,” depending on whether the entire operation is handled on the blockchain. In the case of off-chain order books, typically only the final transaction is settled on the blockchain.

Order-book DEXs may suffer from slow execution and a lack of liquidity. That is, buyers and sellers may not find adequate counterparties, and individual transactions may affect prices too much. DEX aggregators alleviate this problem by collecting the liquidity of various DEXs, which increases the depth of both sides of the market and minimizes slippage (i.e., the difference between the intended and executed price of an order).

An automated market maker (AMM) is another way to solve the liquidity problem in DEXs. Market makers are also derived from traditional finance, where they play a central role in ensuring adequate liquidity in securities markets. AMMs create liquidity pools by rewarding users who “deposit” assets in the smart contract, which then can be used for trades. When a trader proposes an exchange of two assets, the AMM provides an instant quote based on the relative availability (i.e., liquidity) of each asset. When the liquidity pools are sufficiently large, trades are easy to fulfill and slippage is minimized. Automated market makers are currently the dominant form of DEXs, because they resolve the liquidity problem better than alternative mechanisms and thus provide speedier and cheaper transactions.

What Are Stablecoins?

As we described earlier, cryptocurrencies are subject to extreme exchange rate volatility, which makes them highly unsuitable as payment instruments. A stablecoin is a cryptocurrency that ties its value to an asset outside of its control, such as the U.S. dollar. Some stablecoins stabilize their value by pegging to the U.S. dollar, backed with non-U.S. dollar assets; Dai, for example, pegs its value to a senior tranche of other cryptoassets. See Dankrad Feist’s “ On Supply and Demand for Stablecoins ,” 2021. To accomplish this, the stablecoin must effectively convince its liability holders that its liabilities can be redeemed on demand (or on short notice) for U.S. dollars at par (or at some other fixed exchange rate). The purpose of this structure is to render stablecoin liabilities more attractive as payment instruments. Pegging to the U.S. dollar is attractive to people living in the U.S. because the U.S. dollar is the unit of account. Those outside the U.S. may be attracted to the product because the U.S. dollar is the world’s reserve currency. This structure serves to increase demand for the stablecoin. But why would someone want to make U.S. dollar payments using a stablecoin instead of a regular bank account?

The answer ultimately rests on which product offers its clients the services they desire at a price they find attractive. A stablecoin is likely to be attractive at the wholesale level, where firms would be able to make USD payments at each point in an international supply chain without the need for conventional banking arrangements. Stablecoins market themselves as leveraging blockchain technology to deliver safer and more efficient account management and payment processing services. These efficiency gains can then be passed along to customers in the form of lower fees. A more cynical view ascribes these purported lower costs to regulatory arbitrage (i.e., sidestepping certain costs by relocating the transaction outside of the regulatory environment), rather than technological improvements in database management.

A Primer on Stablecoins

Stablecoins are cryptocurrencies that tie their value to an outside asset. In this short video, St. Louis Fed economist Fernando Martin takes a deep dive into stablecoins and how they have characteristics that are similar to money market mutual funds.

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Financial Stability Concerns

U.S. dollar-based stablecoins are similar to money market funds that peg the price of their liabilities to the U.S. dollar. They also look very much like banks without deposit insurance . As the financial crisis of 2007-09 showed, even money market funds are subject to runs when the quality of their assets is questioned. Unless a U.S. dollar-based stablecoin is backed fully by U.S. dollar reserves (it needs an account at the Federal Reserve for this) or by U.S. dollar bills (the maximum denomination is $100, so this seems unlikely), it is potentially prone to a bank run. If a stablecoin cannot dispose of its assets at fair or normal prices, it may fail to raise the U.S. dollars it needs to meet its par redemption promise in the face of a wave of redemptions. In such an event, the stablecoin would turn out to be not so stable.

If the adverse consequences of a stablecoin run were limited to the owners of stablecoins, then standard consumer protection legislation would be sufficient. But regulators also are concerned about the possibility of systemic risk. Consider, for example, the commercial paper market, where firms regularly borrow money on a short-term basis to fund operating expenses. Then consider a stablecoin (or any money market fund) with large holdings of commercial paper. A stablecoin run in this case may compel a fire sale of commercial paper to raise the funds needed to meet the wave of redemptions. This fire sale would likely have adverse economic consequences for firms that make regular use of the commercial paper market: As commercial paper prices decline, the value of commercial paper as collateral falls, and firms may find it more difficult to borrow the funds they normally access with ease. If the fire sale spills over into other securities markets, credit conditions may tighten significantly and lead to the usual woes experienced in an economic recession (missed payments, worker layoffs, etc.). These events are sufficiently difficult for a central bank to handle when the entities involved are domestic money market funds. The problem is compounded if the stablecoin is an unregulated “offshore” DAO. Will offshore stablecoins that are “too big to fail” be able to take advantage of the implicit insurance provided by central bank lender-of-last-resort operations? If so, this would be an example of how the private benefits of DeFi arise from regulatory arbitrage and not from an inherent technological advantage. This possibility presents a significant challenge for national and international regulators.

On the other hand, it may be possible for stablecoins to be rendered “run-proof” by employing smart contracts to design more resilient financial structures. For example, real-time communal monitoring of balance sheet positions is a possibility—a feature that could shine light on what are traditionally opaque financial structures. The opacity of financial structures is not necessary to explain bank runs. For example, the canonical model of bank runs assumes the existence of transparent balance sheets. See Douglas Diamond and Philip Dybvig’s “ Bank Runs, Deposit Insurance, and Liquidity ,” The Journal of Political Economy , 1983. Furthermore, because redemption policies can potentially manifest themselves as computer code, their design can be made more elaborate (state-contingent) and credible (contractual terms that can be credibly executed and not reversed). These features can potentially render stablecoins run-proof in a manner that is not possible with conventional banking arrangements. 

Regulators and Stablecoins

The regulatory concerns with stablecoins are similar to age-old concerns with the banking industry. Banks are in the business of creating money and do so by issuing deposit liabilities that promise a fixed (par) exchange rate against U.S. dollar bills and dollar credits held in Federal Reserve accounts. Lower-yielding liabilities are used to acquire higher-yielding assets. Because commercial banks normally hold only a very small fraction of their assets in the form of reserves, they are called fractional reserve banks. Since the introduction of federal deposit insurance, retail-level bank runs have been practically nonexistent. Banks also have access to the Federal Reserve’s emergency lending facilities. These privileges are matched by a set of regulatory constraints on bank balance sheets (both assets and liabilities) and other business practices.

Some stablecoin issuers would undoubtedly like to base their business models on those of banks or prime institutional money market funds. The motivation is clear: Issuing low-cost liabilities to finance high-yielding assets can be a profitable business. (Until, of course, something goes wrong. Then, regulators and policymakers face blame for permitting such structures to exist in the first place.) This business model naturally involves non-negligible risk and could make for a potentially unstable stablecoin. As stablecoins with these properties interact with off-chain financial activity, they introduce risks that may spill over to other markets and, therefore, prompt some form of regulation.

Other stablecoin issuers are likely to focus on delivering payment services, which can be accomplished by holding only safe assets. These stablecoins would be more akin to government money market funds. Stablecoins that submit to government regulations may be permitted to hold only the safest of securities (e.g., U.S. Treasury securities). If they could, they might even hold only interest-bearing reserves, thereby becoming “narrow banks.” The business model in these cases would be based on generating profits through transaction-processing fees and/or net interest margins enhanced by what stablecoin users would hope to be a wafer-thin capital requirement.

  • The Makeup of a Central Bank Digital Currency

The Board of Governors of the Federal Reserve System, in its recent paper “ Money and Payments: The U.S. Dollar in the Age of Digital Transformation ,” defines a central bank digital currency (CBDC) as a “digital liability of the Federal Reserve that is widely available to the general public.” This essentially means allowing the general public to open personal bank accounts at the central bank. How might a CBDC work?

Today, only financial institutions defined as depository institutions by the Federal Reserve Act and a select number of other agencies (including the federal government) are permitted to have accounts at the Federal Reserve. These accounts are called reserve accounts. The money balances that depository institutions hold in their reserve accounts are called bank reserves. The money account held by the federal government at the Federal Reserve is called the Treasury General Account. In a sense, a CBDC already exists, but only at the wholesale level and only for a small group of agencies. The question is whether to make it more broadly accessible and, if so, how.

What Is a Central Bank Digital Currency?

Economist David Andolfatto notes that there is more than one model for a central bank digital currency. In this short video, he explains how those models vary and highlights one big difference between a CBDC and traditional bank deposits: how they are insured.

central bank essay

As explained above, the general public already has access to a digital currency in the form of digital deposit liabilities issued by depository institutions. Most households and businesses have checking accounts with private banks. The general public also has access to a central bank liability in the form of physical currency (cash). While banks are obligated to redeem their deposit liabilities for cash on demand, deposits are not legally central bank or government liabilities. To put it another way, CBDC is (or would presumably be made) legal tender, while bank deposits represent claims to legal tender.

Federal Deposit Insurance

Bank accounts in the United States are presently insured up to $250,000 by the Federal Deposit Insurance Corp. From a political-economic point of view, bank deposits at the retail level are a de facto government liability. Moreover, given the role of the Federal Reserve as lender of last resort, one could make a case that large-value bank deposits are also a de facto government liability. To the extent this is so, the legal status of CBDC versus bank money may not be important as far as the ultimate safety of money accounts is concerned.

The Question of Counterparty Risk

Safety is only one of the many concerns surrounding money and payments. There is also the question of how counterparty risk may affect access to funds. For example, even if money in a bank account is insured, access to those funds may be delayed if a bank is suddenly subject to financial stress. This type of risk may be one reason corporate cash managers often turn to the repo market, where deposits are typically collateralized with Treasury securities that can be readily liquidated in the event deposited cash is not returned on time. If there is no restriction on the size of CBDC accounts, the product would effectively provide fully insured money accounts for corporations with no counterparty risk. Such a product, if operated effectively, could very well disintermediate (i.e., eliminate) parts of the money market.

Potential for Efficiency Gains

There is also the question of how a CBDC might improve the overall efficiency of the payments system. This is a difficult question to answer. Proponents often compare a well-designed CBDC with the payments system as it exists today in the United States, which has not caught up to developments in other jurisdictions, including in many developing economies. The U.S. payments system, however, is evolving rapidly to a point that may make CBDC a less attractive proposition. For example, The Clearing House now offers a 24/7 real-time payment services platform . The Federal Reserve’s FedNow platform will provide a similar service.

There may be no single best way to organize a payments system. A payments system is all about processing payment requests and debiting/crediting money accounts. Conceptually, bookkeeping is very simple, even if the actual implementation and operation of a payments system are immensely challenging endeavors. Any arrangement would need mechanisms that guard against fraud. Messaging must be made fast and secure. Institutions (or DAOs) must be trusted to manage the ledgers containing money accounts and related information. Property rights over data ownership would need to be specified and enforced. Some have advocated strongly for a CBDC (e.g., John Crawford et al. in “ FedAccounts: Digital Dollars ,” 2021). Others seem less enthusiastic (e.g., Larry White in “ Should the U.S. Government Create a Token-Based Digital Dollar? ” 2020; George Selgin in “ Central Bank Digital Currency as a Potential Source of Financial Instability ,” 2021; and Christopher Waller in “ CBDC: A Solution in Search of a Problem? ” 2021). In principle, a private, public or private-public arrangement could be made to work well.

What Are the Potential Benefits of a CBDC?

Payments systems have evolved over the years, and a central bank digital currency could be the next step in that evolution. In this short video, economist David Andolfatto examines how a CBDC may increase the efficiency of payments systems. He does so also within the context of The Clearing House’s 24/7 real-time payment services platform.

central bank essay

Like most central banks, the Federal Reserve is designed to facilitate payments at the wholesale level. It performs a vital function and overall performs it well. Traditionally, servicing the needs of a large and demanding retail sector in the United States is left to the private sector. A CBDC could be designed to respect this division of labor in one of two ways:

  • Permit free entry into the business of “narrow banking.” This would entail granting Fed master accounts to qualified firms with the requirement that they hold only reserves (and possibly U.S. Treasury bills) as assets. In this arrangement, digital currency remains a private liability (though fully backed by reserves).
  • Grant households and firms direct access to CBDC and delegate the responsibility of processing payments at the retail level to private firms. This latter arrangement is the one described in the Federal Reserve Board’s aforementioned report on CBDC. (See box below.)

Central Bank Digital Currency: Read and Comment on the Fed’s Paper

The Federal Reserve Board’s discussion paper (PDF) , released in January 2022, examines the pros and cons of a potential U.S. CBDC. While the Fed has made no decisions on whether to pursue or implement a CBDC, it has been exploring the potential benefits and risks from a variety of angles. As part of this process, the Board is seeking public feedback on whether and how a CBDC could improve an already safe and efficient U.S. domestic payments system. The comment period is open until May 20, 2022.

The ability to write history is a tremendous power. Who should be entrusted with such power? And how should privileges be restricted to ensure honesty, accuracy and (where needed) privacy?

All sorts of individual and group histories play an important role in coordinating economic activity, including credit histories, work histories, performance histories, educational attainment histories and regulatory compliance histories. In this report, we have focused primarily on payment histories in the context of cryptocurrency—including the fact that histories can be fabricated, and that individuals and organizations may be tempted to misrepresent their own histories for private gain at the expense of the broader community. Even relatively well-functioning societies must devote considerable resources to reconciling conflicting claims of past behavior, given the absence of reliable databases that contain those histories. The U.S. Chamber of Commerce Institute for Legal Reform found the cost of litigation in the United States amounted to $429 billion, or 2.3% of U.S. gross domestic product, in 2016. Over 40% of this cost was used to pay legal, insurance and administrative costs. These costs constitute a lower bound, as most disputes are reconciled outside the legal system.

Much of our everyday economic activity occurs outside any formal record-keeping, and societies have relied on informal communal record-keeping to incentivize individual and organizational behavior. Paper and electronic receipts issued for most commercial exchanges are more formal but are often incomplete and easily fabricated. More important records—for physical property, bank accounts, financial assets, licenses, certificates of education, etc.—are managed by trusted authorities.

These traditional forms of record-keeping are likely to be challenged by blockchain technology, which provides a very different model of information management and communication. Competitive pressures compel organizations and institutional arrangements to evolve in response to technological advances in data storage and communications. Consider, for example, how the telegraph, telephone, computer and internet have transformed the way people interact and organize themselves. Advances in blockchain technology are likely to generate even more dramatic changes, though what these may be remains highly uncertain.

  • For an accessible introduction to the technology, see Fabian Schär and Aleksander Berentsen’s “ Bitcoin, Blockchain, and Cryptoassets: A Comprehensive Introduction ,” MIT Press, 2020.
  • See Narayana Kocherlakota’s “ The Technological Role of Fiat Money ,” Federal Reserve Bank of Minneapolis, Quarterly Review , 1998.
  • Relatively minor patches to the code to fix bugs or otherwise improve performance have been implemented. But certain key parameters, like the one that governs the cap on the supply of bitcoin, are likely impervious to change.
  • Beyond viewing the balances, one can also view the transaction histories of every monetary unit in the account (i.e., its movement from account to account over time since it was created).
  • It is important to note that many cryptocurrency users hold their funds via third parties to whom they relinquish control of their private keys. If an intermediary is hacked and burgled, one’s cryptocurrency holdings may be stolen. This has nothing to do with security flaws in the cryptocurrency itself—but with the security flaws of the intermediary.
  • See David Andolfatto and Andrew Spewak’s “ Whither the Price of Bitcoin? ” Federal Reserve Bank of St. Louis, Economic Synopses , 2019.
  • Legal tender is an object that creditors cannot legally refuse as payment for debt. While deposits are claims to legal tender (they can be converted into cash on demand), they also constitute claims against all bank assets in the event of bankruptcy.
  • For a more extensive review, see Fabian Schär’s “ Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets ,” Federal Reserve Bank of St. Louis, Review , 2021; also see an analysis by Sara Feenan et al. in “ Decentralized Financial Market Infrastructures: Evolution from Intermediated Structures to Decentralized Structures for Financial Agreements ,” The Journal of FinTech , 2021.
  • See Nick Szabo’s “ Smart Contracts ” (1994) and “ The Idea of Smart Contracts ” (1997). The key idea is that contractual terms, once agreed upon, are not renegotiable and are therefore automatically executed in the future. In economic theory, so-called Arrow-Debreu securities have the same property.
  • For example, Hyperledger allows for confidential transactions, whereas Ethereum, a public network, does not. Bitcoin is also able to handle a variety of smart contracts.
  • Some stablecoins stabilize their value by pegging to the U.S. dollar, backed with non-U.S. dollar assets; Dai, for example, pegs its value to a senior tranche of other cryptoassets. See Dankrad Feist’s “ On Supply and Demand for Stablecoins ,” 2021.
  • The opacity of financial structures is not necessary to explain bank runs. For example, the canonical model of bank runs assumes the existence of transparent balance sheets. See Douglas Diamond and Philip Dybvig’s “ Bank Runs, Deposit Insurance, and Liquidity ,” The Journal of Political Economy , 1983.
  • The U.S. Chamber of Commerce Institute for Legal Reform found the cost of litigation in the United States amounted to $429 billion, or 2.3% of U.S. gross domestic product, in 2016. Over 40% of this cost was used to pay legal, insurance and administrative costs. These costs constitute a lower bound, as most disputes are reconciled outside the legal system.

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BoC’s Macklem highlights inflation fighting errors, lessons learned in new essay

central bank essay

Bank of Canada Governor Tiff Macklem delivers a speech in Montreal, on Feb. 6. Christinne Muschi/The Canadian Press

The surge of inflation over the past three years has been a “stark reminder” that central banks can’t always ignore supply shocks and hope price increases stabilize on their own, Bank of Canada Governor Tiff Macklem wrote in an essay published last week as part of a broader soul-searching effort by some of the world’s top central bankers.

In comments that are among his most detailed to date about the bank’s fight with inflation, Mr. Macklem wrote that he and his team had underestimated the inflationary risk posed by the combination of supply shocks and elevated consumer demand during the COVID-19 pandemic. The bank’s models weren’t properly calibrated to measure price pressures throughout the economy, he wrote, and bank officials were “not sufficiently attentive to the risk that inflation could rise sharply.”

The essay appears in an online book published by the Centre for Economic Policy Research, which brings together writing from leading central bankers and economists, including European Central Bank board member Philip Lane, Federal Reserve board member Chris Waller and former Fed chairman Ben Bernanke.

As inflation around the world has retreated – it has fallen to 2.9 per cent in Canada from a peak of 8.1 per cent, for example – policy makers have begun to reflect on what caused the most significant inflationary surge since the 1970s and why central bankers were slow to respond.

They have also begun thinking about how to improve monetary policy making going forward, while wrestling with the after-effects of the most rapid and co-ordinated interest-rate hiking campaign in a generation.

“While the central bank response to the post-pandemic period of high inflation seems to have been successful thus far, the aggressive pivot and then tightening of monetary policy over 2021-2023 generated new risks,” economists Bill English, Kristin Forbes and Ángel Ubide wrote in the introduction to the book.

“The unexpected and aggressive hikes in interest rates have caused financial stress for households, businesses, and financial institutions; bankruptcies are picking up quickly and housing transactions have largely frozen in many countries. The fiscal positions of many countries have worsened and could require substantial reductions in spending and increases in taxes – neither of which will be politically popular.”

Mr. Macklem’s essay focuses on the Bank of Canada’s forecasting errors and why it waited until early 2022 to start raising interest rates despite fast-rising inflation – something he and his colleagues now see, in retrospect, as a mistake.

Historically, central banks have tended to play down supply shocks – such as jumps in oil prices or transportation costs – when setting monetary policy, given that interest rates influence demand in the economy, not the supply of goods and services.

When consumer goods prices jumped in 2021 as a result of a rebound in oil prices, as well as supply chain disruptions and a surge in demand for goods that could be used during pandemic lockdowns, Mr. Macklem and many other central bankers dismissed this as “transitory.”

That proved to be a serious miscalculation. The supply shocks percolated through the economy, mixing with overheated demand that was fuelled by government support cheques, ultra-low interest rates and a shift in consumer spending patterns.

“With businesses having trouble keeping up with demand, they were less worried about losing customers if they raised their prices. Other firms, now facing higher prices for intermediate inputs, would in turn raise their prices, creating a ripple inflationary effect through the supply chain to broadly higher final goods prices,” Mr. Macklem wrote.

“And consumers, eager to finally buy what they couldn’t get through the pandemic, paid the higher prices. As a result, the impact on inflation of the price shocks was faster and more widespread than our models suggested.”

Mr. Macklem wrote that the bank has learned a number of lessons over the past three years. For one, it’s dangerous to discount supply shocks – a crucial point for the bank to take on board in a world that could increasingly be defined by trade conflicts and climate-related disruptions.

He added that bank economists also need to get better at looking under the hood of the economy, and seeing where specific price pressures are coming from, both domestically and internationally. Economic models that focus on aggregate supply and demand numbers can sometimes miss crucial things.

And the bank needs to get better at communicating with the public, he wrote. “The prolonged period over which inflation has been above the 2 per cent target may have undermined the trust that Canadians have in their central bank. While this poses a challenge, it also presents an opportunity. By providing more insights into our monetary policy decisions, we can help citizens understand what we are doing and why.”

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Moscow Tries to Reinvent Itself as Financial Hub

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central bank essay

By Andrew E. Kramer

  • April 3, 2013

MOSCOW — Having tried and failed to become a major financial center, Moscow is trying yet again — only this time it finds itself competing for business with Warsaw, not London, Tokyo and New York.

Moscow wants companies to list on the Moscow stock exchange. It wants money center banks to expand here, as well as insurance companies and law firms that deal with securities, to make Moscow the hub for the former Soviet Union or Eastern Europe.

To do all that, city leaders are inviting business to glittering new skyscrapers, including the Mercury City Tower, which at 75 stories is the tallest building in Europe.

“The idea is to upgrade the position of Moscow in ratings, to become closer to the leaders of innovation and to the big boys of international financial centers,” Andrei V. Sharonov, the deputy mayor for economic affairs, who led a roadshow tour promoting the city in Asia, said in an interview.

This spring, the city government sent deputy mayors to Tokyo, Singapore, Frankfurt, London, Boston and New York to tell banks and other financial companies they should take a closer look at Moscow. The trip was the first concerted effort by the city government to woo investors as tenants for the new high-rise financial district called Moscow City.

Certainly Moscow has a lot of wooing to do. A city of traffic-clogged highways and sprawling concrete apartment blocks, Moscow is widely known as a singularly difficult place to do business. It did attract the big banking houses from New York and London after the fall of Communism. But cronyism, the lack of transparency and shady accounting gave companies pause. Weak courts and selective enforcement encouraged companies to conduct business outside Russia.

Political change in Russia further sapped enthusiasm. Vladimir V. Putin, a skeptic regarding greater integration with the West, succeeded Dmitri A. Medvedev, who was seen as a modernizing figure, as president in a switch known as “the castling” for its resemblance to the chess move.

Mr. Medvedev had named senior Western bank executives to an advisory council for transforming Moscow’s financial sector. They included Jamie Dimon, the chief executive of JPMorgan Chase; Vikram S. Pandit, the former chief executive of Citigroup; and Lloyd C. Blankfein, the chief executive of Goldman Sachs.

But the Global Financial Center Index, published in March by Z/Yen, a consulting agency, placed Moscow 65th out of 79 cities studied. London was first, followed by New York and Hong Kong. The ranking placed Moscow between Bahrain and Mumbai. A survey by the World Bank and the International Finance Corporation even ranked Moscow No. 30 out of 30 Russian cities for ease of doing business.

“Moscow was never going to be an international financial center,” a Western banker working here, who was not authorized to speak for his employer on the matter, said of the effort. “That was a joke.”

So Moscow is setting its sights a little lower. Its biggest problem is to be taken seriously even as a regional center.

The midsize companies in neighboring Ukraine or other former Soviet republics are choosing to go public in Warsaw. They are hardly bothering to look at the carefully laid out welcome mat in Russia. Kernel, a Ukrainian corporate farming enterprise, and Coal Energy, a Ukrainian producer of steam coal, listed in Poland, where a policy of investing pensions in the stock market helps the local exchange.

The Warsaw stock exchange, in fact, has so many Ukrainian company listings it has a Ukraine index. Micex, the Russian stock exchange, has no such index because it has so few listings.

Moscow must compete, said Mr. Sharonov, the deputy mayor, because “there are a lot of other opportunities and competitors all over the world.”

Moscow’s roadshow was intended to illustrate the city’s efforts to become more livable for foreign executives and residents, Mr. Sharonov said. A new interchange links the financial district to nearby roads, for example, easing congestion.

Also, under the federal program to promote banking here, Russian financial regulators tied up loose ends in ways that pleased stock traders and other financial professionals, but have not been widely noticed.

Russia created a central securities depository, introduced standard accounting rules for publicly listed companies and is well on the way to consolidating nearly all financial regulatory authority in the central bank by 2015. And, without much fanfare, the government now insists that all listed Russian companies report financial results in accordance with international accounting standards.

“It’s a substantive change,” said Bruce Bower, the managing director of Verno Capital, a hedge fund that focuses on Russia. “The government realized that by doing a little work, for the first time, it could make a difference.”

Explainer - Why Huge European Central Bank Losses Matter

Reuters

FILE PHOTO: A man walks towards the European Central Bank (ECB) headquarters in Frankfurt, Germany, July 25, 2019. REUTERS/Ralph Orlowski/File Photo

FRANKFURT (Reuters) - The European Central Bank chalked up another large financial loss in 2023, burning through the last of its provisions, and said more losses are forthcoming as high rates push up interest payments to banks.

While the bank said it can operate effectively "regardless of any losses", the accounts have broader implications - from reputation and independence to state finances.

The following explainer looks at the risks and costs associated with losses at the ECB and the national central banks across the 20-nation euro zone.

WILL THAT AFFECT THE ECB'S REPUTATION?

The ECB printed trillions of euros over almost a decade, despite copious warnings from conservative economists. The losses could amplify critical voices, especially if central banks ask for additional capital from their governments, which some may portray as a public bailout.

The losses, which have already reduced state incomes and may lead to additional expenditure, could prompt governments to question how the central bank operates, a potential risk to legitimacy and ultimately independence.

While official bodies from the International Monetary Fund to the Organisation for Economic Co-operation and Development (OECD) argue that losses are not an indication of policy error, the broader public may struggle to understand the nuances, especially because central banks operate differently to any other firm.

Sustained losses could also damage central bank credibility because then investors would assume it would be printing currency over a longer period.

WILL THE LOSSES AFFECT GOVERNMENT BUDGETS?

Governments across the euro zone enjoyed a dividend payout from their central banks for decades, so losses also mean a loss of income to budgets. If provisions are exhausted and losses must be carried forward as is the case now, even future profits become inaccessible to shareholders since the bank must first make up for losses, then rebuild provisions, before any dividends can be paid.

WILL THE ECB NEED RECAPITALISATION?

Central banks do not operate like commercial banks and can even function with negative equity. Indeed, the Reserve Bank of Australia and the Czech National Bank, among others, have negative equity, as did Germany's Bundesbank for some of the 1970s.

However, some, including the central bank of the Netherlands, have warned a negative equity situation cannot be maintained for an "extended period" and a government recapitalisation may be required.

The central banks of the Netherlands, Belgium and Germany have all warned in the past that more large losses are likely.

Sweden's Riksbank - which is not part of the euro zone - has already said that according to its new statutes, it must apply to parliament for recapitalisation because its capital fell below the required threshold.

WILL THAT AFFECT THE ECB'S FRAMEWORK REVIEW?

The ECB is currently reviewing its operational framework, including how it will provide liquidity to lenders in a new normal of central banking.

Over the past decade, it provided "abundant" funds and there is still 3.5 trillion euros ($3.8 trillion) of excess liquidity sloshing around in the financial system, years after ultra-easy monetary policy was abandoned.

One issue under consideration is how much the ECB pays lenders on their excess liquidity parked at the bank overnight. Some policymakers argue that the ECB should remunerate a smaller portion of bank deposits at the 4% deposit rate, thereby lowering its own interest rate expense at the cost of bank earnings.

However, there is little monetary policy justification for such a move and the ECB's only mandate is price stability, so a move to shore up its own finances might be legally contentious.

Still, a longer period of losses may be deemed unacceptable because it questions the sustainability of the framework, so this could provide an acceptable justification for reducing payments to commercial lenders.

($1 = 0.9215 euros)

(Reporting by Balazs Koranyi; Editing by Emelia Sithole-Matarise)

Copyright 2024 Thomson Reuters .

Tags: dividends , European Union , Europe

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Moscow-City: 7 surprising facts about the Russian capital’s business center

central bank essay

1. Guinness World Record in highlining

central bank essay

The record was set in 2019 by a team of seven athletes from Russia, Germany, France and Canada. They did it on September 8, on which the ‘Moscow-City Day’ is celebrated. The cord was stretched at the height of 350 m between the ‘OKO’ (“Eye”) and ‘Neva Towers’ skyscrapers. The distance between them is 245 m. The first of the athletes to cross was Friede Kuhne from Germany. The athletes didn't just walk, but also performed some daredevil tricks. Their record is 103 meters higher than the previous one set in Mexico City in December 2016.

central bank essay

2. Domination of Europe's top-10 highest skyscrapers

7 out of 10 Europe’s highest skyscrapers are located in Moscow-City. Earlier, the  ‘Federation Tower’ complex’s ‘Vostok’ (“East”) skyscraper was the considered the tallest in Europe.

Left to right: the lower of the ‘Neva Towers’ (296 m), Commerzbank Tower in Frankfurt (300 m), Gorod Stolits (“City of Capitals”) Moscow tower (302 m), Eurasia tower (309 m), The Shard’ skyscraper in London (310 m), Mercury City Tower (339 m), Neva Towers (345 m).

Left to right: the lower of the ‘Neva Towers’ (296 m), Commerzbank Tower in Frankfurt (300 m), Gorod Stolits (“City of Capitals”) Moscow tower (302 m), Eurasia tower (309 m), The Shard’ skyscraper in London (310 m), Mercury City Tower (339 m), Neva Towers (345 m).

However, in 2018, the construction of the 462 meter tall ‘Lakhta Center’ in Saint-Petersburg was completed, pushing ‘Vostok’ (374 m) into 2nd place. The 3rd place is taken by OKO’s southern tower (354 m).

3. The unrealized ‘Rossiya’ tower

central bank essay

If all the building plans of Moscow-City were realized, the ‘Lakhta Center’ in St. Petersburg wouldn't have a chance to be Europe's highest skyscraper. Boris Tkhor, the architect who designed the concept of Moscow-City, had planned for the ‘Rossiya’ tower to be the tallest. In his project, it was a 600 meter tall golden cylindrical skyscraper ending with a spire that was inspired by traditional Russian bell towers. Then, the project was reinvented by famous British architect Sir Norman Foster. He had designed ‘Rossiya’ as a pyramid ending with a spire. The skyscraper itself would have been 612 meters tall, and the height including the spire would have reached 744,5 meters (for comparison, the ‘Burj Khalifa’ in Dubai, UAE, would have been just 83,5 meters taller). Unfortunately, the investors faced a lot of economic problems, due to the 2008 financial crisis, so the ‘Rossiya’ skyscraper was never built. A shopping mall and the ‘Neva Towers’ complex was constructed at its place in 2019.

4. Changed appearance of ‘Federation Tower’

central bank essay

In its first project, the ‘Federation Tower’ was designed to resemble a ship with a mast and two sails. The mast was to be represented by a tall glass spire with passages between the towers. It was planned to make a high-speed lift in it. The top of the spire was going to be turned into an observation deck. But the ship lost its mast in the middle of its construction. Experts at the Moscow-city Museum based in the ‘Imperia’ (“Empire”) tower say, that the construction of the spire was stopped, firstly, due to fire safety reasons and secondly, because it posed a threat to helicopter flights – the flickering glass of the spire could potentially blind the pilots. So, the half-built construction was disassembled. However, an observation deck was opened in the ‘Vostok’ tower.

5. Open windows of ‘Federation Tower’

central bank essay

We all know that the windows of the upper floors in different buildings don’t usually open. Experts say that it’s not actually for people’s safety. Falling from a big height is likely to be fatal in any building. The actual reason is the ventilation system. In a skyscraper, it’s managed with a mechanical system, and the building has its own climate. But in the ‘Zapad’ (“West”) tower of the ‘Federation Tower’ complex, the windows can open. The 62nd and last floor of the tower are taken up by a restaurant called ‘Sixty’. There, the windows are equipped with a special hydraulic system. They open for a short period of time accompanied by classical music, so the guests can take breathtaking photos of Moscow.

6. Broken glass units of ‘Federation Tower’

central bank essay

The guests of the ‘Sixty’ restaurant at the top of the ‘Zapad’ tower can be surprised to see cracked glass window panes. It is particularly strange, if we take into consideration the special type of this glass. It is extremely solid and can’t be broken once installed. For example, during experiments people threw all sorts of heavy items at the windows, but the glass wouldn’t break. The broken glass units of ‘Zapad’ were already damaged during shipment . As each of them is curved in its own way to make the tower’s curvature smooth, making a new set of window panes and bringing them to Russia was deemed too expensive . Moreover, the investors had financial problems (again, due to the 2008 financial crisis), so the ‘Vostok’ tower even stood unfinished for several years. Eventually, the cracked window panes were installed in their place.

7. The highest restaurant in Europe

central bank essay

‘Birds’, another restaurant in Moscow-City, is remarkable for its location. It was opened at the end of 2019 on the 84th floor of the ‘OKO’ complex’s southern tower. Guests at the restaurant can enjoy an amazing panoramic view at a height of 336 meters. On January 28, the experts of ‘Kniga Recordov Rossii’ (“Russian Records Book”) declared ‘Birds’ the highest restaurant in Europe, a step toward an application for a Guinness World Record.

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