One doesn’t have to be an economic genius to understand how it is a Central Bank goes about its assigned duty of stabilizing a nation’s economy. For a while now its been assumed that a stable economy is a good thing because, in its absence, little things like wars, starvation, chaos, and dictatorships tend to break out. So, except for the anarchists, are we all in agreement that economic stability is a good thing?
Now comes the fly in the ointment of how exactly a Central Bank should go about the stated mission of providing economic stability. Opinions vary widely. One obvious position that many people take is for the government, in the form of the Central Bank, to get their hands the hell out of the cookie jar and let the people themselves provide a stable economy through the simple act of participating in it. But the reality in this world is that a completely unencumbered capitalistic system is only a theory in a philosopher’s wet dream – it will never come to pass because no government can resist the urge to tinker.
When they do tinker, here are the three permutations that the tinkering generally takes:
1. Open Market Operations: The buying and selling of government bonds is one way the Central Bank can influence an economy. Perhaps the least intrusive method, a government bond buying campaign increases the amount of money in circulation and lowers interest rates. When it reverses the process and begins selling bonds, the widespread economic effect is reversed.
2. Reserve Requirements: Banking regulations require that a certain percentage of checking account liability undertaken by commercial banks’ and other depository institutions’ must be kept at the Central Bank, sort of a tribute payment if you want to think of it like that, to the feudal overlord who grants to the commoners, in its benevolence, permission to conduct business. Though not often done, the government can adjust the percentage required to be held in reserve. For example, increasing the reserve requirements takes money out of circulation, contracts the money supply, and reduces the amount available to borrowers. Changing this requirement is a Big Deal and not an action lightly taken.
3. Discount Window: This allows a commercial bank to borrow from the Central Bank reserve at a discounted rate. The point of this is that banks have the capability to vary their own local economic market condition by adjusting the amount of money the have on hand ready to be loaned. This is an “on demand” service not completely controlled by the government.
There you have it. The preceding discussion lays out in plain terms how a Central Bank generally tries to control an economy. Thank goodness this is not a perfect system and still allows for the vagaries of entrepreneurial endeavors to flourish.
The Heroic Investing Team
Flickr / Cain and Todd Benson
Tags: Central Bank