Central banks are the monetary authority of a country. They are responsible for the following functions:
- Monetary policy: This is the most important function of a central bank. It involves setting interest rates and controlling the money supply in order to achieve the desired level of inflation and economic growth.
- Financial stability: Central banks also play a role in maintaining financial stability. They do this by supervising banks and other financial institutions, and by providing liquidity to the financial system in times of crisis.
- Foreign exchange intervention: Central banks sometimes intervene in the foreign exchange market to influence the value of their currency. They do this by buying or selling foreign currency.
- Banking system lender of last resort: Central banks act as the lender of last resort to banks. This means that they will provide loans to banks that are in financial difficulty, so that they can avoid bankruptcy.
- Issuing currency: Central banks are responsible for issuing the currency of their country.
- Oversight of payment and settlement systems: Central banks also oversee the payment and settlement systems in their country. These systems are used to transfer money between banks and other financial institutions.
Maintenance of the External Value of Currency
The external value of a currency is its value in terms of other currencies. Central banks can play a role in maintaining the external value of their currency by intervening in the foreign exchange market.
There are two main ways that central banks can intervene in the foreign exchange market:
- Buying or selling foreign currency: Central banks can buy or sell foreign currency in order to increase or decrease the supply of their own currency in the market. This can affect the value of their currency.
- Changing interest rates: Central banks can also change interest rates in order to affect the value of their currency. Higher interest rates make it more attractive for investors to hold their money in the country, which can cause the currency to appreciate.
The decision of whether or not to intervene in the foreign exchange market is a complex one. Central banks need to consider a number of factors, such as the level of inflation, the state of the economy, and the exchange rate target.
Multiple Choice Questions
- Which of the following is not a function of a central bank?
- A. Monetary policy
- B. Financial stability
- C. Foreign exchange intervention
- D. Banking system lender of last resort
- E. Issuing currency
The answer is C. Foreign exchange intervention is not a function of all central banks. Some central banks, such as the central bank of the United States, do not intervene in the foreign exchange market.
- How can central banks affect the value of their currency?
- A. By buying or selling foreign currency
- B. By changing interest rates
- C. Both A and B
- D. None of the above
The answer is C. Central banks can affect the value of their currency by buying or selling foreign currency, or by changing interest rates.
- Why do central banks intervene in the foreign exchange market?
- A. To maintain the external value of their currency
- B. To protect their exporters
- C. To prevent excessive volatility in the exchange rate
- D. All of the above
The answer is D. Central banks intervene in the foreign exchange market to maintain the external value of their currency, to protect their exporters, and to prevent excessive volatility in the exchange rate.