Role of Central Bank (Europe)

Finance – Question 5 – Regulation The regulation of a country’s financial system usually is the responsibility of that country’s Central Bank - Role of Central Bank (Europe) introduction. Examples of this would be the United States Federal Reserve, The European Central Bank and the Bank of England. The central bank manages a country’s currency, money supply and interest rates. Central Banks also oversee the commercial banking system. Unlike a commercial bank, the central bank has a monopoly on increasing the country’s monetary base and also usually prints a country’s currency which serves as a nation’s legal tender.

In the case of the Euro Zone, the European Central Bank is responsible for this. Monetary Policy Monetary policy is the process by which a country’s central bank controls the supply of money. The central bank implements a country’s chosen monetary policy. This involves controlling inflation by altering the value of their currency and by doing these controlling prices within a country. They achieve this by managing interest rates and, setting banking reserve ratios and acting as lender of last resort during times of banking insolvency or financial crisis.

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Central banks in developed countries are designed to be independent from political interference. Regulation As already stated the central bank is actively involved in regulation of commercial banks. They achieve this with a number of monetary instruments such as setting a reserve ratio and altering interest rates which ultimately affect a bank’s ability to lend money and a consumer’s ability to borrow money. In order to control inflation, a central bank must control the money supply in a country. They control the supply by means of monetary policy; there are wo policies that are used to control the supply of money: Contractionary Policy & Expansionary Policy Contractionary Policy Contractionary Policy is usually adopted when there is a high level of inflation. The central bank uses this policy to slow the rate of inflation in an economy. Expansionary Policy Expansionary policy is usually adopted during times of recession. This was the chosen course of action for the US Federal Reserve during the financial crisis of 2008. They increased the supply of money in the economy by purchasing treasury financial instruments helping to support the credit markets and increase economic activity.

A central Bank can adopt three methods to increase or decrease the supply of money in an economy: * Open Market Operations * Discount Ratio * Reserve Ratio Open Market Operations This is the primary means used by the central bank to implement monetary policy. The central bank will make the decision to either purchase of sell government securities/bonds from the commercial banks. All the central bank needs to do is simply debit or credit the bank account of commercial banks in the central bank.

By purchasing bonds from the commercial banks, this provides more capital for a bank which results in a bank having a higher ability to lend money. This increases the money supply in an economy (expansionary policy). They can also decide to sell the bonds to the commercial banks reducing the money supply and thus the ability of the banks to lend (contractionary policy). Discount Ratio The rate at which commercial banks and other lending facilities can borrow short term funds from the central bank is called the discount rate. The central bank decides the interest rates.

So, if the interest rates are low then more banks will borrow, if interest rates are high then less banks will borrow ( expansionary/contractionary) Reserve Ratio The central bank also regulates the reserve requirement of commercial banks. This is the amount of money that a bank should keep in reserve to cover unforeseen circumstances. These reserves are usually stored in the central bank. If the reserve is increased then this takes money out of the banks, if it is decreased then it increases a bank’s ability to lend. (contractionary/expansionary)

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