Role of Central Banks

The central bank is known as the “lender of last resort,” which means it is responsible for lending funds to a country’s economy when commercial banks are unable to meet demand. In other words, the central bank keeps the banking system of the country from collapsing.The major purpose of central banks, on the other hand, is to maintain price stability in their countries’ currencies through managing inflation. A country’s monetary policy is regulated by the central bank, which is also the exclusive provider and printer of notes and coins in circulation. Expectations of inflation.Time has shown that the ideal way for the central bank to serve in these roles is for it to be independent of government budgetary policy and hence unaffected by any regime’s political concerns. A central bank’s commercial banking interests should also be entirely unloaded.

Conduct Monetary Policy

Central banks play a critical role in monetary policy, providing price stability (low and stable inflation) and assisting in the management of economic volatility. The policy frameworks under which central banks operate have changed dramatically during the last few decades.

Since the late 1980s, inflation targeting has been the main framework for monetary policy. The central banks of Canada, the eurozone, the United Kingdom, New Zealand, and other nations have set an explicit inflation target.. Many low-income nations are also transitioning from monetary aggregate (a measure of the total amount of money in circulation) to inflation targeting.In recent months, major central banks have been revisiting their monetary policy frameworks, citing growing concerns about eroding policy room in the environment of lower equilibrium interest rates and declining inflation expectations.

To implement monetary policy, central banks modify the quantity of money, usually through open market operations. For example, a central bank could reduce its money supply by selling government bonds and receiving payments from commercial banks under a “sale and buyback” agreement. The purpose of such open market actions is to influence short-term interest rates, which in turn affect longer-term rates and overall economic activity. In many countries, particularly in low-income countries, the monetary transmission mechanism is not as effective as it is in high-income countries.

Foreign exchange regimes and policies

The choice of a monetary framework and an exchange rate regime are inextricably intertwined. In comparison to a country with a more flexible exchange rate, a country with a fixed exchange rate will have little flexibility for autonomous monetary policy. Despite the fact that some countries do not fix the exchange rate, they still attempt to manage its level, which may necessitate a trade-off with the goal of price stability. An effective inflation targeting framework benefits from a completely flexible exchange rate regime.

Macroprudential policy

The global financial crisis demonstrated that countries must use dedicated financial policies to contain risks to the financial system as a whole. Many central banks with a financial stability mandate have improved their financial stability functions, particularly by adopting macroprudential policy frameworks.

To work successfully, macroprudential policy requires a robust institutional framework. Because they have the ability to analyse systemic risk, central banks are well positioned to implement macroprudential policy. Furthermore, they are frequently self-sufficient and autonomous. The macroprudential mission has been delegated to the central bank or a specific committee inside the central bank in many nations.

The global financial crisis highlighted that countries must employ targeted financial policies to mitigate risks to the whole financial system. Many central banks with a financial stability mandate have improved their financial stability functions, notably through the use of macroprudential policy frameworks.

Macroprudential policy requires a strong institutional framework to function effectively. Central banks are well positioned to implement macroprudential policy since they have the ability to analyse systemic risk. They are also frequently self-sufficient and independent. In many countries, the macroprudential role is given to the central bank or a particular committee inside the central bank.

The IMF’s role in promoting successful central bank frameworks

Through multilateral surveillance, policy papers and research, bilateral engagement with its member nations, and data gathering for policy analysis and research, the IMF encourages effective central bank frameworks.

Global results can be improved through multilateral surveillance, policy analysis, and research:

• The IMF has provided policy advice on how to prevent negative consequences of implementing and exiting unconventional monetary policy, as well as set rules for low-income countries’ changing monetary policy regimes.
• The Fund has also looked at how monetary and macroprudential policies interact, and issued guidelines for establishing well-functioning macroprudential frameworks.

Through bilateral surveillance (Article IV consultation), FSAPs, and technical support, the IMF maintains regular contact with member nation central banks:

• The IMF gives advice on monetary policy action to achieve low and stable inflation, as well as on developing effective monetary and macroprudential policy frameworks, via its Article IV consultations.
• The Financial Sector Assessment Program (FSAP) offers member countries an assessment of their financial systems as well as detailed advice on policy frameworks for containing and managing financial stability risks, such as the macroprudential policy framework, which is now frequently covered in dedicated technical notes (e.g., Finland, Netherlands, and Romania).
• Measures to strengthen monetary policy and central bank governance are frequently included in IMF-supported country programmes.

Conclusion

The function of central banks in guaranteeing economic and financial stability is critical. They utilise monetary policy to maintain low and stable inflation. Following the global financial crisis, central banks have expanded their toolkits to cope with financial stability challenges and manage volatile exchange rates. Central banks utilised a variety of traditional and unorthodox instruments to loosen monetary policy, sustain liquidity in important financial markets, and maintain the flow of credit in response to the COVID-19 epidemic. To fulfil their goals, central banks require clear policy frameworks. The efficiency of central bank policies is improved through operational methods that are adapted to each country’s circumstances.The International Monetary Fund (IMF) provides policy advice and technical assistance to governments all around the world.