Principles of Finance 1

Written Assignment Week 5

Introduction

This weeks written assignment is based on the central bank, but what is the central
bank? To briefly sum it up, a central bank is a financial institution that is responsible
for managing a country's monetary policies. It does this by having control over “the
money supply, interest rates, inflation, and other macroeconomic outcomes like
output and employment” (Wright & Quadrini, 2009). In my answer to this
assignment, I will be discussing the importance of the central bank, central bank
independence and why it’s important.

Body

1. What is the importance of the central bank?

In general. central banks play a crucial role in maintaining economic and financial
stability in a country, and their primary function involves implementing monetary
policy and, thus managing a country's money supply. “A central bank is a bank under
some degree of government control that is responsible for influencing the money
supply, interest rates, inflation, and other macroeconomic outcomes like output and
employment” (Wright & Quadrini, 2009). I will now discuss some specific reasons as
to why that is important:

A. ”Stabilizes the macro-economy” (Wright & Quadrini, 2009):

The central bank operates as a banker to other banks. offering financial services to
them, including providing additional funds and acting as a “lender of last resort”
(Wright & Quadrini, 2009).

B. Acts as a governments bank:

“Central banks also often act as the national government’s banker by holding its
deposits and making payments on its behalf” (Wright & Quadrini, 2009)

C. Issues currency:
”Central banks have the power to issue money in cash, generally in the form of notes
and coins” (When and Why, 2023).

D. Controls inflation:
The central bank influences interest rates, and “as a country’s central bank becomes
more independent, its average inflation rate drops” (Wright & Quadrini, 2009). The
central banks lowers interest rates to help economic growth, and raises them when the
economy’s current monetary policy risks causing high inflation.

2. Describe central bank independence and its importance?

Central bank independence means that it is independent from any branch of the
government, and does not need to follow their rules. This is important for a few
reasons:

A. Confidence and credibility:

There been issues in the past with politicians becoming vastly wealthy due to skewed
government banking policies, which of course made many of the country’s citizens
unhappy with the situation. In this regard, An independent central bank instills
confidence in investors, the markets and the public at large because that monetary
policies that get implemented are not implemented due to government interference or
political pressure, but based on economic indicators and necessity. It also increases
economic confidence, as many investors, consumers, and businesses aren't too
worried about the central banks policies being skewed by different short-term political
cycles.

B. Inflation:
I have mentioned before how the central bank helps to control inflation, but it really is
important that an entity with this power is independent from the government. To give
one example, if the government alone had this ability, and the deficit needed to be
financed, the government could consider printing money to do so. The major issue
with this, is that printing money in such a way can lead to hyperinflation.

C. Monetary policy:
Any new monetary policy that needs to be implemented should be aimed towards the
long term financial stability of an economy. Having a central bank implement these
decisions can make the process impartial to any one side. Whereas, if the government
was the one implementing this, the monetary policy could change drastically with
each new short-term political cycle.

An example of a time when the central bank was able to drive down inflation started
thanks to Paul Volcker, the fed chair, and his knowledge of monetary policy. It was at
the cost of record unemployment and two recessions, but “when inflation was at 11
percent and rising, he brought it below 4 percent by 1983, and set The U.S.A. on a
path toward price stability that lasted for decades” (Sommer, 2022)

Conclusion

While most countries in the world do have a central bank, it is not absolutely
necessary for every single country to have. Although, I believe they are for the
betterment of a country. I think that without a central bank, a country would struggle
to control inflation, be tempted to bring about hyperinflation, and manage its money
supply effectively. The more we understand about central banks, the more we see
their importance in maintaining our economies.

Word count: 762

References:

Sommer, J. (September 22nd, 2022). Bad News From the Fed? We’ve Been Here
Before. Retrieved from https://www.nytimes.com/2022/09/22/business/fed-rate-
inflation-volcker.html

When and why is money issued? (January 10th, 2023). Santander Web Site. Retrieved
on July 16th, 2023 from https://www.santander.com/en/stories/issuing-money

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Retrieved from:
https://www.saylor.org/site/textbooks/Money%20and%20Banking.pdf