Chapter 13: Problem 463

What is the main objective of modem central banking? Explain.

Short Answer

Expert verified

The main objective of modern central banking is to maintain price stability by controlling inflation within a specific target range, promoting sustainable economic growth. Central banks achieve this through various monetary policy tools, such as adjusting interest rates and conducting open market operations, which influence the cost of borrowing and money supply in the economy. Additionally, central banks act as the lender of last resort, providing emergency liquidity to financial institutions during times of crisis, ensuring a stable and reliable financial system.

Step by step solution

1. Introduction to Central Banking

Central banks are vital actors in the financial system as they are responsible for implementing monetary policy, ensuring financial stability, and maintaining the overall economic well-being of a country. They conduct these actions through various functions such as setting interest rates, controlling the money supply, and acting as a lender of last resort.

2. Main Objective of Central Banking

The main objective of modern central banking is to maintain price stability, which is crucial to promoting sustainable economic growth. This means controlling inflation with a goal of keeping it within a specific target range. Inflation leads to an increase in the cost of goods and services, eroding the purchasing power of money. A stable inflation rate ensures an environment conducive to investment and savings and helps protect the value of the currency.

3. Monetary Policy

To achieve price stability, central banks use monetary policy tools such as interest rates and open market operations. By adjusting interest rates, central banks can influence the cost of borrowing and, consequently, the level of investment and consumption within the economy. Lower interest rates encourage borrowing and spending, which can stimulate economic growth and reduce unemployment, whereas higher interest rates may slow down the economy to control inflation.

4. Open Market Operations

Open market operations consist of the buying and selling of government securities in the market. By employing these operations, central banks can control the money supply in the economy. When a central bank buys government securities, it injects money into the economy, increasing the amount of money available for lending, and stimulating growth. Conversely, when a central bank sells government securities, it reduces the money supply, tightening credit conditions and controlling inflationary pressures.

5. Lender of Last Resort

Another key function of central banking is to act as the lender of last resort for financial institutions. In the event of a financial crisis or any other risk that threatens the stability of the banking system, central banks provide emergency liquidity to financial institutions, ensuring that banks continue to operate and support economic activities.

6. Conclusion

In conclusion, the main objective of modern central banking is to maintain price stability and control inflation, which supports sustainable economic growth and preserves the value of the currency. Central banks also play essential roles in the financial system as enforcers of monetary policy and lenders of last resort, ensuring a stable and reliable financial system capable of supporting economic activities.

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