Central Bank Functions: Financial and Price Stability

Functions of a Central Bank

Central banks are responsible for two key elements in the development of an economy: financial stability and price stability.

Financial Stability

Financial institutions act as intermediaries between savers and borrowers. For the system to function, these entities must be solvent, and the public must have confidence in their stability. When financial institutions face a mismatch between the maturity of their assets and liabilities, they risk failure. If depositors withdraw funds simultaneously, it creates a liquidity crisis, as most loans are long-term while deposits are accessible on demand.

Financial institutions lend to each other in the interbank market. A crisis can cause systemic uncertainty, leading to bank runs. A primary function of a central bank is to monitor the condition of these institutions to prevent banking panics. Tools include:

• Inspection and supervision of banks and savings institutions.
• Publication of reports on the health of financial institutions.
• Reserve level requirements to ensure adequate liquidity.
• Creation of a Deposit Guarantee Fund to protect individual savers up to a maximum limit.
• Provision of emergency loans to specific entities.

Stability of Prices

Maintaining low and stable inflation is a priority for central banks, as rapid price increases can be devastating:

• Competitiveness: Exporting companies forced to raise prices become less competitive and lose market share.
• Debt Value: Inflation reduces the real value of debt.
• Wage-Price Spiral: High inflation erodes purchasing power, leading workers to demand higher wages, which can further increase the inflation rate.