The central bank (Bank of England for the UK) has the following main responsibilities:
- Provide banking services to the Government
- Act as a bank to retail banks
- Supervise banking system
- Control inflation through base rate
The central bank manipulates the demand-side through setting the base rate. The Monetary Policy Committee in the UK changes the base rate to alter the supply of money. They are independent from the government to avoid bias. They meet monthly to discuss what the base rate should be as this is alters the cost of borrowing and reward for saving. It ultimately controls the interest rate across the country.
Through the base rate, they can influence the rate of inflation which they try to keep at the Government target of 2% (+1%). If inflation is high, they can increase the base rate which will cause retail banks to increase interest rates. This reduces the level of disposable income that consumers have, and business have higher loan repayments. The level of spending (business and personal) will reduce, then causing the average price level to fall.
The central bank is also considered a lender of the last resort. This is when the Government or financial institutions borrow from the B of E when they are close to collapse. This occurs when there is no other method to increase the supply of money and is known as quantitative easing. It can protect individuals who may otherwise lose their bank deposited money and aims to prevent a ‘run on the bank’, caused by consumer panic. Banks will avoid borrowing as it implies they are suffering a financial disaster.
Regulation of the banking industry
Banks have a large influence in the economy and if they fail there would be significant consequences for the economy, so they are regulated. There are several organisations which regulate the banking sector. The Bank of England has the Financial Policy Committee which identifies, monitors and acts to remove/reduce risks within the UK financial system. As well as this, there is the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). The CEOs of both the FCA and PRA are on the FPC. The FCA regulates financial firms to ensure they are being honest to consumers, seek to protect consumer interests and promote competition. The PRA promotes the safety of those within the financial sector (banks, building societies etc.) and ensures consumers are protected.