Role of Central Banks And Monetary Policy - Essay Prowess

Role of Central Banks And Monetary Policy


Role of Central Banks And Monetary Policy


A central bank refers to a monopoly and a nationalised institution which has the responsibility of producing and distribution credit and money. Currently, the central banks formulate monetary policy. The central banks are anticompetitive and are neither government agency for purposes of ensuring that the institution remains politically independent.  Among the first prototypes of the modern central bank is the Bank of England which was established in the 17th century. The bank of England was also the first central bank to exercise the duty of lender of last resort for other commercial banks. Other central banks that were popular were the Reich bank of German and Napoleon’s Bank of France. The two institutions were set up to finance military operations of the government which were expensive. The European central bank managed to facilitate the smooth running of the economy evident through the ability of the government to pay wages. Such significant contribution of central banks challenged other nations to establish similar institutions to grow their economy. Currently, most of the nations have established their local central banks with regional unions like the European Union creating the European Central Bank[.Some of the central banks include the Bank of France, Bank of England and the Deutsche Bundesbank. The banks are charged with the responsibility of formulating favourable economic policies.

The role of central banks and monetary policies

The central banks and the fiscal policies control the money supply in the economy. The government regulates the quantity of money to keep inflation within the required rates. Mesures of increasing the amount of cash include, the central bank buying back the government bonds and bills. When they purchase them, they pay the bearers of the instrument then spend the money by paying for goods and services. Through expenditures, more money circulates within the local economy. On the other hand, when the supply of money is more than the economy, the bank issues the financial instrument and through paying the bills and bonds the banks reduce the currency in circulation (Adler, Castro, & Tovar,2016, p.184)

Also, the central banks promote economic growth by ensuring that there is an adequate supply of financial resources in the economy. Therefore, the central bank engages in monetary expansion policies to supply more money to the market. Besides, the central bank can provide funds to initiate investment in the public sector. The central bank also regulates the services offered by other financial institution. The regulation is to ensure that the firms never use the client money in risky investments which are profitable for the financial institutions alone.

The background and early history of the European Monetary System

The Monetary System was established in the year 1979 to replace Bretton Woods Agreement in 1972. The new system was necessary because of the economic and political pressure across Europe at the time.  The objective of the European Monetary was, therefore, to attain both internal and external monetary stability across Europe. The system would also, promote economic cooperation among member states. The membership to the European Monetary System has been voluntary. Nations like Denmark, France, Germany and Italy have been members voluntarily since the inception of the system. Initially, the United Kingdom joined the system and then withdrew after a two-month run on its currency reserves. However, the nation joined the European Monetary System in October 1990. The European monetary system had three essential components which were an artificial currency known as the European Currency Unit, and the exchange rates which were subject to small fluctuations. The final part of the system was the credit and loan reserves which would assist in stabilising member state currencies during the crisis.

The European Currency Unit which was created in 1979 to replace the European Unit of Account that was previously used to determine the exchange rate. The value of the European currency comprised of the weighted values of the member state currencies compared to that of foreign currencies. The new technique of determining the exchange rate was considered useful in performing long-term financial transactions when compared to the European Unit of Account. The method involved macroeconomics calculations of determining the size of the national economy underlying each State’s currency to allocate weights to the money. There was also the periodic adjustment on the weighted value of the money which was done after every five years. The adjustment made the importance of strong currencies rise while the value of the weak currencies declined. However, after 1986 the changes in interest rates ensured that the currencies fluctuation remained within a narrow range keep the currencies within a close range.
Besides, the European community was using the technique to prepare the budgets and also, floated loans on the international market that were denominated in the European Currency Unit.
The second component of the European Monetary System aimed at achieving stabilisation of the rate of currency exchange in the Member nations. The exchange rates were fixed in 1979, and there were minimal changes at irregular intervals. Also, there was a moderate degree of floating allowed between currencies which would only rise to about six percent during periods of financial crisis in nations. The limitation in fluctuation of exchange rate motivated the financial institutions, and private investors to engage in long-term transactions with an assurance that they would not experience unexpected exchange rate gain or loss at the end of the transaction. Also, the member states had the motivation to fight inflation and avoid deficit spending. Finally, the policy spurred investment while preventing a recession. Therefore, the pegged exchange rate levels were highly satisfactory in practice for over a decade.

The credit mechanism allowed member states to offer short and medium term loans during financial constraints. The short-term financing lasted between 30-45 days while the long-term long lasted five years. There was also a reserve fund set at 25 billion which was made up of 20% gold and 20% of the dollars held by each State’s central bank. The member states who received the loan were to cut on deficit spending and adopt measures that would reduce inflation.

Finally, in the 1990s, the European Monetary System had the problem of conflicting economic programs among its members. The problem was mainly from the reunified Germany, and also the United Kingdom who withdrew from the program. In 1994 there was the development of European Monetary Institute which would help start European Central Bank and a common currency. In 1998 European Central Bank was formed and was charged with the responsibilities of, setting uniform monetary policy for the Eurozone nations. Finally, in 1999, the European Union members adopted the euro, for foreign exchange and electronic payments.

The principle reasons for Exchange rate mechanisms problems in the early 1990s
Speculative pressure to reconcile the stated exchange rate and the real rate was a significant problem facing the exchange rate mechanism. Since 1987 the exchange rates were stable, and there was no realignment of currencies. However, currencies like the peseta, the sterling, and the escudo were introduced to the exchange rate mechanism. The likelihood of experiencing another economic turbulent made the Europeans Members Union consider an incremental extension of the European Monetary System necessary for economic prosperity. The consideration was at the expense of realignment which was crucial in ensuring that the exchange rates were accurate and reflected the macroeconomic activities of each nation. Therefore, the failure to evaluate the exchange rates covered a significant source of instability.

The speculation on the real exchange rate and the nominal exchange rate was attributable to different rates of inflation whereby that of German and Italy differed by 10% in 1988. Thus, making the peseta overvalued when compared to the German currency. Also, there was a complaint that the sterling pound was overvalued in 1990. The fiscal policies and competitive positions in member states also affected the exchange rate mechanism. Failure to reconcile the real and nominal exchange rate made people speculate on the exchange rate as a method of correcting the inaccuracy. Besides, the main reason why the European exchange rate regime had previously succeeded due to frequent realignments. The realignments made it possible for the European Monetary System to execute substantial cumulative changes in exchange rates which were required to counter changes in relative costs and prices gradually. Therefore, without the realignment, the exchange rate never reflected the real value of the member state currency, and thus there was speculation.

Also, the desire of a single currency which could be used by all member states enhanced the rigidity of the system. After the unification of Germany officials from the Bundesbank demanded D-Mark revaluation relative to the other currencies. However, they met resistance from France, a nation that believed the realignment would jeopardise the goal of European Members Union. France also, felt that the revaluation would undermine its franc fort policy. Even the European Monetary System developed a system that contradicted it overall objective leading to the early 1990s crisis.

Initially, the European Currency Unit was necessary for the exchange rate mechanism and that the divergence indicator would help identify the currencies which needed adjustment. Therefore, under the original plan adjustment would affect both the surplus and deficit countries. The arrangement caused controversies when there was the reunification of German. The claim in West Germany was that inflation rate in the European Monetary System would introduce inflationary bias into the system. Therefore, there was an intervention that put much pressure on the weak currencies when compared to the countries experiencing minimal inflation. The response saw nations with strong-currency issue more of its money, while the weak nation draws its foreign currency reserves and borrow funds (Nugent, 2017, p.3).  The limited nature of foreign reserves saw states with high inflation impose restrictive fiscal policies like rising interest rates to discourage domestic inflation and importing.

On the other hand, strong currencies in the European Monetary Systems like the D-mark became the nominal anchor of the system. The strength of the German currency made other members of the European Monetary System to conduct monetary policies that would maintain a stable exchange-rate. The need for realignment was eliminated by the annual rates of inflation which were consistent with the standards in Germany. The tendency of nations to imitate the financial measures of Germany made the exchange rate mechanism unstable as they pursued their domestic priorities thus misleading the other countries. Therefore, when the Bundesbank increased interest rates from 1990 to control local inflation, other European nations had to choose whether to raise their interest rates to ensure price stability but experience slow growth besides, an increase in unemployment. They also had to decide if to allow the difference between their interest rates and that of German to reduce a decision that would make investors prefer the German currency at the expense of the local currency.

Explain the movement of the European single currency and evaluate the success of the introduction of the single currency

A single currency across Europe has seen the benefits member states enjoy from the single market increase. Unlike previously with the Euro the nations’ conveniently purchase the factors of production at a minimum cost of transactions. Therefore, firms who are in operation because of profit margins of less than 5% percent can continue business because the devaluation of currency is within a reasonable range. Further, the Euro has strengthened the European economic zone on the global market. The Eurozone contribute gross domestic product of 14% on the international market(Murs, 2013, p. 61)



Mursa, G. (2013.). euro – advantages and disadvantages. [online] Available at:–-advantages-and-disadvantages [Accessed 26 May 2018].

Adler, G., Castro, P. and Tovar, C.E., 2016. Does central bank capital matter for monetary policy?. Open Economies Review, 27(1), pp.183-205.

Nugent, N., 2017. The government and politics of the European Union. Palgrave.

Sinha, A. (2012). What are the important roles played by Central Bank in developing countries?.[online] Available at: [Accessed 26 May 2018].