Central Banks and Commercial Banks Compared in One Minute

The central bank of a country is the only institution allowed to create physical currency. In other words, coins and paper money. In today’s society however, debt is also money. The dollar you pay with when using credit card has just as much purchasing power as a one dollar bill. Therefore, commercial banks create money as well by issuing loans and since most of the money in existence is not physical, commercial banks actually create more money than central banks. Most countries have one central bank and multiple commercial banks. The central bank has a monopoly on physical money creation. They can create as much physical currency as they deem necessary. Commercial banks however cannot do that. Some people have to deposit money and others have to request loans, otherwise the money creation mechanism of a commercial bank stops working. Therefore maintaining stability is central bank’s main goal and it can do that by

1. Managing interest rates, lowering them to stimulate economic activity or increasing them if it thinks the economy is overheating.

2. Telling banks which rules they need to follow. For example, how much money they need to keep as reserves

3. Acting as a lender and buying assets that nobody wants during times of turbulence. For example, giving banks quick cash by buying the illiquid mortgage backed securities they were stuck with after the great recession.

A central banks can have other goals as well such as full employment, but its core resposibilities revolve around maintaining the stability of a country’s financial system.

© Prabhu for Forex Videos, 2017. |
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