The Role of the Central Bank

Topics: Central bank, Monetary policy, Money supply Pages: 7 (2365 words) Published: May 8, 2013
Role of A Central Bank as Lender of Last Resort


Nowadays, monetary and central bank policy become more and more important. Besides, many references are regularly made to the function of central bank as lender of last resort(LOLR). LOLR contributes a lot to solve the financial crises. As central banks are independent from government, they seem to have strong priorities. In modern society, with the growth of the global economy, central banks have been playing especially important roles in finance systems of modern society(Goodhart& Illing,2002) . The main responsibility of a central bank is to manage the monetary policy in order to keep the economy as well as currency stable. Then, the central banks can manage inflation and deflation. Besides, central banks have to hold foreign exchange reserves. The role of central bank as lender of last resort plays a crucially important role in providing liquidity when financial situation depresses. However, this role suffers great controversy. In an attempt to have a further insight into the roles of central banks, the controversy of LOLR is introduced in this essay. It is vital to analyze this important central bank function in order to better understand this function of central banks. The purpose of this essay is to discuss the role of an LOLR and the controversy of the role(Freixas&Parigi, 2008).

The essay is structured as below. Section 2 discusses what is a central bank and its functions in the monetary and financial area. Section 3 introduces the role of the central bank as lender of last resort. Then, it is deeply discussed in section 4 that why LOLR is controversial. A conclusion of how the central banks will develop complete the essay. 2. Central Bank

2.1 Concept of The Central Bank
A central bank is a public institution that manages interest rates, the currency and money supply of a state. Central banks of their respective countries also usually supervise the system of commercial banking. A central bank is different from a commercial bank, it holds a monopoly on enhancing the monetary base of one nation. That is to say, the central banks regulate the amount of the nations’s money supply and the foreign exchange value of the nations’s currency. Besides, the national currency is printed by the central bank of this country. It is a modern central bank’s principal purposes to make monetary and financial conditions beneficial to an enough level of international reserves, a high rate of production and employment. 2.2 Functions of The Central Bank

By adjusting interest rates, setting the reserve requirement and acting as a lender of last resort when a financial crisis or bank insolvency happens, a central bank performs it primary function----managing the nation's money supply. It manages a country's gold reserves and foreign exchange. In addition, in order to reduce the danger that commercial banks and other financial institutions have when doing financial behaviors, central banks regularly have powers to regulate and supervise the banking industry as well. Thus, central banks are independent from the government in most developed nations. Role of A Central Bank as LOLR

3.1 History of LOLR
The LOLR has a long long history. There is a classical view hold by Bagehot’s (1873) stated that the LOLR role should fulfill at least three requirements below: (i) the loans should be lend to only solvent institutions and on good collateral, (ii) the loans must be at a penalty rate in order to prevent the to use the loans to finance for their daily operations, (iii) the central bank make sure that a bank that is willing to pay back satisfies the requirements above. That is to say, they have the ability to liquidate and warrant (Parigi&Rochet, 2003). 3.2 Definition of LOLR

A lender of last resort is an institution which is willing to provide credit in the last position even when no one will extend credit. In most situations, it is often the central bank of a country who...
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