A Brief History of Central Banks

By Bordo, Michael D. | Economic Commentary (Cleveland), December 2007 | Go to article overview

A Brief History of Central Banks


Bordo, Michael D., Economic Commentary (Cleveland)


A central bank is the term used to describe the authority responsible for policies that affect a country's supply of money and credit. More specifically, a central bank uses its tools of monetary policy-open market operations, discount window lending, changes in reserve requirements-to affect shortterm interest rates and the monetary base (currency held by the public plus bank reserves) in order to achieve important policy goals.

There are three key goals of modern monetary policy. The first and most important is price stability or stability in the value of money. Today this means maintaining a sustained low rate of inflation. The second goal is a stable real economy, often interpreted as high employment and high and sustainable economic growth. Another way to put it is to say that monetary policy is expected to smooth the business cycle and offset shocks to the economy. The third goal is financial stability. This encompasses an efficient and smoothly running payments system and the prevention of financial crises.

Beginnings

The story of central banking goes back at least to the seventeenth century, to the founding of the first institution recognized as a central bank, the Swedish Riksbank. Established in 1668 as a joint stock bank, it was chartered to lend the government funds and to act as a clearing house for commerce. A few decades later (1694), the most famous central bank of the era, the Bank of England, was founded also as a joint stock company to purchase government debt. Other central banks were set up later in Europe for similar purposes, though some were established to deal with monetary disarray. For example, the Banque de France was established by Napoleon in 1800 to stabilize the currency after the hyperinflation of paper money during the French Revolution, as well as to aid in government finance. Early central banks issued private notes which served as currency, and they often had a monopoly over such note issue.

While these early central banks helped fund the government's debt, they were also private entities that engaged in banking activities. Because they held the deposits of other banks, they came to serve as banks for bankers, facilitating transactions between banks or providing other banking services. They became the repository for most banks in the banking system because of their large reserves and extensive networks of correspondent banks. These factors allowed them to become the lender of last resort in the face of a financial crisis. In other words, they became willing to provide emergency cash to their correspondents in times of financial distress.

Transition

The Federal Reserve System belongs to a later wave of central banks, which emerged at the turn of the twentieth century. These banks were created primarily to consolidate the various instruments that people were using for currency and to provide financial stability. Many also were created to manage the gold standard, to which most countries adhered.

The gold standard, which prevailed until 1914, meant that each country defined its currency in terms of a fixed weight of gold. Central banks held large gold reserves to ensure that their notes could be converted into gold, as was required by their charters. When their reserves declined because of a balance of payments deficit or adverse domestic circumstances, they would raise their discount rates (the interest rates at which they would lend money to the other banks). Doing so would raise interest rates more generally, which in turn attracted foreign investment, thereby bringing more gold into the country.

Central banks adhered to the gold standard's rule of maintaining gold convertibility above all other considerations. Gold convertibility served as the economy's nominal anchor. That is, the amount of money banks could supply was constrained by the value of the gold they held in reserve, and this in turn determined the prevailing price level. …

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