Central banks fill an important structural role in the world financial systems as the final arbiters of monetary policy. In essence, they control the amount of money available in an economy, called liquidity, at any given time. They can control liquidity in a number of ways; among them by controlling the exchange rate of a currency, by buying and selling government bonds, and by setting interest rates. Most central banks currently pursue a set of policies that emphasize maintaining a stable, low inflation rate, GDP growth in a range that avoids inflationary pressure, and unemployment at a high enough rate that businesses can hire new employees without driving wages too high.

The tools used by central banks to control liquidity all work in different ways. The first tool of the central bank, the one that gets the most attention from the press and the public, is the ability to set interest rates. In the United States it does this by buying and selling government bonds on the open market. When the Fed wants to lower interest rates it buys Treasury bills--thus increasing the price and lowering the interest rate. Conversely, when it wants to raise interest rates it sells bonds, pushing the price down and increasing the yield. In the US this works because the interest rate that large commercial banks lend to each other at is tied to the current yield of the 30-year T-bill.

The second tool of the central bank in its fight for economic stability is its ability to control the foreign reserves of a country. This allows it to exercise some control over the value of the country's currency. It does this by buying and selling the various currencies that it is holding as reserves. If the Bank of Japan, for instance, wanted to devalue the yen, it would start buying dollars on the currency market. This would tend to drive the value of the dollar relative to the yen up, making one dollar equal to a higher number of yen. This would allow Japanese companies that export to the US to do so more competitively because they'd be able to charge fewer dollars while producing the same number of yen in profit.

There are serious risks to both managing an economy using exchange rates and to maintaining a particular target exchange rate, as the Bank of England discovered in 1992. Then, in an attempt to prop up the value of the pound it lowered interest rates. An investor named George Soros, however, continued to make enormous investments betting that the pound would keep sliding. BoE tried to continue lowering rates, but this triggered a further flight of capital from the pound to currencies that provided higher yields which reinforced the pounds fall. On September 22, 1992 Soros broke the Bank of England which was forced to devalue the pound, in the process losing billions of pounds worth of wealth. Soros' hedge fund made more than $1 billion. Most central banks avoid overt currency manipulation as much as possible now, although there are some exceptions (such as Argentina, whose currency is pegged to the American dollar and whose government intervenes freely to keep it that way).

The world's central banks:


List culled from several smaller, regional lists at the websites of the World Trade Organization (http://www.wto.org/) and the World Bank (http://www.worldbank.org/).

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