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
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/).