A central bank has the important task to make sure the currency system continues to work well. A central bank is responsible for supervising the quantity of money that is available of a particular currency. Mostly this concerns a national currency, but in the case of the European Union, the euro is this Monetary Union’s currency.
A central bank has the monopoly in creating paper money and coins in the legal currency. However, the creation of new money electronically by commercial banks is permitted - this is how most new money is created (see: how is money created?).
A central bank does not influence the total quantity of money by creating or destroying cash, but by establishing the conditions by which commercial banks may create money. Several means are at its disposal.
Establishing reserve conditions
A central bank demands that a commercial bank keeps a certain amount of money in reserve. This demand can be made on the commercial bank’s reserve in its own account, as wel as in its account at the central bank. By increasing or decreasing these claims the central bank can theorinfluence the money quantity a commercial bank can create by giving out loans.
Establishing interest rates
Commercial banks lend to each other the money in their accounts at the central bank. A second way the central bank can influence the quantity of money is by establishing (within range) the interest rate at which the commercial banks lend each other the money at their central bank accounts. When a commercial bank intends to give substantial loans to their clients (and herewith put money in circulation) the amount of money the commercial bank has in reserve deminishes compared to their total credit. To comply to the reserve demands from the central bank, they possibly have to lend money from another commercial bank. When the central bank increases the cost of borrowing from a colleage by increasing the interest rate, the commercial bank will charge these to its clients resulting in dropping demands for new loans.
Bying and selling securities
Central banks can also influence money quantities by bying and selling securities themselves. When a central bank buys securities from a commercial bank, it adds money – new money – to the account of the commercial bank at its central bank account. This commercial bank can now lend out more money and still comply to the reserve claims.
A central bank can also lend out money directly to commercial banks, but only as an ultimate solution in times of crisis. The central bank acts as a so called lender of last resort.
Central banks play a crucial role in the whole financial system. However their social position is rather vague.
Central banks can only execute their tasks well when they operate completely independently: independent of individual banks’ private interest, but also of government. That which is essential for the stability of the financial system can be in conflict with what politicians would like to do in order to remain in favour of the public opinion.
A central bank is not a government service, supervised by democracy. It is a type of overall body of the private banks themselves. Yet laws and certain tasks the central bank implements are being established by the government. The appointment of administrators often is a political decision. But officially the involvement of politics ends here.