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Central Banks and Monetary Policy

Central Banks and Monetary Policy


Understanding the functions of central banks and monetary policy is important for any investor because the decisions of the central bank or Federal Reserve can affect their investment portfolio directly. Some of the things to watch out for include monetary policy meetings, consumer price index (CPI) reports and changes in the base lending rate among other things. The roles of central banks are often dynamic especially in developing countries, or economies that are transitioning to being free market economies.

Without the central bank, there would be price bubbles in almost every sector of the economy. This may lead to chaos as inflation reduces the buying power of money. To prevent this, the central bank uses monetary policy to ensure price stability in the market by controlling inflation. This is usually done by interest rate adjustment, sale and purchase of government bonds, and sale of foreign currency to stabilize exchange rates.

No single commercial bank has enough cash reserves to meet the needs of every consumer in the country. When a bank receives more loan applications than it is currently able to meet, the best course of action is often to borrow from the central bank. Perhaps that is why central banks are sometimes referred to as the banks of banks.

By controlling the inflation in a country the central bank has a strong effect on the economy.  A strong currency makes companies less competitive globally, which can lead to lower stock prices or economic contraction.