Central banks · RiskAtoms Academy

By the end you will be able to

1Name the main central banks and the goals they are given by law.
2Explain how a central bank sets its policy rate and how the change passes through to the economy.
3Explain the lender-of-last-resort role and Bagehot's rule.
4Describe the other tools central banks use, such as quantitative easing and forward guidance.

Why it matters

One committee meeting, a quarter of a percentage point, and the monthly payment on millions of mortgages changes. In a crisis, the same institution can lend billions over a weekend to stop a bank run. Every lesson on interest rates starts here.

Core explanation

The bank behind the banks

A central bank is the bank that banks use. Commercial banks (L1.2.01) hold accounts with it, and their balances there, called reserves, are how they pay each other. Because the central bank is the only one that can create reserves and banknotes, it can set the price of money in the economy: the short-term interest rate.

Central bank	Main goal set by law	Policy rate
US Federal Reserve	Maximum employment and stable prices (the dual mandate)	Federal funds rate
European Central Bank	Price stability: 2% inflation over the medium term	Deposit facility rate
Bank of England	Price stability: 2% CPI inflation, set by the government	Bank Rate
Bank of Japan	Price stability: 2% inflation	Short-term policy rate
Reserve Bank of Australia	Price stability (2–3% inflation) and full employment	Cash rate

Each has a mandate, its goals in law, and most have independence: politicians set the goal, but the central bank decides the rate. The idea is that a central bank free from election cycles will keep inflation under control more reliably.

Setting the rate. A central bank's committee meets about eight times a year and sets the policy rate. It makes that rate stick by paying it on the reserves banks hold and lending reserves at a rate just above it: no bank will lend to another for less than it earns at the central bank, or borrow for more than the central bank charges.

From the rate to prices. The policy rate is only the first link in a chain. This is monetary policy transmission. Click along it.

ExploreHow a rate rise reaches inflation

Click a box to see what happens there.

Policy rate

The committee raises the policy rate, say by a quarter of a point, to cool inflation.

Other tools. When the policy rate is already near zero, central banks have used quantitative easing (QE): creating reserves to buy government bonds, which lowers long-term rates. They also use forward guidance, saying where rates are likely to go, so that markets move before the rate does.

Lender of last resort. Banks borrow short and lend long (L1.2.01), so even a sound bank can run out of cash in a panic. The central bank can create cash without limit, so it can stop a run. It lends against collateral, such as government bonds or loans, after a haircut. This is the lender-of-last-resort role. The classic rule comes from Walter Bagehot's Lombard Street (1873): in a panic, lend freely, against good collateral, at a high rate. Freely, to stop the panic; good collateral, to protect the central bank; a high rate, so banks come only when they must. The risk is moral hazard: banks that expect rescue may take more risk, which is one reason central banks also supervise them.

TimelineCentral banks in a crisis

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1668

The first central bank

Sweden's Riksbank is founded. It is usually counted as the oldest central bank still operating.

The formal version

Central banks use judgement, not a formula. But economist John Taylor showed in 1993 that a simple rule tracked the Fed's decisions well, and central banks still compare their rate with it. Let $\pi$ be inflation, $\pi^*$ the target, $y$ the output gap and $r^*$ the neutral real rate, all in percent.

The rule, for reference

i = r^* + \pi + 0.5\,(\pi - \pi^*) + 0.5\,y

Taylor's original version used $r^* = 2\%$ and $\pi^* = 2\%$ . Estimates of $r^*$ today are lower and uncertain.

Try it

Inflation is 3% and the economy is 1% below normal: the rule suggests 5.00%. Push inflation to 8%, as in 2022 in many countries, and see how high the rule goes. Then set a deep recession, with a gap of −5%, and low inflation: the rule asks for a negative rate, which is when central banks turned to QE.

Try itSet rates with the Taylor rule

Inflation over the past year3.00%

Output gap (economy above or below normal)-1.00%

Neutral real rate (r*)2.00%

Suggested policy rate5.00%

Inflation target2%

Real rate (rate − inflation)2.00%

Suggested rate at every inflation rateThe line is steeper than one-for-one: the rule raises rates by more than inflation rises.

Worked example

A bank at the lender of last resort

A made-up US bank faces heavy deposit withdrawals. It pledges corporate bonds with a market value of $500m to the central bank for 7 days. The central bank's policy rate is 4%; it lends at 1 point above that. Interest uses the US money-market convention: simple interest, actual days over 360.

Borrowing against collateral

Step 1 of 5

1
Apply the haircut
The central bank applies a 8% haircut: $500m × (1 − 8%) = $460m of borrowing capacity.

Regulatory lens

Many central banks are also bank supervisors, and most are responsible for the stability of the financial system as a whole.

Euro area: since 2014 the ECB directly supervises the largest banks through the Single Supervisory Mechanism.
United Kingdom: the Bank of England houses the Prudential Regulation Authority (PRA), which supervises banks and insurers, and the Financial Policy Committee, which watches risks to the whole system.
United States: the Federal Reserve supervises bank holding companies and many banks, alongside other agencies (L1.2.09).
Asia-Pacific: the Monetary Authority of Singapore is both central bank and integrated regulator; the Hong Kong Monetary Authority supervises banks; the Reserve Bank of India regulates banks too.
Liquidity rules: under Basel III, reserves at the central bank count as the highest quality liquid asset in a bank's Liquidity Coverage Ratio.

Money markets and benchmark rates, which the policy rate steers, are covered in L1.6.03 and L1.6.05; real and nominal rates in L1.3.07.

Sparks

SparkInterest rates below zero

In June 2014 the ECB set its deposit rate at −0.10%, charging banks to hold reserves. The Bank of Japan, the Swiss National Bank and others also went negative. The Bank of Japan was the last to leave, in March 2024.

SparkSwap lines: dollars on demand

Banks around the world borrow in US dollars. In 2008 and again in 2020, the Fed lent dollars to other central banks in exchange for their own currencies, so they could lend them on to their banks. It made the Fed a lender of last resort for the world's dollar system.

Key takeaways

A central bank issues money, sets the short-term interest rate and stands behind the banking system.
It steers its policy rate through what it pays on reserves and charges for loans; the change passes to market rates, bank rates, spending and, with a lag, inflation.
The Taylor rule i = r* + π + 0.5(π − π*) + 0.5y is a benchmark for where rates should be.
As lender of last resort it lends freely to sound banks in a panic, against good collateral, at a high rate.
Near zero rates, central banks use QE and forward guidance; many also supervise banks.

Reaction

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Glossary

Central bank: The public institution that issues a country's money, sets its key interest rate and stands behind its banking system.
Mandate: The goals a central bank is given by law, such as stable prices or maximum employment.
Independence: Freedom, set in law, for a central bank to set rates without government instruction.
Policy rate: The interest rate a central bank sets to steer all other short-term rates, such as Bank Rate or the federal funds rate.
Reserves: Money that commercial banks hold in their accounts at the central bank. Banks use it to pay each other.
Transmission: The chain through which a change in the policy rate reaches spending, jobs and inflation.
Output gap: How far the economy's output is above (positive) or below (negative) its normal, sustainable level.
Quantitative easing: Quantitative easing: the central bank creates reserves to buy bonds, pushing long-term interest rates down.
Lender of last resort: Lender of last resort: the central bank's role of lending to sound banks that cannot get cash anywhere else in a panic.
Collateral: Assets pledged to a lender, which it can keep if the loan is not repaid.
Haircut: The cut applied to collateral's value when lending against it, to protect the lender if its price falls.

Deep Dives & Origins

Deep Dives

Mishkin, The Economics of Money, Banking and Financial Markets (Pearson), the chapters on central banks and the conduct of monetary policy. Beginner.
Bagehot, Lombard Street: A Description of the Money Market, Henry S. King, 1873. Intermediate.

Origins

Taylor, “Discretion versus policy rules in practice”, Carnegie-Rochester Conference Series on Public Policy 39, 1993.
Federal Reserve Act of 1913, section 2A (monetary policy objectives).
Treaty on the Functioning of the European Union, Article 127; ECB monetary policy strategy statement, 2021.
Bank of England Act 1998; Bank of Japan, statement on the 2% price stability target, January 2013.
Federal Reserve, Bank Term Funding Program announcement, 12 March 2023; Swiss National Bank press releases, March 2023.

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