The central banks all over the world have played a pivotal role in the international capital market. Their key role has been the formulation of policy interventions to influence growth in the market. Their major goal is usually to maintain stability in the capital market by removing all the possible bottlenecks of trade in the market. Among their key roles include:
Stimulation of economic growth
The central bank serves a complementary role in the capital markets’ efforts of providing long-term investment to the investors. This helps to reduce the pressure in the provision of long-term capital by the banks. Central banks in this process ensure that the conditions are conducive enough to allow the capital market to undertake its mandate. It also ensures that the enabling structures exist to allow the capital market to provide equity capital infrastructural development funds for the construction of roads, housing, and other projects with meaningful social benefits.
Besides these, it ensures the interest rates are favorable enough to allow people to source capital from the capital market. Central banks around the world recognize the important role played by the capital market the world over in pooling resources together in form of domestic savings. These funds are important for the industrialization of any country. The central government plays a pivotal role in facilitating the process since it is important in supplementing the financial market.
Supply of Market Liquidity
The central bank plays a huge role in ensuring the capital market is liquid enough to allow smooth trading. This is usually done by expansion of the money supply in the money market when the market is distressed according to Thornton (2009: Para. 1). For example, during the recent recession, the federal reserve responded by supplying liquidity in the market to ease the credit crunch. This was done through the open market operation and by lending money to the financial institution. Open market operations are a method of credit control employed to expand the money supply in the banking industry. The Federal Reserve pumps money into the banking sector which causes a stimulus effect in the growth of the economy (Open Market Operations – OMO, n.d: Para. 1).
Further to control the supply of money, the central bank purchases and sells government securities through the capital market. The Federal Reserve also uses the discount rate and imposes the minimum reserve requirement to influence the rate at which banks can lend money to each other. Through the discount window, the Federal Reserve can achieve its policy objective. The discount window essentially enables the banks to borrow funds or loans that are usually priced at the discount rate from the central bank (Discount Window, n.d: Para.1).
The reserve may lower or raise the discount rate to attract borrowing or discourage borrowing depending on the policy objective it seeks to achieve to bring financial stability in the market. When there is excess liquidity in the market the fed responds by selling its securities to the public through the capital market a move whose effect is to cut the monetary supply in the market.
Allocation of credit
Lending money to the financial institutions has the effect of enhancing the liquidity level as the institutions become empowered to replace their less liquid assets with those with higher liquidity. This method has been utilized by the Federal Reserve since late 2007 when the signs of recession started looming hence dealing a severe blow to the capital market. By giving a loan to an institution, it is directly allocating credit to it. This credit eventually finds its way into the capital market hence stimulating the trade volumes in the market.
The borrowed credit increases the position of the institution to lend money out which increases the amount of money in circulation. The effects of increased borrowing are usually offset by selling a proportionate number of securities through the open market operation which helps mop up excess liquidity in the market. The offsetting effect reallocates credit to the borrowing institution. In addition, if the FED makes a loan to a depository institution through a discount window facility and that which is offset by the open market operation, credit is thus reallocated to the financial institutions.
Regulation of monetary policy
Central banks all over the world play a key role in the regulation of monetary policies. They set interest rates to bring stability in the capital market in the respective markets (Spencer, n.d: p. 3). For example, the bank of England since 1997 was granted the power to control short-term interest rates to target the rate of inflation at 2.5% (Bhattacharjee & Holly, 2004: P. 2). It is however expected to perform this role in consultation with the monetary policy committee (MPC). It is also expected to maintain economic policy goals to prevent excessive fluctuations of output and inflation to avoid instability in the financial and capital market. Using the monetary policies, the central banks have the power to manipulate the market interest rates which leads to the change of interest rates offered by banks on short-term lending and deposits.
Supply of currency
The central bank is the sole supplier of the monetary base across the world. This monopoly of supply enables it to influence the financial market conditions through short-term interest rates (Monetary policy framework, 2004: Para. 4). If the central bank alters the rates of interest the market players react in a certain way which affects various economic variables such as the level of output and prices of goods and services in the short run.
However, in the long run, the market tends to readjust itself such that only the price level is affected leaving the major economic variables like output and employment unchanged. The long-term effects of inflation can be changed by the central banks’ policies. This ensures price stability which is crucial to improving the country’s economic welfare and the growth potential of an economy. Due to its ability to raise the cost of lending to banks, the commercial banks usually respond by passing on the cost of borrowing to their customers which affects the borrowing trends of the customers.
Stimulation of savings and investment
As a result of the variation in the interest rates by the central bank, the propensity to save, the spending habits, and investment decisions of the households tend to be affected. When the central banks’ monetary policy leads to an increase in interest rates, borrowing becomes expensive and thus unattractive to the households. They respond by cutting down on their consumption and investment plans as a result. Those who owe money to banks in terms of loans find it difficult to repay their loans due to relative expensiveness hence respond by postponing their consumption and investment decisions. This tends to weigh down on investment and output eventually hence adversely affecting the performance of firms which impacts negatively on the capital market.
In addition, the variations of interest rates tend to impact heavily on people’s expectations as a result of the resultant economic conditions caused by the policy. This affects the stock prices in the capital market and exchange rates in the financial market which affects the people’s wealth. As a result, consumption and investment decisions are affected. If the effects are negative to the households, they will react by reducing their consumption and cutting down on their investments while equity prices in the stock market tend to fall. The fall in asset prices can also lead to a decline in aggregate demand due to the fall in the value of people’s collateral which reduces their capacity to access loans from the banks. The decline in the value of collateral usually has the effect of making loans more expensive to acquire which then deters the borrowers from borrowing.
Stabilization of prices
A shift in consumption and investment patterns of households and companies as a result of the central bank’s monetary policy leads to a change in the aggregate demand concerning the supply of domestic goods and services. If the aggregate demand is higher than the supply ceteris paribus, the equilibrium price is shifted upwards. In the long run, when the aggregate demand shifts upwards firms get incentives to increase their output level which increases the demand for more labor. The change in demand for labor may lead to a change in the wage prices in the labor market.
On the other side, when the policy affects the exchange rate of the country, the level of inflation is usually affected in some way. An appreciation of the domestic currency is an effect of reducing the price of imports which in turn helps to contain the inflation if the imports are informed of consumer goods. Where the imports are in form of raw materials, the prices of the final goods decrease in the long run. However, the high exchange rate might pose a challenge to the competitiveness of the locally produced commodities in the international market as it causes these exports to be relatively expensive. This is because the appreciation of the local currency makes it more expensive to trade with. The effects of these changes are reflected in the movement of prices in the stock market.
Supervision of the financial market
The central bank also plays a supervisory role in any country’s banking system a role that helps to stabilize the financial market (Functions of Central Banks, n.d: Para. 1). They do this by monitoring the banking practices and evaluating their conduct against the benchmarks set by the banking regulations. This ensures that the level of confidence in the banking sector is not compromised which would have adverse effects on the banking system and the capital market and thereby the economy as a whole. If there are significant problems in the economy as a result of problems in the banking sector, the capital market is affected negatively as investors lose confidence in the economy.
Lender of last resort
The central bank acts as the ultimate render of funds to the financial market. Whenever there is a liquidity crisis in the market, the central bank is expected to support the financial market, according to Roubiuni (2007: Para.1). Lending during such a crisis becomes only effective if the support is meant to solve a liquidity crisis rather than an insolvency crisis.
Central banks play a vital role to ensure the success of the international capital market. Without their regulatory framework and the enabling environment they create, the capital market would not be able to carry out its mandate effectively. It is thus paramount that nations should create relevant structures within their systems that will enable the bank to play a more supportive role in the running of the capital market.
Bhattacharjee, A. and Holly, S. (2004) Inflation Targeting, Committee Decision Making, and Uncertainty: The case of the Bank of England’s MPC. Web.
Discount Window: What Does Discount Window Mean? (n.d.) Web.
Functions of Central Banks (n.d.). Web.
Monetary policy framework. (2001). Web.
Open Market Operations – OMO. (n.d.). Web.
Roubini, N. (2007) The Moral Hazard Effects of Recent Central Banks’ Liquidity Injections. Web.
Spencer, C. (n.d.) Reaction Functions of Bank of England MPC Members: Insiders versus Outsiders. Web.
Thornton, D. L. (n.d.) The Fed, Liquidity, and Credit Allocation, Federal Reserve Bank of ST. Louis Review. Web.