A central bank is a public institution that manages a country's monetary system, acts as banker to the commercial banking system, and in most cases is the sole issuer of legal tender currency. Central banks sit at the apex of the financial system, and their decisions affect interest rates, inflation, employment, and economic growth across the entire economy.
The core functions of a central bank are well-established. Monetary policy — setting interest rates and controlling the money supply to achieve stable prices and sustainable growth — is the primary function. Issuing banknotes and coins, and maintaining confidence in the currency, is another. Supervising and regulating the banking system, and acting as lender of last resort to solvent but illiquid banks, are the third and fourth functions. Many central banks also manage the country's foreign exchange reserves and serve as the government's banker.
Countries have central banks because market economies cannot function without a credible, trusted institution managing the monetary system. Before central banks existed, private banks issued their own currencies, banking crises were frequent and severe, and there was no mechanism for providing emergency liquidity to prevent panic from cascading. The Bank of England, founded in 1694, is one of the oldest central banks and was originally created to help finance government debt after a military defeat.
The critical design feature of modern central banks is independence from short-term political pressure. Elected governments face incentives to stimulate the economy before elections (leading to higher inflation) and to avoid the pain of rate rises to control inflation. Independent central banks — whose governors are appointed for fixed terms and cannot be instructed by governments on monetary policy — are designed to resist these pressures and focus on price stability.
Research strongly supports the view that independent central banks produce lower and more stable inflation without sacrificing long-run economic growth.