What is the difference between a central bank and a commercial bank?

A commercial bank is a private institution that accepts deposits and extends credit to households and businesses for profit. A central bank does not serve private customers: it is the bank for commercial banks and the government. Only the central bank may issue banknotes, set the policy interest rate for the entire banking system, and act as lender of last resort during crises. The central bank's liabilities — banknotes and reserve deposits — form the monetary base on which commercial banks build their lending.

What is the policy rate and how does it affect the economy?

The policy rate is the interest rate at which the central bank lends short-term funds to commercial banks. When the central bank raises the rate, borrowing becomes more expensive for banks, which in turn raise rates for businesses and households — consumption and investment fall, cooling inflation. Cutting the rate works in reverse: cheaper credit stimulates economic activity, though with the risk of higher inflation. The mechanism operates through several channels: the credit channel, asset price channel, exchange rate channel, and expectations channel.

Why is central bank independence considered important?

Without independence, a central bank may face political pressure — especially before elections — to print money or hold rates artificially low. This leads to inflation and a loss of confidence in the currency. IMF research confirms that countries with more independent central banks achieve lower and more stable inflation on average. The German hyperinflation of 1923 and the subsequent political commitment to an independent Bundesbank are the canonical historical lesson.

What is quantitative easing (QE) and when is it used?

QE is an unconventional monetary policy under which the central bank purchases assets — typically government bonds and mortgage-backed securities — at scale, injecting money into the economy. It is deployed when the policy rate has been cut to zero and traditional tools are exhausted. The Fed used QE extensively after the 2008 crisis and again in 2020; the ECB's Public Sector Purchase Programme ran from 2015–2018 and was relaunched in 2020. Whether QE primarily lifted growth or inflated asset prices remains debated.

What role does the National Bank of Ukraine play?

The NBU issues the hryvnia, sets the discount rate, regulates and supervises the banking sector, and manages foreign exchange reserves. In 2016 it adopted inflation targeting with a 5% ±1 p.p. target. In wartime, the NBU has also performed extraordinary functions: managing the exchange rate regime, maintaining financial stability under external aggression, and coordinating with international partners (IMF, EU) on reserve support.

Economic Terms

Central Bank

Updated At: June 10, 2026

What is a Central Bank?

A central bank is a public or quasi-public financial institution that sits at the apex of a country's banking system. It serves as the "bank of banks" and the "banker's bank," performing functions that no commercial bank can: issuing physical currency, conducting monetary policy, maintaining financial stability, and overseeing payment systems. Without a central bank, neither a stable currency unit nor a functional credit system is possible. The central bank is arguably the most powerful single institution in any modern market economy.

Core Functions

Currency issuance — the central bank holds a monopoly on issuing banknotes and coins, giving it control over the monetary base.
Monetary policy — through changes in interest rates, open-market operations, and reserve requirements, the central bank regulates the money supply to achieve price stability and, in some mandates, maximum employment.
Bank supervision and regulation — the central bank licenses commercial banks, sets capital and liquidity requirements, and examines their balance sheets.
Lender of last resort — during a banking panic or liquidity crisis, the central bank provides emergency loans to solvent banks, preventing the collapse of the financial system.
Foreign reserve management — the central bank holds and manages the country's foreign exchange and gold reserves, using them to support the exchange rate or service external debt.
Fiscal agent of the government — the central bank maintains government accounts, conducts auctions of government securities, and executes treasury payment orders.

History

The first modern central bank — Sweden's Riksbank — was founded in 1668 and remains the oldest continuously operating central bank in the world.

The Bank of England (1694) became the template for most subsequent central banks. Initially a private institution that lent money to the government in exchange for a note-issuance monopoly, it gradually evolved during the eighteenth and nineteenth centuries into a lender of last resort and monetary authority.

Banque de France was founded by Napoleon Bonaparte in 1800 to stabilise public finances after the Revolutionary upheaval.

The United States went without a central bank for much of its history. After a series of banking panics — especially the Panic of 1907 — Congress passed the Federal Reserve Act of 1913, creating the Federal Reserve System.

The twentieth century saw central banks proliferate globally. After both World Wars, newly independent states created central banks as symbols of sovereignty. The collapse of the Soviet Union in 1991 produced a fresh wave, including the National Bank of Ukraine. The 2008–2009 financial crisis transformed central banking: the Fed, ECB, Bank of Japan, and Bank of England deployed unconventional tools — quantitative easing, near-zero rates, massive asset purchases — far beyond textbook monetary policy.

Central Bank Independence

A key debate concerns the degree of central bank independence from government. Most economists and international bodies (IMF, World Bank) argue that independent central banks achieve better inflation outcomes, as they are less susceptible to short-term political pressure — for example, to keep rates artificially low ahead of elections.

Germany's Bundesbank (1957) and the European Central Bank (ECB, 1998) represent the strongest institutional expressions of independence: their statutes explicitly prohibit government budget financing. At the other extreme, the People's Bank of China is formally subordinate to the State Council, while the central banks of Turkey and Argentina have at times experienced political interference that contributed to elevated inflation.

Examples Around the World

USA — Federal Reserve System (the Fed), 1913; dual mandate: price stability and maximum employment.
Eurozone — European Central Bank (ECB), 1998, Frankfurt; sets monetary policy for 20 member states.
UK — Bank of England, 1694; targets inflation at 2%.
Japan — Bank of Japan, 1882; known for prolonged battles with deflation and zero/negative interest rates.
China — People's Bank of China (PBOC), 1948; manages the yuan under a managed float.
Ukraine — National Bank of Ukraine (NBU), 1991; adopted inflation targeting in 2016; target: 5% ±1 p.p.
Switzerland — Swiss National Bank (SNB), 1907; known for large-scale interventions to limit excessive franc appreciation.

Monetary Policy Instruments

1. Key policy rate — the rate at which the central bank lends to commercial banks. Rate increases raise the cost of credit, reducing demand and inflation; cuts stimulate growth.

2. Open market operations — buying or selling government securities to expand or contract the money supply.

3. Reserve requirements — the minimum fraction of deposits that banks must hold at the central bank.

4. Quantitative easing (QE) — large-scale asset purchases when the policy rate is already at zero.

Criticism

Left-wing critics argue that independent central banks are undemocratic institutions making decisions with profound effects on employment without electoral accountability. The Austrian school considers central banks the primary source of business cycles — by manipulating rates, they artificially inflate credit booms that end in crisis. Advocates of the gold standard argue that fiat currency gives central banks unchecked power that leads to long-run currency debasement.

Frequently Asked Questions

Economic Terms