A central bank is an institution responsible for managing a country's or a group of countries' currency and regulating the money supply. Also known as reserve banks, central banks were established to prevent the financial instability that occurred in the past due to their absence, which led to economic booms and busts, including bank failures that wiped out people's savings.

The primary goal of many central banks is to maintain price stability. In some nations, central banks are legally obligated to support full employment as well.

A defining characteristic of a central bank is its legal monopoly, which allows it to issue banknotes and cash. Most central banks operate independently of the government and are viewed as politically neutral entities.

It is important to note that a central bank is not a commercial bank. Individuals cannot open accounts or deposit money at a central bank, nor can they request loans from it.

Central banks implement monetary policy using various tools to influence the money supply, interest rates on loans, and inflation rates. Inflation occurs when prices rise continuously, diminishing the purchasing power of a currency. While moderate inflation can indicate economic growth, excessive inflation can deter investment and lending, eroding the value of savings.

Deflation, the opposite of inflation, refers to a decrease in prices. Central banks strive to manage both inflation and deflation effectively.

Central banks serve as banks for commercial banks, influencing the flow of money and credit in the economy to achieve price stability. Commercial banks can borrow from central banks to meet short-term needs, providing collateral such as government or corporate bonds as a guarantee for repayment.

Commercial banks may encounter liquidity issues, where they have the funds to repay debts but lack the ability to convert them into cash quickly. In such cases, a central bank can act as a "lender of last resort," helping to maintain financial system stability.

In addition to monetary policy, central banks have various responsibilities, including issuing banknotes and coins, ensuring the smooth operation of payment systems, managing foreign reserves, and educating the public about economic conditions. Many central banks also oversee commercial banks to ensure they do not take excessive risks.

As the authority controlling a nation's monetary policy, central banks can either stimulate or slow economic growth. They maintain a reserve of cash that commercial banks can access for loans, with the cost determined by national interest rates.

If inflation rises, a central bank may increase interest rates, making loans more expensive for individuals. It might also halt money production or require commercial banks to purchase financial instruments, thereby reducing the money supply in the economy. This approach is known as contractionary monetary policy.

Conversely, if the economy is slowing, a central bank can lower interest rates, providing commercial banks with cheaper access to funds, which encourages borrowing by individuals and businesses. The central bank may also resume printing money, referred to as expansionary monetary policy.

Most central banks establish reserve requirements for commercial banks, mandating that they retain a certain percentage of their liabilities in cash to prevent insolvency. In countries without reserve requirements, such as the U.K., capital requirements are often used, based on the ratio of a bank's capital to its risk.

Central banks do not directly set the interest rates for savings accounts; instead, they establish a base interest rate. This base rate can be the rate at which commercial banks borrow from each other (as in the U.S. with the federal funds rate) or the rate at which they borrow from the central bank (as in the U.K. with the Bank Rate).

Central banks adjust interest rates to influence economic conditions. Lowering interest rates is referred to as "loosening monetary policy" or "easing," while raising rates is known as "tightening monetary policy." A central bank may reduce rates to stimulate the economy and increase them to control inflation when the economy is growing too quickly.

Lower interest rates can stimulate the economy in several ways: businesses can borrow to invest in profitable projects, lower rates can boost stock market values, and individuals may invest in assets that yield higher returns than low-interest savings accounts.

However, if economic growth accelerates too rapidly, inflation may rise to unstable levels, complicating future planning for households and businesses. To mitigate this risk, a central bank may raise interest rates to slow spending growth and stabilize inflation.

Central banks play a crucial role in currency markets due to their control over monetary policy. Their influence on the money supply directly affects currency demand and pricing.

Through various policies, central banks can attempt to manipulate currency markets to maintain their currency at desired levels. Some countries peg their currency to another currency or a basket of currencies, such as China and Hong Kong, which peg their currencies to the U.S. dollar.

Central banks can also engage in the forex market by buying and selling their currency to prevent excessive fluctuations. Additionally, they may aim to keep their local currency at a specific value to enhance the attractiveness of their economy for international trade.