The Rise of the Central Bank
Today the Central Bank is government owned but separate from the country's ministry of finance. Although the Central Bank is frequently termed the "government's bank" because it handles the buying and selling of government bonds and other instruments, political decisions should not influence Central Bank operations. Of course, the nature of the relationship between the Central Bank and the ruling regime varies from country to country and continues to evolve with time. To ensure the stability of a country's currency, the Central Bank should be the regulator and authority in the banking and monetary systems.
Between 1870 and 1914, when world currencies were pegged to the gold standard (GS), maintaining price stability was a lot easier because the amount of gold available was limited. Consequently, monetary expansion could not occur simply from a political decision to print more money, so inflation was easier to control. The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency; it issued notes based on a country's reserves of gold.
At the outbreak of WWI, the GS was abandoned, and it came apparent that, in times of crisis, governments, facing budget deficits (because it costs money to wage war) and needing greater resources, will order the printing of more money. As governments did so, they encountered inflation. After WWI, many governments opted to go back to the GS to try to stabilize their economies. With this rose the awareness of the importance of the central bank's independence from the political machine.
To increase the amount of money in circulation and decrease the interest rate (cost) for borro-wing, the Central Bank can buy government bonds, bills, or other government-issued notes. This buying can, however, also lead to higher inflation. When it needs to absorb money to reduce inflation, the Central Bank will sell government bonds on the open market, which increases the interest rate and discourages borrowing. Open market operations are the key means by which a central bank controls inflation, money supply, and price stability.
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