To what extent the central bank is the lender of the last resort?
- As it lends to the government
- As it provides finance to agriculture
- As it is the ultimate source of credit in times of crisis
- As it controls the money supply in the economy
Correct Answer: As it is the ultimate source of credit in times of crisis
As it is the ultimate source of credit during times of crisis, the correct answer is (c). The central bank as the lender of last resort refers to its role in providing emergency liquidity and credit to financial institutions facing severe liquidity shortages during times of financial distress or crisis.
A central bank’s ultimate goal is to prevent systemic financial failures and maintain financial stability, acting as a backstop. In order to avoid bank runs and panics that can exacerbate economic instability, the lender of last resort function is crucial.
Why the other options are not correct
a. As it lends to the government:
Central banks manage government debt and may purchase government bonds as part of their monetary policy operations, but this does not fully represent the concept of a lender of last resort. As a lender of last resort, the central bank’s primary purpose is not to lend to the government, but to provide liquidity and credit support to financial institutions in times of crisis.
b. As it provides finance to agriculture:
Although central banks may have specific mandates relating to economic development and financing certain sectors, including agriculture, the lender of last resort role is not directly associated with these mandates.
In order to prevent systemic financial crises and ensure financial system stability, the central bank serves as the lender of last resort by providing emergency funding to financial institutions.
d. As it control the money supply in the economy:
Controlling the money supply in the economy is an important function of the central bank, but it does not define the role of lender of last resort solely. Among the broader responsibilities of the central bank is controlling the money supply so that macroeconomic goals, such as price stability and economic growth, can be achieved.
Even though the central bank’s actions regarding the money supply can affect the overall financial system, the lender of last resort function specifically addresses liquidity needs during crisis situations.
A central bank’s role as a lender of last resort is crucial in maintaining financial stability and preventing systemic financial failures in times of crisis. When financial institutions face severe liquidity shortages, the central bank provides liquidity and credit support to them as the ultimate source of credit.
Consequently, the financial system is stabilized and bank runs and panics are prevented, which can have broader economic consequences.
Its other functions, including managing government debt, supporting sectors like agriculture, and controlling the money supply, are essential aspects of its mandate, but they are distinct from its role as lender of last resort.
As the lender of last resort, the central bank acts as a safety net for financial institutions, instilling confidence in the system and ensuring that essential financial services can continue even in times of severe stress. Understanding this function will help policymakers and central banks better prepare and respond to financial crises, leading to a more stable and resilient financial system in the future.