About central banking
National central banks as separate institutions primarily developed from a need to regulate and arrange currency circulation (cash and non-cash issues) in a state and loan relations between banks. The primary function of Eesti Pank as a traditional central bank is to maintain a stable price level. Eesti Pank also performs other main functions of a central bank: regulating cash circulation; supporting and organising the delivery of transfers from one commercial bank to another; contributing to ensuring financial stability; managing Estonia’s external reserves; producing statistics for the financial sector and balance of payments; and advising the government on matters of the economic policy of Estonia and the euro area.
The independence of the decisions of the central bank requires material independence
To perform its functions, the central bank has to be independent of the government, because the government may be tempted to print more money to cover its expenses. This would lead to a price increase or inflation, controlling which is the primary duty of the central bank.
At the same time, monetary policy can be independent of current policies only if the central bank is not a bank or wallet of the government. The independence of the central bank cannot be absolute, but the law must set out the bank’s objectives on which the framework of its activities and liability depend. In Estonia the activities of the central bank are regulated by the Bank of Estonia (Eesti Pank) Act, and the central bank reports to the Riigikogu.
The primary function of the central bank is to maintain the purchasing power of money or price stability
The function of the central bank is to maintain price stability, i.e. to ensure the stability of money and money circulation. Price stability means that inflation is predictable and low in the medium-term. This means for Eesti Pank (as well as for the national central banks of the other 17 countries in the euro area) that the purchasing power of the euro is preserved. This is necessary so as to enable 331 million residents and companies in the euro area to make daily economic decisions reasonably and be relatively confident in the future value of the euro.
Monetary policy does not have to affect relative prices – for example, how much the price of food changes. If the price of food increases but other consumer goods fall in price and, in summary, the average price rise is low, the central bank is not required to increase interest rates.
A prerequisite for price stability is well-functioning banking
Eesti Pank can only perform its primary function – to maintain price stability – if national banking runs smoothly. This also helps preserve the trust of people and companies in the central bank and commercial banks. Such trust is a prerequisite for the successful implementation of monetary policy. With its activities the central bank supports the smooth operation of banking and a guarantee of reliability, keeping the risks of the system as low as possible and increasing the efficiency of the system. The functioning of banking as a whole must be as transparent and comprehensible as possible.
Safe and fast interbank settlements represent a cornerstone of financial stability
The functioning of settlement systems is crucial in terms of financial stability. The duty of Eesti Pank is to ensure that payments move quickly and safely from one bank to another. Thus, Eesti Pank is liable for the smooth circulation of virtual money. This also means an obligation to update the Estonian payment environment to ensure its flexibility and reliability.
The central bank has the exclusive right to issue cash
In addition to virtual money circulation, the central bank ensures smooth cash circulation. To that end, Eesti Pank equips all credit and payment institutions using cash in Estonia with banknotes and coins. Through banks, money reaches the wallets of companies and individuals. Money moves back from them to Eesti Pank, where all banknotes are inspected as part of automatic checks and damaged or worn-out banknotes are removed.
The central bank maintains the value of money through its reserves and manages itself
To ensure that people trust money, its value and stability must be maintained. This function is performed by the reserves of central banks. In addition to maintaining the stability of money, currency reserves also play an important role in preserving the reliability of the national economy and often in ensuring the stability of the financial system.
Eesti Pank follows conservative principles when investing assets, keeping in mind the preservation and sufficient liquidity of assets (exchange of bonds and other financial instruments for money in a short time without affecting market prices), but also their performance.
The investment revenue earned from asset management covers the daily expenses of the activities of the central bank. In such a way the independence of central banks from the state budget is ensured. The independence of central banks is considered essential around the world, because in the long term it helps guarantee a more stable economic policy in a country where political decisions do not directly influence monetary policy decisions. By a resolution of the Supervisory Board, Eesti Pank assigns part of its earned profit to the state budget of Estonia.
Eesti Pank uses statistics to produce economic analyses
Eesti Pank collects statistics to analyse the Estonian economy and the impact of economic decisions. Economic analyses make it possible to evaluate the health of the national economy. Just as every family and company and the government has to keep an eye on its income and expenses, the revenue and expenditure of the country as a whole (government, individuals and companies) must also be monitored. Information about economic transactions (purchases and sales) and investments is important and Eesti Pank keeps the corresponding records.
In addition, the central bank collects detailed statistics about the financial sector to assess the stability and risks thereof and to make monetary policy analyses.
The central bank advises the government on matters of economic policy
Eesti Pank supports the development of the Estonian economy by advising the government on economic matters. Thanks to its independence and the constant production of economic analyses, the central bank has an integral view of the Estonian economy, which is why it is the best adviser to the government on matters of economic policy. However, in the long term, government policy also influences the work of the central bank. Namely, the functioning of the monetary system depends on several factors, including those not under the control of the central bank. For example, the state’s budget policy plays a role in how monetary policy affects the economy, including price formation. It is therefore logical that the government seeks and receives advice from the central bank regarding how the budget policy influences price stability and takes this into account when planning the budget.
As Estonia belongs to the euro area, Eesti Pank is obliged to support the economy of the euro area. It is important to cooperate with other central banks and several international organisations (e.g. the International Monetary Fund and European Commission) in doing so. Close and confident domestic and international cooperation makes it possible to ensure that the interests of Estonia as a small country are jointly represented outside Estonia and that the economic activities of the country are as uniform as possible.