A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services, including economic research. Its goals are to stabilize the nation's currency, keep unemployment low, and prevent inflation.
Learn more about how central banks carry out these goals, their origins, and what critics have to say.
Definition and Example of a Central Bank
Though they may be established by a governing body, central banks are independent authorities. They have a number of duties related to monetary policy, providing financial services, regulating lower banks, and conducting research. Central banks aim to keep a nation's currency and economy stable.
Most central banks are governed by a board consisting of its member banks. The country's chief elected official appoints the directors. The national legislative body approves them. That keeps the central bank aligned with the nation's long-term policy goals. At the same time, it's free of political influence in its day-to-day operations. The Bank of England first established that model. The U.S. Federal Reserve is another example.
How Central Banks Work
Central banks affect economic growth by controlling the liquidity in the financial system. They have three monetary policy tools to achieve this goal.
First, they set a reserve requirement. It's the amount of cash that member banks must have on hand each night. The central bank uses it to control how much banks can lend.
Second, they use open market operations to buy and sell securities from member banks. It changes the amount of cash on hand without changing the reserve requirement. They used this tool during the 2008 financial crisis. Banks bought government bonds and mortgage-backed securities to stabilize the banking system. The Federal Reserve added $4 trillion to its balance sheet with quantitative easing. It began reducing this stockpile in October 2017.
Third, they set targets on interest rates they charge their member banks. That guides rates for loans, mortgages, and bonds. Raising interest rates slows growth, preventing inflation. That's known as contractionary monetary policy. Lowering rates stimulates growth, preventing or shortening a recession. That's called expansionary monetary policy. The European Central Bank lowered rates so far that they became negative.
Monetary policy is tricky. It can take over a year for it to have its full effects on the economy.
Banks can misread economic data, as the Fed did in 2006. It thought the subprime mortgage meltdown would only affect housing. It waited to lower the fed funds rate. By the time the Fed lowered rates, it was already too late.
Central banks regulate their members. They require enough reserves to cover potential loan losses. They are responsible for ensuring financial stability and protecting depositors' funds.
In 2010, the Dodd-Frank Wall Street Reform Act gave more regulatory authority to the Fed. It created the Consumer Financial Protection Agency. That gave regulators the power to split up large banks, so they don't become "too big to fail." It eliminates loopholes for hedge funds and mortgage brokers. The Volcker Rule prohibits banks from owning hedge funds. It bans them from using investors' money to buy risky derivatives for their own profit.
Dodd-Frank also established the Financial Stability Oversight Council. It warns of risks that affect the entire financial industry. It can also recommend that the Federal Reserve regulate any non-bank financial firms.
Dodd Frank keeps banks, insurance companies, and hedge funds from becoming too big to fail.
Providing Financial Services
Central banks serve as the bank for private banks and the nation's government. They process checks and lend money to their members.
Central banks store currency in their foreign exchange reserves. They use these reserves to change exchange rates. They add foreign currency, usually the dollar or euro, to keep their own currency in alignment. That's called a peg, and it helps exporters keep their prices competitive.
Central banks also regulate exchange rates as a way to control inflation. They buy and sell large quantities of foreign currency to affect supply and demand.
Most central banks produce regular economic statistics to guide fiscal policy decisions. Here are examples of reports provided by the Federal Reserve:
- Beige Book: A monthly economic status report from regional Federal Reserve banks
- Monetary Policy Report: A semiannual report to Congress on the national economy
- Consumer Credit: A monthly report on consumer credit
Criticism of Central Banks
If central banks stimulate the economy too much, they can trigger inflation. Central banks avoid inflation like the plague. Ongoing inflation destroys any benefits of growth. It raises prices for consumers, increases costs for businesses, and eats up any profits. Central banks must work hard to keep interest rates high enough to prevent it.
Politicians and sometimes the general public are suspicious of central banks. That's because they usually operate independently of elected officials. They often are unpopular in their attempt to heal the economy. For example, Federal Reserve Chairman Paul Volcker (served from 1979 to 1987) sent interest rates skyrocketing. It was the only cure for runaway inflation. Critics lambasted him. Central bank actions are often poorly understood, raising the level of suspicion.
Here are a few of the more notable events in central bank history:
- Sweden created the world's first central bank, the Riksbank, in 1668.
- The Bank of England came next in 1694.
- Napoleon created the Banquet de France in 1800.
- Congress established the Federal Reserve in 1913.
- The Bank of Canada began in 1935.
- The German Bundesbank was re-established after World War II.
- In 1998, the European Central Bank replaced all the eurozone's central banks.
- A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services.
- Central banks have three monetary policy tools at hand, including reserve requirements, open market operations, and target interest rates.
- The Consumer Financial Protection Agency was established under the Dodd-Frank Act to give the Fed more regulatory authority.
- Central banks serve a nation's government and private banks. They also manage exchange rates and foreign currency.
- Critics of central banks are wary of their power over interest rates and the potential to cause high inflation.
Frequently Asked Questions (FAQs)
Where is the central bank of the United States located?
The Federal Reserve's Board of Governors is based in Washington, D.C., but its banks are spread around the country, representing 12 regions. These banks are located in:
- Kansas City, Missouri
- New York
- Richmond, Virginia
- St. Louis
- San Francisco
How do central banks increase the money supply?
Central banks increase the money supply through various types of monetary policy. In the U.S., that typically involves the Fed buying securities through open market operations, which gives banks more money to lend. It can also change reserve requirements for banks, adjust the rates it pays for excess reserves, and lower the Fed funds rate, which determines how much banks charge each other for overnight lending.