A central bank is an organization that primarily manages a monetary system. The term often refers to the central bank for a country (or a group of countries like the European Union), but not every governing body uses a central bank.
The duties of a central bank vary from country to country. For example, a central bank might have a goal of “maintaining price stability,” which means (among other things) limiting how quickly prices rise over time due to inflation. Banks often have to juggle competing goals. For example, a bank might also be charged with keeping unemployment low.
Some of the techniques used to fight unemployment, including keeping interest rates low and promoting lending, might cause inflation to move higher than expected.
The central bank of the U.S. is the Federal Reserve System. Created by Congress in 1913, “the Fed” is made up of public and private participants—some appointed by government officials, and others operating in the private sector (in other words, they may be businesses). Input from both public and private interests ideally enables The Fed to operate without too much influence from lawmakers. The Fed serves the interests of the public, and the participants are supposed to represent the public’s voice.
The Fed’s main priority or “mandate” (the goal it is charged with pursuing) is to:
- Keep prices stable (or keep inflation low), and
- Keep people employed (or keep unemployment low)
These two goals are known as a “dual mandate,” which can be a delicate balance. The Fed performs other duties and has additional goals. All the while, the Fed aims to keep the economy growing as it juggles all of its responsibilities.
How the Fed Functions
The U.S. central bank functions in three separate ways.
The Fed’s primary responsibility is to manage the economy by conducting monetary policy. To do so, the Fed can increase or decrease the supply of money in the system. There are three tools for altering the money supply:
- Open market operations: The Fed can buy and sell securities to other banks in order to supply (or absorb) cash. When the Fed buys securities, it injects cash into the system.
- Managing the discount rate: The Fed can make it easier or harder to borrow by lowering or raising interest rates. The Fed does not decide how much you earn in your savings account or how much interest you pay on a loan. Still, the Fed’s actions have an indirect influence on your rates. When you hear that the Fed cut or raised interest rates, it’s a signal that the Fed wants to adjust the pace of economic activity.
- Managing reserve requirements: The Fed can change the amount that banks need to keep internally. When banks are required to hold more buffer funds, they have less money to lend (which may slow down economic growth).
The Fed also regulates banks (the banks that businesses and individuals make deposits to and borrow from) with the goal of maintaining a healthy and fair banking system. By limiting the risks that banks can take and protecting consumers, the Fed aims to avoid the types of problems that arose in the 2008 financial crisis.
Finally, the Fed helps banks conduct business, acting as an intermediary in many transactions. Without the Fed, electronic payments (such as wire transfers and ACH payments) would look much different. The Fed also helps banks clear checks, moving the funds from one institution to another.
The Fed acts as a bank to other banks. Most individual consumers and businesses do not interact with the central bank.
The actions—and even the existence—of central banks cause a significant amount of debate.
On the one hand, some people think that central banks provide valuable services: They protect consumers, facilitate trade, and help to keep the economy running more or less smoothly.
Others take the view that central banks do the opposite. They can interfere with free trade and economic forces that would otherwise play out and create a balanced system. Critics argue that central banks ultimately create unintended consequences that are worse than the problems being solved.
The U.S. central bank, the Fed, is supposed to be a politically-neutral organization focused on price stability, moderate growth, and employment. Ideally, politicians have no say in how the Fed impacts the economy, and the Fed is supposed to be accountable to Congress and the voters.