What is the Central Bank?

Central Bank Overview

US Federal Reserve Building, Washington DC
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A central bank is an organization that primarily manages a monetary system. The term usually refers to the central bank for a country (or a group of countries like the European Union), but not every country uses a central bank.

Goals

The duties of a central bank vary from country to country. For example, the 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 – but some of the techniques used to fight unemployment might cause unwanted inflation.

The Fed

The central bank of the United States is the Federal Reserve System. Created by Congress on December 23, 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 are businesses). This mixture of public and private interests is supposed to allow The Fed to operate without too much influence from lawmakers (but still serve the interests of the public).

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.” the Fed is supposed to keep the economy growing while juggling the goals above.

At the same time, the Fed performs other duties.

How the Fed Functions

The US central bank functions in three separate ways.

Monetary policy: again, the Fed’s main responsibility is to (attempt to) manage the economy by conducting monetary policy. To do this, the Fed increases or decreases the supply of money in the system.

There are three tools for doing so:

  • Open market operations: the Fed can buy and sell securities to other banks in order to supply (or absorb) cash.
  • 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), but those rates are indirectly influenced by Fed actions.
  • Managing reserve requirements: the Fed can change the amount that banks need to keep internally. When banks are required to hold more, they can lend less (which tends to slow down economic growth).

Bank supervision: 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 hopes to avoid the types of problems that arose in the 2008 financial crisis.

Financial services: 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 is acts as a bank to other banks – most individual consumers and businesses do not interact with the central bank.

Controversy

The actions (and even the existence) of central banks are the subject of much debate. Some people think that these institutions provide valuable services: protecting consumers, facilitating trade, and helping to keep the economy running more or less smoothly. Others take the view that central banks interfere with free trade and create unintended consequences that are worse than the problems being solved.