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Definition of a Central Bank:
A central bank
oversees and regulates a nation’s banking system, which means managing the flow of money and credit in the economy. The Federal Reserve is the central bank of the United States.
The central bank is commonly referred to as the bank’s bank. It provides banks with a check-clearing mechanism, which enables a store in Cary, North Carolina, that banks at First Bank of Cary to accept a $1,000 check from Second Bank of College Park, Maryland. The central bank (Fed) would deduct the money from Second Bank of College Park’s account and add it to First Bank of Cary’s account. (First Bank of Cary is responsible for adding the money to the store’s account, while Second Bank of College Park would deduct $1,000 from the buyer’s account.) A central bank is also responsible for regulating banks.
The central bank also lends to other banks, thereby providing liquidity to the economy. This is an essential tool to ward off panic following a bank run. In the United States, the central bank also acts as the government’s fiscal agent, which means the government deposits and withdraws money from the Federal Reserve.
The central bank determines and implements a nation’s monetary policy, which means it manages the economy’s flow of money and credit. The objective is usually to control inflation while growing the economy and increasing employment by manipulating the money supply to adjust interest rates and lending activity. Generally, interest rates are raised to slow the economy and lowered to accelerate economic growth. Usually, a central bank is independent to minimize political pressure.
Tools used by the Federal Reserve to control the United States’ money supply include:
- Setting the discount rate – The discount rate is the rate the Federal Reserve Banks charge commercial banks when they borrow. Increasing the discount rate discourages banks from borrowing from the Federal Reserve and slows the growth of the money supply. Reducing the discount rate increases the money supply.
- Setting the reserve requirement – The reserve requirement is the minimum percentage of deposits a bank or thrift must hold in its vaults or on deposit with the Federal Reserve Bank in its district. This money cannot be loaned or invested. Increasing the reserve requirement reduces the money available to lend, thereby reducing the money supply. Lowering the reserve requirement frees up money to lend and increases the money supply. Before March 26, 2020, the Federal Reserve required banks to maintain a minimum reserve of approximately 10 percent of their deposits. But the threat the COVID pandemic imposed on the economy convinced policymakers at the Fed to drop the reserve requirement to encourage lending and prevent a severe recession.
- Open market operations – Open market operations are used to finely tune the money supply by purchasing and selling government securities. The Federal Reserve buys Treasury securities to increase the money in circulation. It sells government securities when it chooses to reduce the money supply. During the 2008 financial crisis, the Federal Reserve added $4 trillion to the economy by purchasing government and mortgage-backed securities.
During recessions, a central bank uses expansionary monetary policy by pumping money into the economy to lower interest rates and make it easier for borrowers to secure credit. When the economy is overheated, it may strive to slow the economy by slowing the growth rate of the money supply and increasing interest rates.
Dig Deeper With These Free Lessons:
Monetary Policy – The Power of an Interest Rate
Fractional Reserve Banking and The Creation of Money
Gross Domestic Product – Measuring an Economy's Performance
Fiscal Policy – Managing The Economy By Taxing and Spending