Central Bank

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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.

Detailed Explanation:

The central bank, commonly known as the “bank’s bank,” provides a vital check-clearing mechanism that facilitates bank transactions. For instance, a store in Cary, North Carolina, banking at First Bank of Cary, can accept a $1,000 check from Second Bank of College Park, Maryland. The central bank (Fed) deducts the amount from the Second Bank of College Park’s account and credits it to the First Bank of Cary’s account. (First Bank of Cary is responsible for crediting the store’s account, while Second Bank of College Park debits $1,000 from the buyer’s account.) Additionally, the central bank plays a crucial role in regulating banks.

Another critical function of the central bank is providing liquidity to the economy by lending to other banks, particularly during periods of financial instability like a bank run. In the United States, the central bank also serves as the government’s fiscal agent, handling deposits and withdrawals from the Federal Reserve. 

The central bank is tasked with determining and executing a nation’s monetary policy by managing the economy’s flow of money and credit. Typically, the goal is to control inflation, promote economic growth, and increase employment by manipulating the money supply to adjust interest rates and lending activity. Central banks like the Federal Reserve often operate independently to minimize political pressure. 

Tools employed 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. Increasing the reserve requirement restricts lending, reducing the money supply, while lowering it has the opposite effect. During the COVID-19 pandemic, the Federal Reserve dropped the reserve requirement to encourage lending and prevent a severe recession. 
  • Open market operationsOpen market operations are used to fine-tune the money supply by buying and selling government securities. Purchasing Treasury securities injects money into circulation while selling them reduces 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, central banks implement expansionary monetary policies by injecting money into the economy to lower interest rates, making credit more accessible. Conversely, when the economy is overheated, efforts focus on slowing the economy by restraining 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
Business Cycles
Gross Domestic Product – Measuring an Economy's Performance
Fiscal Policy – Managing The Economy By Taxing and Spending

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