Updated Jun 26, 2020Central banks are independent national institutions that provide financial and banking services. One of their main focuses is monetary policy, i.e. the regulation of money supply within a nation’s economy. Monetary policy is necessary to control inflation and ensure the stability of the financial system. Thus, central banks such as the Federal Reserve, the European Central Bank, and the Bank of England play an important role in both a national and global level. In the following paragraphs, we will look at the connections between central banks and monetary policy in more detail.
Monetary Policy
As we learned, monetary policy is one of the main tasks of all central banks. They are supposed to increase or decrease the amount of currency in circulation, depending on what’s best for the economy. In other words, they can literally print new money, or collect existing money and hide it in their vaults. This is possible because most economies today rely on fiat currency and the central banks are authorized by the government to distribute and collect that currency.
An increase in money supply (i.e. an expansionary monetary policy) stimulates economic activity, whereas a decrease in money supply (i.e. a contractionary monetary policy) slows the economy down. Central banks generally have three main tools of monetary control: (1) open-market operations, (2) the interest rate and (3) reserve requirements for commercial banks. Open-market operations describe the process of buying and selling government bonds in the open market. Meanwhile, the interest rate and reserve requirements define the conditions at which commercial banks are able to borrow money from the central banks.
It is important to note that despite their powerful position, central banks are only in indirect control of the overall money supply. This is due to the fact that the largest part of the total money supply is in fact created by commercial banks through so-called fractional reserve banking. A system that allows commercial banks to lend more money than they actually have and thereby increase the money supply (see also Money Multiplier).
Example: The Federal Reserve System
Now that we are familiar with central banks and monetary policy, let’s look at a specific example: the Federal Reserve System.
The Federal Reserve is the central bank system of the United States. It was founded in 1913 and consists of 12 regional Federal Reserve Banks located across the country. There is one regional bank for each district: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Luis, Minneapolis, Kansas City, Dallas, and San Francisco.
These districts operate independently but are supervised by the Federal Reserve Board of Governors. The seven members of this board are appointed by the President. They can serve up to 14 years (i.e. one term). This is considerably longer than most other public appointments. The idea behind this is to minimize members’ vulnerability to political pressure.
The Federal Reserve performs five general functions in the US: (1) it conducts the nation’s monetary policy, (2) it promotes the stability of the financial system, (3) it promotes safety and soundness of financial institutions, (4) it fosters payment and settlement system safety and efficiency, and (5) it promotes consumer protection and community development.
In a Nutshell
Central banks are independent national institutions that provide financial and banking services. They play an important role when it comes to monetary policy. With a number of different tools, they are capable of increasing or decreasing money supply to expand or contract economic activity. However, their control is only indirect, because most of the money within the economy is actually created by commercial banks through fractional reserve banking.
