Unlike the local bank where you may keep your checking account, central banks are responsible for implementing monetary policy. Some of the main activities of central banks include managing currency and controlling the money supply.
These are important responsibilities: Central banks aim to promote financial stability within a country or group of countries. They play an important role in the economy and within consumer banking. Without central banks, other banks couldn’t exist and operate.
While a lot of the work that central banks do happens behind the scenes, it can have far-reaching impacts on how you personally manage your money. Here, you’ll learn more, including:
• What is a central bank?
• What do central banks do?
• What are the pro?
What Is a Central Bank?
Central banks are public institutions that use monetary policy to navigate and manage economic changes. While commercial banks are largely concerned with providing banking products and services to customers, central banks take a broader focus.
So, what do central banks do?
The specific powers a central bank has may vary from one country to another. Generally speaking, central banks are responsible for:
• Effecting interest rate changes to manage monetary policy
• Setting targets for inflation rates to achieve price stability within an economy
• Adjusting the money supply, which can occur through the sale or purchase of securities on the open market
• Regulating interbank activities
• Loaning money to commercial banks in order to maintain solvency during a financial crisis
Most central banks operate independently of the government, which is intended to keep political influence out of decision-making processes. Understanding their function is important when establishing a working central bank definition.
What Is the Central Bank of the United States?
The Federal Reserve System or “Fed” is the central bank of the United States. The Fed operates to manage the economy and promote public interests. In terms of what the Federal Reserve does, its duties are concentrated in five distinct areas:
• Monetary policy. The Fed uses monetary policy to promote employment, create pricing stability, and manage interest rates. For example, when the economy is in danger of overheating, the Fed may raise rates to cool off inflation.
• Financial system stability. Risk management is another important task the Fed carries out. This is done through active monitoring of systemic risks that may endanger the U.S. economy, both domestically and abroad.
• Supervision and regulation. The Federal Reserve is also concerned with ensuring the safety and stability of individual financial institutions. It takes an active role in monitoring and regulating banks to minimize negative impacts on the financial system.
• Payment systems. Payment systems allow money to move through an economy. The Fed monitors payments systems to ensure that they’re safe and efficient so financial transactions can be facilitated.
• Consumer protection and community development. The Federal Reserve is also concerned with ensuring that consumers are protected against unfair banking processes and that attention is given to issues that may hinder consumers ability to get the financial services they need.
The Federal Reserve has three main parts: the Board of Governors, the Reserve Banks, and the Federal Open Market Committee (FOMC). While the Fed is independent, it works in conjunction with other agencies to manage economic policy, including the Department of the Treasury and the Federal Deposit Insurance Corporation (FDIC). There are 12 Federal Reserve banks with 24 branches that operate throughout the U.S.
History of Central Banks
Historically, central banking dates back centuries. A few highlights:
• In the 1600s, the Swedish Riksbank was founded. The bank, which was chartered in 1668, was designed to operate as a joint stock bank. Its functions included lending money to the government and acting as a clearinghouse for commercial transactions.
• In 1694, the Bank of England was founded for a similar purpose. This joint stock bank purchased government debt. These early central banks were soon followed by other central banks in other European countries, including the Banque de France which was established by Napoleon in 1800.
• The history of the Fed begins a little later, with its founding in 1913 through the passage of the Federal Reserve Act. The Act was passed in response to widespread instability within the banking system and the greater economy. Earlier attempts had been made to centralize banking following the end of the Revolutionary War but that goal was only fully realized with the creation of the Fed.
• Since its initial inception, the Federal Reserve’s powers and duties have expanded and evolved. The latest change occurred in 2010 with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act expanded the Fed’s supervisory responsibilities while also making its operations more transparent.
Today, central banks operate in countries around the world. For example, the European Central Bank manages monetary policy for countries that are part of the European Union and use the euro as their currency. The Reserve Bank of Australia is the central bank that controls monetary policy for the states and territories of Australia.
💡 Recommended: What Is a Bank Reserve?
Are Central Banks Effective?
Whether central banks are effective ultimately depends on the scope of powers they have, how they approach monetary policy, and the outcomes of that approach. If a central bank’s policies produce the intended result then, yes, they can be considered effective. On the other hand, if the end result is significantly different from what was intended, that could be an argument against the bank’s effectiveness. In other words, there is much variation in making this assessment.
In the U.S., for example, economists have argued for and against the effectiveness of the Federal Reserve’s decision to raise or cut interest rates at different points in time. The Fed’s rate hikes may attempt to curb inflation and keep the economy from burning out and plunging into what is known as a recession. Rate cuts, on the other hand, are designed to encourage spending and stimulate the economy.
Consider a specific example: In March 2022, the Fed began a series of rate hikes in an attempt to put the brakes on rising inflation. At that point in time, inflation hovered around 8%. By April 2023, the inflation rate had fallen to 5%. Based on the numbers, it would seem that the Fed’s policy is working. In general, the greater transparency there is around central banking, the more effective it may be.
Are There Downsides to Central Banks?
Central banks are not perfect, and there are some potential disadvantages associated with a central banking system. Here, what are central banks’ downsides:
• For example, how a central bank uses interest rates to control monetary policy can have a direct impact on consumers and businesses. When the central bank raises rates, borrowing becomes more expensive. On one hand, that’s a good thing if the end goal is to rein in consumer spending. However, if you’re trying to get a mortgage or you need a business loan to cover expenses, you’re going to pay more in interest for convenience of borrowing.
• The money supply is another issue. If a central bank has the authority to print money at will and artificially inflate the money supply, that can lead to devaluation of the currency. When a central bank also has the ability to purchase assets that can lead to an increase in a country’s national debt.
• Finally, there’s the question of regulation and accountability. If central banks are established and operated independent of government agencies, it can be difficult to draw a line on what the bank can or cannot do. That can open the door for central banks to take risks they might otherwise avoid when there’s no government oversight to keep them in check.
The Takeaway
Central banks help to keep economies balanced and stable, while providing a safe banking environment for consumers. The next time you’re swiping your debit card or logging in to online banking to pay bills, remember that central banking makes those activities possible.
3 Money Tips
- Banish bank fees. Open a new bank account with SoFi and you’ll pay no overdraft, minimum balance, or any monthly fees.
- When you overdraft your checking account, you’ll likely pay a non-sufficient fund fee of, say, $35. Look into linking a savings account to your checking account as a backup to avoid that, or shop around for a bank that doesn’t charge you for overdrafting.
- If you’re faced with debt and wondering which kind to pay off first, it can be smart to prioritize high-interest debt first. For many people, this means their credit card debt; rates have recently been climbing into the double-digit range, so try to eliminate that ASAP.
FAQ
What is the difference between a bank and a central bank?
A bank is a financial institution that accepts deposits and makes loans. Banks make it possible for their customers to move money from point A to B, and they can also pay interest on deposits. Central banks, however, play a larger role, overseeing monetary policy to ensure the smooth operation of a country’s economy.
What is the difference between a federal and a central bank?
A federal bank is a bank that operates under the regulation of a federal government. They receive their charter from the federal government, rather than a state government. Central banks typically operate independently of any government agency or institution.
What is a central bank and its function?
A central bank is a public institution that directs monetary policy within a country, state, or territory, or within a group of countries, states, and territories. The main function of a central bank is to promote financial and economic stability. Central banks do that by controlling the money supply and adjusting interest rates.
Photo credit: iStock/ismagilov
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SoFi® Checking and Savings is offered through SoFi Bank, N.A. ©2023 SoFi Bank, N.A. All rights reserved. Member FDIC. Equal Housing Lender.
The SoFi Bank Debit Mastercard® is issued by SoFi Bank, N.A., pursuant to license by Mastercard International Incorporated and can be used everywhere Mastercard is accepted. Mastercard is a registered trademark, and the circles design is a trademark of Mastercard International Incorporated.
SoFi members with direct deposit activity can earn 4.60% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Direct Deposit means a deposit to an account holder’s SoFi Checking or Savings account, including payroll, pension, or government payments (e.g., Social Security), made by the account holder’s employer, payroll or benefits provider or government agency (“Direct Deposit”) via the Automated Clearing House (“ACH”) Network during a 30-day Evaluation Period (as defined below). Deposits that are not from an employer or government agency, including but not limited to check deposits, peer-to-peer transfers (e.g., transfers from PayPal, Venmo, etc.), merchant transactions (e.g., transactions from PayPal, Stripe, Square, etc.), and bank ACH funds transfers and wire transfers from external accounts, do not constitute Direct Deposit activity. There is no minimum Direct Deposit amount required to qualify for the stated interest rate.
SoFi members with Qualifying Deposits can earn 4.60% APY on savings balances (including Vaults) and 0.50% APY on checking balances. Qualifying Deposits means one or more deposits that, in the aggregate, are equal to or greater than $5,000 to an account holder’s SoFi Checking and Savings account (“Qualifying Deposits”) during a 30-day Evaluation Period (as defined below). Qualifying Deposits only include those deposits from the following eligible sources: (i) ACH transfers, (ii) inbound wire transfers, (iii) peer-to-peer transfers (i.e., external transfers from PayPal, Venmo, etc. and internal peer-to-peer transfers from a SoFi account belonging to another account holder), (iv) check deposits, (v) instant funding to your SoFi Bank Debit Card, (vi) push payments to your SoFi Bank Debit Card, and (vii) cash deposits. Qualifying Deposits do not include: (i) transfers between an account holder’s Checking account, Savings account, and/or Vaults; (ii) interest payments; (iii) bonuses issued by SoFi Bank or its affiliates; or (iv) credits, reversals, and refunds from SoFi Bank, N.A. (“SoFi Bank”) or from a merchant.
SoFi Bank shall, in its sole discretion, assess each account holder’s Direct Deposit activity and Qualifying Deposits throughout each 30-Day Evaluation Period to determine the applicability of rates and may request additional documentation for verification of eligibility. The 30-Day Evaluation Period refers to the “Start Date” and “End Date” set forth on the APY Details page of your account, which comprises a period of 30 calendar days (the “30-Day Evaluation Period”). You can access the APY Details page at any time by logging into your SoFi account on the SoFi mobile app or SoFi website and selecting either (i) Banking > Savings > Current APY or (ii) Banking > Checking > Current APY. Upon receiving a Direct Deposit or $5,000 in Qualifying Deposits to your account, you will begin earning 4.60% APY on savings balances (including Vaults) and 0.50% on checking balances on or before the following calendar day. You will continue to earn these APYs for (i) the remainder of the current 30-Day Evaluation Period and through the end of the subsequent 30-Day Evaluation Period and (ii) any following 30-day Evaluation Periods during which SoFi Bank determines you to have Direct Deposit activity or $5,000 in Qualifying Deposits without interruption.
SoFi Bank reserves the right to grant a grace period to account holders following a change in Direct Deposit activity or Qualifying Deposits activity before adjusting rates. If SoFi Bank grants you a grace period, the dates for such grace period will be reflected on the APY Details page of your account. If SoFi Bank determines that you did not have Direct Deposit activity or $5,000 in Qualifying Deposits during the current 30-day Evaluation Period and, if applicable, the grace period, then you will begin earning the rates earned by account holders without either Direct Deposit or Qualifying Deposits until you have Direct Deposit activity or $5,000 in Qualifying Deposits in a subsequent 30-Day Evaluation Period. For the avoidance of doubt, an account holder with both Direct Deposit activity and Qualifying Deposits will earn the rates earned by account holders with Direct Deposit.
Members without either Direct Deposit activity or Qualifying Deposits, as determined by SoFi Bank, during a 30-Day Evaluation Period and, if applicable, the grace period, will earn 1.20% APY on savings balances (including Vaults) and 0.50% APY on checking balances.
Interest rates are variable and subject to change at any time. These rates are current as of 10/24/2023. There is no minimum balance requirement. Additional information can be found at https://www.sofi.com/legal/banking-rate-sheet.
SOBK0423019
