Central Banks Defined and Explained

By Rebecca Lake · July 03, 2023 · 8 minute read

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Central Banks Defined and Explained

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.

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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.


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