A central bank or reserve bank is a public institution that controls a state’s currency, money supply, and interest rates. Central banks usually control the commercial banking system of their countries. Compare to a commercial bank, a central bank have a monopoly on increasing the amount of money in the nation, and usually also prints the national currency, which usually serves as the nation’s legal tender.
The primary function of a central bank is to manage the nation’s monetary policy, with active duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended to prevent bankrupts and to reduce the risk that commercial banks and other financial institutions engage in fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political interference.
Functions of a central bank may include implementing monetary policies, determining interest rates, controlling the nation’s entire money supply, the Government’s banker and the bankers’ bank, managing the country’s foreign exchange and gold reserves and the Government’s stock register, regulating and supervising the banking industry, setting the official interest rate and ensuring that this rate takes effect via a variety of policy mechanisms. Central banks follow a country’s chosen monetary policy.
At the most basic level, this involves establishing what form of currency the country may have, whether a fiat currency, gold-backed currency, currency board or a currency union. Federal Reserve Bank Federal Reserve Bank, also known as FED or Federal Reserve System is created on December 23, 1913. It was founded for responding to a series of financial panics, particularly a severe panic in 1907. The seven-member Board of Governors is a federal agency. It is charged with the overseeing of the 12 District Reserve Banks and setting national monetary policy. It also supervises and regulates the U.S. banking system in general.
Governors are appointed by the President of the United States and confirmed by the Senate for staggered 14-year terms. The Chairman and Vice Chairman of the Board of Governors are appointed by the President from among the sitting Governors. They both serve a four-year term and they can be chosen as many times as the President chooses, until their terms on the Board of Governors expire. There are 12 Federal Reserve Banks located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St Louis, Minneapolis, Kansas City, Dallas, and San Francisco.
Each reserve Bank is responsible for member banks located in its district. The size of each district was set based with the population distribution of the United States. Each regional Bank has a president, who is the chief executive officer of their Bank. Each regional Reserve Bank’s president is chosen by their Bank’s board of directors. Presidents serve five-year terms and may be reappointed. The primary aim for creating the Federal Reserve System was to address banking panics.
Other purposes are stated in the Federal Reserve Act, such as “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes”. Before the founding of the Federal Reserve System, the United States underwent several financial crises. A particularly severe crisis in 1907 led Congress to enact the Federal Reserve Act in 1913. The Government’s Bank The Federal Reserve acts as the banker for the U. S. government. In this role, the Federal Reserve maintains the Treasury Department’s checking account and clears U.
S. Treasury checks. The Fed processes a wide range of electronic payments for the government, such as Social Security and payroll checks. The Fed also issues, transfers, and redeems U. S. Treasury securities and conducts Treasury securities auctions. Depository institutions send food stamps to the Federal Reserve for processing and redemption. The Fed as Regulator The Federal Reserve and state and federal agencies supervise and regulate the nation’s financial institutions to ensure their financial soundness and compliance with banking, consumer, and other applicable laws.
The Fed also has responsibilities for writing rules and enforcing a number of major laws that protects customers. Some examples of Federal Reserve regulations are: Truth in Lending: ensures that accurate information about the cost of credit is available to consumers. Equal Credit Opportunity: prohibits discrimination in lending. Home Mortgage Disclosure: requires depository institutions to disclose the geographic distribution of their mortgage and home improvement loans.
Electronic Fund Transfer: It identifies the rights, liabilities, and responsibilities of consumers and financial institutions for electronic transfer services, such as automated teller machines (ATMs). Community Reinvestment: It encourages depository institutions to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. The Fed as Lender The Federal Reserve provides credit to depository institutions to help them adjust to temporary, unexpected changes in their deposits or loan portfolios. The Fed also helps institutions that have seasonal or emergency needs for credit.
The Fed serves as the lender of last resort to the nation’s banks. During business downturns, the Fed may assist banks that are basically healthy but need help to see them through temporary credit problems. The Fed’s Role in Monetary Policy The country’s economic performance is influenced by many factors; economic performance abroad, fiscal policy determined by the government, and monetary policy carried out by the Federal Reserve. The Federal Reserve’s most critical role is to keep the economy healthy through the proper application of monetary policy.
The objective of monetary policy is to influence the country’s economic performance to promote stable prices, maximum employment, and a steady economic growth. The Fed’s monetary policy actions affect prices, employment, and economic growth by influencing the availability and cost of money and credit in the economy. This automatically affects consumers’ and businesses’ willingness to spend money on goods and services. The Fed’s instruments for monetary policy are: Open Market Operations The Fed’s most flexible and often-used tool of monetary policy is its open market operations for buying or selling government securities.
The Federal Open Market Committee (FOMC) sets the Fed’s monetary policy, which is carried out through the trading desk of the Federal Reserve Bank of New York. If the FOMC decides that more money and credit should be available, it directs the trading desk in New York to buy securities from the open market. The Fed pays for these securities by crediting the reserve accounts of banks involved with the sale. With more money in these reserve accounts, banks have more money to lend, interest rates may fall, and consumer and business spending may increase, encouraging economic expansion.
To tighten money and credit in the economy, the FOMC directs the New York trading desk to sell government securities, collecting payments from banks by reducing their reserve accounts. With less money in these reserve accounts, banks have less money to lend, interest rates may increase, consumer and business spending may decrease, and economic activity may slow down. The Discount Rate The discount rate is the interest rate a Reserve Bank charges eligible financial institutions to borrow funds on a short-term basis.
Unlike open market operations, which interact with financial market forces to influence short-term interest rates, the discount rate is set by the boards of directors of the Federal Reserve Banks, and it is subject to approval by the Board of Governors. Under some circumstances, changes in the discount rate can affect other open market interest rates in the economy. Changes in the discount rate also can have an announcement effect, causing financial markets to respond to a potential change in the direction of monetary policy.
A higher discount rate can indicate a more restrictive policy, while a lower rate may be used to signal a more expansive policy. Reserve Requirements By law, financial institutions, whether or not they are members of the Federal Reserve System, must set aside a percentage of their deposits as reserves to be held either as cash on hand or as reserve account balances at a Reserve Bank. The Federal Reserve sets reserve requirements for all commercial banks, savings banks, savings and loans, credit unions, and U. S. branches and agencies of foreign banks.
Depository institutions use their reserve accounts at Federal Reserve Banks not only to satisfy reserve requirements, but also to process many financial transactions through the Federal Reserve, such as check and electronic payments and currency and coin services. Changing reserve requirements is rarely used as a monetary policy tool. However, reserve requirements support the implementation of monetary policy by providing a more predictable demand for bank reserves, which increases the Fed’s influence over short-term interest rate changes when implementing open market operations.