Monetary and central bank

A central bank, reserve bank, or monetary authority is an institution that manages a state’s currency, money supply, and interest rates. Central banks also usually oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses 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. [1][2] Examples include the European Central Bank (ECB) and the Federal Reserve of the United States.

[3] The primary function of a central bank is to manage the nation’s money supply (monetary policy), through 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 bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political interference.

In most cases they are not public, in the sense that they are neither state-owned nor directly regulated by government, parliament or another elected body. [4][5] Still, limited control by the executive and legislative bodies usually exists [6] . [7] The chief executive of a central bank is normally known as the Governor, President or Chairman. Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.

[1][2] The official goals usually include relatively stable prices and low unemployment. Monetary economics provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.

Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values. Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing. [3] What It Is: Monetary policy is the means by which the Federal Reserve manipulates the U. S. money supply in order to influence the U. S. economy’s overall direction, particularly in the areas of employment, production, and prices. How It Works/Example:

Monetary policy is not the same as fiscal policy, which is carried out through government spending and taxation. To understand monetary policy, it is important to understand a bit about the Federal Reserve, which is the central bank of the United States. The Federal Reserve is a bank for banks. It has several branches around the U. S. hold deposits for and lend to banks. As a means of ensuring the safety of the nation’s financial institutions, the Federal Reserve requires banks to keep a strict percentage of their deposits on reserve at a Federal Reserve bank.

The Federal Reserve determines the appropriate percentage, called the reserve requirement. If a bank is unable to meet its reserve requirement, it can borrow from the Federal Reserve to meet the requirement. The interest rate on these funds is called the discount rate. (Banks can also borrow the excess reserves of other banks, and this interest rate, called the federal funds rate, is determined by the open market. The Federal Reserve works to keep the discount rate close to the federal funds rate. ) Now, let’s assume that policymakers feel employment is too low and interest rates are too high.

The Federal Reserve could enact expansionary monetary policy and encourage economic growth by doing one or all of these three things: Direct the Federal Open Market Committee (FOMC) to purchase U. S. Treasuries on the open market Lower the reserve requirement Lower the discount rate Each of these choices increases the supply of money and creates a chain reaction. For example, when the FOMC (an agent of the Federal Reserve) purchases U. S. Treasuries in the open market, it gives money to the sellers. The sellers deposit these payments at their local banks.

The banks then lend most of these new deposits to other bank customers and earn interest. These customers in turn deposit the loan proceeds in themit own bank accounts, and the process continues indefinitely. Thus, every dollar of securities that the Federal Reserve buys increases the money supply by several dollars. This in turn lowers the lending rate as there is more supply of loanable monies, thus encouraging growth. Likewise, if the Federal Reserve lowers the reserve requirement, more of a bank’s deposits become available for lending.

This increase in the supply of available funds lowers the price of those funds (i.e. , the lending rate), making debt cheaper and more enticing to borrowers. With money being cheaper to borrow, individuals and companies are more likely to take out loans to build and improve, thereby growing the economy. Additionally, if the Federal Reserve lowers the discount rate, it becomes cheaper for banks to borrow money from the Fed, thus making it cheaper to lend to customers. This leads to the same outcome as both purchasing Treasuries and lowering the reserve requirement. Now consider what would happen if policymakers felt employment was too high and interest rates were too low.

This may sound attractive, but it is a recipe for runaway inflation. If the Federal Reserve wants to encourage an economic slowdown (that is, implement restrictive monetary policy), it can do one or all of these three things: Direct the FOMC to sell U. S. Treasuries on the open market Raise the reserve requirement Raise the discount rate When the FOMC offers Treasury securities for sale, it bids up interest rates in order to entice investors, who take money out of their bank accounts to buy the Treasuries. This leaves less money in the banking system, which means banks have less money to lend.

With less money to lend, the price (that is, the interest rate) on the remaining loanable funds increases, which in turn makes car loans, mortgages, and credit card purchases more expensive. This slows down demand and lowers prices across the economy. If the Federal Reserve increases the reserve requirement (which leaves less of a bank’s deposits available for lending) or increases the discount rate (which makes it more expensive for banks to borrow money from the Federal Reserve, thus making it less lucrative to borrow money to lend to customers), it compounds the slow-down effects.

Economists measure the effectiveness of monetary policy by its influence on inflation, employment, and industrial production. Most economists agree that because monetary policy often takes several months or even several years before the effects are felt, policy action is not something that should be taken in response to current, short-term economic conditions. One should note that monetary policy also has a global reach, in addition to its domestic effects.

When the Federal Reserve’s actions result in lower interest rates, this makes domestic bonds less attractive than bonds issued in countries with higher working capitals. Therefore, money tends to flow out of the U. S. and into these other countries. This causes demand for and thus the value of American dollars to fall in relation to other currencies, which makes the prices of American goods seem cheaper to foreign purchasers. This encourages them to import more American goods, raising the balance of trade. At the same time, improved demand from foreign sources causes more U.S. businesses to borrow money to expand, and this in turn leads to more jobs.

Why It Matters: Ultimately, the goal of monetary policy is to promote a stable economy. Many economists agree that the Federal Reserve is the most important political tool a government has, because each of a monetary policy’s effects influences the everyday financial decisions of the citizens of the economy: Whether they should buy a car, save more money, or start a business. What It Is: A central bank is an institution responsible for determining the monetary policy of a nation or group of nations.

How It Works/Example: Exact duties vary by country, but generally a central bank’s main goals are to maintain a stable currency, control inflation and maximize employment through the promotion of reasonable economic growth. Examples include the Federal Reserve Bank (U. S. ), the European Central Bank (EU) and the Bank of Japan (Japan). Central banks have several methods of controlling monetary policy, but the three most basic and widely used tools are short-term target rates, open market operations, and capital requirements.

Short-term rate changes are the most publicly followed central bank actions. Entities with a fiat currency (a currency backed by the full faith of the issuer) can loan as much money to banks as they want. The lower the rate, the more banks want to borrow in order to lend to consumers. Thus, by changing the short-term rate target a central bank can influence the amount of lending and borrowing in a country. Open market operations are another key economic influence. With this method, the central bank either buys or sells Treasury bonds.

Buying Treasuries puts money into circulation and selling Treasuries removes it — thereby increasing or decreasing the supply of money in an economy. The last tool is the use of capital requirements. Commercial banks take in deposits and then loan it out at higher interest rates. But they don’t necessarily loan out one dollar for every dollar they take in; banks are required to keep a certain amount of capital on hand in order to safely cover a surge in withdrawals from customers.

Increasing this capital requirement results in less money being available for lending — thus potentially slowing an economy. Likewise, lowering the capital requirement leads to a greater amount of funds being available for borrowing. Why It Matters: Central banks are the heart of a country’s monetary policy, and their actions exert considerable influence on every aspect of a country’s economy. Thus, central banks are key in ensuring boom and bust cycles do not hurt the long-term direction of their respective economies and ensuring steady, stable economic growth.