The critical feature of a central bank—distinguishing it from other banks—is its legal monopoly status, which gives it the privilege to issue banknotes and cash.
Private commercial banks are only permitted to issue demand liabilities, such as checking deposits. Although their responsibilities range widely, depending on their country, central banks' duties and the justification for their existence usually fall into three areas. First, central banks control and manipulate the national money supply: issuing currency and setting interest rates on loans and bonds.
Typically, central banks raise interest rates to slow growth and avoid inflation; they lower them to spur growth, industrial activity, and consumer spending. In this way, they manage monetary policy to guide the country's economy and achieve economic goals, such as full employment.
Second, they regulate member banks through capital requirements, reserve requirements which dictate how much banks can lend to customers, and how much cash they must keep on hand , and deposit guarantees, among other tools. Finally, a central bank also acts as an emergency lender to distressed commercial banks and other institutions, and sometimes even a government. By purchasing government debt obligations, for example, the central bank provides a politically attractive alternative to taxation when a government needs to increase revenue.
Along with the measures mentioned above, central banks have other actions at their disposal. In the U. In contrast, raising reserve requirements decreases the money supply. When the Fed lowers the discount rate that banks pay on short-term loans , it also increases liquidity. Lower rates increase the money supply, which in turn boosts economic activity. But decreasing interest rates can fuel inflation, so the Fed must be careful.
And the Fed can conduct open market operations to change the federal funds rate. The Fed buys government securities from securities dealers, supplying them with cash, thereby increasing the money supply.
The Fed sells securities to move the cash into its pockets and out of the system. The first prototypes for modern central banks were the Bank of England and the Swedish Riksbank, which date back to the 17 th century.
The Bank of England was the first to acknowledge the role of lender of last resort. It was principally because European central banks made it easier for federal governments to grow, wage war, and enrich special interests that many of United States' founding fathers—most passionately Thomas Jefferson—opposed establishing such an entity in their new country.
The National Banking Act of created a network of national banks and a single U. The United States subsequently experienced a series of bank panics in , , , and In response, in the U. Congress established the Federal Reserve System and 12 regional Federal Reserve Banks throughout the country to stabilize financial activity and banking operations.
Between and , when world currencies were pegged to the gold standard , maintaining price stability was a lot easier because the amount of gold available was limited. Consequently, monetary expansion could not occur simply from a political decision to print more money, so inflation was easier to control. The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency; it issued notes based on a country's reserves of gold.
At the outbreak of World War I, the gold standard was abandoned, and it became apparent that, in times of crisis, governments facing budget deficits because it costs money to wage war and needing greater resources would order the printing of more money.
As governments did so, they encountered inflation. After the war, many governments opted to go back to the gold standard to try to stabilize their economies. With this rose the awareness of the importance of the central bank's independence from any political party or administration. During the unsettling times of the Great Depression in the s and the aftermath of World War II, world governments predominantly favored a return to a central bank dependent on the political decision-making process.
This view emerged mostly from the need to establish control over war-shattered economies; furthermore, newly independent nations opted to keep control over all aspects of their countries — a backlash against colonialism. The rise of managed economies in the Eastern Bloc was also responsible for increased government interference in the macro-economy. Eventually, however, the independence of the central bank from the government came back into fashion in Western economies and has prevailed as the optimal way to achieve a liberal and stable economic regime.
Over the past quarter-century, concerns about deflation have spiked after big financial crises. Japan has offered a sobering example.
Learn More About Lending Central. Toggle navigation. Central Bank. Home Central Bank. Additionally, the Fed is responsible for check processing. When you write a check, for example, to buy groceries, the grocery store deposits the check in its bank account. Then, the physical check or an image of that actual check is returned to your bank, after which funds are transferred from your bank account to the account of the grocery store. The Fed is responsible for each of these actions.
On a more mundane level, the Federal Reserve ensures that enough currency and coins are circulating through the financial system to meet public demands. For example, each year the Fed increases the amount of currency available in banks around the Christmas shopping season and reduces it again in January.
Finally, the Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws. For example, banks are forbidden from discriminating on the basis of age, race, sex, or marital status.
Banks are also required to disclose publicly information about the loans they make for buying houses and how those loans are distributed geographically, as well as by sex and race of the loan applicants. Watch Mr.
Clifford at the Federal Reserve building in Washington D. Improve this page Learn More. Skip to main content. Module Monetary Policy. Search for:. Federal Reserve Discuss how central banks impact monetary policy, promote financial stability, and provide banking services. Try It. Watch It Watch Mr.
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