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A central bank is an independent national authority that conducts monetary

policy, regulates banks, and provides financial services including economic


research. Its goals are to stabilize the nation's currency, keep unemployment low,
and preventinflation.

Most central banks are governed by a board consisting of its member banks. The
country's chief elected official appoints the director. The national legislative body
approves him or her.

That keeps the central bank aligned with the nation's long-term policy goals. At
the same time, it's free of political influence in its day-to-day operations.
The Bank of England first established that model. Conspiracy theories to the
contrary, that's also who owns the U.S. Federal Reserve.

Monetary Policy

Central banks affect economic growth by controlling the liquidity in the financial
system. They have three monetary policy tools to achieve this goal.

First, they set a reserve requirement. It's the amount of cash that
member banks must have on hand each night. The central bank uses it to control
how much banks can lend.

Second, they use open market operations to buy and sell securities from member
banks. It changes the amount of cash on hand without changing the reserve
requirement. They used this tool during the 2008 financial crisis. Banks bought
government bonds and mortgage-backed securities to stabilize the banking
system.

The Federal Reserve added $4 trillion to its balance sheet with quantitative
easing. It began reducing this stockpile in October 2017.

Third, they set targets on interest rates they charge their member banks. That
guides rates for loans, mortgages, and bonds. Raising interest rates slows
growth, preventing inflation.

That's known as contractionary monetary policy. Lowering rates stimulates


growth, preventing or shortening a recession. That's called expansionary
monetary policy. The European Central Bank lowered rates so far that they
became negative.

Monetary policy is tricky. It takes about six months for the effects to trickle
through the economy. Banks can misread economic data as the Fed did in 2006.
It thought the subprime mortgage meltdown would only affect housing. It waited
to lower the fed funds rate. By the time the Fed lowered rates, it was already too
late.

But if central banks stimulate the economy too much, they can trigger inflation.
Central banks avoid inflation like the plague. Ongoing inflation destroys any
benefits of growth. It raises prices for consumers, increases costs for businesses,
and eats up any profits. Central banks must work hard to keep interest rates high
enough to prevent it.

Politicians and sometimes the general public are suspicious of central banks.
That's because they usually operate independently of elected officials. They often
are unpopular in their attempt to heal the economy. For example, Federal
Reserve Chairman Paul Volcker sent interest rates skyrocketing.

It was the only cure to runaway inflation. Critics lambasted him. Central bank
actions are often poorly understood, raising the level of suspicion

Bank Regulation

Central banks regulate their members. They require enough reserves to cover
potential loan losses. They are responsible for ensuring financial stability and
protecting depositors' funds.

In 2010, the Dodd-Frank Wall Street Reform Act gave more regulatory authority
to the Fed. It created the Consumer Financial Protection Agency.
That gave regulators the power to split up large banks, so they don't become "too
big to fail." It eliminates loopholes for hedge funds and mortgage
brokers. The Volcker Rule prohibits banks from owning hedge funds. It bans
them from using investors' money to buy risky derivatives for their own profit.

Dodd-Frank also established the Financial Stability Oversight Council.

It warns of risks that affect the entire financial industry. It can also recommend
that the Federal Reserve regulate any non-bank financial firms. That's to
keep insurance companies or hedge funds from becoming too big to fail.

Provide Financial Services

Central banks serve as the bank for private banks and the nation's government.
That means they process checks and lend money to their members.
Central banks store currency in their foreign exchange reserves. They use these
reserves to change exchange rates. They add foreign currency, usually the dollar
or euro, to keep their own currency in alignment. That's called a peg, and it helps
exporters keep their prices competitive.

Central banks also regulate exchange rates as a way to control inflation. They
buy and sell large quantities of foreign currency to affect supply and demand.

Most central banks produce regular economic statistics to guide fiscal


policy decisions. Here are examples of reports provided by the Federal Reserve:

 Beige Book: A monthly economic status report from regional Federal


Reserve banks.
 Monetary Policy Report: A semiannual report to Congress on the national
economy
 Credit Card Debt: A monthly report on consumer credit.

History

Sweden created the world' first central bank, the Riks, in 1668. The Bank of
England came next in 1694. Napoleon created the Banquet de France in 1800.
Congress established the Federal Reserve in 1913. The Bank of Canada began
in 1935, and the German Bundesbank was reestablished after World War II. In
1998, the European Central Bank replaced all the eurozone's central bank

Central banks have three main monetary policy tools: open market operations,
the discount rate and the reserve requirement. Most central banks also have a lot
more tools at their disposal. Here's what the three primary tools are and how they
work together to sustain healthy economic growth.

1. Open Market Operations

Open market operations are when central banks buy or sell securities. These are
bought from or sold to the country's private banks.

When the central bank buys securities, it adds cash to the banks' reserves. That
gives them more money to lend. When the central bank sells the securities, it
places them on the banks' balance sheets and reduces its cash holdings. The
bank now has less to lend. A central bank buys securities when it
wants expansionary monetary policy. It sells them when it
executes contractionary monetary policy.
Quantitative easing is open market operations on steroids. Before the recession,
the U.S. Federal Reserve maintained between $700 to $800 billion of Treasury
notes on its balance sheet. It added or subtracted to affect policy, but kept it
within that range. QE nearly quintupled this amount to more than $4 trillion by
2014.

2. Reserve Requirement

The reserve requirement refers to the money banks must keep on hand
overnight. They can either keep the reserve in their vaults or at the central bank.
A low reserve requirement allows banks to lend more of their deposits.

It's expansionary because it creates credit.

A high reserve requirement is contractionary. It gives banks less money to loan.


It's especially hard for small banks since they don't have as much to lend in the
first place. That's why most central banks don't impose a reserve requirement on
small banks.

Central banks rarely change the reserve requirement because it's expensive and
disruptive for member banks to modify their procedures.

Central banks are more likely to adjust the targeted lending rate. It achieves the
same result as changing the reserve requirement with less disruption. The fed
funds rate is perhaps the most well-known of these tools. Here's how it works. If
a bank can't meet the reserve requirement, it borrows from another bank that has
excess cash. The interest rate it pays is the fed funds rate. The amount it
borrows is called the fed funds. The Federal Open Market Committee sets a
target for the fed funds rate at its meetings.

Central banks have several tools to make sure the rate meets that target. The
Federal Reserve, the Bank of England and the European Central Bank pay
interest on the required reserves and any excess reserves. Banks won't lend fed
funds for less than the rate they're receiving from the Fed for these reserves.
Central banks also use open market operations to manage the fed funds rate.

3. Discount Rate

The discount rate is the third tool. It's the rate that central banks charge its
members to borrow at its discount window. Since the rate is high, banks only use
this if they can't borrow funds from other banks.
There is also a stigma attached. The financial community assumes that any bank
that uses the discount window is in trouble. Only a desperate bank that's been
rejected by others would use the discount window.

How It Works

Central bank tools work by increasing or decreasing total liquidity. That’s the
amount of capital available to invest or lend. It's also money and credit that
consumers spend. It's technically more than the money supply. That
only consists of M1 (currency and check deposits) and M2 (money market
funds, CDs and savings accounts). Therefore, when people say that central bank
tools affect the money supply, they are understating the impact.