A central bank oversees and manages a nation’s monetary policy. It is responsible for controlling a country’s money supply (through the issuance of fiat currency), and to set interest rates. Some of its stated goals are to prevent inflation, fight unemployment and stabilize the currency system. A nation’s money supply can greatly impact these and other economic factors, and that is why central banks often turn to currency manipulation when a country is facing economic strife - as an attempt to stabilize the economy.
In the United States, the Federal Reserve Bank - the “Fed” - operates as the nation’s central bank. Other notable central banks around the world include the European Central Bank, the People’s Bank of China, and the Bank of England.
Central banks exist in most countries around the world. They use various methods to manage their nations’ monetary systems along with commercial banks. In the US, commercial banks that are registered as part of the Federal Reserve System are also called member banks. Some common methods include setting reserve requirements, adjusting banking interest rates, and directing open market operations.
Reserves are necessary as part of the fractional reserve banking system that most financial institutions use internationally. The central bank is responsible for setting the minimum reserve requirement for commercial banks, meaning that these banks must hold a small percentage of the money deposited by their customers in their accounts, while still being able to make loans with the rest of the money.
Central banks set the rates of interest charged to member banks when they advance credit through short-term loans. The member banks are responsible for offering loans to businesses and consumers for mortgages, vehicles, business expansion, equipment, and other large purchases. They also sell bonds at set interest rates. The central bank’s interest rate is meant to guide commercial banks in their lending activities. When the interest rate is low, banks are more likely to loan more money. But when the central bank raises the rates, member banks tighten their lending practices.
Open Market Operations
Member banks sell and buy securities from the central bank (e.g., government bonds and mortgage-backed securities). When a central bank buys securities from its member banks, it gives the commercial banks more cash to loan to their consumers. In recent economic crises, central banks have used this method in attempts to help in economic recovery through quantitative easing (QE). In short, QE strategies “created” new money by adding currency to a bank’s financial reserves through credit.