Central Bank
What is Central Bank?
A central bank is a national institution that manages a country's money supply, interest rates, and banking system.
The U.S. central bank is the Federal Reserve. It conducts monetary policy through open market operations, the discount rate, and reserve requirements, and acts as a lender of last resort. Its usual goals are stable prices and full employment.
Central Bank: a worked example
Suppose the required reserve ratio is 10 percent and the central bank buys 500 million dollars of government bonds from commercial banks. Bank reserves rise by 500 million, all of it excess, since the purchase created no new deposits. The simple deposit multiplier is 1 divided by 0.10, which is 10, so checkable deposits can expand by 500 million x 10 = 5 billion dollars at most. Suppose instead the first bank decides to sit on 50 million and lend only 450 million, with later banks lending everything they can. Deposits then expand by 450 million x 10 = 4.5 billion dollars, half a billion less than the textbook figure. The multiplier sets a ceiling on what one open market purchase can achieve, never a promise, because banks choose how much of the new reserve to lend.
The mistake students make with central bank
Household intuition says selling something brings money in, so students write that a central bank sells bonds in order to expand the money supply. The direction runs the other way. A sale takes payment out of the public's accounts and drains reserves from the banking system, which contracts lending, while a purchase credits reserves and expands it. Remember it through the buyer: whoever the central bank pays gets paid with newly created reserves. The same logic keeps the other tools straight, since raising the reserve requirement or the discount rate also tightens.
Central Bank questions
What does a central bank actually do?
A central bank manages the quantity of reserves in the banking system, steers short term interest rates toward a target, supervises banks, and stands ready as lender of last resort when a solvent bank cannot borrow anywhere else. Most also issue the national currency and hold foreign exchange reserves. The daily work is trading government securities, since buying and selling those securities is what moves reserves and therefore moves the rate banks charge one another overnight.
How is a central bank different from a commercial bank?
A commercial bank takes deposits from households and firms and lends to them for profit. A central bank does neither: its customers are the government and the commercial banks themselves, and its objectives are stable prices and full employment rather than earnings. Only a central bank can create reserves out of nothing, which is exactly what allows it to act as lender of last resort during a panic while a commercial bank can simply run out of funds.
Why are central banks usually independent from the government?
Independence is meant to keep short run political pressure from producing inflation. An official facing a coming election has reason to want cheap credit and a hot economy even when prices are already climbing, so a central bank that could be overruled would struggle to hold inflation expectations down. The independence is operational rather than absolute, because the legislature still writes the mandate and can change the law, yet it does not pick the interest rate.
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