What Is a Central Bank?

A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.

Central banks are inherently non-market-based or even anti-competitive institutions. Although some are nationalized, many central banks are not government agencies, and so are often touted as being politically independent. However, even if a central bank is not legally owned by the government, its privileges are established and protected by law.

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.

Understanding Central Banks

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.

Most central banks today set interest rates and conduct monetary policy using an inflation target of 2-3% annual inflation.

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. They also provide loans and services for a nation’s banks and its government and manage foreign exchange reserves.

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.

Example: The Federal Reserve

Along with the measures mentioned above, central banks have other actions at their disposal. In the U.S., for example, the central bank is the Federal Reserve System, aka “the Fed”. The Federal Reserve Board (FRB), the governing body of the Fed, can affect the national money supply by changing reserve requirements. When the requirement minimums fall, banks can lend more money, and the economy’s money supply climbs. In contrast, raising reserve requirements decreases the money supply. The Federal Reserve was established with the 1913 Federal Reserve Act.

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.

Central Banks and Deflation

What Is Deflation?

• Deflation is a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time.

Over the past quarter-century, concerns about deflation have spiked after big financial crises. Japan has offered a sobering example. After its equities and real estate bubbles burst in 1989-90, causing the Nikkei index to lose one-third of its value within a year, deflation became entrenched.

 The Japanese economy, which had been one of the fastest-growing in the world from the 1960s to the 1980s, slowed dramatically. The ’90s became known as Japan’s Lost Decade.

The Great Recession of 2008-09 sparked fears of a similar period of prolonged deflation in the United States and elsewhere because of the catastrophic collapse in prices of a wide range of assets. The global financial system was also thrown into turmoil by the insolvency of a number of major banks and financial institutions throughout the United States and Europe, exemplified by the collapse of Lehman Brothers in September 2008.

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