Central banks carry out a nation's monetary policy and control its money supply, often mandated with maintaining low inflation and steady GDP growth. On a macro basis, they influence interest rates and participate in open market operations to control the cost of borrowing and lending throughout an economy.
If that sounds confusing, this article aims to simplify the central bank meaning, connect its definition to ‘the Fed’, and help you understand how their actions may impact you regardless of your nationality.
Central Bank Meaning
A central bank is a financial institution that 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.
A central bank 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. For the purpose of this article, we’ll be referencing the Fed as it is arguably the most powerful central bank-financial institution in the world.
Goals Of The Federal Reserve
Technically three goals – price stability, low inflation (at about 2 percent), and maximum employment – but because price stability and inflation are directly related, experts say the Fed has two main goals, or the so-called dual mandate. Since these two goals are inherently in tension with each other, the Fed acts on a Goldilocks principle: trying to ensure that the economy grows and that new jobs are created while not letting it grow too quickly lest inflation rise too much.
While the dual mandate is the most essential part of the Fed’s job, it has other responsibilities too. It promotes the stability of the financial system, supervises and regulates the practices of financial institutions including commercial banks, works to make the systems used to conduct financial transactions safe and efficient, and advocates for consumer protections. The Fed also puts the dollars we use into circulation.
How Does The Fed Accomplish Its Goals?
The Fed wants to keep prices stable and inflation at around 2 percent, and it seeks maximum employment. But the Fed isn’t Congress and can’t make laws to regulate the economy. So it acts indirectly, by changing the money supply or the amount of money in the economy. The Fed has several policy tools at its disposal to do this, including setting a target interest rate.
When a bank loans you money, it makes you pay interest on the money, say 5 or 10 percent of the loan amount. As you pay back a loan, you also pay the interest to the lender. Interest rates and money supply have an inverse relationship. When interest rates are low, you can afford to borrow more or more people can afford to borrow; thus, the money supply (i.e., the amount of money in the economy) increases. The reverse is also true.
The Fed also stipulates how much money commercial banks are required to have on hand and can’t loan out; sets the interest rate that commercial banks pay for short-term loans from a Federal Reserve bank; and buys and sells securities, basically government IOUs. Each of these options presents an opportunity to increase or decrease the money supply.
The Fed can undertake contractionary monetary policy – that is, use tools to decrease the money supply – when it wants to slow down the economy and curb inflation; it undertakes expansionary monetary policy – that is, uses tools to increase the money supply – when it wants to energize the economy and stimulate growth.
How Do The Fed’s Actions (or Inaction) Affect Us?
The easiest way to see the Fed’s effects on your life is to focus on interest rates. Earlier, we discussed how the tools the Fed uses to regulate the money supply directly affect the interest rates that commercial banks charge customers like you. And these interest rates affect everything: what you can afford to buy, what jobs are available, and the prices of goods and services.
When you apply for a credit card or a loan to buy a house or car, for example, you expect to pay interest on the borrowed money. Lower interest rates mean you can borrow money more cheaply and because you have access to more money, you’re likely to spend more money. This helps you buy the things you need and it also helps the economy grow, potentially hiking inflation.
Of course, higher interest rates do the opposite. People and businesses typically spend less and save more when interest rates are high, which helps to slow the economy and often leads to deflation. Deflation can make borrowing more expensive and the job market more competitive, but it gives your dollars more purchasing power.
Keeping the economy from not getting too hot and too cold sounds deceptively simple. But in practice, it’s an enormous responsibility that requires a deep understanding of how the tools the Fed has at its disposal affect the economy as well as how to handle shocks and economic crises when they occur.
Closing Thoughts
The functions of the central bank have a great importance in the economy of a country. The soundness of the monetary and banking system of a country depends in large measure on the efficient discharge of these functions by the central bank. Hence, that is why it is so crucial to understand central bank meaning and the role they play in the micro and macroeconomy.
