Governments create central banks to perform a variety of functions. The functions actually performed vary considerably from country to country. Broadly speaking, central banks serve as the government’s banker, as the banker to the banking system, and as the policymaker for monetary and financial matters.
As the government’s banker, the central bank can act as the repository for government receipts, as the collection agent for taxes, and as the auctioneer for government debt. It can also act as a lender to the government and as the government’s advisor on financial matters. As the banker for the country’s banks, the central bank can act as the repository for bank reserves, as the supervisor and regulator of banks, as the facilitator of interbank services such as check clearing and money transfers, and as a lender when banks need money to honor deposit withdrawals or other needs for liquidity.
As the country’s monetary policymaker, the central bank controls the amount of credit and money available, the level of interest rates, and the exchange rate (the rate at which one nation’s currency can be exchanged for another nation’s). To achieve its monetary policy objectives, central bankers use a combination of policy tools. For example, the central bank may increase or decrease the amount of money (coin and currency) in circulation by buying or selling government debt instruments, such as bonds, on the open market. This policy tool is known as open market operations. Since interest rates are usually related to how much money and credit are available in the economy, the central bank can usually lower interest rates by buying bonds from the public with money. This increases the amount of money in the economy and lowers interest rates. To raise rates, the authority would sell bonds, thereby reducing the amount of money available to the public. The central bank could also cause a lowering or raising of interest rates by increasing or decreasing the amount of money banks must hold as a reserve against their deposits. By increasing reserves, the central bank forces banks to hold more money in their vaults, which means they can lend less money. Less money available for loans makes loans harder to get which, in turn, causes banks and other lenders to raise interest rates on loans.
Central banks can be either privately owned or owned by the government. In Europe, central banks are owned and operated by the government. In the United States, commercial banks own the central bank, which is called the Federal Reserve. The Federal Reserve, established in 1913, consists of a seven-person Board of Governors located in Washington, D.C., and the presidents of 12 regional Federal Reserve Banks. Each member of the Board of Governors is appointed by the U.S. president and confirmed by the U.S. Senate for staggered 14-year terms. From among the seven governors, the president also designates and the Senate confirms a chairman of the board for a four-year term. Alan Greenspan is the current chairman of the Federal Reserve Board. The Federal Reserve’s primary policy group is called the Federal Open Market Committee (FOMC). It consists of the seven governors plus five regional Federal Reserve Bank presidents. The FOMC is responsible for controlling the money supply and interest rates in the United States.
Because central banks control the money supply, there is always the danger that central banks will simply create more money and then lend it to the government to finance its expenditures. This often leads to excessive money creation and inflation (a continuous increase in the prices of goods), which can be caused by having too much money available to purchase goods. Inflation occurred in the United States when the government printed Continental dollars to pay for the Revolutionary War. So many were printed that they became worthless, and a popular slogan of the day was “It’s not worth a Continental.” The danger of inflation is particularly acute in countries where the government owns the central bank. Government ownership of the central bank is illegal in the United States, except in national emergencies. European countries agreed in the Maastricht Treaty of 1992 not to allow central banks to lend money to their governments.