Central Banks and Monetary Policy

Central Banks and Monetary Policy

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Central Banks and Monetary Policy

Instead of taking deposits and making loans as normal banks do, a central bank – such as the Bank of England, the U.S. Federal Reserve or the Bank of Japan – acts as banker to the government and to the banking sector. It controls the economy by increasing or decreasing the country’s supply of money.

In fact, in most modern economies printed notes and coins are only a small percentage – often less than 10 percent – of the money supply. Central banks usually print only enough currency to satisfy everyday needs of businesses and consumers. The U.S. Federal Reserve, for example, has the Bureau of Printing and Engraving printing up bills from time to time simply to replace worn-out money in the economy at large.

Since most “money” is actually nothing more than a savings or checking account at a local bank, the most effective way for a central bank to control the economy is to increase or decrease bank lending and bank deposits. When banks have money to lend to their customers, the economy grows. When the banks are forced to cut back lending, the economy slows.

Once a customer deposits money in a local bank, it becomes available for further lending. A hundred dollars deposited at a bank in San Francisco, for example, doesn’t lie idle for long. After setting aside a small amount of each deposit as a “reserve”, the bank can lend out the remainder, further increasing the money supply without any new currency being printed.

A bank’s supply of money for lending is limited only by its deposits and its reserve requirements, which are determined by the central bank. Central banks are known to often use these reserve requirements to control the money supply. When a bank is required to keep a certain amount of its funds on reserve with the central bank – 10 percent of deposits, for example – it is unable to lend these funds back to customers. When a central bank decides to increase the money supply, it can reduce this reserve requirement, allowing banks more of their funds to lend to businesses and consumers. This may well increase the money supply quickly because of a multiplier effect: as the new loans enter the economy, deposits increase – and banks have even more money to lend, which generates further deposits providing more money for further loans.

Another way of controlling the money supply is to raise or lower interest rates. When a central bank decides that the economy is growing too slowly – or not growing at all – it can reduce the interest rate it charges on the loans to the country’s banks. When banks are allowed to get cheaper money at the central bank, they can make cheaper loans to businesses and consumers, providing an important stimulus to economic growth. Alternatively, if the economy shows signs of growing too quickly, a central bank can increase the interest rate on its loans to banks, putting the brakes on economic growth.

Perhaps the most dramatic way of increasing or decreasing the money supply is through open market operations, where a central bank buys or sells large amounts of securities, such as government treasury bonds, in the open market. By buying them from a bank or a securities house the central bank pumps money into the economy because money held at central banks, such as the U.S. Federal Reserve, is not considered part of the money supply. When it is used to buy securities, usually government bonds, in the open market, the money supply is increased.

In a sense, the central bank creates money every time it dips into its vaults to buy bonds in the open market.

In addition to coordinating the country’s monetary policy, a central bank serves as a watchdog to supervise the banking system, in most cases acting independently of its government to provide a stabilizing influence on the country’s economy.