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What is a 'Central Bank'

A central bank, or monetary authority, is a monopolized and often nationalized institution given privileged control over the production and distribution of money and credit. In modern economies, the central bank is responsible for the formulation of monetary policy and the regulation of member banks.

The central bank of the United States is the Federal Reserve System, or “the Fed,” which Congress established with the 1913 Federal Reserve Act.

BREAKING DOWN 'Central Bank'

Central banks are inherently non-market-based or even anticompetitive institutions. Many central banks, including the Fed, are often touted as independent or even private. 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 legal monopoly privilege for the issuance of bank notes and cash; privately owned commercial banks are only permitted to issue demand liabilities, such as checking deposits.

Functions of Central Banks

The normative justification for central banking rests on three critical factors. First, the central bank manages the growth of national monetary aggregates in an attempt to guide economic policy, often with the aim of full employment. The bank also acts as an emergency lender to distressed commercial banks and other institutions. Finally, a central bank offers much greater financing flexibility the central government by providing a politically attractive alternative to taxation.

Central banks conduct standard monetary policy by manipulating the money supply and interest rates. They regulate member banks through capital requirements, reserve requirements and deposit guarantees, among other tools.

The first prototypes for modern central banking were the Bank of England and the Swedish Riksbank in the 17th century. The Bank of England was the first to acknowledge the role of lender of last resort. Other early central banks, notably Napoleon’s Bank of France and Germany's Reichsbank, were established to finance expensive government military operations.

Central Banking in the United States

It was principally because European central banks made it easier for governments to grow, wage war and enrich special interests that many of America's founding fathers, most passionately Thomas Jefferson, opposed central banking. Despite these objections, the early United States used both official central banks and numerous state-chartered banks, except for the “free-banking period” between 1837 and 1863.

The National Banking Act of 1863 created a network of national banks and a single U.S. currency, with New York as the central reserve city. The United States subsequently experienced a series of bank panics in 1873, 1884, 1893 and 1907. In response, the United States established the Federal Reserve System and spread 12 Federal Reserve Banks throughout the country to stabilize financial activity.

The new Fed helped finance World War I and World War II by purchasing Treasury bonds. Unfortunately, even more severe financial crises persisted in the Fed era, notably in 1929, 1937, 1980 and 2007. Despite the best efforts of the Federal Reserve and its board of governors, stable central bank policy remains elusive.

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