Essay on Central Bank | Banking

central bank essay

In this essay we will discuss about central bank. After reading this essay you will learn about: 1. Essay on the Definition of a Central Bank 2. Essay on the Functions of a Central Bank 3. Essay on the Objectives of Credit Control by the Central Bank 4. Essay on the Role of Central Bank in a Developing Economy 5. Essay on the Need for Central Bank.

Essay Contents:

  • Essay on the Need for Central Bank

1. Essay on the Definition of a Central Bank:

A central bank has been defined in terms of its functions. According to Vera Smith, “The primary definition of central banking is a banking system in which a single bank has either complete control or a residuary monopoly of note issue.” W.A. Shaw defines a central bank as a bank which control credit. To Hawtrey, a central bank is that which is the lender of the last resort. According to A.C.L. Day, a central bank is “to help control and stabilise the monetary and banking system.”


According to Sayers, the central bank “is the organ of government that undertakes the major financial operations of the government and by its conduct of these operations and by other means, influences the behaviour of financial institutions so as to support the economic policy of the Government.” Sayers refers only to the nature of the central bank as the government’s bank. All these definitions are narrow because they refer only to one particular function of a central bank.

On the other hand, Samuelson’s definition is wide. According to him, a central bank “is a bank of bankers. Its duty is to control the monetary base…. and through control of this ‘high-powered money’ to control the community’s supply of money.” But the broadest definition has been given by De Kock.

In his words, a central bank is “a bank which constitutes the apex of the monetary and banking structure of its country and which performs as best as it can in the national economic interest, the following functions:

(i) The regulation of currency in accordance with the requirements of business and the general public for which purpose it is granted either the sole right of note issue or at least a partial monopoly thereof,

(ii) The performance of general banking and agency for the state,

(iii) The custody of the cash reserves of the commercial banks,

(iv) The custody and management of the nation’s reserves of international currency,

(v) The granting of accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and dealers, or other financial institutions and the general acceptance of the responsibility of lender of the last resort,

(vi) The settlement of clearance balances between the banks,

(vii) The control of credit in accordance with the needs of business and with a view to carrying out the broad monetary policy adopted by the state.” De Kock’s definition is too long to be called a definition. For, a definition must be brief.

2. Essay on the Functions of Central Bank:

A central bank performs the following functions, as given by De Kock and accepted by the majority of economists:

1. Regulator of currency :

The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the government mint but they are put into circulation through the central bank.

Central banks have been following different methods of note issue in different countries. The centred bank is required by law to keep a certain amount of gold and foreign securities against the issue of notes. In some countries, the amount of gold and foreign securities bears a fixed proportion, between 25 to 40 per cent of the total notes issued.

In other countries, a minimum fixed amount of gold and foreign currencies is required to be kept against note issue by the central bank. This system is operative in India whereby the Reserve Bank of India is required to keep Rs115crores in gold and Rs85crores in foreign securities. There is no limit to the issue of notes after keeping this minimum amount of Rs200crores in gold and foreign securities.

The monopoly of issuing notes vested in the central bank ensures uniformity in the notes issued which helps in facilitating exchange and trade within the country. It brings stability in the monetary system and creates confidence among the public.

The central bank can restrict or expand the supply of cash according to the requirements of the economy. Thus it provides elasticity to the monetary system. By having a monopoly of note issue, the central bank also controls the banking system by being the ultimate source of cash. Last but not the least, by entrusting the monopoly of note issue to the central bank, the government is able to earn profits from printing notes whose cost is very low as compared with their face value.

2. Banker, fiscal agent and adviser to the g overnment :

Central banks everywhere act as bankers, fiscal agents and advisers to their respective governments. As banker to the government, the central bank keeps the deposits of the central and state governments and makes payments on behalf of governments. But it does not pay interest on governments deposits. It buys and sells foreign currencies on behalf of the government., It keeps the stock of gold of the government.

Thus it is the custodian of government money and wealth. As a fiscal agent, the central bank makes short-term loans to the government for a period not exceeding 90 days. It floats loans, pays interest on them, and finally repays them on behalf of the government. Thus it manages the entire public debt.

The central bank also advises the government on such economic and money matters as controlling inflation or deflation, devaluation or revaluation of the currency, deficit financing, balance of payments, etc. As pointed out by De Kock, “Central banks everywhere operate as bankers to the state not only because it may be more convenient and economical to the state, but also because of the intimate connection between public finance and monetary affairs.”

3. Custodian of cash reserves of commercial banks :

Commercial banks are required by law to keep reserves equal to a certain percentage of both time and demand deposits liabilities with the central banks. It is on the basis of these reserves that the central bank transfers funds from one bank to another to facilitate the clearing of cheques. Thus the central bank acts as the custodian of the cash reserves of commercial banks and helps in facilitating their transactions.

There are many advantages of keeping the cash reserves of the commercial banks with the central bank, according to De Kock.

In the first place, the centralisation of cash reserves in the central bank is a source of great strength to the banking system of a country.

Secondly, centralised cash reserves can serve as the basis of a large and more elastic credit structure than if the same amount were scattered among the individual banks.

Thirdly, centralised cash reserves can be utilised fully and most effectively during periods of seasonal strains and in financial crises or emergencies.

Fourthly, by varying these cash reserves the central bank can control the credit creation by commercial banks. Lastly, the central bank can provide additional funds on a temporary and short term basis to commercial banks to overcome their financial difficulties.

4. Custody and management of foreign exchange reserves :

The central bank keeps and manages the foreign exchange reserves of the country. It is an official reservoir of gold and foreign currencies. It sells gold at fixed prices to the monetary authorities of other countries. It also buys and sells foreign currencies at international prices. Further, it fixes the exchange rates of the domestic currency in terms of foreign currencies.

It holds these rates within narrow limits in keeping with its obligations as a member of the International Monetary Fund and tries to bring stability in foreign exchange rates. Further, it manages exchange control operations by supplying foreign currencies to importers and persons visiting foreign countries on business, studies, etc. in keeping with the rules laid down by the government.

5. Lender of the last resort :

De Kock regards this function as a sine qua non of central banking. By granting accommodation in the form of re-discounts and collateral advances to commercial banks, bill brokers and dealers, or other financial institutions, the central bank acts as the lender of the last resort. The central bank lends to such institutions in order to help them in times of stress so as to save the financial structure of the country from collapse.

It acts as lender of the last resort through discount house on the basis of treasury bills, government securities and bonds at “the front door”. The other method is to give temporary accommodation to the commercial banks or discount houses directly through the “back door”.

The difference between the two methods is that lending at the front door is at the bank rate and in the second case at the market rate. Thus the central bank as lender of the last resort is a big source of cash and also influences prices and market rates,

6. Clearing house for transfer and settlement :

As bankers’ bank, the central bank acts as a clearing house for transfer and settlement of mutual claims of commercial banks. Since the central bank holds reserves of commercial banks, it transfers funds from one bank to other banks to facilitate clearing of cheques.

This is done by making transfer entries in their accounts on the principle of book-keeping. To transfer and settle claims of one bank upon others, the central bank operates a separate department in big cities and trade centres. This department is known as the “clearing house” and it renders the service free to commercial banks.

When the central bank acts as a clearing agency, it is time-saving and convenient for the commercial banks to settle their claims at one place. It also economises the use of money. “It is not only a means of economising cash and capital but is also a means of testing at any time the degree of liquidity which the community is maintaining.”

7. Controller of credit :

The most important function of the central bank is to control the credit creation power of commercial bank in order to control inflationary and deflationary pressures within this economy. For this purpose, it adopts quantitative methods and qualitative methods.

Quantitative methods aim at controlling the cost and quantity of credit by adopting bank rate policy, open market operations, and by variations in reserve ratios of commercial banks. Qualitative methods control the use and direction of credit. These involve selective credit controls and direct action. By adopting such methods, the central bank tries to influence and control credit creation by commercial banks in order to stabilise economic activity in the country.

Besides the above noted functions, the central banks in a number of developing countries have been entrusted with the responsibility of developing a strong banking system to meet the expanding requirements of agriculture, industry, trade and commerce. Accordingly, the central banks possess some additional powers of supervision and control over the commercial banks.

They are the issuing of licences; the regulation of branch expansion; to see that every bank maintains the minimum paid up capital and reserves as provided by law; inspecting or auditing the accounts of banks; to approve the appointment of chairmen and directors of such banks in accordance with the rules and qualifications; to control and recommend merger of weak banks in order to avoid their failures and to protect the interest of depositors; to recommend nationalisation of certain banks to the government in public interest; to publish periodical reports relating to different aspects of monetary and economic policies for the benefit of banks and the public; and to engage in research and train banking personnel etc.

3. Essay on the Objectives of Credit Control by the Central Bank :

Credit control is the means to control the lending policy of commercial banks by the central bank.

The central bank controls credit to achieve the following objectives:

1. To stabilise the internal price level:

One of the objective of controlling credit is to stabilise the price level in the country. Frequent changes in prices adversely affect the economy. Inflationary or deflationary trends need to be prevented. This can be achieved by adopting a judicious policy of credit control.

2. To stabilise the rate of foreign exchange:

With the change in the internal prices level, exports and imports of the country are affected. When prices fall, exports increase and imports decline. Consequently, the demand for domestic currency increases in the foreign market and its exchange rate rises. On the contrary, a rise in domestic prices leads to a decline in exports and an increase in imports.

As a result, the demand for foreign currency increases and that of domestic currency falls, thereby lowering the exchange rate of the domestic currency. Since it is the volume of credit money that affects prices, the central bank can stabilise the rate of foreign exchange by controlling bank credit.

3. To protect the outflow of gold:

The central bank holds the gold reserves of the country in its vaults. Expansion of bank credit leads to rise in prices which reduce exports and increase imports, thereby creating an unfavourable balance of payments. This necessitates the export of gold to other countries. The central bank has to control credit in order to prevent such outflows of gold to other countries.

4. To control business cycles:

Business cycles are a common phenomenon of capitalist countries which lead to periodic fluctuations in production, employment and prices. They are characterised by alternating periods of prosperity and depression. During prosperity, there is large expansion in the volume of credit, and production, employment and prices rise.

During depression, credit contracts, and production, employment and prices fall. The central bank can counteract such cyclical fluctuations through contraction of bank credit during boom periods, and expansion of bank credit during depression.

5. To meet business needs:

According to Burgess, one of the important objectives of credit control is the “adjustment of the volume of credit to the volume of business.” Credit is needed to meet the requirements of trade and industry. As business expands, larger quantity of credit is needed, and when business contracts less credit is needed. Therefore, it is the central bank which can meet the requirements of business by controlling credit.

6. To have growth with stability:

In recent years, the principal objective of credit control is to have growth with stability. The other objectives, such as price stability, foreign exchange rate stability, etc., are regarded as secondary. The aim of credit control is to help in achieving full employment and accelerated growth with stability in the economy without inflationary pressures and balance of payments deficits.

4. Essay on the Role of Central Bank in a Developing Economy :

The central bank in a developing economy performs both traditional and non-traditional functions. The principal traditional functions performed by it are the monopoly of note issue, banker to the government, bankers’ bank, lender of the last resort, controller of credit and maintaining stable exchange rate. But all these functions are related to the foremost function of helping in the economic development of the country.

The central bank in a developing country aims at the promotion and maintenance of a rising level of production, employment and real income in the country. The central banks in the majority of underdeveloped countries have been given wide powers to promote the growth of such economies.

They, therefore, perform the following functions towards this end:

Creation and expansion of financial institutions:

One of the aims of a central bank in an underdeveloped country is to improve its currency and credit system. More banks and financial institutions are required to be set up to provide larger credit facilities and to divert voluntary savings into productive channels. Financial institutions are localised in big cities in underdeveloped countries and provide credit facilities to estates, plantations, big industrial and commercial houses.

In order to remedy this, the central bank should extend branch banking to rural areas to make credit available to peasants, small businessmen and traders. In underdeveloped countries, the commercial banks provide only short-term loans. Credit facilities in rural areas are mostly non-existent.

The only source is the village moneylender who charges exorbitant interest rates. The hold of the village moneylender in rural areas can be slackened if new institutional arrangements are made by the central bank in providing short-term, medium term and long-term credit at lower interest rates to the cultivators.

A network of co-operative credit societies with apex banks financed by the central bank can help solve the problem. Similarly, it can help the establishment of lead banks and through them regional rural banks for providing credit facilities to marginal farmers, landless agricultural workers and other weaker sections.

With the vast resources at its command, the central bank can also help in establishing industrial banks and financial corporations in order to finance large and small industries.

Proper adjustment between demand for and supply of money:

The central bank plays an important role in bringing about a proper adjustment between demand for and supply of money. An imbalance between the two is reflected in the price level. A shortage of money supply will inhibit growth while an excess of it will lead to inflation. As the economy develops, the demand for money is likely to go up due to gradual monetization of the non-monetized sector and the increase in agricultural and industrial production and prices.

The demand for money for transactions and speculative motives will also rise. So the increase in money supply will have to be more than proportionate to the increase in the demand for money in order to avoid inflation. There is, however, the likelihood of increased money supply being used for speculative purposes, thereby inhibiting growth and causing inflation.

The central bank controls the uses of money and credit by an appropriate monetary policy. Thus in an underdeveloped economy, the central bank should control the supply of money in such a way that the price level is prevented from rising without affecting investment and production adversely.

A suitable interest rate policy:

In an underdeveloped country the interest rate structure stands at a very high level. There are also vast disparities between long-term and short-term interest rates and between interest rates in different sectors of the economy. The existence of high interest rates acts as an obstacle to the growth of both private and public investment, in an underdeveloped economy. A low interest rate is, therefore, essential for encouraging private investment in agriculture and industry.

Since in an underdeveloped country businessmen have little savings out of undistributed profits, they have to borrow from the banks or from the capital market for purposes of investment and they would borrow only if the interest rate is low.

A low interest rate policy is also essential for encouraging public investment. A low interest rate policy is a cheap money policy. It makes public borrowing cheap, keeps the cost of servicing public debt low, and thus helps in financing economic development.

In order to discourage the flow of resources into speculative borrowing and investment, the central bank should follow a policy of discriminatory interest rates, charging high rates for non-essential and unproductive loans and low rates for productive loans.

But this does not imply that savings are interest-elastic in an underdeveloped economy. Since the level of income is low in such economies, a high rate of interest is not likely to raise the propensity to save.

In the context of economic growth, as the economy develops, a progressive rise in the price level is inevitable. The value of money falls and the propensity to save declines further. Money conditions become tight and there is a tendency for the rate of interest to rise automatically. This would result in inflation. In such a situation any effort to control inflation by raising the rate of interest would be disastrous. A stable price level is, therefore, essential for the success of a low interest rate policy which can be maintained by following a judicious monetary policy by the central bank.

Debt management:

Debt management is one of the important functions of the central bank in an underdeveloped country. It should aim at proper timing and issuing of government bonds, stabilizing their prices and minimizing the cost of servicing public debt. It is the central bank which undertakes the selling and buying of government bonds and making timely changes in the structure and composition of public debt.

In order to strengthen and stabilize the market for government bonds, the policy of low interest rates is essential. For, a low rate of interest raises the price of government bonds, thereby making them more attractive to the public and giving an impetus to the public borrowing programmes of the government.

The maintenance of structure of low interest rates is also called for minimizing the cost of servicing the national debt. Further, it encourages funding of debt by private firms. However, the success of debt management would depend upon the existence of well-developed money and capital markets in which wide range of securities exist both for short and long periods. It is the central bank which can help in the development of these markets.

Credit control:

Central Bank should also aim at controlling credit in order to influence the patterns of investment and production in a developing economy. Its main objective is to control inflationary pressures arising in the process of development. This requires the use of both quantitative and qualitative methods of credit control.

Open market operations are not successful in controlling inflation in underdeveloped countries because the bill market is small and undeveloped. Commercial banks keep an elastic cash-deposit ratio because the central bank’s control over them is not complete. They are also reluctant to invest in government securities due to their relatively low interest rates.

Moreover, instead of investing in government securities, they prefer to keep their reserves in liquid form such as gold, foreign exchange and cash. Commercial banks are also not in the habit of rediscounting or borrowing from the central bank.

The bank rate policy is also not so effective in controlling credit in LDCs due to:

(a) The lack of bills of discount;

(b) The narrow size of the bill market;

(c) A large non-monetized sector where barter transactions take place;

(d) The existence of a large unorganised money market;

(e) The existence of indigenous banks which do not discount bills with the central banks; and

(f) The habit of commercial banks to keep large cash reserves.

The use of variable reserve ratio as method of credit control is more effective than open market operations and bank rate policy in LDCs. Since the market for securities is very small, open market operations are not successful. But a rise or fall in the reserve ratio by the central bank reduces or increases the cash available with the commercial banks without affecting adversely the prices of securities. Again, the commercial banks keep large cash reserves which cannot be reduced by a raise in the bank rate or sale of securities by the central bank.

But raising the cash-reserve ratio reduces liquidity with the banks. However, the use of variable reserve ratio has certain limitations in LDCs. First, the non-banking financial intermediaries do not keep deposits with the central bank so they are not affected by it. Second, banks which do not maintain excess liquidity are not affected than those who maintain it.

The qualitative credit control measures are, however, more effective than the quantitative measures in influencing the allocation of credit, and thereby the pattern of investment. In underdeveloped countries, there is a strong tendency to invest in gold, jewellery, inventories, real estate, etc., instead of in alternative productive channels available in agriculture, mining, plantations and industry.

The selective credit controls are more appropriate for controlling and limiting credit facilitates for such unproductive purposes. They are beneficial in controlling speculative activities in food grains and raw materials. They prove more useful in controlling ‘sectional inflations’ in the economy. They curtail the demand for imports by making it obligatory on importers to deposit in advance an amount equal to the value of foreign currency.

This has also the effect of reducing the reserves of the banks in so far as their deposits are transferred to the central banks in the process. The selective credit control measures may take the form of changing the margin requirements against certain types of collateral, the regulation of consumer credit and the rationing of credit.

Solving the balance of payments problem:

The central bank should also aim at preventing and solving the balance of payments problem in a developing economy. Such economies face serious balance of payments difficulties to fulfill the targets of development plans. An imbalance is created between imports and exports which continues to widen with development.

The central bank manages and controls the foreign exchange of the country and also acts as the technical adviser to the government on foreign exchange policy. It is the function of the central bank to avoid fluctuations in the foreign exchange rates and to maintain stability. It does so through exchange controls and variations in the bank rate. For instance, if the value of the national currency continues to fall, it may raise the bank rate and thus encourage the inflow of foreign currencies.

5. Essay on the Need for Central Bank:

It is widely recognised that the central bank is a valuable and indispensable institution for the proper functioning of a modern economy. But, there is a difference of opinion regarding the necessity and usefulness of the central bank in economically backward countries having underdeveloped money markets.

Some people argue that the central bank is not necessary in such countries for various reasons: such as the absence of well-organised banking institutions over which the central bank exercises its supervision and control, the absence of short-term money markets and of well-developed bill markets to enable the central bank to perform the rediscounting operations properly, the fear of political pressure of the governments of these countries over the normal working of the central bank, and others. For all these reasons it is argued that the central bank in the under-developed countries cannot execute its monetary policy and control-techniques properly and effectively.

But, the fact remains that the central bank is as indispensable in the underdeveloped countries as it is in the developed countries.

For this reason it is now established that every country, whether developed or underdevel­oped, must set up a central bank for the following reasons:

(a) Economic stability:

The central bank is indispensable for maintaining stability in the economy of a country. It can maintain both price and foreign exchange stability through the exercise of proper and effective control over the country’s total money supply.

Such economic stability is as essential for underdeveloped countries as for developed ones, for promoting rapid economic growth. No other institutions except the central bank is competent enough to maintain this overall economic stability.

(b) Control over bank credit:

The central bank is necessary to exercise a judicious control over bank credit. As bank credit constitutes the most important component of the money supply, its supply is to be properly regulated in time for avoiding instability in the price-level and for regulating its supply in accordance with the country’s requirements.

(c) Control and supervision over the activities of other banks:

The central bank of a country can develop the banking system by exercising proper control and supervision over the operations of other banks. In the absence of the central bank, it becomes a difficult task to bring about proper co-ordination among the banks and to develop these institutions along a sound line.

(d) Proper execution of the monetary policy:

The central bank is the leader of the money market of a country. Therefore, its existence is of utmost importance for pursuing the country’s monetary (credit) policy.

(e) Special role of the central bank in a developing economy:

The central bank has a special role to play in a developing economy in promoting economic growth with stability, in providing special finance for agriculture, industry and other top priority sectors.

(f) Foreign exchange regulations and international dealings:

Every country, whether a developed or an underdeveloped one, must have a monetary institution like the central bank for foreign exchange regulations Sid for dealing with international institutions like the International Mone­tary Fund and the Bank for International Settlements. When the gold standard was in existence, it had some special importance.

(g) Control over the money supply:

The central bank is also necessary for the control over the money supply and for the regulation of the country s interest rates. For this reason the central bank enjoys the monopoly power regarding the issue of paper notes, and its rate of interest (i.e., the bank rate) acts as the pace-setter to other rates such as market rates of interest.


The above description shows that every country, whether a developed or an underdeveloped one, must set up a Central Bank of its own.

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Role of Central Bank Essay

Custodian of commercial banks, control of banks interest rates, management of inflation, the government’s bank, custodian of foreign currency.


Different countries operate their own central bank that controls and monitors operations of commercial banks within their economy; central banks are the custodians of commercial bank. Other than being the sole printer of notes and coins currency of a nation, central banks provide their countries’ currencies with price stability by controlling inflation.

To control and intervene in an economy, central banks use monetary and fiscal policies; the idea of central banks was aimed at creating a bank that controls an economy without political influences, however the separation has been a challenge in many nations. This paper discusses the role played by central bank in an economy.

Before commercial banks gets an operating license, it must be cleared and accepted by the central bank, the bank considers issues with security, liquidity and the quality of facilities with the applying bank.

There are some bench marks that need to be fulfilled by a trader before being allocated the license, it’s upon the central bank to ensure that the bank has fulfilled the requirements. After licensing, central banks have the role of controlling, monitoring and ensuring that the bank is not engaging in fraudulent business practices. In case of such a move, the powers with the bank can revoke the operating license.

Banks operate with a loan facility that they are given by the central bank. The central banks in various countries issue the loans to banks at a certain rate if interest. The banks on their side have the objective like any other business has, that is to make profits; the major source of their income is from loans given to their customers. When they are lending to the outside customer, they have to charge an interest that is higher than that that the central bank is offering.

When commercial banks are offering their lending services, they use finances they have collected from their depositors as well the money lend by central bank; an adjustment of the liquidity fund and the rate of lending the finances means an effect on the interest rates. By liquidity fund we mean that the money that central bank requires a bank to hold at one time; which is a percentage of the bank’s capital.

If the amount is increased, it means that the money available for lending have been reduced and thus the money available can only be lend at a high interest rate. On the other hand, in the case that banks are offering loans at high rates, the central bank can reduce the liquidity performance as well as it bank lending rate to facilitate the reduction of bank lending rates.

Another major determinant of the interest rate that the bank is going to charge a certain loan facility is the level of risk that the loan is likely to have. Other countries central banks has power to set the rate of interest that commercial banks are going to charge; this is a direct control of the banking sector that is not common but it can work. The rate that the central bank authorizes to be charged may be lower than what the banks are willing to sell at; it then settles the deficit.

In cases of inflation the economy has more funds in circulation than it should be having. This makes the cost of good expensive; this has a negative effect on the growth of the economy and discourages foreign and local investments. There are various reasons that can make the central bank to increase the rate of interest. This use mostly monetary policies and fiscal policies that are used to cure inflation in the country.

Money get into the country through the operating commercial banks and so if borrowing money is made more difficult than the flow of currency in the economy is regulated. For this to happen it is a series of activities where the particular country’s central bank is involved; it thus follows that the rate that central bank offers advances to commercial banks will determine the rate at which commercial banks offers loans to the public.

If central bank offers credit to the banks at a higher rate, then the rate of interest that commercial banks will offer loans to the public will be high; this reduces the attractiveness of the facilities; in its return it reduces the flow of money in the economy. This on the other hand cures inflation. These are short term and medium term policies.

There are long term policies that central bank employs they include; issue of treasury bills and bonds and direct participation in the market. Treasury bills and bonds are offered for the general public and companies to buy. When the rate rises, the loan purchasers’ will be discouraged from buying them and circulate the money in other areas of the economy and thus curing the deficit.

When the circulation of money in the economy is higher than the equilibrium, then central bank can aim to offer attractive interest rates; this makes them attractive and the money holders opt to buy them instead of keeping money. It also stops participating in the market. This will make the rate of interest in the country to increase [1] .

Central banks are termed as the bank of the government where policies regarding financial operations of the government are operated. To finance different projects, money comes from the central bank to treasury for implementation. On the other hand, monies collected in an economy as taxation or other central government funds are banked with central bank.

In modern globalized world, there is increased trade among nations, for trade to prevail; trading partners needs to have the currencies of other partner. Central banks have a store for foreign currency and with the currency; it controls deficiencies and surpluses of the funds. For instance with the foreign reserve, the bank can decide to sell some of the reserve to cure a deficit; alternatively it can decide to buy from the market to cure a surplus.

When the flow of foreign currency is controlled, then a country is able to cure deficits in balance of payment [2] .

Banks are important institutions in every economy. They are the medium through which the government uses to control the financial standing of the country that affect a country. Central bank is a central organ that oversees the activities of commercial banks. It uses both monetary and fiscal policies to influence the interests that prevail in an economy. Its participation in the market, either directly or indirectly is aimed at curbing economic vices existing in an economy.

Sullivan, A & SM Sheffrin, Economics: Principles in Action , Pearson Prentice Hall, New Jersey,2003.

Touffut,J, Central banks as economic institutions, Edward Elgar Publishing, New Jersey, 2008.

  • J Touffut, Central banks as economic institutions, Edward Elgar Publishing, New Jersey, 2008.
  • A Sullivan & SM Sheffrin, Economics : Principles in Action , Pearson Prentice Hall, New Jersey, 2003.
  • Chicago (A-D)
  • Chicago (N-B)

IvyPanda. (2018, December 27). Role of Central Bank.

"Role of Central Bank." IvyPanda , 27 Dec. 2018,

IvyPanda . (2018) 'Role of Central Bank'. 27 December.

IvyPanda . 2018. "Role of Central Bank." December 27, 2018.

1. IvyPanda . "Role of Central Bank." December 27, 2018.

IvyPanda . "Role of Central Bank." December 27, 2018.

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Federal Reserve History logo

Overview: The History of the Federal Reserve

1913 to today.

Marriner S. Eccles building, October 20, 1937

David C. Wheelock, Federal Reserve Bank of St. Louis

The Federal Reserve System (“Fed”) is the central bank of the United States. This website serves as a gateway to the history of the Federal Reserve for educators, students, and the general public. The Fed has a complex structure and mission. The purpose of this site is to help demystify the Fed and its role in the economy, and to explain how the Fed and its mission have evolved over its more than 100-year history. The site is organized around eight time periods in the Fed’s history, with essays devoted to key events, policy actions, legislation, and the everyday work of Fed employees during each period. It also includes short  biographies of Federal Reserve Board members and Reserve Bank presidents.

How It All Began

Founded by an act of Congress in 1913, the Federal Reserve System was established with several goals in mind. Perhaps most important was to make the American banking system more stable. Banking panics—events characterized by widespread bank runs and payments suspensions and, to a degree, outright bank failures—had occurred often throughout the 19 th century. Such panics were widely blamed on the nation’s “inelastic currency.”

The national banking acts of the 1860s created an environment in which most of the nation’s currency consisted of notes issued by national banks (commercial banks with charters issued by the federal government) comprised most of the nation’s currency. The volume of notes that a national bank could issue was tied to the amount of U.S. government bonds the bank held. The supply of notes was largely unresponsive to changes in demand, especially when an unforeseen event or news caused bank customers to worry about the safety of their deposits and “run” to their banks to withdraw cash.

Reformers focused on ways to expand the supply of notes rapidly to meet the public’s demand for liquidity. The desire for an “elastic” currency was ultimately realized by the creation of the Federal Reserve and a new currency form—the Federal Reserve note. Federal Reserve notes are the predominant form of U.S. currency today and supplied in amounts needed to meet demand.

More broadly, the Federal Reserve System was established to improve the flow of money and credit throughout the United States in an effort to ensure that banks had the resources to meet the needs of their customers in all parts of the country.

Before the Fed

Although the problems with the U.S. banking system were widely recognized and studied throughout the 19 th century, reforming the system was difficult because of competing interests and goals. The first of eight period essays on this website, “ Before the Fed: The Historical Precedents of the Federal Reserve System ,” delves into the evolution of the American banking system and efforts to manage the nation’s money supply before the Fed’s founding. The essay shows that the federal system of American government, which had its roots in the nation’s earliest history, shaped the American banking system. Before the Civil War, most banks were chartered by states. Notable, and controversial, exceptions were two banks chartered by the federal government. Shifts in the balance of power between politicians who favored a strong federal government, such as Alexander Hamilton, and those who tended to support states’ rights and limited federal power, such as Thomas Jefferson and Andrew Jackson, led first to the establishment and then demise of the two U.S. banks (both named Bank of the United States) in the early 19 th century. As the essay describes, Jackson’s “war” with the second Bank of the United States eliminated a bank that performed some functions of a modern central bank.

In the mid-nineteenth century, the United States still had no central banking authority and dissatisfaction with the banking system had not improved. The nation’s next attempt at banking stabilization involved laws enacted during and shortly after the Civil War. These “National Banking” acts created a new federal banking charter. Banks chartered under these acts were much different than the two pre-Civil War national banks. Unlike the early banks, the new national banks were entirely privately owned and operated, restricted to a single office location, and subject to the supervision and regulation of the Office of the Comptroller of the Currency (a division of the U.S. Treasury established by the Banking Act of 1863 to issue charters to and supervise national banks).

One important feature of the post-Civil War banking landscape was the almost total absence of branch banking. Banks chartered by state governments were never permitted to branch into other states, which put them at a disadvantage relative to the two pre-Civil War U.S. banks which had extensive multi-state branching networks. Antipathy toward the U.S. banks and to large banks in general resulted in strong prohibitions on branching in federal banking law and in the laws of most states. Consequently, the U.S. banking system was characterized by thousands of small, one-office (or “unit”) banks scattered throughout the country. Unit banking contributed to instability by making it harder for banks to reach an efficient size or diversify their loan portfolios. The inherently fragile unit banking structure coupled with an inelastic currency was a recipe for a crisis prone system. Finding a political solution was difficult, however, because it pitted the interests of large city banks against those of banks in smaller cities and rural areas. It also stirred old conflicts over states’ rights and the power of the federal government to regulate the banking system. As the essay describes, a political solution was eventually found after the Panic of 1907, when in December 1913 Congress passed and President Woodrow Wilson signed the Federal Reserve Act.

The Early Years

The Federal Reserve Act attempted to deal with the “inelastic currency” problem by creating an entirely new currency—the Federal Reserve note—and a mechanism to get those notes quickly into circulation. The Act established a system of Reserve Banks with capital provided by the member commercial banks in their designated territories. National banks were required to purchase capital in their local Reserve Bank and thereby become members of the System with access to loans and other services provided by the Reserve Bank. Membership in the System was made optional for state-chartered banks. Although the Reserve Banks are technically private corporations with their own boards of directors, they are overseen by a board (today, the Board of Governors of the Federal Reserve System) comprised of government appointees, and the shareholder rights of the System’s member banks are limited and tightly regulated.

The Discount Window

The Federal Reserve Act required the Fed’s member banks to hold reserves in the form of Federal Reserve notes or deposit accounts with their local Reserve Bank. A member bank could obtain additional currency or reserve deposits by borrowing at the “Discount Window” of its Reserve Bank. 1 A bank that wished to obtain funds in this way would provide some of its short-term commercial or agricultural loans as collateral for the loan. The Fed’s discount window was thus a mechanism for transforming illiquid bank loans quickly into cash and thus providing the nation’s money supply with the desired “elasticity.” An important function of central banks is to serve as lender of last resort to the banking system, and discount window lending has traditionally been a key part of how the Fed has performed that role.

The essay “ The Fed’s Formative Years ” describes in more detail the establishment of the discount window and other Federal Reserve operations in the Fed’s first years. The essay also discusses how cities were chosen for the locations of Reserve Banks and how Federal Reserve district boundaries were drawn. The Fed was just a few years old when the United States entered World War I, and the essay describes the Fed’s role in helping to finance the war effort as well as the effects of the war on the Fed and its policies.

The Payments System

The founding of the Fed had profound effects on the U.S. payments system, not only by creating a new currency, but also by making the processing of payments more efficient and rapid. The Reserve Banks provided check clearing services for their member banks, for example, which reduced the time and cost for banks of obtaining funds for checks that were deposited in their banks. An early innovation was the development of an electronic system for making long-distance payments using the telegraph which later became known as Fedwire. 2

Monetary Policy

The Fed’s early years also saw the beginnings of monetary policy in the modern sense of the term. The Federal Reserve Act did not mention monetary policy. It also did not provide criteria for setting Reserve Bank discount rates. It did, however, require the Reserve Banks to maintain gold reserves equal to specific percentages of their outstanding note and deposit liabilities. Implicitly, this requirement was intended to limit the amount of currency and loans the Fed could issue and thus serve as a brake on inflation. Most of the Act concerned the Fed’s lending and other operations, however, and did not specify broad macroeconomic goals, such as price stability or maximum employment. Those goals—the so-called “dual mandate”—were not written into the Federal Reserve Act until the 1970s.

In the 1920s, the Fed began to adjust its discount rate and buy and sell U.S. government securities to achieve macroeconomic objectives. The Federal Reserve Act permitted the Reserve Banks to buy (and sell) U.S. government securities, mainly so the Banks would have interest income to cover their expenses. As the “Formative Years” essay describes, the Reserve Banks discovered that their purchases influenced short-term interest rates and credit conditions. Purchases of securities tended to lower rates and make credit more widely available while sales had the opposite effects. The Fed purchased securities in 1924 and 1927 when the economy slipped into recessions. By easing U.S. credit conditions, the purchases also helped in restoring the international gold standard which had been disrupted by World War I. In 1928, the Fed sold securities as policymakers sought tighter credit conditions to discourage stock market speculation. The Fed’s apparent success with adjusting the levers of monetary policy in the 1920s seemed to suggest that the new central bank could tame the business cycle and preserve price stability. However, it all went terribly wrong in the 1930s when the U.S. had the worst economic depression in its history.

  • The Great Depression

The bottom dropped out of the U.S. economy in the 1930s. Economic activity peaked in the summer of 1929 and began to fall precipitously after the stock market crashed in October. Total output of goods and services (GDP) fell by some 30 percent, prices fell sharply, and the unemployment rate soared to 25 percent by 1933. As the essay “ The Great Depression ” explains, many economists blame the depression on the Fed—specifically on the Fed’s limited response to banking panics and their disrupting effects on the economy. Economists and historians continue to debate why the Fed failed to prevent the Great Depression after apparently successfully steering the economy out of trouble during the 1920s.

Not surprisingly, the Great Depression brought many changes to the Fed. Various pieces of legislation altered the Fed’s structure, gave it some new powers but took away others, and fundamentally reshaped the structure and regulation of the American financial system. The Banking Acts of 1933 and 1935 shifted the balance of power within the Federal Reserve away from the 12 Reserve Banks to the Federal Reserve Board, which was renamed and reconstituted as the Board of Governors of the Federal Reserve System. The Board was given new authority over the setting of Reserve Bank discount rates and a majority of seats on the Fed’s open-market committee (the FOMC). Overall, however, the Fed’s power was reduced relative to the U.S. President and Treasury. Shortly after entering office, Congress gave President Franklin Roosevelt authority to revalue the dollar in terms of gold and to regulate the gold standard. The establishment of the Exchange Stabilization Fund, financed by a revaluation of gold transferred from the Fed to the Treasury, gave the Treasury a large pool of funds that it could use to manage the dollar. By the mid-1930s, the Treasury effectively had as much or more power than the Fed to determine the nation’s monetary policy.

The Great Depression also brought significant changes to the U.S. banking system and the establishment of several new government agencies focused on the financial system. For example, a federal deposit insurance system was introduced and operated by the Federal Deposit Insurance Corporation. The FDIC was given supervisory authority over all insured state-chartered banks that did not belong to the Federal Reserve System. The Fed retained its authority to supervise state member banks, while the Office of the Comptroller of the Currency continued to supervise national banks.

World War II and Beyond

The U.S. economy was still recovering from the Great Depression when the United States entered World War II in December 1941. Interest rates were already at low levels when the Fed agreed to prevent them from rising during the war. As the essay “ From WWII to the Treasury-Fed Accord ” explains, the Fed kept the yield on long-term U.S. government bonds from rising above 2.5 percent and pegged those on short-term term Treasury securities at lower levels throughout the war, thereby ensuring that the Treasury could borrow at low rates to finance the war effort. As it did during World War I, the Fed actively supported the war effort by promoting war bond sales to the public.

Large government deficits and the Fed’s policy of preventing the yields on government securities from rising caused the nation’s money supply to increase sharply. Wartime spending and armed forces mobilization brought full employment and rising household incomes which alongside highly expansionary fiscal and monetary policies put upward pressure on prices. To keep inflation in check, controls were put on wages and prices as well as on the growth of private credit. Wage and price controls were removed in summer of 1946, unleashing the suppressed inflation. As the essay describes, this triggered a debate between Fed and Treasury officials over whether to allow the yields on U.S. Treasury securities to rise. Fed officials pressed for higher interest rates to contain inflation, but the Treasury argued for holding the line on rates to keep down the government’s borrowing costs. Although Treasury officials eventually acquiesced to a small increase in short-term rates, they insisted that the yield on long-term government bonds not be allowed to rise above 2.5 percent. Ultimately, however, the situation became untenable. Inflation began to rise rapidly in 1950 as the Fed’s efforts to keep interest rates from rising pumped more money into the economy. The Fed and Treasury ultimately reached an agreement in March 1951, known as the Accord, which ended interest rate controls and freed the Fed to use its monetary tools to control inflation.

After the Treasury-Fed Accord

The Accord enabled the Fed to use monetary policy to achieve macroeconomic goals. As the essay “ From the Treasury-Fed Accord to the Mid-1960s ” explains, the Fed pulled back from broad support of the Treasury market and usually conducted its open-market operations in short-term Treasury bills. However, the Fed continued to assist the Treasury by agreeing to limit interest rate moves when the Treasury was issuing new debt and to intervene if needed to prevent Treasury auctions from failing.

The Accord also brought a change in leadership to the Fed. President Harry Truman nominated William McChesney Martin, Jr., to chair the Fed’s Board of Governors. Martin had negotiated the Accord for the Treasury Department and went on to be the Fed’s longest-serving chair, serving until 1970. Federal Reserve monetary policy evolved considerably under Martin’s tenure. The essay describes how the Fed’s policy goals changed over time under the influence of new economic thinking and pressure from the President and Congress. Whereas the Eisenhower administration had supported the Fed’s focus on price stability and mostly ignored the Fed, the Kennedy and, especially, Johnson administrations pressured the Fed to support faster economic growth and low interest rates. Martin, famous for his statements that the Fed’s job is to remove the punch bowl “just when the party [is] really warming up,” 3 resisted political pressure but ultimately was unable to prevent inflation from increasing.

  • The Great Inflation

After an extended period of low and relatively stable inflation from the early 1950s through the mid-1960s, U.S. inflation began to rise and was unusually high and volatile from the late-1960s through the 1970s. As the essay, “ The Great Inflation ,” explains, by the 1960s many economists and policymakers had come to believe in the existence of a reliable and exploitable tradeoff between unemployment and inflation, known as the Phillips Curve. By accepting somewhat higher inflation, it seemed possible to drive the unemployment rate down significantly and, perhaps, permanently. Although many saw monetary policy as less effective than fiscal policy at taming the business cycle and stimulating growth, the Fed was encouraged to keep interest rates low to help promote full employment and hold down the government’s borrowing cost. To keep interest rates from rising the Fed pumped more and more money into the economy, and higher inflation was the result.

By the early 1970s, policymakers sought ways to contain inflation without tightening monetary policy and causing a recession. Fed chair Arthur Burns, who replace Martin in 1970, worked out an apparent solution with the Nixon Administration in the form of wage and price controls. Temporary controls on prices, it was thought, could squash inflation without having to raise interest rates or slow the growth of the money supply. Burns supported the move and agreed to chair a committee charged with encouraging voluntary restraints on interest rates and dividends.

Unfortunately, wage and price controls proved ineffective at controlling inflation for very long. As the essay explains, at the time, Burns and others publicly blamed inflation on a variety of causes, including government budget deficits, pricing power of firms and labor unions, and sharply rising prices of oil and other commodities. Economists also overestimated the economy’s potential growth rate, which led them to believe that an easier monetary policy could spur economic activity without generating higher inflation.

Burns was succeeded as Fed chair in 1978 by G. William Miller. Miller served as Fed chair for just a year when President Jimmy Carter named him Treasury Secretary and nominated Paul Volker, then President of the Federal Reserve Bank of New York, to be Fed chair. Volcker had previously been employed as a Fed economist and an official in the Treasury Department, as well as in the private sector. Soon after his appointment to the Board, Volcker convinced the FOMC to adopt new operating procedures to enhance control of the money supply and bring inflation under control. Under Volcker’s leadership, the Fed accepted responsibility for controlling inflation and persevered in its efforts to bring inflation down despite a significant “double-dip” recession in 1980-82.

The poor performance of the U.S. economy in the 1970s and early 1980s led to several pieces of legislation with a bearing on the Fed. Among them were:

  • The Federal Reserve Reform Act of 1977, which requires the Fed to direct its policies toward achieving maximum employment and price stability and report regularly to Congress. The act also required Senate confirmation for the chair and vice chair of the Board of Governors while limiting their terms to four years.
  • The Community Reinvestment Act of 1977, which requires the Fed and other bank regulators to evaluate banks on their performance in meeting the credit needs of low- and moderate-income communities in the markets they serve.
  • The Full Employment and Balanced Growth Act of 1978, which amended the Employment Act of 1946 and makes more explicit the Fed’s “dual mandate” to support maximum sustainable employment and price stability.
  • The Depository Institutions Deregulation and Monetary Control Act of 1980 which, among other things, granted access to Federal Reserve loans and payments services to banks and other depository institutions that are not members of the Federal Reserve System, and requires that the Fed charge fees for the services it provides. Further, the act sought to give the Fed greater control over the growth of the nation’s money supply by subjecting all banks to reserve requirements set by the Fed.
  • The Great Moderation

The Great Inflation was followed by a period of about 20 years commonly referred to as the Great Moderation. Compared with the Great Inflation era, inflation was low and stable, and fluctuations in economic activity were modest. The essay, “ The Great Moderation ,” explores possible reasons why the performance of the economy was so good during this period. It notes that “reducing inflation and establishing basic price stability laid the foundation for the Great Moderation.” The essay also points to structural changes in the economy and the absence of large shocks during the period. The Fed also began to communicate more information to the public about its monetary policy actions and approach. Since February 1994, the FOMC has issued a statement at the conclusion of each of its meetings followed by the release of meeting minutes a few weeks later. In 2007, the Committee began to release a quarterly summary of economic projections by FOMC members, and since 2011 the chair has regularly held press conferences following FOMC meetings to provide information about the deliberations and decisions made at the meeting. As the essay explains, greater transparency and communication might make policy more effective and perhaps contributed to economic stability during the Great Moderation period.

Significant legislation affecting the Fed and financial system during the Great Moderation era included:

  • The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). Enacted in response to a large number of bank and savings institution failures in the 1980s, FDICIA aims to protect the federal deposit insurance system by requiring the Fed and other bank regulators to take “prompt corrective action” when banks become financially weak, and to resolve bank failures at the lowest cost to the insurance fund. The act also limits the Fed’s lending to troubled banks.
  • The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which permits banks and bank holding companies to operate branches across state lines.
  • The Gramm-Leach-Bliley Financial Services Modernization Act of 1999, which repealed large parts of the Glass-Steagall Act of 1933 (a section of the Banking Act of 1933 that prohibited the commingling of commercial and investment banks). Among other provisions, the act created the financial holding company charter with the Fed as the primary regulator of financial holding companies.
  • The Check Clearing for the 21 st Century Act of 2003 (Check 21), which permits electronic collection of most checks and makes paper copies of the front and back of a check legally the same as the original check. The act eliminated the need to physically transport checks between banks and thereby increased the speed and efficiency of check collection. The Fed subsequently consolidated its check processing operations and sharply reduced employment and resources devoted to check processing in Reserve Bank offices.

The Great Financial Crisis, Recession, and Aftermath

The Great Moderation ended, or perhaps was interrupted, when a major financial crisis triggered a serious recession. The essay, “ The Great Recession and Its Aftermath ,” explains that the financial crisis of 2007-08 began when firms and investors started to experience losses on home mortgage-related financial assets. As the crisis spread, several large firms experienced severe financial distress and turbulence rocked many financial markets.

The Fed took several actions to fight the crisis and lessen its impact on the broader economy. First it eased terms on discount window loans and created new programs to encourage banks to borrow funds to meet their own liquidity needs and those of their customers. Next the Fed used authorities under Section 13(3) of the Federal Reserve Act to create several programs intended to provide liquidity to specific financial markets and firms. Finally, the FOMC cut its target for the federal funds rate effectively to zero and then began a series of large scale purchases of U.S. Treasury and mortgage-backed securities (widely referred to a “quantitative easing” or QE) to stimulate economic activity. Despite the efforts of the Fed and Congress, the recession of 2007-09 was severe: Gross domestic product (GDP) fell by 4.5 percent and the unemployment rate doubled from under 5 percent to 10 percent. The recovery from the recession, especially the recovery of employment, was also slow. To support the recovery, the FOMC maintained a highly accommodative monetary policy, keeping its federal funds rate target at zero until December 2015.

As with previous crises, Congress responded to the Great Financial Crisis with sweeping financial legislation. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 called for tougher capital, risk management and other rules for bank holding companies and other firms whose failure could threaten the stability of the U.S. financial system, and gave the Fed more authority to scrutinize the activities of nonbank companies. In addition, the act established a Financial Stability Oversight Council, of which the Fed chair is a member, to monitor the financial system and identify financial firms that pose systemic risk. The act also established the Consumer Financial Protection Bureau, and it clipped the Fed’s ability to lend to nonbank firms in financial emergencies by requiring that all such lending be in programs that are broadly available to many borrowers, not just a single firm.

The COVID-19 Crisis and the Fed

The Federal Reserve and the nation were confronted with another crisis in 2020 by the COVID-19 pandemic. Financial market turmoil erupted in early March when the pandemic began to spread across the United States. The Fed acted swiftly. The FOMC reduced its federal funds rate target effectively to zero and began to purchase substantial quantities of U.S. Treasury and mortgage-backed securities to provide liquidity and ensure market functioning. Working with the U.S. Treasury, the Board of Governors established several programs to provide funding for specific financial markets, including programs that had previously been used during the Great Financial Crisis as well as new programs. The Fed’s aggressive response likely prevented a financial crisis and aided in the recovery from a severe but very short recession. Most of the programs were terminated at the end of 2020 or in early 2021 as financial market distress had largely abated. However, the FOMC retained its highly accommodative monetary policy into 2021 to encourage further recovery of the economy and as prescribed by a new policy framework that it introduced in mid-2020.

Written as of September 13, 2021. See disclaimer .

  • 1 The Reserve Banks made loans on a discount basis, i.e., lending a sum that was less than the amount received from the member bank when the loan matured with the difference determined by the Reserve Bank’s discount rate.
  • 2 Information on the history and evolution of Fedwire is available from the Federal Reserve Bank of New York.
  • 3 Martin, William McChesney, Jr. Address before the New York Group of the Investment Bankers Association of America , October 19, 1955, via FRASER .

Essays in this Time Period

  • The Great Recession and Its Aftermath
  • Before the Fed: The Historical Precedents of the Federal Reserve System
  • The Fed's Formative Years
  • From WWII to the Treasury-Fed Accord
  • From the Treasury-Fed Accord to the Mid-1960s

Federal Reserve History

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Journal of Democracy

Rethinking Central-Bank Independence

Matthias matthijs.

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Read the full essay here .

How can central-bank independence be reconciled with the modern need for political accountability in times of unconventional monetary policy and increased financial-oversight powers? The world experienced a startling convergence toward central-bank independence during the 1990s, as interests and ideas combined to make the notion into a virtually uncontested institutional norm. The ensuing boom years added credibility to the view that technocrats were superior to politicians in dealing with monetary affairs. The global financial crisis, however, exposed central bankers as powerful political actors rather than mere technocrats. Moving far beyond their narrow mandates, they became more overtly distributive and increasingly politicized agents. While unconventional monetary policy and financial supervision offer short-term benefits, they create future uncertainty and raise questions of political accountability. This paper argues that central banks will need to channel contestation over monetary policy into a more conventional political arena if they are to maintain their democratic legitimacy.

About the Authors

Erik Jones is director of the Robert Schuman Centre for Advanced Studies at the European University Institute.

View all work by Erik Jones

Matthias Matthijs is assistant professor of international political economy at the Paul H. Nitze School of Advanced International Studies (SAIS), Johns Hopkins University.

View all work by Matthias Matthijs

Further Reading

Volume 6, Issue 3

Departures from Communism

  • Jan S. Prybyla

A review of  From Reform to Revolution: The Demise of Communism in China and the Soviet Union,  by Minxin Pei and Sowing the Seeds of Democracy in China: Political Reform in the…

Volume 25, Issue 2

Ethnic Power Sharing: Three Big Problems

  • Donald L. Horowitz

In severely divided societies, ethnic cleavages tend to produce ethnic parties and ethnic voting. Power-sharing institutions can ameliorate this problem, but attempts to establish such institutions, whether based on a consociational or…

Shifting Tides in South Asia: Sri Lanka’s Postwar Descent

  • Jason G. Stone

With the defeat of the Tamil Tigers in a 26-year civil war, Sri Lanka had a chance for genuine reconciliation, but that chance is being  squandered by the government of…

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This doctoral thesis engages the political economy of central banking and central bank independence (short: CBI) by challenging and qualifying prevalent pre-crisis and post-crisis accounts of CBI as well as existing explanations of the policy-making of major central banks. Central banks have emerged from the economic and financial crises of the late-2000s as one of the key actors in the macroeconomy of advanced political economies. Understanding their actions and motivations, as well as the evolving relationship and communication between central banks and their variegated stakeholders, has thus become a more relevant feat than hardly ever before. The thesis consists of a set of three essays, employing a mixed-methods strategy which combines quantitative text analysis (in the first essay) with élite interviews (in the second and third essays) as well as qualitative document analyses (in all three essays). The first of the three essays revisits the Eurozone's unparalleled monetary-fiscal 'divorce' in light of an equally unparalleled involvement of the ECB in fiscal policy issues throughout the crisis. It argues that a situation best characterized as 'financial dominance' can help explain this puzzling observation, drawing our attention to the ECB's concerns about bearing financial risks on its balance sheet and its desire for fiscal solutions to alleviate these concerns. The second and third essays, in turn, pick up on and dig deeper into this apparent risk aversion on behalf of central banks in the context of unconventional monetary policy, probing into the understudied and perplexing political economy of central bank capital and concerns for central bank solvency. While the thesis as a whole is focused on the case of the Eurozone, it also leverages pertinent comparisons with other advanced political economies, notably the United Kingdom and Japan.

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  • Monetary Policy
  • Federal Reserve

What Is a Central Bank, and Does the U.S. Have One?

central bank essay

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 .

Key Takeaways

  • A central bank is a financial institution that is responsible for overseeing the monetary system and policy of a nation or group of nations, regulating its money supply, and setting interest rates.
  • Central banks enact monetary policy, by easing or tightening the money supply and availability of credit, central banks seek to keep a nation's economy on an even keel.
  • A central bank sets requirements for the banking industry, such as the amount of cash reserves banks must maintain vis-à-vis their deposits.
  • A central bank can be a lender of last resort to troubled financial institutions and even governments.

Investopedia / Zoe Hansen

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. They influence the sentiment of markets as they issue currency and set 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.

A Brief History of Central Banks

The first prototypes for modern central banks were the Bank of England and the Swedish Riksbank, which date back to the 17 th 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.

It was principally because European central banks made it easier for federal governments to grow, wage war, and enrich special interests that many of United States' founding fathers—most passionately Thomas Jefferson—opposed establishing such an entity in their new country. Despite these objections, the young country did have both official national banks and numerous state-chartered banks for the first decades of its existence, until a “free-banking period” was established 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, in 1913 the U.S. Congress established the Federal Reserve System and 12 regional Federal Reserve Banks throughout the country to stabilize financial activity and banking operations. The new Fed helped finance World War I and World War II by issuing Treasury bonds .

Between 1870 and 1914, when world  currencies  were pegged to the  gold standard , maintaining price stability was a lot easier because the amount of gold available was limited. Consequently, monetary expansion could not occur simply from a political decision to print more money, so  inflation  was easier to control. The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency; it issued notes based on a country's reserves of gold.

At the outbreak of World War I, the gold standard was abandoned, and it became apparent that, in times of crisis, governments facing  budget deficits  (because it costs money to wage war) and needing greater resources would order the printing of more money. As governments did so, they encountered inflation. After the war, many governments opted to go back to the gold standard to try to stabilize their economies. With this rose the awareness of the importance of the central bank's independence from any political party or administration.

During the unsettling times of the  Great Depression  in the 1930s and the aftermath of World War II, world governments predominantly favored a return to a central bank dependent on the political decision-making process. This view emerged mostly from the need to establish control over war-shattered economies; furthermore, newly independent nations opted to keep control over all aspects of their countries—a backlash against colonialism. The rise of managed economies in the Eastern Bloc was also responsible for increased government interference in the macro-economy. Eventually, however, the independence of the central bank from the government came back into fashion in Western economies and has prevailed as the optimal way to achieve a liberal and stable economic regime.

Central Banks and Deflation

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.

The Federal Reserve's Approach

In response, in December 2008, the Federal Open Market Committee (FOMC) , the Federal Reserve's monetary policy body, turned to two main types of unconventional monetary policy tools: (1) forward policy guidance and (2) large-scale asset purchases, aka quantitative easing (QE) .

The former involved cutting the target federal funds rate essentially to zero and keeping it there at least through mid-2013. But it's the other tool, quantitative easing, that has hogged the headlines and become synonymous with the Fed's easy-money policies. QE essentially involves a central bank creating new money and using it to buy securities from the nation's banks so as to pump liquidity into the economy and drive down long-term interest rates. In this case, it allowed the Fed to purchase riskier assets, including mortgage-backed securities and other non-government debt.

This ripples through to other interest rates across the economy and the broad decline in interest rates stimulate demand for loans from consumers and businesses. Banks are able to meet this higher demand for loans because of the funds they have received from the central bank in exchange for their securities holdings.

Other Deflation-Fighting Measures

In January 2015, the European Central Bank (ECB) embarked on its own version of QE, by pledging to buy at least 1.1 trillion euros' worth of bonds, at a monthly pace of 60 billion euros, through to September 2016. The ECB launched its QE program six years after the Federal Reserve did so, in a bid to support the fragile recovery in Europe and ward off deflation, after its unprecedented move to cut the benchmark lending rate below 0% in late-2014 met with only limited success.

While the ECB was the first major central bank to experiment with negative interest rates , a number of central banks in Europe, including those of Sweden, Denmark, and Switzerland, have pushed their benchmark interest rates below the zero bound.

Results of Deflation-Fighting Efforts

The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war. Meanwhile, the concerted moves to fend off deflation globally have had some strange consequences: 

  • QE could lead to a covert currency war: QE programs have led to major currencies plunging across the board against the U.S. dollar. With most nations having exhausted almost all their options to stimulate growth, currency depreciation may be the only tool remaining to boost economic growth, which could lead to a covert currency war .
  • European bond yields have turned negative: More than a quarter of debt issued by European governments, or an estimated $1.5 trillion, currently has negative yields . This may be a result of the ECB's bond-buying program, but it could also be signaling a sharp economic slowdown in the future.
  • Central bank balance sheets are bloating: Large-scale asset purchases by the Federal Reserve, Bank of Japan, and the ECB are swelling balance sheets to record levels. Shrinking these central bank balance sheets may have negative consequences down the road.

In Japan and Europe, the central bank purchases included more than various non-government debt securities. These two banks actively engaged in direct purchases of corporate stock in order to prop up equity markets , making the BoJ the largest equity holder of a number of companies including Kikkoman, the largest soy-sauce producer in the country, indirectly via large positions in exchange-traded funds (ETFs ).

Modern Central Bank Issues

Currently, the Federal Reserve, the European Central Bank, and other major central banks are under pressure to reduce the balance sheets that ballooned during their recessionary buying spree.

Unwinding, or tapering these enormous positions is likely to spook the market since a flood of supply is likely to keep demand at bay. Moreover, in some more illiquid markets, such as the MBS market, central banks became the single largest buyer. In the U.S., for example, with the Fed no longer purchasing and under pressure to sell, it is unclear if there are enough buyers at fair prices to take these assets off the Fed's hands. The fear is that prices will then collapse in these markets, creating more widespread panic. If mortgage bonds fall in value, the other implication is that the interest rates associated with these assets will rise, putting upward pressure on mortgage rates in the market and putting a damper on the long and slow housing recovery.

One strategy that can calm fears is for the central banks to let certain bonds mature and to refrain from buying new ones, rather than outright selling. But even with phasing out purchases, the resilience of markets is unclear, since central banks have been such large and consistent buyers for nearly a decade.

Federal Reserve System. " Federal Reserve Act ."

Federal Reserve System. " Open Market Operations ."

Macrotrends. " Nikkei 225 Index - 67 Year Historical Chart ."

Federal Reserve Bank of St. Louis. " Federal Funds Effective Rate (FEDFUNDS) ."

Federal Reserve System. " Quantitative Easing and the "New Normal" in Monetary Policy ."

European Central Bank. " Annual Report 2016 ."

European Central Bank. " Asset Purchase Programmes ."

European Central Bank. " Going Negative: The ECB’s Experience ."

Bloomberg. " ‘Why Am I Holding This?’ Saying Bye to Europe’s Negative Yields ."

Barron's. " Kikkoman Corp ."

  • The Impact of Interest Rate Changes by the Federal Reserve 1 of 30
  • What Is a Central Bank, and Does the U.S. Have One? 2 of 30
  • Federal Reserve System (FRS): Functions and History 3 of 30
  • U.S. Treasury vs. Federal Reserve: What’s the Difference? 4 of 30
  • Prime Rate vs. Discount Rate: What's the Difference? 5 of 30
  • The Fed's Tools for Influencing the Economy 6 of 30
  • Federal Funds Rate: What It Is, How It's Determined, and Why It's Important 7 of 30
  • Forces That Cause Changes in Interest Rates 8 of 30
  • What Happens If Interest Rates Increase Too Quickly? 9 of 30
  • Do Lower Interest Rates Increase Investment Spending? 10 of 30
  • How Does Money Supply Affect Interest Rates? 11 of 30
  • Interest Rates Explained: Nominal, Real, and Effective 12 of 30
  • How Negative Interest Rates Work 13 of 30
  • Monetary Policy Meaning, Types, and Tools 14 of 30
  • How the Federal Reserve Manages Money Supply 15 of 30
  • What Is Quantitative Easing (QE) and How Does It Work? 16 of 30
  • Fiscal Policy vs. Monetary Policy: Pros and Cons 17 of 30
  • How the Federal Reserve Devises Monetary Policy 18 of 30
  • How to Prepare for Rising Interest Rates 19 of 30
  • How to Invest for Rising Interest Rates 20 of 30
  • How Are Money Market Interest Rates Determined? 21 of 30
  • Open Market Operations vs. Quantitative Easing: What’s the Difference? 22 of 30
  • Interest Rate Risk Between Long-Term and Short-Term Bonds 23 of 30
  • How Higher Interest Rates Impact Your 401(k) 24 of 30
  • How Interest Rates Affect the U.S. Markets 25 of 30
  • Average Credit Card Interest Rate for May 2024: 24.37% APR 26 of 30
  • The Most Important Factors Affecting Mortgage Rates 27 of 30
  • How Interest Rates Work on Car Loans 28 of 30
  • These Sectors Benefit From Rising Interest Rates 29 of 30
  • How Banks Set Interest Rates on Your Loans 30 of 30

central bank essay

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The Oxford Handbook of Public Choice, Volume 2

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25 The Politics of Central Bank Independence

Jakob de Haan is Head of Research at De Nederlandsche Bank and Professor of Political Economy at the University of Groningen.

Sylvester Eijffinger is Full Professor of Financial Economics and Jean Monnet Professor of European Financial and Monetary Integration at Tilburg University.

  • Published: 11 February 2019
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This chapter reviews recent research on the political economy of monetary policymaking, both by economists and by political scientists. The traditional argument for central bank independence is the desire to counter inflationary biases. However, studies in political science suggest that governments may delegate monetary policy in order to detach it from political debates and power struggles. The recent financial crisis has changed the role of central banks, as evidenced by unconventional monetary and macro-prudential policy measures. Financial stability and unconventional monetary policies have stronger distributional consequences than conventional monetary policies, with implications for central bank independence. However, the authors’ results do not suggest that that has happened in the wake of the Great Financial Crisis, nor has there been higher turnover of central bank governors.

25.1 Introduction

Central bank independence (CBI) means that monetary policy is delegated to unelected officials and that the government’s influence on monetary policy is restricted.* However, even the most independent central bank does not operate in a political vacuum (Fernández-Albertos 2015). For instance, in a survey of 24 central banks, Moser-Boehm (2006) shows that central bankers and government officials frequently meet and also have informal ways for discussing (the coordination of) monetary and fiscal policy. In addition, there may be political pressure on the central bank—where the ultimate threat is to remove the central bank’s independence—notably if politicians disagree with the central bank’s policies (see Ehrmann and Fratzscher 2011 , and references cited therein). 1

This chapter reviews recent research on the political economy of monetary policymaking, both by economists and by political scientists, thereby updating our previous surveys on this topic ( Eijffinger and de Haan 1996 ; Berger et al. 2001 ; and Klomp and de Haan 2010a ).

The theoretical case for CBI rests on countering inflationary biases that may occur for various reasons in the absence of an independent central bank ( Fischer 2015 ). 2 One reason for such a bias is political pressure to boost output in the short run for electoral reasons. Another reason is the incentive for politicians to use the central bank’s power to issue money as a means to finance government spending. The inflationary bias can also result from the time-inconsistency problem of monetary policymaking. In a nutshell, this is the problem that policymakers are not credible—i.e., they have an incentive to renege in the future on their promise made today to keep inflation low. 3 By delegating monetary policy to an independent and conservative (i.e., inflation-averse) central bank, promises to keep inflation low are more credible. In the words of Bernanke (2010) :

a central bank subject to short-term political influences would likely not be credible when it promised low inflation, as the public would recognize the risk that monetary policymakers could be pressured to pursue short-run expansionary policies that would be inconsistent with long-run price stability. When the central bank is not credible, the public will expect high inflation and, accordingly, demand more-rapid increases in nominal wages and in prices. Thus, lack of independence of the central bank can lead to higher inflation and inflation expectations in the longer run, with no offsetting benefits in terms of greater output or employment. 4

It is important to realize that in the model of Rogoff (1985) , which is the theoretical basis for the views outlined by Bernanke (2010) , the time-inconsistency problem of monetary policy can only be reduced if monetary authority is delegated to an independent and conservative central bank. “Conservative” means that the central bank is more inflation averse than the government. If the central bank would have the same preferences as the government, it would follow the same policies as the government and independence would not matter. Likewise, if the central bank would be fully under the spell of the government, its inflation aversion would not matter. Only if the central bank is more inflation averse than the government, and can decide on monetary policy without political interference, can it credibly promise to keep inflation low ( Berger et al. 2001 ). It is the combination of central bank independence (CBI) and central bank conservatism (CBC) that matters. The optimum level of inflation can be realized under several combinations of CBI and CBC. 5

What determines central bankers’ conservativeness? In economic models, the central bank’s conservativeness is usually assumed given, but Adolph (2013) comes up with an interesting approach making it endogenous, arguing that many of the influences on bureaucrats’ preferences are bound up in their observable career paths. Career backgrounds shape policy ideas (career socialization). In addition, they are shaped by bureaucrats’ desire to move their careers forward (career incentive), which makes them respond to the preferences of future employers, be it the government or the financial sector. Bureaucrats respond to these “shadow principals.” Using central bankers’ career paths, Adolph (2013) comes up with an index of Central Banker Career Conservatism (CBCC), which depends on how long the central banker has had “conservative” jobs, where four types of jobs are considered—namely, financial sector, finance ministry, central bank, and government. According to Adolph, the first two are “conservative,” while the latter two are “liberal.” This classification is based on regressions of inflation and career components, controlling for CBI. 6 It turns out that the CBCC index is strongly related to inflation. Adolph’s regression results suggest that a one standard deviation increase in central banker conservatism leads to a point and a half decline in inflation in advanced countries and a single point decline in developing countries, where the effect is stronger in countries with an independent central bank.

An alternative way to measure central bank conservativeness has been proposed by Levieuge and Lucotte (2014) . They use the Taylor curve, showing the trade-off between the variability of the inflation rate and the variability of the output gap, which is derived from the minimization of a central bank’s quadratic loss function. The index is based on the value of the angle of the straight line joining the origin and a given point on the Taylor curve. Once rescaled to [0, 1], this angle measure constitutes the central bank’s inflation aversion. The authors calculate their index for 32 OECD countries for the period 1980–98.

Most empirical evidence on the impact of CBI on inflation does not explicitly take central bank conservatism into account, which—from a theoretical perspective—is a serious shortcoming. There is strong evidence for a negative relationship between CBI measures—such as those of Cukierman et al. (1992) , 7 and Grilli et al. (1991) , which are discussed in more detail in section 25.4 —and inflation. Countries with an independent central bank on average have lower inflation than countries where the central bank is controlled by the government. 8 In their meta regression analysis, Klomp and de Haan (2010a , 612) conclude that their evidence “corroborates the conventional view by finding a significant ‘true effect’ of CBI on inflation, once we control for a significant publication bias. The effect is strongest when a study focuses on OECD countries, the period 1970–1979, considers the labour market, and when the relation is estimated using a bivariate regression.” 9

Giordano and Tommasino (2011) highlight another benefit of delegating monetary policy to an independent central bank—namely, the increased debt sustainability of a country. They show that countries with more independent central banks are less likely to default on their debt. The authors explain this by a theoretical model that analyzes the default decision as a political process, where different groups in the society (poor, middle class, and rich) may have different interests. They show that if a central bank is sufficiently independent and conservative, the incentives for the government to default are lower. Also, some other recent studies report evidence that CBI may constrain fiscal policy. For instance, Bodea and Higashijima (2017) find that CBI in democracies has a deterrent effect on fiscal overspending, mediated by partisanship and the electoral cycle. Likewise, Bodea (2013) reports for a sample of 23 democratic and undemocratic post-communist countries that that independent central banks restrain budget deficits only in democracies.

Although there is a strong case for instrument independence (i.e., the ability of the central bank to decide on the use of its instruments without political interference), this is different for goal independence (i.e., the ability of the central bank to set its own goals for monetary policy). The argument against goal independence is that in a democracy, the government is accountable to the electorate. As central bankers are not elected, the ultimate goals of monetary policy should therefore be set by the elected government ( Mishkin 2011 ). Indeed, it seems that a “broad consensus has emerged among policymakers, academics, and other informed observers around the world that the goals of monetary policy should be established by the political authorities, but that the conduct of monetary policy in pursuit of those goals should be free from political control” ( Bernanke 2010 ). 10 Central banks, in other words, have a delegated authority to achieve their legally mandated objective(s) and have instrument independence to reach their objective(s). This requires that the central bank is protected from what Sargent and Wallace (1981) call a “regime of fiscal dominance”—i.e., a regime in which the central bank is forced to support government’s fiscal policy.

However, things have changed since the onset of the 2008 financial crisis. First, during the crisis, central banks had to intervene on a grand scale to maintain financial stability. And, as pointed out by Blinder (2012) , during a financial crisis the monetary and fiscal authorities have to work together more closely than under more normal situations for several reasons:

[W]hen it comes to deciding which financial institutions shall live on with taxpayer support (e.g., Bank of America, Citigroup, AIG, . . .) and which shall die (e.g., Lehman Brothers violently, Bear Stearns peacefully), political legitimacy is critically important. The central bank needs an important place at the table, but it should not be making such decisions on its own. If the issue becomes politicized, as is highly likely, the Treasury, not the central bank, should be available to take most of the political heat--even if the central bank provides most of the money. 11

Since the financial crisis, many central banks are paying major attention to financial stability, sometimes because they have been given explicit responsibility for macro-prudential supervision, and sometimes because they now construe financial stability as essential to the traditional pursuit of macroeconomic stability ( Cerutti et al. 2017 ).

Additionally, nowadays the inflation problem in most leading economies is that inflation is too low, not too high. And this has led to the use of different monetary policy instruments. Before the crisis, monetary policymakers in most countries primarily relied on short-term (e.g., overnight) interest rates to maintain price stability. Under this framework, policymakers would announce a desired level of the policy rate and enforce it relatively easily with liquidity management operations. Thus monetary policy could be, and was, implemented without large changes in the size of the central bank’s balance sheet. But the depth of the recession following the financial crisis pushed short-term nominal interest rates to or near their effective lower bound (ELB), rendering the traditional policy instrument almost useless. In response, many central banks turned to forward guidance and/or a variety of unconventional monetary policies, such as lending to banks (and sometimes even to nonbanks) in huge-volume and large-scale asset purchases (“quantitative easing”). In both cases, the central bank actively used its balance sheet to affect market conditions. According to Bernanke (2010) ,

there is a good case for granting the central bank independence in making quantitative easing decisions, just as with other monetary policies. Because the effects of quantitative easing on growth and inflation are qualitatively similar to those of more conventional monetary policies, the same concerns about the potentially adverse effects of short-term political influence on these decisions apply. Indeed, the costs of undue government influence on the central bank’s quantitative easing decisions could be especially large, since such influence might be tantamount to giving the government the ability to demand the monetization of its debt, an outcome that should be avoided at all costs.

The new responsibilities and instruments of central banks have two important consequences. First, financial stability and unconventional monetary policies of central banks have stronger distributional implications (Fernández-Albertos 2015). Of course, decisions by central banks will always affect relative prices and therefore their decisions will have redistributive effects. But financial stability and unconventional monetary policies have much stronger distributional consequences than conventional monetary policies, and this has potential implications for the central bank’s independence (section 25.2 ). Second, it may have changed the regime from monetary dominance to fiscal dominance (section 25.3 ). An important question, therefore, is whether these changes have made the pendulum swing in the other direction: Has CBI decreased since the financial crisis (section 25.4 )? Section 25.5 concludes.

25.2 Political Economy of CBI

The economic case for CBI as outlined in section 25.1 is often considered as the main explanation for the increase in CBI that occurred in most countries during the 1980s and 1990s (see Crowe and Meade 2007 , 2008 ; Cukierman 2008 ). 12 According to Lohmann (2006 , 536), “in monetary policy, macro political economy made the unthinkable thinkable, and more: turned it into conventional wisdom.” However, political scientists have come up with different explanations for the increase in CBI. 13 As Bernhard et al. (2002 , 694) argue:

the time-inconsistency framework does not capture how political actors evaluate the benefits and costs of different monetary arrangements. The choice of these institutions may have less to do with the desire to fight inflation than with the desire to redistribute real income to powerful constituents, assemble an electoral coalition, increase the durability of cabinets, or engineer economic expansions around elections. . . . . [W]e need to move beyond [the time-inconsistency framework] to incorporate factors that influence the opportunity costs of adopting alternative monetary institutions.

Several authors provide political explanations for why delegating monetary policy to independent monetary authorities might be attractive. For instance, according to Bernhard (1998) , information asymmetries create potential conflicts between different political actors, such as backbench legislators, coalition partners, and government ministers. The severity of these conflicts conditions politicians’ incentives regarding the choice of central bank institutions. If backbenchers and coalition partners can credibly threaten to withdraw their support from the government, politicians will choose an independent central bank. But if legislators, coalition partners, and government ministers share similar policy incentives or where the government’s position in office is secure, central bank independence will be low. Bernhard (1998) provides evidence in support for this view. Several proxies suggested by this theory, such as the Alford index (measuring class voting), a proxy for bicameral systems, and the threat of punishment (reflecting the polarization of the political system, legislative institutions, and the existence of coalition and minority governments), are all significant in cross-country regressions explaining differences in CBI.

Hallerberg (2002) provides two additional political factors that determine CBI. First, he argues that multi-party governments will primarily use fiscal policy to target key constituencies, which makes it attractive to leave (non-targetable) monetary policy in the hands of an independent central bank. Second, subnational governments in federal systems prefer an independent central bank to restrain central political authorities’ control over monetary policy. Hallerberg’s evidence suggests that central banks in federal countries with multi-party governments have the highest level of independence. Also, some other studies report that countries with federal structures are associated with more politically independent central banks ( Moser 1999 ; Farvaque 2002 ; Pistoresi et al. 2011 ).

A similar argument—which is also based on the number of veto players—has been made by Keefer and Stasavage ( 2002 , 2003 ). The more veto players, the more difficult it will be for the government to overturn the independence of the central bank. This suggests that independent central banks will be more likely in systems with many veto players. Following Keefer and Stasavage (2002) , this can be explained as follows. Under a system with only one veto player, the central bank will provide the inflation preferred by the veto player, knowing that it otherwise would be overridden. In contrast, when political power is divided among multiple veto players with different preferences, the central bank can now successfully implement policies that one veto player would prefer to override. The empirical evidence of Keefer and Stasavage suggests that increased CBI only has a negative effect on inflation in countries with a relatively high level of checks and balances. Likewise, Crowe (2008) argues that policy delegation can cut the cost of coalition formation by reducing the dimensionality of political conflict. The model yields the empirically testable proposition that delegation is more likely when the correlation of agents’ preferences is lower across different policy dimensions.

According to Goodman (1991) , CBI may be interpreted as an attempt of current governments to tie the hands of future ones. Current governments can extend the implementation of their preferred policies beyond their electoral mandates by delegating monetary policy to central bankers who share their policy preferences. A related but slightly different view has been put forward by Lohmann (1997) . Referring to Germany, Lohmann (1997) argues that if the monetary preferences of the two main political parties are different but their time horizons are sufficiently long, the parties might benefit from committing to a monetary institution that implements an intermediate monetary policy, thereby eliminating the negative social cost associated with the partisan business cycle generated by the alternation in power between the two parties. 14   Alesina and Gatti (1995) provide a formal analysis of this argument. While in Rogoff’s (1985) model the lower level of average inflation following delegation of monetary to an independent (and conservative) central bank is achieved at the cost of higher output variance, in this model an independent central bank can achieve at the same time lower inflation and more output stabilization because the politically induced variance in output is reduced.

The literature discussed here suggests that in politically heterogeneous contexts (federal systems, strong checks and balances, strong partisan differences), the emergence of independent monetary authorities is more likely. 15 As pointed out by Fernández-Albertos (2015), many of the arguments used to explain the political decision to delegate monetary policy to independent central banks are remarkably similar to those used to understand why other nonelected institutions remain autonomous from political interference. In their seminal paper, Alesina and Tabellini (2008) address the issue whether society might benefit from delegating certain tasks to bureaucrats, taking them away from the direct control of politicians. Both types of policymakers have different incentives. Politicians aim to be reelected, and they therefore need to provide enough utility to a majority of the voters. Bureaucrats instead have career concerns, and they want to appear as competent as possible, looking ahead toward future employment opportunities. Given these different incentive structures, Alesina and Tabellini show that it is optimal for society to delegate certain types of activities to nonelected bureaucrats with career concerns, while others are better left in the hands of elected politicians. Delegation to bureaucrats is especially beneficial for tasks in which there is imperfect monitoring of effort, and talent is very important because of the technical nature of the tasks. Under normal circumstances, monetary policy is a policy task relatively technical in nature and therefore would be a good candidate for delegation to a career bureaucrat. An important consideration is the extent to which redistribution is at play:

Consider first policies with few redistributive implications, such as monetary policy or foreign policy. Bureaucrats are likely to be better than politicians if the criteria for good performance can be easily described ex ante and are stable over time, and if political incentives are distorted by time inconsistency or short-termism. Monetary policy indeed fulfills many of these conditions, and the practice of delegating it to an independent agency accords well with some of these normative results. . . . Politicians instead are better if the policy has far reaching redistributive implications so that compensation of losers is important, if criteria of aggregate efficiency do not easily pin down the optimal policy, and if there are interactions across different policy domains.” ( Alesina and Tabellini 2008 , 444)

25.3 Interactions Between Central Banks and Fiscal Authority

25.3.1 fiscal dominance and monetary–fiscal policy interactions.

In their seminal work, Sargent and Wallace (1981) highlight how a central bank might be constrained in determining inflation by a fiscal authority that counts on seigniorage to service its debt, a situation referred to as “fiscal dominance.” For a long time, it was rather treated as a theoretical caveat, at least in the case of advanced economies, but with the rise of government debt to levels unseen for decades, the risk of fiscal policy dominating monetary policy has become real.

Resende (2007) proposes to measure central bank independence in terms of lack of fiscal dominance. Fiscal dominance is defined as in Aiyagari and Gertler (1985) —namely, as the fraction of government debt 1 − δ that needs to be backed by monetary policy. When δ = 0, there is no fiscal dominance and monetary policy is fully independent. The author uses a cointegrating relationship among government debt, consumption, and money supply and the structural relationships between those variables to estimate the parameter δ for a large sample of countries. The results show that there is no fiscal dominance in all OECD countries and in some of the developing countries. The δ-measure of central bank independence is substantially different from traditional measures of CBI (see later). It shows weak correlation with de jure CBI measures and a somewhat stronger correlation with de facto measures. Resende and Rebei (2008) estimate the δ-measure of central bank independence using a structural DSGE model and Bayesian techniques. The empirical results point to independent monetary policies in Canada and the United States, but suggest fiscal dominance in Mexico and South Korea.

Kumhof et al. (2010) consider whether a central bank can target inflation under fiscal dominance. Using a DSGE model of a small open economy, these authors study the case when fiscal policy does not react sufficiently to government debt, implicitly relying on monetary policy to stabilize the economy. They show that a central bank could extend its interest-rate rule to react also to government debt. In such a setup, if the central bank wants to follow inflation targeting, it has to set the coefficient of inflation in its reaction function higher than 1, a condition typically referred to as the Taylor principle. The authors show, however, that under fiscal dominance such an interest-rate rule would imply high inflation volatility and a frequently occurring effective lower bound. Therefore, they conclude that fiscal dominance makes it impossible for the monetary authority to target inflation. This lesson was originally considered relevant for developing economies, but might become (or even already be) relevant for advanced economies as well.

Leeper (1991) proposes a somewhat different approach in which he differentiates between two regimes, an active and a passive regime, for monetary and fiscal policy. The active monetary policy regime means a strong response of interest rates to inflation, while the regime is passive if the response of monetary policy to inflation is weak. The opposite terminology applies for fiscal policy, where a strong response of taxes to debt characterizes the passive regime and a weak response characterizes the active regime. Leeper (1991) studies the implications of the different regimes for the economy in a dynamic general equilibrium model. He shows that the model’s dynamics are determined only for two out of the four policy regime combinations—namely, active monetary, passive fiscal policy (AMPF); and passive monetary, active fiscal policy (PMAF). The first regime is the standard one considered by modern macroeconomists under which monetary policy stabilizes inflation, while fiscal policy stabilizes government debt. Under the second regime, fiscal policy no longer fully stabilizes government debt, while monetary policy is no longer able to fully control inflation. Under those circumstances, higher debt levels translate into higher inflation levels. Davig and Leeper (2011) construct a DSGE model where regime switches among the four different regimes are possible. They estimate this model for the United States from 1949 to 2008, and find that most of the Great Moderation period was characterized by the active monetary and passive fiscal policy regime, whereas during the last six years of their sample (2002–2008), a passive monetary and active fiscal policy regime was in place. This might actually indicate that the regime switch to fiscal dominance took place well before the crisis.

Leeper and Walker (2013) show that the risk of central banks’ losing control over inflation are far greater than suggested by Sargent and Wallace (1981) . In particular, they consider three cases where monetary policy stops being effective even if fiscal policy is passive—that is, an economy at the fiscal limit, 16 an economy with risky sovereign debt, and a monetary union with one of the countries running unsustainable fiscal policy. In all those cases, higher debt levels translate into higher inflation, despite the central bank’s effort to stabilize inflation.

In line with Leeper’s (1991) approach, Bhattarai et al. ( 2012 , 2016 ) build a DSGE model allowing for different policy regime combinations and estimate it for the U.S. pre-Volcker and post-Volcker eras. They show that the post-Volcker era can be best described by the active monetary and passive fiscal policy regime, in which the central bank has full control of inflation. At the same time, they find that the pre-Volcker era is characterized by a regime where both policies are passive, possibly leading to indeterminacy. As the prevailing regime has important consequences for macroeconomic variables, the authors show that had the pre-Volcker era been characterized by an active monetary and passive fiscal policy regime, then the inflation increase in the 1970s could have been lower by approximately 25%.

Bhattarai et al. (2014) combine the literature on fiscal and monetary dominance (by Sargent and Wallace 1981 ) with the literature on active and passive policies ( Leeper 1991 ). They build a DSGE model in which they analyze the effects of the different policies and debt levels. In particular, they compare the monetary dominance regime with the AMPF regime and fiscal dominance with the PMAF regime. They show that government debt has no effect on inflation under monetary dominance and under AMPF. The opposite is true, however, for the fiscal dominance and PMAF regimes, under which higher debt levels translate into higher inflation. This exercise shows that only under monetary dominance and AMPF central banks are able to fully control inflation.

25.3.2 Financial Independence and Balance Sheet Concerns

Stella (2005) was among the first to highlight the importance of the financial dimension of central bank independence. The author associates the financial strength of the central bank with the probability that it will be able to attain its policy goal without external financial support. A financially weak central bank faces a large risk of failing to achieve its policy goals, as losses will force the central bank to resort to current or future money creation. Whereas central banks in advanced economies have recorded long periods of substantial profits, this is not true for central banks in Latin America. In particular, the Argentinian and Jamaican central banks in the late 1980s are mentioned as two prominent cases of central bank losses leading to an abandonment of policy goals.

The notion of financial independence of the central bank gained importance after the financial crisis, when major central banks saw their balance sheets and their financial risks increase. Hall and Reis (2015) define new-style central banking as the strategy pursued by many advanced economies central banks, where they borrow large amounts of funds from commercial banks in the form of reserves and invest those in risky assets with differing maturities. The new strategy is in sharp contrast to the old-style central banking under which central banks were mostly holding low-risk short-term government bonds. According to the authors, this new strategy has important implications for the financial position of central banks. In one explosive scenario, central banks either have to engage in a Ponzi scheme or have to apply to the government for fiscal support. In both cases, the central bank can no longer remain an independent financial institution and cannot pursue its goal of price stability. Hall and Reis (2015) argue that different central banks are currently facing different types of risks. The U.S. Federal Reserve faces mostly risks connected to raising interest rates. An interest rate increase would imply higher payments on reserves owed to commercial banks, while at the same time it would reduce the value of the Fed’s portfolio on longer-term bonds. The European Central Bank faces the same kind of interest-rate risk, but more important for its situation is the default risk connected to the bonds of the peripheral countries of the euro area. The default risk is connected to direct holdings of bonds, as well as to the indirect exposure owing to accepting government bonds as collateral from commercial banks. The third type of risk faced by central banks is exchange-rate risk faced by the central banks of small open economies such as the Swiss National Bank. Hall and Reis (2015) , using historical data, also calculate the financial strength of the three aforementioned central banks. According to their calculations, the actual risk of any of those banks becoming insolvent is small. However, Del Negro and Sims (2015) argue that the use of historical data to extrapolate the future risk of insolvency for central banks may be misleading. Therefore, they consider a theoretical model to study whether the lack of fiscal support may imply that the central bank is no longer able to control inflation. The authors distinguish between fiscal support and fiscal backing, where the latter is defined as in Cochrane (2011) —that is, a commitment of the fiscal authority to set fiscal policy in line with the inflation target of the central bank (see also Reis 2015 ). The model may have self-fulfilling equilibria in which the public’s belief that the central bank will resort to additional seigniorage to cover its losses is enough to cause a solvency crisis. The calibration of the model to reflect the current balance sheet of the Fed shows, however, that insolvency is only possible under extreme scenarios. Nevertheless, a guarantee by the government that it will make automatic fiscal transfers if the central bank incurs losses could eliminate the threat of insolvency altogether. The same effect could be obtained by holding the central bank’s risky assets on a separate account guaranteed by the government, as is the case for Bank of England.

25.4 Has Central Bank Independence Changed Since the Crisis?

The previous sections would suggest that CBI has changed as current mandates and instruments of central banks have stronger distributional consequences than in the past, while a regime of fiscal dominance may have become more likely. To examine CBI, one needs an indicator of the extent to which the monetary authorities are independent from politicians. 17 Most empirical studies use either an indicator based on central bank laws in place, or the turnover rate of central-bank governors (TOR). The most widely employed legal indicators of central bank independence are (updates of) the indexes of Cukierman et al. (1992) and Grilli et al. (1991) . Even though these and other indicators are supposed to measure the same phenomenon, and are all based on interpretations of the central bank laws in place, their correlation is sometimes remarkably low ( Eijffinger and de Haan 1996 ). Furthermore, legal measures of CBI may not reflect the true relationship between the central bank and the government. Especially in countries where the rule of law is less strongly embedded in the political culture, there can be wide gaps between the formal, legal institutional arrangements and their practical impact. This is particularly likely in many developing economies. Cukierman et al. (1992) argue that the TOR may therefore be a better proxy for CBI in these countries than measures based on central bank laws. The TOR is based on the presumption that, at least above some threshold, a higher turnover of central-bank governors indicates a lower level of independence. There are, however, some theoretical objections against using governor turnover as a proxy for CBI (see Adolph 2013 , 288–290, for a discussion). The most important objection is that a high tenure of the central-bank governor could also reflect that the governor behaves in accordance with the wishes of the government.

25.4.1 Legal Independence

Bodea and Hicks (2015) have expanded the Cukierman et al. (1992) index of central bank independence for 78 countries from the end of the Bretton Woods system until 2010. The result is an original data set that codes independence annually and covers legislation changes in the last 25 years. Table 25.1 shows the average level of legal CBI before and after the start of the financial crisis for several groups of countries (based on IMF classifications). The table does not suggest that CBI has decreased after 2007.

However, Masciandaro and Romelli (2015) come to a different conclusion. These authors provide empirical evidence on the evolution of central bank independence (based on updates of the Grilli et al. 1991 GMT index of legal CBI) for a sample of 45 countries during the period 1972 to 2014. They find that a clear reversal in the level of independence is noticeable following the Global Financial Crisis, where this decrease is more pronounced in non-OECD countries. This trend reflects that central banks in many countries have become responsible for banking supervision, which in the GMT index reduces CBI. However, this feature of the GMT index has been severely criticized, as it not obvious that a responsibility for banking supervision reduces CBI (see Eijffinger and de Haan 1996 ).

25.4.2 Turnover Rates

Even central banks that have a high degree of independence are not immune from political pressure. Politicians seeking to influence monetary policy may, for instance, choose to undermine CBI by filling important positions at central banks with individuals they believe are favorably predisposed to their preferred policies. Adolph (2013) shows that left- and right-wing governments tend to appoint central bankers with different monetary preferences. By the same logic, central bankers following policies that are not in line with those preferred by the government may be removed. Indeed, Adolph (2013) reports that central-bank tenures tend to be significantly shorter when inflation is high only under right-wing governments and when unemployment is high under left-wing ones. Of course, the extent to which governments are able to replace central-bank governors depends on the law in place. The evidence of Klomp and de Haan (2010c) suggests that governor turnover is lower following the implementation of central bank reform that strengthens CBI. 18

Several recent papers have examined economic and political determinants of the central-bank governor turnover rate. For instance, Keefer and Stasavage (2003) find that multiple constitutional checks and balances and political polarization reduce the bank governor’s risk of being fired within six months after elections take place. Using new data on the term in office of central-bank governors for a large set of countries for 1970–2005, Dreher et al. (2010) estimate a model for the probability that a central-bank governor is replaced before the end of his legal term in office. They conclude that, apart from economic factors such as inflation and the development of the financial sector, political and regime instability and the occurrence of elections increase the probability of a turnover. Using the data of Dreher et al. (2010) for 101 countries during the period 1970–2007, Artha and de Haan (2015) find that also financial crises increase the probability of a turnover.

Vuletin and Zhu (2011) differentiate between new governors drawn from the ranks of the executive branch of the government (“government ally”) and new governors who come from outside the executive branch (“non-government ally”). Their evidence suggests that the removal of central-bank governors only causes inflation when they are replaced with individuals drawn from the government sector (former politicians and bureaucrats).

Ennser-Jedenastik (2014) has collected data on the partisan background of 195 central-bank governors in 30 European countries between 1945 and 2012 to test whether partisan congruence between governors and the executive (the government or the president) is associated with a higher probability of governor turnover. The author finds that partisan ties to the government strongly increase a governor’s odds of survival vis-à-vis nonpartisan and opposition-affiliated individuals. Further examination reveals that the effect of opposition affiliation is time-dependent. “Hostile” governors face greater odds of removal early in their term, but this effect vanishes after fewer than four years.

Including ECB.

Including Macau.

Including Aruba, Bermuda, and Cuba.

Including “Bank of Central African States” and “Central Bank of West African States.”

Table 25.2 shows average turnover rates for different groups of countries before and after the Global Financial Crisis. The results do not suggest that the number of central-bank governor turnovers has changed since the Great Financial Crisis. This holds both for the total number of turnovers and irregular turnovers (when the governor is replaced before the end of his or her legal term in office).

25.5 Conclusion

This survey has investigated the recent theoretical and empirical literature on central bank independence. The traditional argument for CBI is based on the desire to counter inflationary biases. However, recent studies on determinants of central bank independence suggest that governments may choose to delegate monetary policy in order to detach it from political debates and power struggles. This argument would be especially valid in countries with coalition governments, federal structures, and strongly polarized political systems. Such reasoning brings the discussion on central bank independence closer to the political economy studies on the independence of other nonelected institutions. Those developments may allow for an incorporation of the question of central bank independence into a broader framework of institutional setup and political economy.

As documented by the macroeconomic literature, the recent financial crisis and the following European debt crisis have put much pressure on central banks and changed monetary policy. The altered role of modern central banks is evident in the large set of new, unconventional monetary policy measures employed during the recent decade. The new tools and responsibilities of the central banks come with new challenges for central bank independence.

A first risk is that, in an environment of global debt hangover, the balance of power between fiscal and monetary policy changes. With high public debt levels, fiscal authorities may be tempted to rely on monetary policy to generate additional inflation to alleviate the debt burden. Opposite to previous decades, the threat of fiscal dominance might be particularly strong in the developed world, which has seen remarkably strong increases in sovereign debt levels.

The second risk to central bank independence stems from the consequences of central bank policies. The unprecedented size of the central bank balance sheets has far-reaching implications for the financial dimension of independence. Theoretical studies differ in their assessments of the financial risk faced by central banks. Even if it is small, the financial risk should not be underestimated, as lack of financial independence and the reliance on government financing of the central bank would strongly undermine the credibility of a central bank. Credibility, in turn, is crucial for controlling inflation and inflation expectations. This calls for a very careful consideration and design of exit strategies by the central banks—that is, policies aimed at the reduction of balance sheets to more conventional levels.

The last threat to central bank independence is also associated with the set of unconventional monetary policies employed during the crisis. Crucial for any arguments in favor of central bank independence is the assumption that monetary policy has no or little redistributive consequences. The recent policies employed by central banks threaten, however, to undermine this argument, as they are far more redistributive than traditional monetary policy. The survey also highlights the further need for work on CBI measures, as all existing measures have their limitations. Incorporating the abovementioned risks into those measures might be one of the largest challenges in future studies on CBI.

The views expressed do not necessarily reflect the official views of De Nederlandsche Bank. The authors thank Michal Kobielarz MSc and Henk van Kerkhoff for their excellent support.

Following a similar methodology as proposed by Havrilesky (1993) for the case of the European Central Bank, Ehrmann and Fratzscher (2011) show that politicians, on average, favor significantly lower interest rates. They find that politicians put relatively less weight on inflation. In addition, politicians’ preferences are affected by political economy motives, while they also primarily focus on national economic objectives rather than the euro area as a whole.

There always have been critics of this view. For instance, Stiglitz (2013 31) argues that the

notion of the desirability of an independent central bank was predicated on the belief that monetary policy was a technocratic matter, with no distributional consequences. There was a single policy that was best for all—a view to which the simplistic models that the central banks employed may have contributed, but which was not supported by more general models. There does not, in general, exist a Pareto superior monetary policy. That in turn implies that delegating the conduct of monetary policy and regulations to those who come from and reflect the interests of the financial market is going to result in policies that are not necessarily (and weren’t) in society’s broader interests.

Seminal references are Kydland and Prescott (1977) , Barro and Gordon (1983) , and Rogoff (1985) . Alesina and Stella (2010) provide an excellent review of the models used in these papers.

Another way of enhancing credibility is to delegate monetary authority to an independent and conservative (i.e., inflation-averse) foreign central bank by fixing the exchange rate (see Bernhard et al. 2002 ; Bodea 2010 ; and Fernández-Albertos 2015 for details). Although these two institutional choices might be alternative ways to achieve monetary credibility in the short run, once a fixed exchange rate regime has been adopted, a central bank might be instrumental in making the currency commitments politically sustainable over the long run (Fernández-Albertos 2015).

Eijffinger and Hoeberichts ( 1998 , 2008 ) examine this trade-off between CBI and CBC in more detail. Hefeker and Zimmer (2011) revisit this issue using a setting where there is uncertainty about the preferences of the central bank. In particular, they concentrate on the case in which the public cannot perfectly observe the output-gap target of the central bank. In their model, full CBI is not optimal, as the uncertainty about the central bank’s preferences induces too much volatility in the economy. Therefore, it is no longer true that the government can simply give the central bank a certain level of independence and choose the optimal level of CBC to attain the first best solution. Also, CBC and CBI are not necessarily substitutes anymore.

However, for a sample of 20 OECD countries for the period 1974–2008, Neuenkirch and Neumeier (2015) report that the professional background of the governors of the central bank does not come out significantly in their estimates of the Taylor rule, while political affiliation does. Adolph (2013) focuses on the career background of all monetary policy committee members.

It should be pointed out that under the measure of Cukierman et al. (1992) , a central bank is considered more independent if its charter states that price stability is the sole or primary goal of monetary policy. Our interpretation is that the measure of Cukierman et al. captures both central bank independence and central bank “conservativeness as embedded in the law.”

However, this evidence has been criticized by various authors, claiming that the results are sensitive with respect to the measure of CBI used (see, for instance, Forder 1996 ), the specification of the model (see, for instance, Posen 1995; Campillo and Miron 1997 ) or the inclusion of high-inflation observations (see, for instance, de Haan and Kooi 2000 ). Klomp and de Haan (2010b) report that CBI only has a significant effect on inflation in a minority of the countries in their sample.

The political economy literature suggests that political and economic institutions significantly influence the extent to which an independent bank will reduce inflation. For example, Franzese (1999) shows that the effect of central bank independence on inflation is conditional on several political and institutional factors, such as government partisanship and labor-market organization. For a discussion of this line of research we refer to Berger et al. (2001) and Fernández-Albertos (2015).

Not everyone agrees with this view. For instance, Alesina and Stella (2015, 15–16) argue: “One may or may not agree with the idea of Central Bank independence. But the ‘compromise’ of instrument independence does not reconcile the two views, it is essentially a refinement of the idea that Central Banks should not be independent, at least for what really matters.”

Likewise Cukierman (2013 , 381) argues:

It appears that in democratic societies, financial crises that require large liquidity injections cannot be left only to the discretion of the CB. The reason is that as the magnitude of those injections rises, they become more similar to fiscal policy in that they involve a redistribution of wealth, at least potentially. This violates the (implicit) principle that at least in a democratic society, distributional policies should be determined by elected officials rather than by unelected bureaucrats.

Under Dodd-Frank, emergency lending by the Fed must be approved by the Secretary of the Treasury.

Crowe and Meade (2008) perform a regression analysis to highlight the determinants of the reforms to CBI. Their evidence suggests that reform is correlated with low initial levels of CBI and high prior inflation, meaning that the failure of past anti-inflationary policies led to more independence for the central bank; reform is also correlated with democracy and less flexible initial exchange rates.

The following heavily draws on Fernández-Albertos (2015).

There is some evidence suggesting that partisan factors affect central bank policy. See, for instance, Belke and Potrafke (2012) and references cited therein. These authors find that left-wing governments have somewhat lower short-term nominal interest rates than right-wing governments when central bank independence is low. In contrast, short-term nominal interest rates are higher under left-wing governments when central bank independence is high.

A few studies have pointed to international finance to explain the rise of CBI. For instance, according to Maxfield (1997) , countries raise CBI as a signaling device aimed at convincing international investors of their commitment to economic openness and sound macroeconomic policymaking. Similarly, Polillo and Guillen (2005) argue that pressures to compete in the global economy force governments to imitate the organizational forms adopted by other countries.

The fiscal limit is modeled as an extreme reluctance to increase taxes above some threshold level. Once the fiscal authority reaches a level close to the fiscal limit, the option to use higher tax revenues to stabilize debt is constrained and fiscal policy switches from passive to active.

This part heavily draws on Klomp and de Haan (2010a) .

However, the strength of this effect depends on how well the country concerned adheres to the rule of law and its degree of political polarization. If a country does not adhere to the rule of law while there is a high degree of political polarization, the central bank law reform will not affect the term in office of the central bank governor.

Adolph, C.   2013 . Bankers, Bureaucrats and Central Bank Politics: The Myth of Neutrality . Cambridge: Cambridge University Press.

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The Decentralized Central Bank: A Review Essay on The Power and Independence of the Federal Reserve by Peter Conti-Brown

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The role of Central bank

What are the roles and functions of central banks? Why do they need Economic staff? How far should central banks get involved in data collection and areas such as seasonal adjustment, as well as economic analysis?

Introduction Though Central Bank is viewed as one of the primary mechanisms of macroeconomic stabilization there are a number of arguments about other areas of Central Bank’s involvement. This paper will explore the different areas, including the role of Central Bank in effecting monetary policy and intervening body in exchange rate trades, Central Bank as a Last Lender Resort (LLR), and Central Bank as a regulatory body of the financial sector. Prior to further discussion, it is important to stress that the role of Central Bank and the scope of its involvement may vary due to the effect of different legislations and the presence of various stakeholders. Thus, US Central Bank does not act as a regulatory body of the financial sector (Driffill  et al. , 2005), whereas the intervention activity of Japan Central Bank requires the approval of other governmental bodies (Fujiwara, 2005).

This paper discusses the importance of Central Bank’s publications of economic forecasts and other information related to Central Bank’s views of the further state of macroeconomic trends. The discussion shows that this information is highly important for other market players and forecasting agencies as it reduces the information asymmetry.

The role of Central bank in macroeconomic stabilization Chandavarkar (1996 cited in Geraats, 2002) claims that macroeconomic stabilization is the pivotal role of the Central Bank. The stabilization duties include such aspects as the stabilization of the domestic price level and exchange rate as well as domestic payment systems. The entry and operations of MNEs on the domestic market as well is the growing interdependence of the domestic economy on the business cycles of other leading global players might create serious financial repression (Geraats, 2002). The challenge is that these distortions of prices, including interest rates and foreign exchange rates, might cause severe fluctuations, create insolvency, and threat and disrupt the domestic economy (Beine  et al. , 2005). Beine & Bernal (2005) state that financial stability is critically important for the economic development of the country. They claim that in the absence of stability, economy becomes fragile, causes a moral hazard and reduces agents’ confidence. As a result, potential borrowers obtain lower wealth relative to the size of the projects. Whereas unpredictability and low confidence give rise to the agency costs and undermines the performance in the investment sector. Driffill  et al.  (2003) draw a parallel line between monetary policy and financial stability. They claim that the Central Bank’s activities designed to smooth interest rates and stabilize the price fluctuations lead to greater stability without disrupting market equilibrium.

Speaking of foreign exchange rates stabilization, Beine & Bernal (2005) differentiate between secret and open interventions. Referring to the practice of the Central Bank of Japan they state that these interventions are designed to minimize negative development of foreign exchange trades. Beine & Bernal (2005) claim that the reason for resorting to secret interventions (a practice which is used by a large number of developed countries) is to avoid sending the wrong signals to other market agents. As in Beine  et al.  (2005) the activity of the Central Bank is closely monitored by other market agents who form their expectations on the degree of the consistency of these interventions with the earlier data supplied by the Central Bank. In this case, if there is a controversy between intervention and prior activities of the Central Bank, market players can get confused and increase the overall noise on the market. As a result, it can cause higher fluctuations of rates and a greater degree of information asymmetry between the market agents. Hence, the objective of the Central Bank is to undertake stabilization measures which are consistent with the rational expectations of market agents. The failure to do so may increase the level of noise and cause severe market failures.

The national agenda and the reasons behind the changes of the inclusion policy One of the main reasons directing changes for the inclusion policy was the social changes that the UK has been going through over the past two decades. The rise of the immigration flow has changed the British society and culture, and the schools should be ready to face this change. The Race Relation (Amendment) Act in 2002 sets guidelines for every school to have a policy which values diversity and challenges racism. What is more, the national curriculum regarding the taught information given to students needed to be changed in order to promote inclusion.

Another factor which brought changes to the agenda regarding inclusive learning was the demand for lifelong learning (Shapiro and Rich, 1999). David Blunkett’s Green Paper in 1998 put emphasis on lifelong learning and it requested the educational system to broaden the learning age. The policy of inclusion had to be changed once again so that for the educational system to consider adults as people who were willing to learn and as people who were actually in need of further education. The fact that adults were broadly entering the educational system has also brought changes to the national agenda and to the national curriculum. Because of increasing social competitiveness and subsequently the need for employment, the inclusion policy and the national curriculum were changed so as to provide to adult learners job-related learning opportunities. In this manner, the taught subjects were changed so as to include the ‘newcomers’ and their needs (Shapiro and Rich, 1999).

Finally, it should be noted that the national agenda cannot remain static (Halliday, 1998). Changes need to be made so as to address the needs of different students in a better manner. School curricula need to be responsive to social changes and should be ready to adapt to the differences which the several groups of students bring into the school environment (Halliday, 1998).

Central Bank’s forecasts and publications According to Fujiwara (2005) the publications and forecasts of Central Bank are highly important. Having analysed the behaviour of other forecasting agencies prior to and after Central Bank’s publications, Fujiwara (2005) inferred that they adjust their predictions in line with Central Bank’s information. Geraats (2002) argues that market agents do not posses the wealth of information which might be accumulated by Central Bank. Carroll (2003) claims that most economic agents may be considered to form rational expectations based on professional forecasts, whereas professional agents base their forecasts on the data from the Central Bank’s reports. Romer & Romer (2000) state that Central Bank possesses information about the future development of the economy which is far beyond what is known to market participants. Hence, their predictions of future market development are based on asymmetric information which they have at their disposal. Under such conditions, the publications of Central Bank reduce the information asymmetry. And it is optimal for commercial forecasters to modify their forecasts and adopt the data of Central Bank. Geraats (2002) adds that Central Bank’s publications also act as a signal about the way Central Bank views the macroeconomic situation. On the basis of this information, market agents might predict the future steps of Central Bank and adjust their strategies accordingly. However, Geraats (2002) notes that this effect takes place only if market agents act rationally and have confidence in Central Bank’s consistency. As Huanga & Weib (2005) put it, rational expectation theory only works when the Central Bank as well as other authorities act consistently and have sufficient public credibility. With regards to developing economies and those in transition, the situation might differ. Huanga & Weib (2005) claim that, due to corruption, macroeconomic instability and weak governmental institutions, Central Bank might lack credibility.

When discussing the effect and role of Central Bank’s forecasts on expectation formation Geraats (2002) claims that the issues of transparency and credibility of Central Bank’s forecasts are crucial. Whereas transparency is defined as “the absence of asymmetric information between monetary policy makers and other economic agents” (Geraat, 2002). He claims that transparency, credible and consistent information reduces the likelihood of heterogeneous behaviour resulting from different expectations of the further macroeconomic development. Referring to the practice of developed countries, Geraats (2002) states that the Central Banks of New Zealand, Canada, the UK and Sweden specifically adopted new procedures to increase the level of transparency, known as explicit inflation targeting. The similar approach was also adopted by the Central Banks of Brazil, the United States, Japan and Switzerland.

With regards to credibility of the information supplied by the Central Bank employees, Cechetti & Krause (2002) note that this information shall create the proper set of expectations and reduce the noise which might stem from the Central Bank’s interventions and other activities. In other words, one of the major roles of information coming from the Central Bank is to create a set of expectations which will enable rational market agents to respond accordingly to the given information. As a result, the Central Bank might predict the possible behaviour of other agents and plan its policy accordingly. Moreover, the consistency of information coming from the Central Bank with its steps, promotes the potential efficiency of markets.

Central Bank as Last Lender Resort Humphrey & Keleher (2002) believe that Central Banks traditionally played the role of LLR. Both Humphrey & Keleher (2002) and Gerdrup (2005) state that acting as LLR Central Bank minimizes the potential risk of disruption of the whole banking system. As Gerdrup (2005) makes it clear, under certain situations, the market and interest rate volatility might create a problem of insolvency where a single bank might fail to meet its obligations in intra-bank relations. This case might create a domino (knock-on) effect, creating a negative impact on the whole banking system. At the same time, Driffill  et al.  (2003) argue that the excessive support of banks in terms of LLR activities might induce a form of moral hazard. Referring to the case of the US banks, they claim that commercial banks and other financial institutions may overestimate the favourability of stable macroeconomic climate and the Central Bank support. As a result, these players might commit to risky portfolios of loans and deposits failing to take into account present market risks. Consequently, the short-term exchange rate fluctuation might create the insolvency problem and create a necessity for Central Bank to bail-out the banks which are in trouble. The threat for macroeconomic stability is that the mass insolvency might undermine the Central Bank’s capacity to cover all insolvency issue, meaning the whole financial system might face a crisis.

To avoid the development of a similar scenario, the Federal Reserve System warns market participants in advance about its capacity to act as LLR (Driffill  et al. , 2003). In other words, in periods of high interest volatility banks have to adopt a risk aversive approach. In this respect Borchgrevink & Moe (2004) call for tighter monitoring by Central Bank’s of banks’ and financial institutions’ risk management policies. Gerdrup (2005) notes that in Norway the Central Bank collaborates with the Financial Supervisory Authority with regards to monitoring the activities of individual institutions. The latter body is granted with broad powers to intervene in case it foresees that the activity of a certain financial institution (private and public) might create a threat to stability.

Borchgrevink & Moe (2004) suggest that the Central Bank should limit LLR activities and force market agents to be more prudent. Driffill  et al.  (2003) take the opposite stance. They claim that certain types of risks are not predictable due to the fact that banks borrow short and lend long. Hence, the sudden inflation scare might cause a dramatic short-term change of rates; induce a tightening of monetary policy and cause insolvency issue of the number of banks.

Central Bank as regulatory and monitoring body of financial system Ioannidou (2003) believes that in a large number of countries Central Banks combine functions of macroeconomic stabilization with the management of a financial system. Borchgrevink & Moe (2004) claim that in many transition economies the Central Bank acts as the backbone of the financial system, combining both macroeconomic stabilization and micro control of the emerging financial system. Such a combination creates various debates. The comparative studies of Heller (1991) and Goodhart & Schoenmaker (1992) showed that Central Banks’ macroeconomic decisions might be affected by its involvement in the management of the financial system. The roots of this influence might stem from the conflict of interests. Whereas the desires for certain levels of interest rates (to resolve inflation issues or exchange rate matters) might go against the policy of increasing the profitability of the banking sector. The problem is that due to the nature of banks’ activities (borrow for short periods and lending for long periods) the banks might suffer from the adverse effects of higher interest rates on the solvency. In this regard, Russia’s crisis of 1998 demonstrates the adverse outcomes of this combination. In Russia, the Central Bank’s involvement in the management of the financial system undermined its prudence on the macroeconomic scale and led to an extensive financial crisis. According to Ioannidou (2003), policymakers in the UK, Japan, and several Scandinavian countries recently removed their Central Bank from its role in bank supervision, whereas the European Central Bank was given no supervisory responsibilities, to avoid a conflict of interest.

Goodhart & Schoenmaker (1992) claim that the conflict of interest between different duties of the Central Bank stem from the different nature of regulatory and monetary functions. The regulatory functions might require the microeconomic decisions of short-term nature. Quite to the contrary, the macroeconomic activities are long run and might go at the cost of short-term losses. Ioannidou (2003) put it in the following way: “Monetary policy is usually countercyclical, while the effects of regulation and supervision tend to be procyclical, offsetting to some extent the objectives of monetary policy”.

The other side effect of the Central Bank’s combination of different duties is the issue of credibility. If a bank failure occurs when the Central Bank holds responsibility for bank monitoring and control, the market agents might reduce their level of perceived trust towards that bank.

Conclusions This paper outlined the role of Central Bank and the degree of its involvement in the macro and microeconomic development of a country. The discussion showed that Central Bank is the pivotal element which provides the macroeconomic stabilization of a country by adjusting interest rates and undertaking the foreign currency exchange interventions. Such activities prevent possible disruption and minimize the side effects of the activities of both global and large local market agents.

The discussion also highlighted the role of Central Bank as the disseminator of the economic forecasts regarding the future development of the economy. The closer investigation of the essence of these forecasts revealed that Central Bank needs to be greatly involved in collecting information about the market. The data regarding business cycles, economic trends and other important dimensions of a country’s development serves for Central Bank’s employees as the basis to develop future forecasts, devise its policy and spread information to other market agents. As a result, this data minimizes information asymmetry and provides a more fruitful basis to make the Central Bank procedures more effective.

The discussion outlined the role of Central Bank as the LLR. It showed that under certain conditions, Central Bank becomes the last ditch resort for banks which experience insolvency problems. The support of Central Bank prevents the crisis spreading into and affecting other market agents and the whole economy of a country. At the same time, the paper stressed the importance of a prudential approach as excessive support might cause the effect of moral hazard and lead to an extensive financial crisis.

This paper considered the regulatory function of Central Bank. The considered views of various academics showed that under certain conditions Central Bank might shape the development of the financial system. Nevertheless, the possible conflict of interests might arise and affect the prudence of its macroeconomic policy or its ability to handle microeconomic issues. Hence, the governments of the developed countries tend not to endow Central Banks with confronting obligations and rights.

References Beine, M., & Bernal, O. (2005) Why do central banks intervene secretly? Preliminary evidence from the BoJ. Journal of International Financial Markets, Institutions and Money.

Beine, M., Bénassy-Quéréc A., and MacDonald, R. (2005) The impact of central bank intervention on exchange-rate forecast heterogeneity. Journal of the Japanese and International Economies.

Borchgrevink, H. & Moe, T.G. (2004) Management of financial crises in cross-border banks. Economic Bulletin 4/04, Norges Bank.

Carroll, C. (2003) Macroeconomic expectations of households and professional forecasters. Quarterly Journal of Economics, Vol. 118, pp. 269–298.

Driffill, J., Rotondi, Z., Savona, P. and Zazzara, P. (2003) Monetary policy and financial stability: What role for the futures market?, Journal of Financial Stability, March.

Fujiwara, I. (2005) Is the central bank’s publication of economic forecasts influential? Economic Letters, Vol. 89, Iss. 3, pp. 255–261.

Geraats, P. M. (2002) Central Bank Transparency, The Economic Journal, Vol. 112, Issue 483, pp. F532 – F565.

Gerdrup, K.R. (2005) Norges Bank’s role in the event of liquidity crises in the financial sector. Economic Bulletin, Q2, pp.80 – 89.

Huanga, H. & Weib, S, J. (2005) Monetary policies for developing countries: The role of institutional quality, Journal of International Economics, Vol. 1016, pp. 1–14.

Humphrey, T. M. and R. E. Keleher (2002) The Lender of Last Resort: A Historical Perspective, in Goodhart, C.& Illing G. (ed.) Financial Crisis, Contagion, and the Lender of Last Resort. Oxford University Press.

Ioannidou, V.P. (2005) Does monetary policy affect the Central Bank’s role in bank supervision? Journal of Financial Intermediation, Vol. 14, Issue 1, Jan., pp. 58–85.

Romer, C. & Romer, M. (2000) Federal reserve information and the behavior of interest rates. American Economic Review, Vol. 90, pp. 429–457

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What Is a Central Bank?

Central Banks Explained

Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest.

central bank essay

Definition and Example of a Central Bank

How central banks work, criticism of central banks, notable happenings, frequently asked questions (faqs).

The Balance / Bailey Mariner

A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services, including economic research. Its goals are to stabilize the nation's currency, keep unemployment low, and prevent inflation.

Learn more about how central banks carry out these goals, their origins, and what critics have to say.

Key Takeaways

  • A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services.
  • Central banks have three monetary policy tools at hand, including reserve requirements, open market operations, and target interest rates.
  • The Consumer Financial Protection Agency was established under the Dodd-Frank Act to give the Fed more regulatory authority.
  • Central banks serve a nation's government and private banks. They also manage exchange rates and foreign currency.
  • Critics of central banks are wary of their power over interest rates and the potential to cause high inflation.

Though they may be established by a governing body, central banks are independent authorities. They have a number of duties related to monetary policy, providing financial services, regulating lower banks, and conducting research. Central banks aim to keep a nation's currency and economy stable.

Most central banks are governed by a board consisting of its member banks. The country's chief elected official appoints the directors. The national legislative body approves them. That keeps the central bank aligned with the nation's long-term policy goals. At the same time, it's free of political influence in its day-to-day operations. The Bank of England first established that model.  The U.S. Federal Reserve is another example.

Monetary Policy

Central banks affect economic growth by controlling the liquidity in the financial system. They have three  monetary policy tools  to achieve this goal.

First, they set a reserve requirement. It's the amount of cash that member banks must have on hand each night. The central bank uses it to control how much banks can lend.

Second, they use open market operations to buy and sell securities from member banks. It changes the amount of cash on hand without changing the reserve requirement. They used this tool during the 2008 financial crisis. Banks bought government bonds and mortgage-backed securities to stabilize the banking system. The Federal Reserve added $4 trillion to its balance sheet with quantitative easing . It began reducing this stockpile in October 2017.

Third, they set targets on interest rates they charge their member banks. That guides rates for loans, mortgages, and bonds.  Raising interest rates slows growth, preventing inflation. That's known as contractionary monetary policy. Lowering rates stimulates growth, preventing or shortening a recession. That's called  expansionary monetary policy . The European Central Bank lowered rates so far that they became negative.

Monetary policy is tricky. It can take over a year for it to have its full effects on the economy.

Banks can misread economic data, as the Fed did in 2006. It thought the subprime mortgage meltdown would only affect housing. It waited to lower the fed funds rate . By the time the Fed lowered rates, it was already too late.

Bank Regulation

Central banks regulate their members. They require enough reserves to cover potential loan losses. They are responsible for ensuring financial stability and protecting depositors' funds.

In 2010, the Dodd-Frank Wall Street Reform Act gave more regulatory authority to the Fed. It created the Consumer Financial Protection Agency. That gave regulators the power to split up large banks, so they don't become "too big to fail." It eliminates loopholes for hedge funds and mortgage brokers. The Volcker Rule prohibits banks from owning hedge funds. It bans them from using investors' money to buy risky derivatives for their own profit.

Dodd-Frank also established the Financial Stability Oversight Council. It warns of risks that affect the entire financial industry. It can also recommend that the Federal Reserve regulate any non-bank financial firms.

Dodd Frank keeps banks, insurance companies, and hedge funds from becoming too big to fail.

Providing Financial Services

Central banks serve as the bank for private banks and the nation's government. They process checks and lend money to their members.

Central banks store currency in their foreign exchange reserves . They use these reserves to change exchange rates. They add foreign currency, usually the dollar or euro, to keep their own currency in alignment. That's called a peg , and it helps exporters keep their prices competitive.

Central banks also regulate exchange rates as a way to control inflation. They buy and sell large quantities of foreign currency to affect supply and demand.

Most central banks produce regular economic statistics to guide fiscal policy decisions. Here are examples of reports provided by the Federal Reserve:

  • Beige Book : A monthly economic status report from regional Federal Reserve banks
  • Monetary Policy Report : A semiannual report to Congress on the national economy
  • Consumer Credit : A monthly report on consumer credit

If central banks stimulate the economy too much, they can trigger inflation. Central banks avoid inflation like the plague. Ongoing inflation destroys any benefits of growth. It raises prices for consumers, increases costs for businesses, and eats up any profits. Central banks must work hard to keep interest rates high enough to prevent it.

Politicians and sometimes the general public are suspicious of central banks. That's because they usually operate independently of elected officials. They often are unpopular in their attempt to heal the economy. For example, Federal Reserve Chairman Paul Volcker (served from 1979 to 1987) sent interest rates skyrocketing. It was the only cure for runaway inflation. Critics lambasted him. Central bank actions are often poorly understood, raising the level of suspicion.

Here are a few of the more notable events in central bank history:

  • Sweden created the world's first central bank, the Riksbank, in 1668.
  • The Bank of England came next in 1694.
  • Napoleon created the Banquet de France in 1800.
  • Congress established the Federal Reserve in 1913.
  • The Bank of Canada began in 1935.
  • The German Bundesbank was re-established after World War II.
  • In 1998, the European Central Bank replaced all the eurozone's central banks.

Where is the central bank of the United States located?

The Federal Reserve's Board of Governors is based in Washington, D.C., but its banks are spread around the country, representing 12 regions. These banks are located in:

  • Kansas City, Missouri
  • Minneapolis
  • Philadelphia
  • Richmond, Virginia
  • San Francisco

How do central banks increase the money supply?

Central banks increase the money supply through various types of monetary policy. In the U.S., that typically involves the Fed buying securities through open market operations , which gives banks more money to lend. It can also change reserve requirements for banks, adjust the rates it pays for excess reserves, and lower the Fed funds rate, which determines how much banks charge each other for overnight lending.

U.S. Department of the Treasury. " About FSOC ."

Federal Reserve Bank of Cleveland. " A Brief History of Central Banks ."

Bank of England. " Governance and Funding ."

The Federal Reserve. " Who Owns the Federal Reserve? "

Organisation for Economic Co-operation and Development. " Reserve Requirements ."

The Federal Reserve. " Reserve Requirements ."

Joseph Aschheim. " Open-Market Operations Versus Reserve-Requirement Variation ," The Economic Journal .

Federal Reserve Bank of St. Louis. " Quantitative Easing: How Well Does This Tool Work? "

The Federal Reserve. " Open Market Operations ."

The Federal Reserve. " Interest on Reserve Balances ."

Federal Reserve of St. Louis. " Federal Funds Effective Rate ."

Federal Reserve Bank of St. Louis. " Expansionary and Contractionary Policy ."

European Central Bank. " Monetary Policy Decisions ."

Bank of Canada. " Understanding How Monetary Policy Works ."

Bank of England. " Monetary Policy ."

Federal Reserve History. " Subprime Mortgage Crisis ."

Bank for International Settlements. " Roles and Objectives of Modern Central Banks ," Page 2.

U.S. Securities and Exchange Commission. " Implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act ."

U.S. Department of the Treasury. " Financial Stability Oversight Council ."

European Central Bank. " Trends in Central Banks' Foreign Currency Reserves and the Case of the ECB ."

Federal Reserve Bank of New York. " Foreign Exchange Operations ."

The Federal Reserve. " Publications ."

The Federal Reserve. " Consumer Credit ."

Federal Reserve Bank of San Francisco. " What Are Some of the Factors That Contribute to a Rise in Inflation? "

White House Archives. " Chairman Paul A. Volcker ."

Tax Policy Center. " Paul Volcker Taught Us How Tax and Monetary Policy Can Work Together To Enhance Growth ."

The Bank of Canada. " The Bank's History ."

Deutsche Bundesbank. " History of the Deutsche Bundesbank ."

European Central Bank. " Economic and Monetary Union (EMU) ."

The Federal Reserve. " The Twelve Federal Reserve Districts ."

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The Blockchain Revolution: Decoding Digital Currencies

By David Andolfatto and Fernando M. Martin

  • Introduction

Few people took notice of an obscure white paper published in 2009 titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” authored by a pseudonymous Satoshi Nakamoto. The lack of fanfare at the time is hardly surprising given that innovations in the way we make payments are not known to generate tremendous amounts of excitement, let alone inspire visions of a revolution in finance and corporate governance. But just over a decade later, the enthusiasm for cryptocurrencies and decentralized finance spawned by Bitcoin and blockchain technology has grown immensely and shows no signs of abating.

Because cryptocurrencies are money and payments systems, they have naturally drawn the interest of central banks and regulators. The Federal Reserve Bank of St. Louis was the first central banking organization to sponsor a public lecture on the topic: In March 2014, presenters outlined the big picture of cryptocurrencies and the blockchain by discussing its possibilities and pitfalls. Since that time, the Bank’s economists and research associates have published numerous articles and explainers on these topics, all of which are freely available to the general public. This essay represents a continuation of our effort to help educate the public and offer our perspective of the phenomenon as central bankers and economists.

Understanding how cryptocurrencies work “under the hood” is a challenge for most people because the protocols are written in computer code and the data are managed in an esoteric mathematical structure. To be fair, it’s difficult to understand any technical language (e.g., legalese, legislation and regulation). Because we are not technical experts in this space, we spend virtually no time discussing the technology in detail. For an accessible introduction to the technology, see Fabian Schär and Aleksander Berentsen’s “ Bitcoin, Blockchain, and Cryptoassets: A Comprehensive Introduction ,” MIT Press, 2020. What we offer instead is an overview of cryptocurrencies and blockchain technologies, explaining the spirit of the endeavor and how it compares with traditional operations.

In this essay, we explore four key areas:

  • Money, digital money and payments
  • Cryptocurrencies, blockchain and the double-spend problem of digital money
  • Understanding decentralized finance
  • The makeup of a central bank digital currency
  • Money, Digital Money and Payments

It is sometimes said that money is a form of social credit. One can think of this idea in the following way: When people go to work, they are in effect providing services to the community. They are helping to make others’ lives better in some way and, by engaging in this collective effort, make their own lives better as well.

In small communities, individual consumption and production decisions can be debited and credited, respectively, in a sort of communal ledger of action histories. This is because it is relatively easy for everyone to monitor and record individual actions. A person who has produced mightily for the group builds social credit. Large social credit balances can be “spent” later as consumption (favors drawn from other members of the community).

In large communities, individual consumption and production decisions are difficult to monitor. In communities the size of cities, for example, most people are strangers. Social credit based on a communal record-keeping system does not work when people are anonymous. See Narayana Kocherlakota’s “ The Technological Role of Fiat Money ,” Federal Reserve Bank of Minneapolis, Quarterly Review , 1998. Producers are rewarded for their efforts by accumulating money balances in wallets or bank accounts. Accumulated money balances can then be spent to acquire goods and services (or assets) from other members of the community, whose wallets and bank accounts are duly credited in recognition of their contributions. In this manner, money—like social credit—serves to facilitate the exchange of goods and services.

The monetary object representing this social credit may exist in physical or nonphysical form. In the United States, physical cash takes the form of small-denomination Federal Reserve bills and U.S. Treasury coins. Cash payments are made on a peer-to-peer (P2P) basis, for example, between customer and merchant. No intermediary is required for clearing and settling cash payments. As the customer debits his or her wallet, cash is credited to the merchant’s cash register, and the exchange is settled. Hardly any time is spent inspecting goods and money in small-value transactions. Some trust is required, of course, in the authority issuing the cash used in transactions. While that authority is typically the U.S. government, there is no law preventing households and businesses from accepting, say, foreign currency, gold or any other object as payment.

When people hear the word “money,” they often think of cash. But, in fact, most of the U.S. money supply consists of digital dollars held in bank accounts. The digital money supply is created as a byproduct of commercial bank lending operations and central bank open market operations. Digital money is converted into physical form when depositors choose to withdraw cash from their bank accounts. Most people hold both forms of money. The reasons for preferring one medium of exchange over the other are varied and familiar.

Digital dollar deposits in the banking system are widely accessible by households and businesses. This digital money flows in and out of bank accounts in the form of credits and debits whenever a party initiates a purchase. Unlike with cash, making payments with digital money has traditionally required the services of a trusted intermediary. A digital money payment is initiated when a customer sends an encrypted message instructing his or her bank to debit the customer’s account and credit the merchant’s account with an agreed-upon sum. This debit-credit operation is straightforward to execute when both customer and merchant share the same bank. The operation is a little more complicated when the customer and merchant do not share the same bank. In either case, clearing and settling payments boils down to an exercise in secure messaging and honest bookkeeping.

  • Cryptocurrencies, Blockchain and the Double-Spend Problem of Digital Money

One can think of cryptocurrencies as digital information transfer mechanisms. If the information being transferred is used as an everyday payment instrument, it fulfills the role of money. In this case, a cryptocurrency can be thought of as a money and payments system.

Every money and payments system relies on trust. The difference between cryptocurrencies and conventional money and payments systems lies in where this trust is located. In contrast to conventional systems, no delegated legal authority is responsible for managing and processing cryptocurrency information. Instead, the task is decentralized and left open to “volunteers” drawn from the community of users, similar in spirit to how the internet-based encyclopedia Wikipedia is managed. These volunteers—called miners—work to update and maintain a digital ledger called the blockchain. The protocols that govern the read-write privileges associated with the blockchain are enshrined in computer code. Users trust that these rules are not subject to arbitrary changes and that rule changes (if any) will not benefit some individuals at the expense of the broader community. Overall, users must trust the mathematical structure embedded in the database and the computer code that governs its maintenance.

Managing a digital ledger without a delegated accounts manager is not a trivial problem to solve. If just anyone could add entries to a public ledger, the result likely would be chaos. Malevolent actors would be able to debit an account and credit their own at will. Or they could create social credit out of thin air, without having earned it. In the context of money and payments systems, these issues are related to the so-called double-spend problem.

To illustrate the double-spend problem, consider the example of a dollar stored in a personal computer as a digital file. It is easy for a customer to transfer this digital file to a merchant on a P2P basis, say, by email. The merchant is now in possession of a digital dollar. But how can we be sure that the customer did not make a copy of the digital file before spending it? It is, in fact, a simple matter to make multiple copies of a digital file. The same digital file can then be spent twice (hence, a double-spend). The ability to make personal copies of digital money files would effectively grant each person in society his or her own money printing press. A monetary system with this property is not likely to function well.

Physical currency is not immune from the double-spend problem, but paper bills and coins can be designed in a manner to make counterfeiting sufficiently expensive. Because cash is difficult to counterfeit, it can be used more or less worry-free to facilitate P2P payments. The same is not true of digital currency, however. The conventional solution to the double-spend problem for digital money is to delegate a trusted third party (e.g., a bank) to help intermediate the transfer of value across accounts in a ledger. Bitcoin was the first money and payments system to solve the double-spend problem for digital money without the aid of a trusted intermediary. How?

The Digital Village: Communal Record-Keeping

The cryptocurrency model of communal record-keeping resembles the manner in which history has been recorded in small communities, including in networks of family and friends. It is said that there are no secrets in a small village. Each member of the community has a history of behavior, and this history is more or less known by all members of the community—either by direct observation or through communications. The history of a small community can be thought of as a virtual database living in a shared (or distributed) ledger of interconnected brains. No one person is delegated the responsibility of maintaining this database—it is a shared responsibility.

Among other things, such a database contains the contributions that individuals have made to the community. As we described above, the record of these contributions serves as a reputational history on which individuals can draw; the credit they receive from the community can be considered a form of money. There is a clear incentive to fabricate individual histories for personal gain—the ability to do so would come at the expense of the broader community in the same way counterfeiting money would. But open, shared ledgers are very difficult to alter without communal consensus. This is the basic idea behind decentralized finance, or DeFi.

Governance via Computer Code

All social interaction is subject to rules that govern behavior. Behavior in small communities is governed largely by unwritten rules or social norms. In larger communities, rules often take the form of explicit laws and regulations. At the center of the U.S. money and payments system is the Federal Reserve, which was created in 1913 through an act of Congress. The Federal Reserve Act of 1913 specifies the central bank’s mandates and policy tools. There is also a large body of legislation that governs the behavior of U.S. depository institutions. While these laws and regulations create considerable institutional inertia in money and payments, the system is not impervious to change. When there is sufficient political support—feedback from the American people—changes to the Federal Reserve Act can be made. The Humphrey-Hawkins Act of 1978 , for example, provided the Fed with three mandates: stable prices, maximum employment and moderate long-term interest rates. And the Dodd-Frank Act of 2010 imposed stricter regulations on financial firms following the financial crisis in 2007-09.

Because cryptocurrencies are money and payments systems, they too must be subject to a set of rules. In 2009, Satoshi Nakamoto brought forth his aforementioned white paper, which laid out the blueprint for Bitcoin. This blueprint was then operationalized by a set of core developers in the form of an open-source computer program governing monetary policy and payment processing protocols. Adding, removing or modifying these “laws” governing the Bitcoin money and payments system is virtually impossible. Relatively minor patches to the code to fix bugs or otherwise improve performance have been implemented. But certain key parameters, like the one that governs the cap on the supply of bitcoin, are likely impervious to change.

Concerted attempts to change the protocol either fail or result in breakaway communities called “forks” that share a common history with Bitcoin but otherwise go their separate ways. Proponents of Bitcoin laud its regulatory system for its clarity and imperviousness, especially relative to conventional governance systems in which rules are sometimes vague and subject to manipulation.

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Bitcoin: Beyond the Basics

Learn about the structure and fundamentals of Bitcoin in this Timely Topics podcast with St. Louis Fed economist David Andolfatto. During the 16-minute episode , Andolfatto examines how distributed ledgers work and explains the mining process. This podcast was released Aug. 27, 2018.

How Blockchain Technology Works

As with any database management system, the centerpiece of operations is the data itself. For cryptocurrencies, this database is called the blockchain. One can loosely think of the blockchain as a ledger of money accounts, in which each account is associated with a unique address. These money accounts are like post office boxes with windows that permit anyone visiting the post office to view the money balances contained in every account. Beyond viewing the balances, one can also view the transaction histories of every monetary unit in the account (i.e., its movement from account to account over time since it was created). These windows are perfectly secured. It is important to note that many cryptocurrency users hold their funds via third parties to whom they relinquish control of their private keys. If an intermediary is hacked and burgled, one’s cryptocurrency holdings may be stolen. This has nothing to do with security flaws in the cryptocurrency itself—but with the security flaws of the intermediary. While anyone can look in, no one can access the money without the correct password. This password is created automatically when the account is opened and known only by the person who created the account (unless it is voluntarily or accidentally disclosed to others). The person’s account name is pseudonymous (unless voluntarily disclosed). These latter two properties imply that cryptocurrencies (and cryptoassets more generally) are digital bearer instruments. That is, ownership control is defined by possession (in this case, of the private password). It is worth noting that large-denomination bearer instruments are now virtually extinct. Today, bearer instruments exist primarily in the form of small-denomination bills and metal coins issued by governments. For this reason, cryptocurrencies are sometimes referred to as “digital cash.”

As with physical cash, no permission is needed to acquire and spend cryptoassets. Nor is it required to disclose any personal information when opening an account. Anyone with access to the internet can download a cryptocurrency wallet—software that is used to communicate with the system’s miners (the aforementioned volunteer accountants). The wallet software simultaneously generates a public address (the “location” of an account) and a private key (password). Once this is done, the front-end experience for consumers to initiate payment requests and manage money balances is very similar to online banking as it exists today. Of course, if a private key is lost or stolen, there is no customer service department to call and no way to recover one’s money.

Cryptocurrencies have become provocative and somewhat glamorous, but their unique and key innovation is how the database works. The management of money accounts is determined by a set of regulations (computer code) that determines who is permitted to write to the database. The protocols also specify how those who expend effort to write to the database—essentially, account managers—are to be rewarded for their efforts. Two of the most common protocols associated with this process are called proof-of-work (PoW) and proof-of-state (PoS). The technical explanation is beyond the scope of this essay. Suffice it to say that some form of gatekeeping is necessary—even if the effort is communal—to prevent garbage from being written to the database. The relevant economic question is whether these protocols, whatever they are, can process payments and manage money accounts more securely, efficiently and cheaply than conventional centralized finance systems.

Native Token

Recording money balances requires a monetary unit. This unit is sometimes referred to as the native token. From an economic perspective, a cryptocurrency’s native token looks like a foreign currency, albeit one whose monetary policy is governed by a computer algorithm rather than the policymakers of that country. Much of the excitement associated with cryptocurrencies seems to stem from the prospect of making money through capital gains via currency appreciation relative to the U.S. dollar (USD). (To see how the prices of bitcoin and ethereum, another cryptocurrency, have changed over the past decade, see the FRED charts below.) It seems to have less to do with the promise of the underlying record-keeping technology stressed by Nakamoto’s white paper. To be sure, the price of a financial security can be related to its underlying fundamentals. It is not, however, entirely clear what these fundamentals are for cryptocurrency or how they might generate continued capital gains for investors beyond the initial rapid adoption phase. Moreover, while the supply of a given cryptocurrency such as Bitcoin may be capped, the supply of close substitutes (from the perspective of investors, not users) is potentially infinite. Thus, while the total market capitalization of cryptocurrencies may continue to grow, this growth may come more from newly created cryptocurrencies and not from growth in the per-unit price of any given cryptocurrency, such as Bitcoin. See David Andolfatto and Andrew Spewak’s “ Whither the Price of Bitcoin? ” Federal Reserve Bank of St. Louis, Economic Synopses , 2019.

central bank essay

SOURCE: Coinbase, retrieved from FRED (Federal Reserve Economic Data).

NOTE: Gray shaded areas indicate U.S. recessions. For more data from Coinbase, see these series .

In any case, conceptually, there is a distinction to be made between the promise of a cryptocurrency’s underlying technology and the market price of its native token. Bitcoin (BTC) as a payments system could, in principle, function just as well at any given BTC/USD exchange rate.

Cryptocurrency Applications

Cryptocurrencies designed to serve as money and payments systems have continued to struggle in their quest for adoption as an everyday medium of exchange. Their main benefit to this point—at least for early adopters—has been as a long-term store of value. But their exchange rate volatility makes them highly unsuitable as domestic payment instruments, given that prices and debt contracts are denominated in units of domestic currency. While year-over-year returns can be extraordinary, it is not uncommon for a cryptocurrency to lose most of its value over a relatively short period of time. How a cryptocurrency might perform as a domestic payments system when it is also the unit of account remains to be seen. El Salvador recently adopted bitcoin as its legal tender, and people will be watching this experiment closely. Legal tender is an object that creditors cannot legally refuse as payment for debt. While deposits are claims to legal tender (they can be converted into cash on demand), they also constitute claims against all bank assets in the event of bankruptcy.

A use case touted early in Bitcoin history was its potential to serve as a vehicle currency for international remittances. One of the attractive attributes of Bitcoin is that anyone with access to the internet can access the Bitcoin payments system freely and without permission. For example, a Salvadoran working in the United States can convert his or her USD into BTC at an online exchange and send BTC to a relative in El Salvador in minutes for (usually) a relatively low fee, compared with sending money through conventional channels.

As with any tool, bitcoin may be used for good or ill purposes. Because BTC is a permissionless bearer instrument (like physical cash), it may become a popular way to finance illegal activities, terrorist organizations and money laundering operations. Recently, it has been used in ransomware attacks, in which nefarious agents blackmail hapless victims and demand payment in bitcoin, thereby bypassing the banking system.

But possibly the most attractive characteristic of Bitcoin is that it operates independently of any government or concentration of power. Bitcoin is a decentralized autonomous organization (DAO). Its laws and regulations exist as open-source computer code living on potentially millions of computers. The blockchain is beyond the (direct) reach of government interference or regulation. There is no physical location for Bitcoin. It is not a registered business. There is no CEO. Bitcoin has no (conventional) employees. The protocol produces a digital asset, the supply of which is, by design, capped at 21 million BTC. Participation is voluntary and permissionless. Large-value payments can be made across accounts quickly and cheaply. It is not too difficult to imagine how these properties can be attractive to many people.

Policy Considerations of Cryptocurrency

To a central bank, a cryptocurrency looks very much like a foreign currency. From this perspective, there is nothing revolutionary here. Foreign currency is sometimes seen as a threat by governments. This is not the case for the United States, since the U.S. dollar remains the world’s reserve currency, but many other countries often take measures to discourage the domestic use of foreign currency. Citizens may be prohibited, for example, from holding foreign currency or opening accounts in foreign banks. Because cryptocurrencies are freely available and permissionless, it would likely be considerably more difficult to enforce cryptocurrency controls. The cryptocurrency option may also serve to constrain domestic monetary and fiscal policies—in particular, by imposing a more stringent limit on the amount of seigniorage (i.e., the “printing” of more money to finance government spending).

A dominant foreign currency may cause another problem: As it turns out, it is often cheaper to issue debt denominated in a dominant foreign currency. The problem with this activity is that when the domestic currency depreciates, debtors may have trouble repaying, and a financial crisis may ensue. When that dominant foreign currency is the U.S. dollar, the central bank of a foreign country can sometimes find relief by borrowing dollars from the Federal Reserve through a currency-swap line. But if debt instruments are denominated in cryptocurrency, there is no negotiating with the DAO of that cryptocurrency. Because this is the case, domestic regulators might want to regulate the practice of issuing cryptocurrency-denominated debt more stringently, if the practice ever became sufficiently widespread to pose significant systemic risk.

  • Understanding Decentralized Finance

Decentralized finance broadly refers to financial activities that are based on a blockchain. Unlike conventional or traditional finance that relies on intermediaries and centralized institutions, DeFi relies on so-called smart contracts. The removal of those intermediaries in transactions between untrusted parties would significantly reduce costs and grant the parties more control over the terms of such agreements. Still, intermediaries oftentimes play meaningful roles beyond verification and enforcement, which means they would not altogether disappear. Here, we examine some of these concepts to explain what DeFi means and implies. For a more extensive review, see Fabian Schär’s “ Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets ,” Federal Reserve Bank of St. Louis, Review , 2021; also see an analysis by Sara Feenan et al. in “ Decentralized Financial Market Infrastructures: Evolution from Intermediated Structures to Decentralized Structures for Financial Agreements ,” The Journal of FinTech , 2021.

What Are the Benefits and Challenges of Decentralized Finance?

DeFi allows parties to engage in financial transactions without the need for intermediaries. In this short video, St. Louis Fed economist Fernando Martin looks at how DeFi works with smart contracts and digital tokens.

central bank essay

What Are Smart Contracts?

A smart contract is a computer program designed to execute an agreed-upon set of actions. The concept was first introduced in the mid-1990s by Nick Szabo, who proposed vending machines as a primitive example: A vending machine is a mechanism that dispenses a product in exchange for a listed amount of coins (or bills); anyone with a sufficient amount of money can participate in this exchange. See Nick Szabo’s “ Smart Contracts ” (1994) and “ The Idea of Smart Contracts ” (1997). The key idea is that contractual terms, once agreed upon, are not renegotiable and are therefore automatically executed in the future. In economic theory, so-called Arrow-Debreu securities have the same property. Smart contracts allow interested parties to engage in secure financial transactions without the participation of third parties. As we explain below, their application goes beyond conventional financial transactions.

Ethereum is a blockchain with smart contract capability that was released in 2015. In this case, smart contracts are a type of account, with their own balance and the capability to interact with the network. Rather than being controlled by a user, smart contracts run as programmed, with their code and data residing at a specific address on the Ethereum blockchain. Other platforms may implement smart contracts in different ways. For example, Hyperledger allows for confidential transactions, whereas Ethereum, a public network, does not. Bitcoin is also able to handle a variety of smart contracts.

Like cryptocurrencies, smart contracts overcome security and transparency concerns in transactions between untrusted parties, without the need for a trusted third party. In fact, smart contracts aim to do away with intermediaries such as brokers, custodians and clearinghouses.

Consider a collateralized loan as an example. In traditional finance, a borrower seeks a bank to lend funds or a broker to find potential lenders. The parties then agree on the terms of the loan: interest rate, maturity, type and value of collateral, etc. The borrower’s collateral is placed in escrow. If the borrower fulfills the terms of the contract, the collateral is released and full ownership rights are returned. If the borrower defaults, the collateral is used to fulfill the contract (e.g., repay the remaining principal, interest and penalties). There are many parties involved in this transaction: financial intermediaries, appraisers, loan servicers, asset custodians, and others.

In a smart contract, the entire agreement is specified as part of the computer program and is stored on a blockchain. The program contains the terms of the loan, as well as the specific actions it will take based on compliance (e.g., the transfer of collateral ownership in the event of default). Since the blockchain handles the faithful execution of the contract, there is no need to involve any parties beyond the borrower and lender.

Asset Tokenization

The example above illustrates an important wrinkle: It may not be possible for all the elements and actions of a contract to be handled by the blockchain—particularly when it comes to collateral. If collateral is not available as an asset in the native protocol (i.e., the specific blockchain where the smart contracts exist), then, as in traditional finance, the contract necessitates a third party to provide escrow services. Naturally, this exposes the contract to counterparty risk. One solution to this problem is asset tokenization.

Asset tokenization consists of converting the ownership of an asset into digital tokens, each representing a portion of the property. If the asset exists in physical form (e.g., a house), then tokenization allows the asset to exist in a blockchain and be used for various purposes (e.g., as collateral). An important issue is how to enforce property rights stored in the blockchain for assets that exist in the physical world. This is an ongoing challenge for DeFi and one that may never be fully resolved.

Tokens also have a variety of nonfinancial applications. For example, they may grant owners voting rights to an organization. This allows for the decentralized control of institutions within a blockchain, as we describe below. Another popular application is the creation of nonfungible tokens (NFTs), which provide ownership of a digital image created and “signed” by an artist. Although the image could in principle be replicated countless times, there is only one version that is verifiably authentic. The NFT serves as a certificate of authenticity in the same way that artists’ signatures ensure paintings are originals and not copies. The advantage of an NFT is the security provided by the blockchain—signatures can be forged, whereas the authenticity of the NFT is validated by a decentralized communal consensus algorithm.

Decentralized Autonomous Organization

Smart contracts could transform the way we organize and control institutions. Applications may range from investment funds to corporations and perhaps even the provision of public goods and services.

A decentralized autonomous organization, or DAO, is an organization represented by a computer code, with rules and transactions maintained on a blockchain. Therefore, DAOs are governed by smart contracts. A popular example is MakerDAO, the issuer of the stablecoin Dai, whose stakeholders use tokens to help govern decisions over protocol changes.

The concept of governance refers to the rules that balance the interests of different stakeholders of an institution. For example, a corporation’s stakeholders may include shareholders, managers, creditors, customers, employees, the government and the general public, among others. The board of directors typically plays the critical role in corporate governance. One of the main issues corporate governance is designed to mitigate is agency problems: when managers do not act in the best interest of shareholders. But governance extends beyond regulating internal matters and may, for example, manage the role of a corporation inside a community or relative to the environment.

DAOs may be created for ongoing projects, such as a DeFi entity, or for specific and limited purposes, such as public works. Because they offer an alternative governance model by encoding rules in a smart contract, they replace the traditional top-down structure with a decentralized consensus-based model. Two prominent examples—the decentralized exchange Uniswap and the borrowing and lending platform Aave—started out in the traditional way, by having their respective development teams in charge of day-to-day operations and development decisions. They eventually issued their own tokens, which distributed governance to the wider community. With varying details, holders of governance tokens may submit development proposals and vote on them.

Centralized and Decentralized Exchanges

Currently, the most popular way in which cryptoassets are traded is through a centralized exchange (CEX), which works like a traditional bank or a broker: A client opens an account by providing personal identifiable information and depositing funds. With an account, the client can trade cryptoassets at listed prices in the exchange. The client does not own these assets, however, as the exchange acts as a custodian. Hence, clients’ trades are recorded on the exchange’s database rather than on a blockchain. Binance and Coinbase are CEXs that offer accessibility to users. However, since they stand between users and blockchains, they need to overcome the same trust and security issues as traditional intermediaries.

Decentralized exchanges (DEXs), on the other hand, rely on smart contracts to enable trading among individuals on a P2P basis, without intermediaries. Traders using DEXs keep custody of their funds and interact directly with smart contracts on a blockchain.

One way to implement a DEX is to apply the methods from traditional finance and rely on order books. These order books consist of lists of buy and sell orders for a specific security that display the amounts being offered or bid on at each price point. CEXs also work in this way. The difference with DEXs is that the list and transactions are handled by smart contracts. Order books can be “on-chain” or “off-chain,” depending on whether the entire operation is handled on the blockchain. In the case of off-chain order books, typically only the final transaction is settled on the blockchain.

Order-book DEXs may suffer from slow execution and a lack of liquidity. That is, buyers and sellers may not find adequate counterparties, and individual transactions may affect prices too much. DEX aggregators alleviate this problem by collecting the liquidity of various DEXs, which increases the depth of both sides of the market and minimizes slippage (i.e., the difference between the intended and executed price of an order).

An automated market maker (AMM) is another way to solve the liquidity problem in DEXs. Market makers are also derived from traditional finance, where they play a central role in ensuring adequate liquidity in securities markets. AMMs create liquidity pools by rewarding users who “deposit” assets in the smart contract, which then can be used for trades. When a trader proposes an exchange of two assets, the AMM provides an instant quote based on the relative availability (i.e., liquidity) of each asset. When the liquidity pools are sufficiently large, trades are easy to fulfill and slippage is minimized. Automated market makers are currently the dominant form of DEXs, because they resolve the liquidity problem better than alternative mechanisms and thus provide speedier and cheaper transactions.

What Are Stablecoins?

As we described earlier, cryptocurrencies are subject to extreme exchange rate volatility, which makes them highly unsuitable as payment instruments. A stablecoin is a cryptocurrency that ties its value to an asset outside of its control, such as the U.S. dollar. Some stablecoins stabilize their value by pegging to the U.S. dollar, backed with non-U.S. dollar assets; Dai, for example, pegs its value to a senior tranche of other cryptoassets. See Dankrad Feist’s “ On Supply and Demand for Stablecoins ,” 2021. To accomplish this, the stablecoin must effectively convince its liability holders that its liabilities can be redeemed on demand (or on short notice) for U.S. dollars at par (or at some other fixed exchange rate). The purpose of this structure is to render stablecoin liabilities more attractive as payment instruments. Pegging to the U.S. dollar is attractive to people living in the U.S. because the U.S. dollar is the unit of account. Those outside the U.S. may be attracted to the product because the U.S. dollar is the world’s reserve currency. This structure serves to increase demand for the stablecoin. But why would someone want to make U.S. dollar payments using a stablecoin instead of a regular bank account?

The answer ultimately rests on which product offers its clients the services they desire at a price they find attractive. A stablecoin is likely to be attractive at the wholesale level, where firms would be able to make USD payments at each point in an international supply chain without the need for conventional banking arrangements. Stablecoins market themselves as leveraging blockchain technology to deliver safer and more efficient account management and payment processing services. These efficiency gains can then be passed along to customers in the form of lower fees. A more cynical view ascribes these purported lower costs to regulatory arbitrage (i.e., sidestepping certain costs by relocating the transaction outside of the regulatory environment), rather than technological improvements in database management.

A Primer on Stablecoins

Stablecoins are cryptocurrencies that tie their value to an outside asset. In this short video, St. Louis Fed economist Fernando Martin takes a deep dive into stablecoins and how they have characteristics that are similar to money market mutual funds.

central bank essay

Financial Stability Concerns

U.S. dollar-based stablecoins are similar to money market funds that peg the price of their liabilities to the U.S. dollar. They also look very much like banks without deposit insurance . As the financial crisis of 2007-09 showed, even money market funds are subject to runs when the quality of their assets is questioned. Unless a U.S. dollar-based stablecoin is backed fully by U.S. dollar reserves (it needs an account at the Federal Reserve for this) or by U.S. dollar bills (the maximum denomination is $100, so this seems unlikely), it is potentially prone to a bank run. If a stablecoin cannot dispose of its assets at fair or normal prices, it may fail to raise the U.S. dollars it needs to meet its par redemption promise in the face of a wave of redemptions. In such an event, the stablecoin would turn out to be not so stable.

If the adverse consequences of a stablecoin run were limited to the owners of stablecoins, then standard consumer protection legislation would be sufficient. But regulators also are concerned about the possibility of systemic risk. Consider, for example, the commercial paper market, where firms regularly borrow money on a short-term basis to fund operating expenses. Then consider a stablecoin (or any money market fund) with large holdings of commercial paper. A stablecoin run in this case may compel a fire sale of commercial paper to raise the funds needed to meet the wave of redemptions. This fire sale would likely have adverse economic consequences for firms that make regular use of the commercial paper market: As commercial paper prices decline, the value of commercial paper as collateral falls, and firms may find it more difficult to borrow the funds they normally access with ease. If the fire sale spills over into other securities markets, credit conditions may tighten significantly and lead to the usual woes experienced in an economic recession (missed payments, worker layoffs, etc.). These events are sufficiently difficult for a central bank to handle when the entities involved are domestic money market funds. The problem is compounded if the stablecoin is an unregulated “offshore” DAO. Will offshore stablecoins that are “too big to fail” be able to take advantage of the implicit insurance provided by central bank lender-of-last-resort operations? If so, this would be an example of how the private benefits of DeFi arise from regulatory arbitrage and not from an inherent technological advantage. This possibility presents a significant challenge for national and international regulators.

On the other hand, it may be possible for stablecoins to be rendered “run-proof” by employing smart contracts to design more resilient financial structures. For example, real-time communal monitoring of balance sheet positions is a possibility—a feature that could shine light on what are traditionally opaque financial structures. The opacity of financial structures is not necessary to explain bank runs. For example, the canonical model of bank runs assumes the existence of transparent balance sheets. See Douglas Diamond and Philip Dybvig’s “ Bank Runs, Deposit Insurance, and Liquidity ,” The Journal of Political Economy , 1983. Furthermore, because redemption policies can potentially manifest themselves as computer code, their design can be made more elaborate (state-contingent) and credible (contractual terms that can be credibly executed and not reversed). These features can potentially render stablecoins run-proof in a manner that is not possible with conventional banking arrangements. 

Regulators and Stablecoins

The regulatory concerns with stablecoins are similar to age-old concerns with the banking industry. Banks are in the business of creating money and do so by issuing deposit liabilities that promise a fixed (par) exchange rate against U.S. dollar bills and dollar credits held in Federal Reserve accounts. Lower-yielding liabilities are used to acquire higher-yielding assets. Because commercial banks normally hold only a very small fraction of their assets in the form of reserves, they are called fractional reserve banks. Since the introduction of federal deposit insurance, retail-level bank runs have been practically nonexistent. Banks also have access to the Federal Reserve’s emergency lending facilities. These privileges are matched by a set of regulatory constraints on bank balance sheets (both assets and liabilities) and other business practices.

Some stablecoin issuers would undoubtedly like to base their business models on those of banks or prime institutional money market funds. The motivation is clear: Issuing low-cost liabilities to finance high-yielding assets can be a profitable business. (Until, of course, something goes wrong. Then, regulators and policymakers face blame for permitting such structures to exist in the first place.) This business model naturally involves non-negligible risk and could make for a potentially unstable stablecoin. As stablecoins with these properties interact with off-chain financial activity, they introduce risks that may spill over to other markets and, therefore, prompt some form of regulation.

Other stablecoin issuers are likely to focus on delivering payment services, which can be accomplished by holding only safe assets. These stablecoins would be more akin to government money market funds. Stablecoins that submit to government regulations may be permitted to hold only the safest of securities (e.g., U.S. Treasury securities). If they could, they might even hold only interest-bearing reserves, thereby becoming “narrow banks.” The business model in these cases would be based on generating profits through transaction-processing fees and/or net interest margins enhanced by what stablecoin users would hope to be a wafer-thin capital requirement.

  • The Makeup of a Central Bank Digital Currency

The Board of Governors of the Federal Reserve System, in its recent paper “ Money and Payments: The U.S. Dollar in the Age of Digital Transformation ,” defines a central bank digital currency (CBDC) as a “digital liability of the Federal Reserve that is widely available to the general public.” This essentially means allowing the general public to open personal bank accounts at the central bank. How might a CBDC work?

Today, only financial institutions defined as depository institutions by the Federal Reserve Act and a select number of other agencies (including the federal government) are permitted to have accounts at the Federal Reserve. These accounts are called reserve accounts. The money balances that depository institutions hold in their reserve accounts are called bank reserves. The money account held by the federal government at the Federal Reserve is called the Treasury General Account. In a sense, a CBDC already exists, but only at the wholesale level and only for a small group of agencies. The question is whether to make it more broadly accessible and, if so, how.

What Is a Central Bank Digital Currency?

Economist David Andolfatto notes that there is more than one model for a central bank digital currency. In this short video, he explains how those models vary and highlights one big difference between a CBDC and traditional bank deposits: how they are insured.

central bank essay

As explained above, the general public already has access to a digital currency in the form of digital deposit liabilities issued by depository institutions. Most households and businesses have checking accounts with private banks. The general public also has access to a central bank liability in the form of physical currency (cash). While banks are obligated to redeem their deposit liabilities for cash on demand, deposits are not legally central bank or government liabilities. To put it another way, CBDC is (or would presumably be made) legal tender, while bank deposits represent claims to legal tender.

Federal Deposit Insurance

Bank accounts in the United States are presently insured up to $250,000 by the Federal Deposit Insurance Corp. From a political-economic point of view, bank deposits at the retail level are a de facto government liability. Moreover, given the role of the Federal Reserve as lender of last resort, one could make a case that large-value bank deposits are also a de facto government liability. To the extent this is so, the legal status of CBDC versus bank money may not be important as far as the ultimate safety of money accounts is concerned.

The Question of Counterparty Risk

Safety is only one of the many concerns surrounding money and payments. There is also the question of how counterparty risk may affect access to funds. For example, even if money in a bank account is insured, access to those funds may be delayed if a bank is suddenly subject to financial stress. This type of risk may be one reason corporate cash managers often turn to the repo market, where deposits are typically collateralized with Treasury securities that can be readily liquidated in the event deposited cash is not returned on time. If there is no restriction on the size of CBDC accounts, the product would effectively provide fully insured money accounts for corporations with no counterparty risk. Such a product, if operated effectively, could very well disintermediate (i.e., eliminate) parts of the money market.

Potential for Efficiency Gains

There is also the question of how a CBDC might improve the overall efficiency of the payments system. This is a difficult question to answer. Proponents often compare a well-designed CBDC with the payments system as it exists today in the United States, which has not caught up to developments in other jurisdictions, including in many developing economies. The U.S. payments system, however, is evolving rapidly to a point that may make CBDC a less attractive proposition. For example, The Clearing House now offers a 24/7 real-time payment services platform . The Federal Reserve’s FedNow platform will provide a similar service.

There may be no single best way to organize a payments system. A payments system is all about processing payment requests and debiting/crediting money accounts. Conceptually, bookkeeping is very simple, even if the actual implementation and operation of a payments system are immensely challenging endeavors. Any arrangement would need mechanisms that guard against fraud. Messaging must be made fast and secure. Institutions (or DAOs) must be trusted to manage the ledgers containing money accounts and related information. Property rights over data ownership would need to be specified and enforced. Some have advocated strongly for a CBDC (e.g., John Crawford et al. in “ FedAccounts: Digital Dollars ,” 2021). Others seem less enthusiastic (e.g., Larry White in “ Should the U.S. Government Create a Token-Based Digital Dollar? ” 2020; George Selgin in “ Central Bank Digital Currency as a Potential Source of Financial Instability ,” 2021; and Christopher Waller in “ CBDC: A Solution in Search of a Problem? ” 2021). In principle, a private, public or private-public arrangement could be made to work well.

What Are the Potential Benefits of a CBDC?

Payments systems have evolved over the years, and a central bank digital currency could be the next step in that evolution. In this short video, economist David Andolfatto examines how a CBDC may increase the efficiency of payments systems. He does so also within the context of The Clearing House’s 24/7 real-time payment services platform.

central bank essay

Like most central banks, the Federal Reserve is designed to facilitate payments at the wholesale level. It performs a vital function and overall performs it well. Traditionally, servicing the needs of a large and demanding retail sector in the United States is left to the private sector. A CBDC could be designed to respect this division of labor in one of two ways:

  • Permit free entry into the business of “narrow banking.” This would entail granting Fed master accounts to qualified firms with the requirement that they hold only reserves (and possibly U.S. Treasury bills) as assets. In this arrangement, digital currency remains a private liability (though fully backed by reserves).
  • Grant households and firms direct access to CBDC and delegate the responsibility of processing payments at the retail level to private firms. This latter arrangement is the one described in the Federal Reserve Board’s aforementioned report on CBDC. (See box below.)

Central Bank Digital Currency: Read and Comment on the Fed’s Paper

The Federal Reserve Board’s discussion paper (PDF) , released in January 2022, examines the pros and cons of a potential U.S. CBDC. While the Fed has made no decisions on whether to pursue or implement a CBDC, it has been exploring the potential benefits and risks from a variety of angles. As part of this process, the Board is seeking public feedback on whether and how a CBDC could improve an already safe and efficient U.S. domestic payments system. The comment period is open until May 20, 2022.

The ability to write history is a tremendous power. Who should be entrusted with such power? And how should privileges be restricted to ensure honesty, accuracy and (where needed) privacy?

All sorts of individual and group histories play an important role in coordinating economic activity, including credit histories, work histories, performance histories, educational attainment histories and regulatory compliance histories. In this report, we have focused primarily on payment histories in the context of cryptocurrency—including the fact that histories can be fabricated, and that individuals and organizations may be tempted to misrepresent their own histories for private gain at the expense of the broader community. Even relatively well-functioning societies must devote considerable resources to reconciling conflicting claims of past behavior, given the absence of reliable databases that contain those histories. The U.S. Chamber of Commerce Institute for Legal Reform found the cost of litigation in the United States amounted to $429 billion, or 2.3% of U.S. gross domestic product, in 2016. Over 40% of this cost was used to pay legal, insurance and administrative costs. These costs constitute a lower bound, as most disputes are reconciled outside the legal system.

Much of our everyday economic activity occurs outside any formal record-keeping, and societies have relied on informal communal record-keeping to incentivize individual and organizational behavior. Paper and electronic receipts issued for most commercial exchanges are more formal but are often incomplete and easily fabricated. More important records—for physical property, bank accounts, financial assets, licenses, certificates of education, etc.—are managed by trusted authorities.

These traditional forms of record-keeping are likely to be challenged by blockchain technology, which provides a very different model of information management and communication. Competitive pressures compel organizations and institutional arrangements to evolve in response to technological advances in data storage and communications. Consider, for example, how the telegraph, telephone, computer and internet have transformed the way people interact and organize themselves. Advances in blockchain technology are likely to generate even more dramatic changes, though what these may be remains highly uncertain.

  • For an accessible introduction to the technology, see Fabian Schär and Aleksander Berentsen’s “ Bitcoin, Blockchain, and Cryptoassets: A Comprehensive Introduction ,” MIT Press, 2020.
  • See Narayana Kocherlakota’s “ The Technological Role of Fiat Money ,” Federal Reserve Bank of Minneapolis, Quarterly Review , 1998.
  • Relatively minor patches to the code to fix bugs or otherwise improve performance have been implemented. But certain key parameters, like the one that governs the cap on the supply of bitcoin, are likely impervious to change.
  • Beyond viewing the balances, one can also view the transaction histories of every monetary unit in the account (i.e., its movement from account to account over time since it was created).
  • It is important to note that many cryptocurrency users hold their funds via third parties to whom they relinquish control of their private keys. If an intermediary is hacked and burgled, one’s cryptocurrency holdings may be stolen. This has nothing to do with security flaws in the cryptocurrency itself—but with the security flaws of the intermediary.
  • See David Andolfatto and Andrew Spewak’s “ Whither the Price of Bitcoin? ” Federal Reserve Bank of St. Louis, Economic Synopses , 2019.
  • Legal tender is an object that creditors cannot legally refuse as payment for debt. While deposits are claims to legal tender (they can be converted into cash on demand), they also constitute claims against all bank assets in the event of bankruptcy.
  • For a more extensive review, see Fabian Schär’s “ Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets ,” Federal Reserve Bank of St. Louis, Review , 2021; also see an analysis by Sara Feenan et al. in “ Decentralized Financial Market Infrastructures: Evolution from Intermediated Structures to Decentralized Structures for Financial Agreements ,” The Journal of FinTech , 2021.
  • See Nick Szabo’s “ Smart Contracts ” (1994) and “ The Idea of Smart Contracts ” (1997). The key idea is that contractual terms, once agreed upon, are not renegotiable and are therefore automatically executed in the future. In economic theory, so-called Arrow-Debreu securities have the same property.
  • For example, Hyperledger allows for confidential transactions, whereas Ethereum, a public network, does not. Bitcoin is also able to handle a variety of smart contracts.
  • Some stablecoins stabilize their value by pegging to the U.S. dollar, backed with non-U.S. dollar assets; Dai, for example, pegs its value to a senior tranche of other cryptoassets. See Dankrad Feist’s “ On Supply and Demand for Stablecoins ,” 2021.
  • The opacity of financial structures is not necessary to explain bank runs. For example, the canonical model of bank runs assumes the existence of transparent balance sheets. See Douglas Diamond and Philip Dybvig’s “ Bank Runs, Deposit Insurance, and Liquidity ,” The Journal of Political Economy , 1983.
  • The U.S. Chamber of Commerce Institute for Legal Reform found the cost of litigation in the United States amounted to $429 billion, or 2.3% of U.S. gross domestic product, in 2016. Over 40% of this cost was used to pay legal, insurance and administrative costs. These costs constitute a lower bound, as most disputes are reconciled outside the legal system.

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IMF Working Papers

New perspectives on quantitative easing and central bank capital policies.


Tobias Adrian ; Christopher J. Erceg ; Marcin Kolasa ; Jesper Lindé ; Roger McLeod ; Romain M Veyrune ; Pawel Zabczyk

Publication Date:

May 17, 2024

Electronic Access:

Free Download . Use the free Adobe Acrobat Reader to view this PDF file

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Central banks have come under increasing criticism for large balance sheet losses associated with quantitative easing (QE), and some observers have also argued that QE helped fuel the post-COVID-19 inflation boom. In this paper, we reconsider the conditions under which QE may be warranted considering the recent high inflation experience. We emphasize that the merits of QE should be evaluated based on the macroeconomic stimulus it provides and its effects on the consolidated fiscal position, and not simply on central bank profits or losses. Using an open economy DSGE model with segmented asset markets, we show how QE can provide a sizeable boost to output and inflation in a deep recession and improve the consolidated fiscal position—even if the central bank experiences considerable losses. However, the commitment-based features of QE and the possibility that upside inflation risks are bigger than recognized pre-pandemic call for more caution in using QE closer to full employment. We then consider how central banks might modify their policies for allocating profits to the government in light of large-scale losses. In short, we suggest that a more forward-looking and risk-based approach may be desirable in helping protect central bank financial autonomy and ultimately independence.

Working Paper No. 2024/103



Please address any questions about this title to [email protected]


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