What Are Central Banks? Why Do They Matter?

Let us understand central banks with a simple example.

Think of a country’s central bank as the manager of a supermarket. In a supermarket, the manager looks after the stock, prices, and the overall well-being of the store. They also set price limits, offer discounts, and replenish the stocks in the case of a shortage. The manager may stock the supermarket with suitable alternatives if certain products are unavailable.

Similarly, a central bank manages the money supply in a country, sets interest rates for commercial banks, and ensures that the economy runs seamlessly. The public institution is responsible for managing the currency of a single country or a group of countries. Considering the global economic scenario, it makes important currency and metal reserves decisions.

One of the many ways in which a central bank ensures economic stability is by regulating a country’s gold reserves.

    Interesting Facts about the Founding of the Fed in the US

The central bank of the United States is called The Federal Reserve, or simply The Fed. Today, it has a major role to play in ensuring the financial stability and security of the US Government as well as its citizens. It is also one of many reasons the US emerged as a global leader after the Second World War.

Let us take a look at a few interesting facts and events that led to the formation of The Fed:

    The First Bank of the US

1791 marks the establishment of the first bank in the US after Alexander Hamilton (one of the US’s founding fathers) advocated a central bank’s creation. Headquartered in Philadelphia, this bank had a capital stock of $10 million. However, the bank’s influence started frightening people, and its charter was never renewed. This led to a significant amount of chaos, especially after the War of 1812. The country lacked a centralized regulating mechanism for banking and credit.

---

    The Second Bank of the US

The chaos caused by the lack of a centralized banking mechanism led to the establishment of the second bank of the US in 1816. Much larger than the first one, this bank had a capital of $35 million. Just like the previous case, the bank wielded immense power. Citizens and politicians perceived it as a threat to themselves and the US democracy. Again, the charter of the second bank of the US was not renewed once it expired in 1836.

For almost a quarter of the next century, several state-chartered banks with no federal regulation handled the country’s banking and credit matters. A clear lack of a centralized banking system made the American economy unstable, leading to risky loans, insufficient capital, and inadequate reserves against bank notes.

---

    The National Banking Act of 1863

After experiencing economic uncertainties, the US sought some relief in the National Banking Act of 1863. The act introduced and promoted currency notes issued by nationally chartered banks instead of state-chartered banks. Still, the lack of a centralized banking system made this new legislation fall short. Toward the end of the 19th century, rapid industrialization further increased the need for a stable central bank. The fire was fueled by the Depression of 1893 - the most severe depression in US history.

---

    The Birth of the Federal Reserve System

In 1912, the House Banking and Currency Committee held hearings to assess the control banking and other financial resources have on the nation. It concluded that the country’s banking system was in the hands of a “money trust,” leading to high concentration and control of money (and credit) in the hands of a few men. The public was made aware that such a monopoly on the US banking system was important to bring about financial reform.

In 1912, the newly elected President Wilson submitted the Glass-Willis proposal. This proposal suggested the creation of multiple privately controlled regional reserve banks instead of a single central bank. These banks would hold some portion of the member banks’ reserves and perform essential central banking functions. While the President approved this proposal, he also insisted upon creating a central board that would control and coordinate the activities performed by the regional reserve banks.

---

    The Federal Reserve Act of 1913

President Wilson’s input regarding the reforms in the US banking system led to the Federal Reserve Act of 1913. The act facilitated a regional Federal Reserve System that operates under a supervisory board in the national capital (Washington, D.C.). It finally became law on December 23, 1913.

    Why Do Central Banks Matter?

Now that we know what a central bank does and how The Fed came into existence in the US, let us understand the importance of central banks in a country:

    Setting Interest Rates

A country’s central bank decides the interest rates, influencing financial instruments like loans, mortgages, corporate bonds, bank deposits, and more. In most cases, a central bank has a target interest that it aims to achieve through open market operations.

The rates a central bank sets directly influence the financial decisions the citizens make. For example, if you are saving money to get yourself a bike, putting money into a savings bank account when the interest rates are high will help you make more money in a shorter span of time. Conversely, if you want to take out a loan or line of credit to finance the purchase of the bike, then you will find that the current low interest rates make borrowing money more appealing.

    Ensuring Price Stability

Central banks also ensure price stability through effective inflation and deflation control. They are responsible for preventing unhealthy fluctuations in either direction – up (inflation) or down (deflation). Most central banks aim to keep inflation rates low and stable, giving their citizens enough purchasing power.

Price stability also ensures the financial stability of citizens. This is true for all commodities – from luxury items to groceries. Let’s say you buy apples regularly. If the prices of apples keep fluctuating in an unhealthy way, i.e., they are too high one day and too low the other, managing your budget will be an issue. Central banks ensure that you are not faced with this dilemma every time you purchase apples.

    Printing Money

The money a central bank prints plays a key role in a country’s monetary policies and financial health. These banks have the exclusive authority to print and circulate currencies in their respective countries. A central bank resorts to printing more money when it wants to increase money supply in the country. It does so by purchasing financial assets or government bonds through open market operations.

However, central banks are also mindful of the power they have. Excessive money supply in the country can be a fodder for unhealthy inflation. For example, if every visitor at a cafeteria gets a free coupon, the cafeteria may increase the price of its dishes to make money.

    Helping Commercial Banks in Trouble

A central bank is commonly known as the lender of last resort. If customers lose faith in a commercial bank, they may excessively withdraw their money, encroaching upon the bank’s cash reserves. When commercial banks face such crises, they can seek a central bank’s help and borrow money from it. In return, commercial banks pledge collaterals in the form of loans, bonds, or other relevant assets to prevent the central bank from losing money.