Question

What are the functions of a central bank? How is the FED, the US central bank structured? What tools does the FED use to perform the functions of a central bank? How do those tools work to carryout the functions of a central bank?

Answer 1

The central bank of a country is the apex institution that regulates banking system and conducts monetary policy for the economy. The functions of the central bank includes printing and regulation of currency notes in the country, conducting monetary policy and controlling liquidity, providing banking services to the government and regulating the banking system of the country. The central bank also maintains stable economic conditions with lower inflation that favour the businesses. The central bank's function differs across countries.

FED is the central bank of United States. It was founded in 1913 by the Congress to provide the nation a safer, flexible and stable banking and financial system. The Fed has two part structure - with board of directors in Washington DC being the central authority and a decentralised network of 12 federal reserve banks located throughout the country. The Board is an independent governmental agency that oversees the Federal Reserve System. The 12 Fed banks perform day to day functions of the federal reserve system.

The FED has monetary policy tools that help it perform the functions of central bank. These are four tools that include Open market operations, reserve requirements, discount rate and interest on reserves. All of these tools affect the amount of money in the economy. FED can increase or decrease money supply in the economy using these tools.

Through open market operations, the Fed buys or sells government bonds in the market. During recessions, Fed buys bonds so as to increase the money supply in the economy. An increase in money supply decrease interest rates and boost investment and economic growth.

Reserve requirements means the amount of reserves the banks of the country has to keep with the Fed to meet legal reserve requirement. Reserves means the amount of checkable deposits that cannot be loaned out. When fed increase reserve requirement, the loaning capacity of banks is constrained. Thus, it decrease money supply and increase interest rates.

The discount rate is the interest rate Reserve Banks charge commercial banks for short-term loans. When discount rates are higher, the commercial banks find it difficult to raise funds and thus maintain excess reserves. Thus, increasing discount rates is contractionary policy. It reduces money supply.

Interest on Reserves is the newest and most frequently used tool given to the Fed by Congress after the Financial Crisis of 2007-2009. Interest on reserves is paid on excess reserves held at Reserve Banks. These interest rates incentivize the commercial banks to maintain excess reserves and loan out lesser. When Fed increases this rate, the banks would be more willing to maintain excess reserves and loan out lesser. Thus, reduce the money supply.

Thus fed can use all these tools to effect money supply in economy and thus effect the market.