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Central bank

Central banks help stabilize the economy in times of financial crisis. Bankrate explains.

What is a central bank?

A central bank is a state institution that usually has the power to regulate commercial banks, create monetary policy, and provide financial services. They help stabilize the currency of the nation, prevent inflation, and keep unemployment low. The central bank of the U.S. is called the Federal Reserve.

Deeper definition

Central banks were established as a bulwark against financial crisis. As the institution that controls a nation’s monetary policy, central banks have the ability to both boost and slow the growth of the economy. That’s because central banks have a reserve of cash that commercial banks can draw from to give out loans, the cost of which is determined by national interest rates.

If inflation is increasing, the central bank can raise interest rates, which makes it more expensive for an individual to take out a loan from her bank. The central bank might stop producing money or compel commercial banks to buy financial instruments like treasury bills or foreign currency, which reduces the supply of money in an economy. This is called contf97ractionary money policy.

On the other hand, if the economy is sagging, the central bank can lower interest rates, giving commercial banks cheaper access to funds that therefore let individuals and businesses borrow more. The central bank might start printing money again. This is called expansionary money policy.

Most central banks set a reserve requirement for commercial banks, meaning that they must retain a specified percentage in cash of what they owe to account holders, which makes sure banks don’t run out of money. Countries that don’t set a reserve requirement, like the U.K., often have capital requirements instead, which are determined by the ratio of a bank’s capital to its risk.

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Central bank example

The Federal Reserve was signed into law by President Woodrow Wilson in 1913 following a series of financial panics that left many commercial banks around the country bankrupt. Congress sets its objectives, but in theory it’s an independent body, although the president appoints its chairman.

The policies it enacts often have unforeseen consequences: for example, while keeping interest rates low helped to grow the economy and decrease unemployment in the short term, they also contributed to the subprime mortgage crisis and the Great Recession. At the same time, it developed the monetary policy that brought the country out of recession and now has the ability to regulate banking institutions in the hope of preventing another one.


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