Introduction to Central Banks and the Creation of Money

What is a central bank?

The central bank is first and foremost a bank. It takes deposits, makes loans, and facilitates payments, just like any other bank. The difference between a central bank and a commercial bank is its customers. The customers of central banks are governments and commercial banks.

Commercial banks have deposit accounts at the central bank, known as reserve accounts.

What do central banks do with bank reserves?

Money in reserve accounts is known as “bank reserves”. Commercial banks use reserves to make payments. All payments between commercial banks go through their reserve accounts at the central bank.

The central bank also lends reserves to commercial banks. Like any bank, when it lends, it creates new money. Thus, money in reserve accounts is initially lent into existence by the central bank. The central bank also provides commercial banks with new banknotes and coins so that their customers can obtain physical cash.

Does the central bank create money?

Bank reserves, banknotes and coins collectively make up what is known as “base money” or M0 - the money directly issued by the central bank. But although the central bank is responsible for issuing and managing the country’s currency, it doesn’t create all the money itself.

It licenses commercial banks to create money when they lend, and it guarantees the value of the money licensed banks create.

Does the central bank lend money to the government?

Governments usually have deposit accounts at their central banks. But the services that the central bank can provide to the government are often restricted to deposit-taking and payment services. Many countries prohibit the central bank from lending to the government, because they fear that it will cause runaway inflation.

However, financing the UK government remained a principal function of the Bank of England until it was granted independence in 1998. The responsibility for financing the government has now moved to the Government’s Debt Management Office. But a remnant of the older relationship still remains, in the “Ways and Means” overdraft facility, which was last used in 2008 to bail out the failing mortgage lender Bradford & Bingley.

What is the function of America’s Federal Reserve?

Unlike many of the older central banks, America’s Federal Reserve was not created to finance or support the government, but to provide the nation with a safer, more flexible and more stable financial system.

In 1907, the failure of the Knickerbocker Trust had caused a financial crisis, to which the U.S. government had been unable to respond. A consortium of bankers led by John Pierpont Morgan, founder of the bank J.P. Morgan, propped up the collapsing financial system with their own money. But after the crisis, there was a general view that something more robust was needed. A commission convened by Senator Aldrich came up with a design for a “National Reserve Bank”. In 1913 Congress passed the Federal Reserve Act, establishing the twelve Federal Reserve Banks.

Are central banks privately owned?

In the past, many central banks were privately owned. The Bank of England and Banque de France, for example, were both privately owned until 1946.

Some central banks still have private shareholdings, although usually without voting rights. For example, commercial banks hold minority stakes in the Federal Reserve Banks, and the central banks of Belgium, Switzerland and Japan have publicly traded shares.

However, private shareholdings don’t necessarily mean the central bank is in private ownership. For example, commercial banks are obliged to hold shares in the Federal Reserve Banks in order to gain access to the Federal Reserve system. They don’t profit from their shareholdings, and they don’t dictate policy to the Fed.

Historically, what was the main functionality of a central bank?

For much of their existence, central banks managed a monetary system based on gold or some other metal:

• The European central banks, led by the Bank of England, actively intervened to maintain a stable financial system
• The United States relied on the Bank of England to smooth out the seasonal fluctuations in demand for money that arose from its agrarian economy

How did central banks find a new role after the gold standard era ended?

The dream of an international gold standard remained. Towards the end of World War II, the Bretton Woods conference designed a new global financial system anchored to gold. This time, only one currency – the dollar – would be linked to gold; the rest would be linked to the dollar.

The Bretton Woods system, troubled from the start, proved short-lived.

In 1971, President Nixon suspended the dollar’s convertibility to gold. The gold standard never returned. For the subsequent two decades, governments repeatedly tried to manage exchange rates, but as inflation rose to dizzy heights, central banks found a new role.