Functions of Central Bank| Money Supply|CBCS

The Federal Reserve System

We have seen how the private banking system creates money by making loans. However, private banks are not free to create money at will. Their ability to create money is controlled by the volume of reserves in the system, which is controlled by the Central Bank(Fed). The Fed therefore has the ultimate control over the money supply. We will now examine the structure and function of the Fed.

 

The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve bank. These districts are indicated on the map in Figure. The district banks are like branch offices of the Fed in that they carry out the rules, regulations, and functions of the central system. Federal Open Market Committee (FOMC) is a group composed of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of the other 11 district bank presidents on a rotating basis; it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York. The FOMC sets goals concerning the money supply and interest rates, and it directs the Open Market Desk in the New York Federal Reserve Bank to buy and/or sell government securities.

Functions of the Central Bank 

The Fed is the central bank of the United States. Central banks are sometimes known as “bankers’ banks” because only banks can have accounts in them. As a private citizen, you cannot go to the nearest branch of the Fed and open a checking account or apply to borrow money. It's crucial role is to control the money supply, the Fed also performs several important functions for banks. These functions include clearing interbank payments, regulating the banking system, and assisting banks in a difficult financial position. The Fed is also responsible for managing exchange rates and the nation’s foreign exchange reserves. 

Clearing interbank payments works as follows:

Suppose you write a $100 check drawn on your bank, the First Bank of Fresno (FBF), to pay for tulip bulbs from Crockett Importers of Miami, Florida. Because Crockett Importers does not bank at FBF, but at Banco de Miami, how does your money get from your bank to the bank in Florida? The Fed does it. Both FBF and Banco de Miami have accounts at the Fed. When Crockett Importers receives your check and deposits it at Banco de Miami, the bank submits the check to the Fed, asking it to collect the funds from FBF. The Fed presents the check to FBF and is instructed to debit FBF’s account for the $100 and to credit the account of Banco de Miami. Accounts at the Fed count as reserves, so FBF loses $100 in reserves, and Banco de Miami gains $100 in reserves. The two banks effectively have traded ownerships of their deposits at the Fed. The total volume of reserves has not changed, nor has the money supply. This function of clearing interbank payments allows banks to shift money around virtually instantaneously. All they need to do is wire the Fed and request a transfer, and the funds move at the speed of electricity from one computer account to another. Besides facilitating the transfer of funds among banks, the Fed is responsible for many of the regulations governing banking practices and standards.

An important responsibility of the Fed is to act as the lender of last resort for the banking system. As our discussion of goldsmiths suggested, banks are subject to the possibility of runs on their deposits. In the United States, most deposits of less than $100,000 are insured by the Federal Deposit Insurance Corporation (FDIC), a U.S. government agency that was established in 1933 during the Great Depression. Deposit insurance makes panics less likely. Because depositors know they can always get their money, even if the bank fails, they are less likely to withdraw their deposits. Not all deposits are insured, so the possibility of bank panics remains. However, the Fed stands ready to provide funds to a troubled bank that cannot find any other sources of funds. 

The Fed is the ideal lender of last resort for two reasons. First, providing funds to a bank that is in dire straits is risky and not likely to be very profitable, and it is hard to find private banks or other private institutions willing to do this. The Fed is a nonprofit institution whose function is to serve the overall welfare of the public. Thus, the Fed would certainly be interested in preventing catastrophic banking panics. Second, the Fed has an essentially unlimited supply of funds with which to bail out banks facing the possibility of runs. The reason, as we shall see, is that the Fed can create reserves at will. A promise by the Fed that it will support a bank is very convincing. Unlike any other lender, the Fed can never run out of money. Therefore, the explicit or implicit support of the Fed should be enough to assure depositors that they are in no danger of losing their funds.

Don’t forget to subscribe for updates.

Do like, comment and share.