One of my favorite topics! To answer, let’s first look broadly at the general purpose of a central bank.
What is a central bank and why do they exist? What is monetary policy?
Most economies today rely on fiat money. Fiat money is money that is established by government decree and has no intrinsic value; in contrast, commodity money is money with intrinsic value, like gold or silver.1 Whenever an economy relies on fiat money, an institution is needed to determine the appropriate supply of money to be released into the economy for circulation and to oversee its distribution. A central bank is an institution that is charged with this task. Because most economies today rely on fiat money, virtually every country has a central bank.
To summarize, the fundamental responsibility of a central bank is conducting monetary policy: balancing the supply of money with the needs of the economy. Putting too much money into the economy produces inflation, and that can be costly (please see my March 2006 answer on the costs of inflation). Yet, not having enough money in the economy can curtail economic growth, which has its own costs.
The U.S. Federal Reserve’s responsibilities
As stated in the The Federal Reserve System: Purposes and Functions, the Federal Reserve’s responsibilities fall into four general areas:
- Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum sustainable employment, stable prices, and moderate long-term interest rates.
- Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.
- Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets.
- Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.
To become familiar with the broad responsibilities of other central banks, you may wish to visit their respective websites and see what types of responsibilities they are charged with in addition to monetary policy.
The goals of monetary policy
In addition to their broad responsibilities, most central banks have articulated goals for their monetary policy responsibilities. The Federal Reserve has two monetary policy goals: to promote maximum sustainable employment, and stable prices.
Broadly speaking, there are some common ways in which monetary policy goals can differ across countries:
Single vs. multiple goals: Some central banks have one primary monetary policy goal. For these central banks, the goal often has to do with price stability,2 and some central banks take the extra step of establishing an inflation targeting regime. The Fed, with the “dual mandate” described above, is an example of a central bank that has multiple goals. Having just one monetary policy goal instead of two certainly doesn’t make monetary policy any easier, just different.
Exchange rate policy: Because interest rates affect exchange rates, and vice versa, many central banks oversee the exchange rate of their nation’s currency. The Federal Reserve is not one of these central banks. While the Fed works with the U.S. Treasury in the implementation of any exchange rate policies, the U.S. Treasury has overall responsibility for setting the U.S. international financial policy. Moreover, the U.S. has had a flexible exchange rate policy since the early 70s, when the Bretton Woods currency arrangement was abandoned.3 The website of the International Monetary Fund (IMF) is a great resource on the different monetary policy regimes of different central banks, and specifies which countries’ central banks manage exchange rates. See the IMF’s “Classification of Exchange Rate Arrangements and Monetary Policy Frameworks”. Additionally, the Federal Reserve Bank of New York’s Fedpoints series explains how the Fed sometimes, but increasingly less frequently, operates in the foreign exchange market.
Monetary policy goals of selected central banks from around the world
Finally, this list of the official policy goals of central banks might give you a flavor of the similarities and differences between the monetary policy goals of different central banks.
U.S. Federal Reserve System: “Monetary policy has two basic goals: to promote ‘maximum’ sustainable output and employment and to promote ‘stable’ prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act.”
Bank of Japan: “The Bank of Japan, as the central bank of Japan, decides and implements monetary policy with the aim of maintaining price stability.”
European Central Bank: “To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible.
This is laid down in the Treaty establishing the European Community, Article 105 (1).”
Bank of England: “The Bank sets interest rates to keep inflation low, issues banknotes and works to maintain a stable financial system.”
Bank of Canada: “The goal of Canadian monetary policy is to contribute to rising living standards for all Canadians through low and stable inflation.”
Central Bank of Chile: “The main purpose of the Central Bank of Chile’s monetary policy is to keep inflation low and stable, defined as a range of 2% to 4% per
annum, centered on 3%.”
Tools of monetary policy
At this point a reasonable question would be what tools are available to central banks to achieve these ambitious monetary policy goals. Before I describe these tools, it is important to know that one can’t paint all central banks with the same brush. The list below may not necessarily be exhaustive for every central bank, and not all tools are available in the same way to every central bank. With that caveat aside, three of the primary tools of monetary policy are somewhat similar across central banks in theory, though they differ in practice:
- Open market operations: Central banks can affect both the quantity of funds (i.e., the money supply) available to borrowers, and the price (i.e., interest rate) at which they are offered through the buying and selling of assets, typically government securities, on the open market or through repurchase agreement-type transactions.
- Short-term interest rates: Central banks often have responsibility for setting or influencing a short-term interest rate that directly affects banks and the cost of short-term credit and that is directly linked to other interest rates in the economy.
- Reserve requirements: Central banks often are in charge of determining what fraction of overall deposits commercial banks are required to hold (i.e., not lend) as cash reserves. Reserve requirements are used to manage the overall supply of funds in circulation.
The Federal Reserve indeed has access to each of these monetary policy tools. The tool it uses most commonly is open market operations (buying and selling U.S. Treasury securities): the Fed conducts open market operations almost daily to maintain the federal funds rate, the rate at which banks make overnight loans to each other, at its target rate (which is set by the Federal Open Market Committee). You can track daily open market operations on the website of the Federal Reserve Bank of New York, where the open market desk is located. The Federal Reserve also sets the discount rate, which is the short-term rate at which the Fed loans directly to financial institutions. For the Federal Reserve, reserve requirements are by far the least used tool of monetary policy.4
Recently, to address the turmoil in the financial markets that started in August 2007, the Federal Reserve implemented a new set of tools of monetary policy. To read more about the Fed’s tools of monetary policy, please refer to the web page of the Board of Governors of the Federal Reserve System and a recent speech by Chairman Bernanke
I hope this gives you a better idea of the differences between central banks! I’d encourage you to look through the websites of other central banks to gain a better understanding of their similarities and differences. To assist your research, the Bank for International Settlements provides a list of the world’s central banks and their respective websites.
NOTE: On January 25, 2012, the Federal Open Market Committee issued a "Statement of Longer-Term Goals and Policy Strategy." The document expresses the FOMC's:
- Commitment to the Fed's "statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates."
- Specifies a longer-run goal for the personal consumption expenditure price index of 2 percent.
- Provided an estimate of the longer-run normal rate of unemployment in the 5.2 to 6.0 percent.
1. Fiat simply means an order or decree. A good example of commodity money is gold, which has intrinsic value: it can be used for purposes other than being used as money, for instance, you can make jewelry out of it. Although it is no longer the case, historically gold was a common form of money, since it was easy to carry, measure, and verify for impurities.
3. For more information, see the Fedpoints section on “currency devaluation and revaluation” on the New York Fed’s website.
4. For information on why reserve requirements are not frequently changed, see my August 2001 posting.
Federal Reserve Bank of New York, 2007, “Currency Devaluation and Revaluation,” Fedpoint.
Federal Reserve Bank of San Francisco, 2004, “U.S. Monetary Policy: An Introduction.”
International Monetary Fund, June 30, 2004, “Classification of Exchange Rate Arrangements and Monetary Policy Frameworks.”
Mishkin, Frederic S., April 10, 2007, “Monetary Policy and the Dual Mandate,” speech to Bridgewater College, Bridgewater, Virginia.
Gerdesneier, Dieter, Francesco Paolo Mongelli, and Barbara Roffia, March 2007, “The Eurosystem, The U.S. Federal Reserve, and the Bank of Japan: Similarities and Differences,” European Central Bank Working Paper Series No. 742.
Gonzales-Paramo, Jose Manuel, June 23, 2005, “The European Central Bank’s Monetary Policy in an International Context: Principles and Challenges,” speech to the University of La Laguna, Tenerife.
Ruckriegel, Karlheinz, and Franz Seitz, February 2002, “The Euro System and the Federal Reserve System Compared: Facts and Challenges”, Center for European Integration Studies.