This thread is about central banks, but I’ll be focusing mostly on the Fed, because it’s the one I know most about. I am, of course, happy to hear about other central banks work, if they work differently.
First I want to revisit one point I made in the previous thread.
Commercial banks create a demand for money in the future, at the same time they create actual money in the present. Or, to put it differently, commercial banks create a demand for money in the present, because of the loans they made in the past. Commercial bank money, therefore, has a special feature: it creates a demand for itself, to the exact extent that people try to obtain money to pay off loans they’ve already taken out. Furthermore, the amount necessary to pay off a loan is always more than the loan itself: for example, if I was to take out a $200,000, 30 year mortgage at 5% interest, the amount I’d pay back would be about $365,000. Of course, like any business, banks have expenses. And those expenses get paid out of the interest and other fees banks generate. Nevertheless, there is a sense in which banks are in the business of continually creating more debt than there is money necessary to pay it off.
While the commercial bank way of creating money is sustainable for a time, it is inherently unstable: banks are susceptible to boom and bust cycles. When times are good, banks lend more than when times are bad. Unfortunately, bad times are exactly when people need the money banks are no longer willing to lend. Since the amount of money owed is more than the amount of money there is, some people or businesses inevitably default. When they default, that can and does lead to problems for banks. In some cases, banks fail. When that happens, the banks’ customers - people who have deposits at the banks - lose their deposits, meaning there’s that much less money in the economy, both for paying back loans, and for making daily transactions. People spend less, and when they spend less, they eliminate jobs for other people whose jobs depended on their spending. In the worst cases, the cycle ends up in something like the Great Depression.
Anyway, understanding how commercial banks work, and how they fail, is important in order to understand the significance of a central bank.
Central banks are different from commercial banks in a number of ways. One is that central banks produce currency and reserves. Commercial banks produce commercial bank deposits.
Another is that, unlike a commercial bank, the a central bank cannot fail. The reason is simple: central bank liabilities (reserves and currency) are not backed by anything.
While a commercial bank can be forced to close its doors, if too many depositors show up to demand their money, central bank liabilities are unredeemable. That means that if you were to show up at the Fed, for example, and demanded something in return for $1, the most you could expect to get newer $1 in return.
The fact that central banks can’t fail is important. It means, for one thing, there’s a sense of reliability about central bank liabilities - like dollar bills. It also means central banks always have the power, should they choose to use it, to stop financial panics. In the most recent financial panic in the US, the Fed chose to let Lehman Brothers fail. I won’t comment on whether that was a good decision or a bad one (since I don’t know), but the point is that the Fed had the power, should it have chosen to use it, to save Lehman, as it did other Wall Street banks.
Central banks also have the power to regulate commercial banks. They can set, or change, required reserves for example. Central banks also have the power to force commercial banks to adopt or adhere to capital requirements.
Furthermore, commercial banks use the Fed as their bank; the same way that you or I use Chase or Bank of America. They have deposits at the Fed, and use their Fed deposits to transfer money back and forth. The same way I might use my account at Wells Fargo to transfer money to a creditor, Wells Fargo uses its deposit account at the Fed to transfer money to other banks.
The Fed uses its power to destroy reserves in order to increase interest rates. In normal times (and these are not normal times) the Fed destroys reserves by selling assets in order to force interest rates to go up. Reserves, like everything else, are subject to the law of supply and demand. When reserves are plentiful, the price of reserves fall. Since the “price” of reserves is the cost to borrow them, that means the interest rate for borrowing reserves falls. When the Fed eliminates reserves - by selling assets - it reduces reserves. When reserves are scarce, the price of reserves increases: banks have to pay more interest in order to obtain them. Banks price all other interest rates based on the cost of reserves. (Banks can’t lend for less than the cost of obtaining reserves, because doing so forces them to operate at a loss: in other words, to lose money on every loan.)
Finally, a central bank of a country that has control over its own currency (like the US) and whose debts are denominated in the country’s own currency (like the US), can never involuntary go bankrupt. (It can, of course, choose to go bankrupt.) The Fed could purchase all US debt from every wiling seller, if it wanted to.
Over the course of the past several years, the Fed has purchased about $3.2 trillion of debt, increasing the size of its balance sheet from about $800 billion to about $4 trillion. During that same time period, unemployment has fallen from about 10% to close to 5%. The European Central Bank, on the other hand, has increased the size of its balance sheet only incrementally. EU unemployment now stands at about 11%.
Which demonstrates one more ability of a central bank: it can use its power to affect things like unemployment and economic growth, should it choose to do so.