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What Are Central Banks and How Do Central Banks Work?

NEW YORK (TheStreet) -- How do central banks inject billions into their economies, and does that money need to be paid back? -- C.P.

Central banks look out for the monetary policy of their countries. When a country's economy is in trouble, it is the central bank that can "save" the proverbial day, but how central banks manage that feat is the trillion-dollar question.

What Is a Central Bank?

Central banks are responsible for controlling the monetary policy of their countries. Essentially, this means that one of their key jobs is to manipulate the money supply in that country to meet its economic goals (such as market growth).

Here in the U.S., the central bank is the Federal Reserve (commonly referred to as "the Fed"). Other important central banks around the world include the European Central Bank, the Bank of England and the People's Bank of China.

But you might be wondering why everyone's always on "Fed watch." It's because the money supply really is a big deal. Here's why.

Money Doesn't Grow on Trees

Most people will agree that money is a limited resource. While that Lamborghini would definitely make a nice addition to my driveway, I can't really afford the $311,000 price tag. The same is true for the economy -- as a whole, money is scarce.

But from an economic standpoint, the scarcity of money doesn't just affect what we're able (or not able) to buy. Factors such as, employment rates and market growth are all affected by the money supply situation.

When the economy is hurting, it's often because the money supply is low. One way to counter this is by simply increasing the amount of money, or liquidity, that is present in the economy. Conversely, if the economy is growing too fast (a sign of bad inflation to come) decreasing the money supply is often the Fed's solution. Economists refer to increasing the money supply as "expansionary policy," while decreasing it is known as "contractionary policy."

And the Fed has been pretty successful, according to Tim Gindling, a professor of economics at the University of Maryland, Baltimore County. Gindling says, "Since the Great Depression, the Federal Reserve has done a good job using their control over the supply of money to stabilize the economy. The most clear evidence of this is that we have not had a depression since the 1930s."

Believe it or not, though, there's more to controlling the money supply than hitting the start button on those machines that print greenbacks. Here's how they go about it.

How Central Banks Control the Money Supply

Methods used by central banks to control the money supply can vary a bit from country to country, depending on the powers that are vested in the central banks. Here in the U.S., there are three main ways that the Federal Reserve is able to alter the money supply:

  • Reserve requirements
  • Interest rates
  • Open market operations

Reserve Requirements

As a rule, banks are mandated to keep a certain percentage of all deposits in the bank. This is known as the "reserve requirement." The Fed sets the reserve requirement for U.S. banks. By decreasing the reserve requirements, more money is available for the bank to lend out, and the money supply increases.

Interest Rates

The control that a central bank has over interest rates can differ quite a bit from country to country. Contrary to what many believe, the Fed doesn't set the interest rates you pay on your mortgage (because it can't). That's not to say that the rates the Fed has control over aren't important -- you can bet that they trickle down to the consumer level.

Domestically, the Fed has direct control over the "discount rate," the rate the Fed charges banks that borrow from it. The Fed also has some level of indirect control over the "federal funds rate," the rate that banks charge each other for overnight federal loans.

Most recently, the Fed lowered the discount rate to 5.75% from 6.25% (see "Fed Cuts Discount Rate" and "Fed Plots Measured Course" ), a move that was designed to increase the money supply and add liquidity to the economy.

How does changing interest rates accomplish that?

From an economic perspective, interest rates are the "cost of money." Therefore, decreasing interest rates lowers the cost of money and increases the money supply. But while adjusting reserve requirements and interest rates are effective ways to change the money supply, their results aren't as quickly seen as is often necessary. That's where open market operations come in.

Open Market Operations

Open market operations are a way of affecting the money supply by buying or selling securities -- usually government securities. Essentially, if the Fed wants to increase the supply of money, it turns to the market and purchases Treasury securities (such as T-bills, T-notes and T-bonds). When it buys these securities, it gives the sellers money, and that increases the supply of money in the economy.

When the Fed wants to decrease the money supply, it does so by selling Treasury securities and collecting money in exchange. The Fed makes these trades by using its reserve cash. And because the Fed doesn't issue the securities that it trades to change the money supply, making good on the promises of those Treasury securities is the responsibility of the U.S. Treasury, not the Fed.

Because the U.S. economy isn't in dire straits on a daily basis, the most common type of open market operation the Fed engages in is an overnight repurchase agreement, or a "repo." A Fed repo basically alters the money supply for a short time, by temporarily buying or selling government securities (see "What's the Fed Really Up To?" on TheStreet.com TV).

It's also worth noting that the Federal Reserve's open market operations are not relegated to government securities. While government securities have historically been the instrument of choice for the Fed and other central banks, the Fed has "saved the day" in other ways as well.

For example, the Fed recently bought $38 billion in subprime mortgages and other securites (see mortgage-backed security), and that increased the money supply and added liquidity to the battered subprime home loan market at the same time (see "Wall Street Limits Damage"). (To learn more about subprime mortgages, check out ""Booyah Breakdown: Subprime Time" and "Why Mortgages Blew Up").

Consider This

While most people probably don't pay much attention to the Fed's nightly "repos," the fact is that those actions have a huge impact on the finances of investors and companies.

And there are definitely right and wrong ways to add money to an economy. The wrong way often includes printing massive amounts of money that can lead to hyperinflation. Many countries have fallen victim to bad monetary policy as a consequence of politics or unrealistic borrowing. Such has been the case most recently with Zimbabwe, a country whose annual inflation rate is climbing beyond 3,700% (see England's Times Online).

By comparison, U.S. inflation for 2006 was around 2.5% (see CIA data). Zimbabwe's practice of printing money as a means of alleviating debts has proved to be a big contributor to its monster inflation rate.

By using tactics such as open market operations and interest rate manipulation, central banks (including the U.S. Federal Reserve) work hard to make sure that the country's economy operates in a healthy, sustainable manner.

Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.

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