A major sector of any modern monetary system is the central banking system, which is important to the functioning of the private economy and the fiscal operations of the national government. Central banking is an activity separate from ordinary commercial banking, because a central bank usually has few transactions with private customers, dealing primarily with commercial bank and with the national government. The roots of the central banking system go back more than two centuries. Nevertheless, central banks as we know them today are relatively recent development. Like electric power and the automobile, central banks are pretty much the products of the twentieth century. For example, at the turn of this century no central bank existed in any country of Western Hemisphere. The central banking system for the United States (Federal Reserve System) was created late in 1913, and the Bank of Canada appeared in 1934.
The characteristics of the Modern Central Bank. It is difficult to give a brief definition of a central bank that is both comprehensive and accurate. The nature of a central bank depends largely on its function, which vary according to time and setting. Essentially, a modern central bank performs at least three functions: managing the nation’s monetary system, serving as a bankers’ bank, and acting as fiscal agent for the national government.
Monetary control. The most important characteristic of the modern central bank is its control over the monetary system for facilitating the achievement of national economic goals. In exerting this control, the central bank regulates the supply, cost, and availability of money and credit. Monetary control is enhanced by the central bank’s monopoly on the banknote issue and its ability to create and destroy monetary reserves by its lending and “investing” activities. Since monetary control is a prerogative of the sovereign government, the central bank is a public service organization that emphasizes the national interest rather than its own profit or welfare.
Bankers bank. Being a bankers’ bank implies that the central bank provides services to the commercial banking system similar to those that the commercial banking system performs for individuals and business firms. Commonplace services that nevertheless promote the smooth operation of the monetary and banking systems include, for example, the clearing and collecting of checks, distributing coin and paper currency to commercial banks, and providing some degree of supervision and regulation over the activities of commercial banks.
Fiscal agency function. In its role as a fiscal agent, the central bank serves as a banker for the national government. Here the central bank receives, holds, transfers, and disburses funds of the central government.
Central and commercial banking functions involve widely differing objectives and methods, and therefore these functions are kept separate. The central bank orients its policy primarily toward the attainment of national economic objectives, whereas the commercial banking system is essentially profit-motivated.