Who’s in charge of ensuring that banks maintain enough reserves? Who decides how large the monetary base will be? The answer, in the United States, is an institution known as the Federal Reserve (or, informally, as “the Fed”). The Federal Reserve is a central bank—an institution that oversees and regulates the banking system and controls the monetary base. Other central banks include the Bank of England, the Bank of Japan, and the European Central Bank, or ECB. The ECB acts as a common central bank for 18 European countries: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. The world’s oldest central bank, by the way, is Sweden’s Sveriges Riksbank, which awards the Nobel Prize in economics.

The legal status of the Fed, which was created in 1913, is unusual: it is not exactly part of the U.S. government, but it is not really a private institution either. Strictly speaking, the Federal Reserve system consists of two parts: the Board of Governors and the 12 regional Federal Reserve Banks.

The Board of Governors, which oversees the entire system from its offices in Washington, D.C., is constituted like a government agency: its seven members are appointed by the president and must be approved by the Senate. However, they are appointed for 14-year terms, to insulate them from political pressure in their conduct of monetary policy. (Why this is a potential problem will become clear in the next chapter, when we discuss inflation.) Although the chair is appointed more frequently—every four years—it’s traditional for chairs to be reappointed and serve much longer terms. For example, William McChesney Martin was chair of the Fed from 1951 until 1970. Alan Greenspan, appointed in 1987, served as the Fed’s chair until 2006, and Ben Bernanke, Greenspan’s successor, served until 2014.

The 12 Federal Reserve Banks each serve a region of the country, providing various banking and supervisory services. One of their jobs, for example, is to audit the books of private-sector banks to ensure their financial health. Each regional bank is run by a board of directors chosen from the local banking and business community. The Federal Reserve Bank of New York plays a special role: it carries out open-market operations, usually the main tool of monetary policy. Figure 29-6 shows the 12 Federal Reserve districts and the city in which each regional Federal Reserve Bank is located.

Decisions about monetary policy are made by the Federal Open Market Committee, which consists of the Board of Governors plus five of the regional bank presidents. The president of the Federal Reserve Bank of New York is always on the committee, and the other four seats rotate among the 11 other regional bank presidents. The chairman of the Board of Governors normally also serves as the chairman of the Open Market Committee.

The effect of this complex structure is to create an institution that is ultimately accountable to the voting public because the Board of Governors is chosen by the president and confirmed by the Senate, all of whom are themselves elected officials. But the long terms served by board members, as well as the indirectness of their appointment process, largely insulate them from short-term political pressures.

The Fed has three main policy tools at its disposal: reserve requirements, the discount rate, and, most importantly, open-market operations.

In our discussion of bank runs, we noted that the Fed sets a minimum reserve ratio requirement, currently equal to 10% for checkable bank deposits. Banks that fail to maintain at least the required reserve ratio on average over a two-week period face penalties.

What does a bank do if it looks as if it has insufficient reserves to meet the Fed’s reserve requirement? Normally, it borrows additional reserves from other banks via the federal funds market, a financial market that allows banks that fall short of the reserve requirement to borrow reserves (usually just overnight) from banks that are holding excess reserves. The interest rate in this market is determined by supply and demand—but the supply and demand for bank reserves are both strongly affected by Federal Reserve actions. As we’ll see in the next chapter, the federal funds rate, the interest rate at which funds are borrowed and lent in the federal funds market, plays a key role in modern monetary policy.

Alternatively, banks in need of reserves can borrow from the Fed itself via the discount window. The discount rate is the rate of interest the Fed charges on those loans. Normally, the discount rate is set 1 percentage point above the federal funds rate in order to discourage banks from turning to the Fed when they are in need of reserves. Beginning in the fall of 2007, however, the Fed reduced the spread between the federal funds rate and the discount rate as part of its response to an ongoing financial crisis, described in the upcoming Economics in Action. As a result, by the spring of 2008 the discount rate was only 0.25 percentage point above the federal funds rate. And in the summer of 2014 the discount rate was still only 0.65 percentage point above the federal funds rate.

In order to alter the money supply, the Fed can change reserve requirements, the discount rate, or both. If the Fed reduces reserve requirements, banks will lend a larger percentage of their deposits, leading to more loans and an increase in the money supply via the money multiplier. Alternatively, if the Fed increases reserve requirements, banks are forced to reduce their lending, leading to a fall in the money supply via the money multiplier.

If the Fed reduces the spread between the discount rate and the federal funds rate, the cost to banks of being short of reserves falls; banks respond by increasing their lending, and the money supply increases via the money multiplier. If the Fed increases the spread between the discount rate and the federal funds rate, bank lending falls—and so will the money supply via the money multiplier.

Under current practice, however, the Fed doesn’t use changes in reserve requirements to actively manage the money supply. The last significant change in reserve requirements was in 1992. The Fed normally doesn’t use the discount rate either, although, as we mentioned earlier, there was a temporary surge in lending through the discount window beginning in 2007 in response to a financial crisis. Ordinarily, monetary policy is conducted almost exclusively using the Fed’s third policy tool: open-market operations.

Like the banks it oversees, the Federal Reserve has assets and liabilities. The Fed’s assets normally consist of holdings of debt issued by the U.S. government, mainly short-term U.S. government bonds with a maturity of less than one year, known as U.S. Treasury bills. Remember, the Fed isn’t exactly part of the U.S. government, so U.S. Treasury bills held by the Fed are a liability of the government but an asset of the Fed. The Fed’s liabilities consist of currency in circulation and bank reserves. Figure 29-7 summarizes the normal assets and liabilities of the Fed in the form of a T-account.

In an open-market operation the Federal Reserve buys or sells U.S. Treasury bills, normally through a transaction with commercial banks—banks that mainly make business loans, as opposed to home loans. The Fed never buys U.S. Treasury bills directly from the federal government. There’s a good reason for this: when a central bank buys government debt directly from the government, it is lending directly to the government—in effect, the central bank is printing money to finance the government’s budget deficit. As we’ll see later in the book, this has historically been a formula for disastrously high levels of inflation.

The two panels of Figure 29-8 show the changes in the financial position of both the Fed and commercial banks that result from open-market operations. When the Fed buys U.S. Treasury bills from a commercial bank, it pays by crediting the bank’s reserve account by an amount equal to the value of the Treasury bills. This is illustrated in panel (a): the Fed buys $100 million of U.S. Treasury bills from commercial banks, which increases the monetary base by $100 million because it increases bank reserves by $100 million. When the Fed sells U.S. Treasury bills to commercial banks, it debits the banks’ accounts, reducing their reserves. This is shown in panel (b), where the Fed sells $100 million of U.S. Treasury bills. Here, bank reserves and the monetary base decrease.

You might wonder where the Fed gets the funds to purchase U.S. Treasury bills from banks. The answer is that it simply creates them with a stroke of the pen—or, more likely, a click of the mouse—that credits the banks’ accounts with extra reserves. (The Fed prints money to pay for Treasury bills only when banks want the additional reserves in the form of currency.) Remember, the modern dollar is fiat money, which isn’t backed by anything. So the Fed can create additional monetary base at its own discretion.

The change in bank reserves caused by an open-market operation doesn’t directly affect the money supply. Instead, it starts the money multiplier in motion. After the $100 million increase in reserves shown in panel (a) of Figure 29-8, commercial banks would lend out their additional reserves, immediately increasing the money supply by $100 million. Some of those loans would be deposited back into the banking system, increasing reserves again and permitting a further round of loans, and so on, leading to a rise in the money supply. An open-market sale has the reverse effect: bank reserves fall, requiring banks to reduce their loans, leading to a fall in the money supply.

Economists often say, loosely, that the Fed controls the money supply—checkable deposits plus currency in circulation. In fact, it controls only the monetary base—bank reserves plus currency in circulation. But by increasing or reducing the monetary base, the Fed can exert a powerful influence on both the money supply and interest rates. This influence is the basis of monetary policy, the subject of our next chapter.

As we noted earlier, the Fed is only one of a number of central banks around the world, and it’s much younger than Sweden’s Sveriges Riksbank and Britain’s Bank of England. In general, other central banks operate in much the same way as the Fed. That’s especially true of the only other central bank that rivals the Fed in terms of importance to the world economy: the European Central Bank.

The European Central Bank, known as the ECB, was created in January 1999 when 11 European nations abandoned their national currencies and adopted the euro as their common currency and placed their joint monetary policy in the ECB’s hands. (Seven more countries have joined since 1999.) The ECB instantly became an extremely important institution: although no single European nation has an economy anywhere near as large as that of the United States, the combined economies of the eurozone, the group of countries that have adopted the euro as their currency, are roughly as big as the U.S. economy. As a result, the ECB and the Fed are the two giants of the monetary world.

Like the Fed, the ECB has a special status: it’s not a private institution, but it’s not exactly a government agency either. In fact, it can’t be a government agency because there is no pan-European government! Luckily for puzzled Americans, there are strong analogies between European central banking and the Federal Reserve system.

First of all, the ECB, which is located in the German city of Frankfurt, isn’t really the counterpart of the whole Federal Reserve system: it’s the equivalent of the Board of Governors in Washington. The European counterparts of the regional Federal Reserve Banks are Europe’s national central banks: the Bank of France, the Bank of Italy, and so on. Until 1999, each of these national banks was its country’s equivalent to the Fed. For example, the Bank of France controlled the French monetary base.

Today these national banks, like regional Feds, provide various financial services to local banks and businesses and conduct open-market operations, but the making of monetary policy has moved upstream to the ECB. Still, the various European national central banks aren’t small institutions: in total, they employ more than 50,000 people; in 2014, the ECB employed only around 2,000.

In the eurozone, each country chooses who runs its own national central bank. The ECB’s Executive Board is the counterpart of the Fed’s Board of Governors; its members are chosen by unanimous consent of the eurozone national governments. The counterpart of the Federal Open Market Committee is the ECB’s Governing Council. Just as the Fed’s Open Market Committee consists of the Board of Governors plus a rotating group of regional Fed presidents, the ECB’s Governing Council consists of the Executive Board plus the heads of the national central banks.

Like the Fed, the ECB is ultimately answerable to voters, but given the fragmentation of political forces across national boundaries, it appears to be even more insulated than the Fed from short-term political pressures.