At its most basic, a central bank does only two things. One, it rediscounts bills of exchange originally discounted by its member commercial banks. Two, it purchases mortgages and bills of exchange issued by non-member banks, businesses, and individuals on the “open market.”
By rediscounting bills of exchange of member banks, the central bank ensures that its member banks always have enough credit for their customers. By engaging in open market operations, the central bank ensures that there is always enough money in the economy to carry out transactions.
We’ll look at open market operations first because it’s easy to understand. If there is not enough money in the economy (as, for example, happened during the “money famine” following the Panic of 1893), the central bank goes to the financial markets and creates money to purchase existing qualified securities. If there is too much money in the economy, the central bank sells qualified securities out of its inventory.
That’s it. Central banks were never supposed to deal in government securities, because government securities are not asset-backed. Government securities are only backed by the ability of the government to collect taxes in the future. Those securities become worthless if people lose confidence in the government.
In a “pure” system, rediscounting is only available to a central bank’s member banks. When a commercial bank accepts a bill of exchange and issues a promissory note, it accepts the bill at a discount off the face amount of the bill.
You’ll often find the discount rate referred to as an interest rate, but that is not correct. A discount rate and an interest rate are two different things.
A discount reflects the present value of the future payment made when the bill is redeemed out of future savings. Interest is a share of the profits due to a lender of past savings.
So, a commercial bank accepts a bill offered by a borrower, and issues a promissory note to “purchase” the bill, and creates a demand deposit (checking account) for the borrower. The borrower agrees to pay back the face amount of the bill, although he only gets the discounted amount in his new checking account. The difference represents the bank’s fee for the service it provides.
The commercial bank can stop there, of course. It has just created money. The problem is that the borrower might write checks to people who don’t have an account at that bank, and don’t want a check drawn on that bank. They want cash, specifically, whatever reserve currency the bank uses.
If the commercial bank has enough cash in reserves, fine. It pays out the cash to the people presenting the checks for payment. No problem.
If the commercial bank does not have enough cash in reserves, there is still no problem — if the commercial bank is a member of a central bank. In that case, the commercial bank takes some of the bills it has discounted, and offers them to the central bank.
Assuming that the central bank accepts the bills offered by a member commercial bank (and that’s a pretty safe assumption, or there would be no benefit to belonging to a central bank), the central bank issues its own promissory note to the commercial bank, making the commercial bank a borrower from the central bank.
The central bank uses the new promissory note to back either a new demand deposit that the commercial bank can draw checks on to pay out to people presenting checks drawn on the commercial bank, or the central bank can print new legal tender reserve currency for the commercial bank to pay out the same way — whichever the people presenting checks for payment prefer.
When the original borrower repays his loan and redeems his bill, the commercial bank takes the cash, and uses it to repay the loan the commercial bank got from the central bank and buy back the original bill of exchange. The commercial bank then takes the bill of exchange it bought back from the central bank, and hands it back to the original borrower, who cancels it. Both the commercial bank and the central bank cancel the promissory notes they issued.
As you can see, in pure theory, it’s possible always to have exactly the right amount of money in the economy if you use the commercial and central banking system properly. If, however, the government starts selling its bonds to the commercial banks or the central bank, then a wild card is inserted into the game, and the system eventually falls apart.