A central bank policy typically consists of tools that affect the quantities or prices of a central bank’s liabilities (such as the reserves it supplies to commercial banks) or assets (such as government securities that the central bank buys or sells). Central banks use contractionary monetary policy (which decreases money supply) when they want to slow economic growth and curb inflation; they undertake expansionary monetary policy (which increases money supply) when they seek to energize the economy and increase employment. A key challenge is maintaining credibility, which is enhanced by clear communication and by a willingness to adjust policy sooner than anticipated if the economy changes.
A second challenge is keeping up with financial innovations that can undermine stability. Such innovations often take advantage of the opacity of the financial system to circumvent regulations, reduce transaction costs, or enhance leverage. In the worst cases, they can derail the financial system and create an economic crisis. Central banks can try to defuse these crises by providing emergency liquidity during a crisis; however, it is challenging to do so without triggering recessionary forces.
A central bank normally exerts its influence over dimensions of macroeconomic activity, such as prices and inflation, output and employment rates, or designated monetary aggregates, by setting short-term interest rates. The traditional story is that other short-term market interest rates adjust when the central bank’s policy rate changes, and in the desired direction. However, empirical evidence of this transmission is elusive.
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