Central bank policy is the set of rules and instruments used by a central bank to manage its country’s money supply and achieve price stability. Central banks oversee the nation’s banks and government finances, regulate the financial system through capital requirements, deposit guarantees, and reserve requirements, and manage foreign exchange reserves. In addition, they promote the growth of money and capital markets.
The core purpose of most central banks is to promote stable economic growth and price stability. To do this, they usually aim to target a low rate of inflation over the long run. However, when big shocks hit the economy, a central bank may temporarily deviate from its long-run inflation goal to stimulate the economy. It does this by cutting interest rates. Banks are then encouraged to lend money, boosting aggregate demand. When the crisis is over, the central bank will raise rates to bring inflation back toward its target.
Changing the money supply is key to Central bank policy. The easiest way to do this is to change the discount rate, a key policy tool that sets the price at which the central bank will lend its excess funds to commercial banks. The central bank can also expand the money supply by purchasing assets from the market. This is known as quantitative easing, and it increases the size of the central bank’s balance sheet and injects new cash into the economy.
Finally, central banks can control short term interest rates in the money market by adjusting their target overnight policy rate and conducting open market operations. Changing the overnight policy rate signals the central bank’s monetary policy stance and has an effect on all other interest rates in the economy.
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