Central bank policy is the decisions made by a central bank in managing its money supply, currency and other financial instruments to achieve economic goals such as price stability (or inflation) and full employment. It also has wider responsibilities including regulating member banks, overseeing the national payment system and managing a nation’s foreign exchange reserves.
A central bank’s main tool in its monetary policy is changing interest rates. Lowering them boosts liquidity and economic activity by increasing the money supply, while raising them slows growth and discourages risk-taking in the economy. Central banks can also affect the quantity of base currency in circulation by conducting open market operations to buy or sell financial instruments such as government bonds, treasury bills, repurchase agreements or repos, company bonds or foreign currencies in exchange for money on deposit at the bank. This is known as monetary tightening.
The objectives of a central bank typically include both price and employment targets, but some central banks target only inflation, while others have a dual mandate that also includes full employment. The goal of the latter is to ensure that people who want to work have jobs, and that wages and prices rise slowly over time.
The effectiveness of a central bank’s monetary policy also depends on the expectations that it creates in credit markets. If people believe that the central bank will raise rates if they see a credit bubble forming, then this can help deflate it.
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