A central bank uses monetary policy to influence borrowing, spending, economic growth, business activity, and hiring. It also tries to control inflation. It does this by changing the rates it charges financial institutions for loans or the amount of cash that banks are required to hold as reserves. It can buy or sell government bonds, target foreign exchange rates, and revise the amount of collateral that financial institutions must hold to borrow.
The key focus of most central banks is the rate at which they lend to one another (the “policy interest rate”). They usually also set other short-term market rates, such as those that govern foreign exchange rates and long-term interest rates. The aim is to affect prices and inflation, output and employment, or a designated monetary aggregate like the quantity of money and credit.
There are challenges to achieving this. One is that the central bank must stay on top of innovations in financial markets that can derail a policy. This is a particular problem with new financial instruments that can dissipate risk and reduce transaction costs by pooling illiquid assets with sounder ones. Examples include mortgage-backed securities, commercial paper, and structured finance vehicles.
The other challenge is ensuring that the policy reaches the right places. During the crisis, for example, central banks set policy to stimulate certain specific credit markets. They did this by purchasing large amounts of financial instruments, a process called quantitative easing. This increased the size of the central bank’s balance sheet and pumped liquidity into the economy through higher lending and lower interest rates.
About the Author
