Central bank policy has a number of dimensions that interact with each other. One key is the scope of the central bank’s footprint in financial markets. This has to do with what fraction of reserves is backed by outright holdings and what portion comes from ceiling tools (the standing repo facility, for instance, and temporary lending operations). Another dimension is the cost/benefits of central bank lending into money markets.
A third dimension has to do with the central bank’s statutory mandate: price stability and maximum employment. A fourth dimension has to do with globalization and developments outside the control of policymakers, such as oil prices, commodity shocks, and international exchange rates.
One of the most important tasks for central banks is to respond to business cycle booms and busts. Orthodox central bank policy is to refrain from defusing asset booms before they turn into busts for fear of triggering recessions but to react quickly when they do occur and supply ample liquidity to support the payment and banking systems.
A related challenge is to keep abreast of financial innovations that can undermine financial stability, such as credit derivatives that can be used to create complex instruments with lower transaction costs and greater leverage. Finally, central banks are often tasked with acting as the lender of last resort when private sector financial problems arise, and this requires substantial resources.
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