Central bank policy aims to sustain an economy at full employment and maintain price stability (currently defined as low inflation over the long run). It does this through manipulating interest rates and other financial variables. These variables affect borrowing, spending, savings, and investment. Central banks can also regulate financial markets to keep them stable and prevent excessive risk-taking that could threaten the value of a country’s currency.
A central bank may use various tools to achieve its goals, including reducing or raising the required reserve ratio (a percentage of total assets a bank must hold), buying or selling securities in the market (open market operations), and lending money directly to banks at a discounted rate (discount window). The central bank also can set requirements for the quality of collateral it accepts from financial institutions; these acts serve as an effective limit on leverage.
The challenge facing modern central banks is the need to balance price and output objectives. Research has shown that a focus on containing inflation may depress economic growth and unemployment, even if it is successful in limiting future inflation. Moreover, large supply shocks are often longer-lasting than expected, which can magnify their impact on inflation.
In these cases, many economists believe that a central bank should temporarily depart from its long-run inflation goal and ease monetary policy to boost economic growth and mitigate the impact of the shock on inflation. This strategy requires credibility, so that people believe the central bank will tighten policies if inflation becomes a concern again.
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