The most basic central bank policy is to change the quantity of money in circulation. It does this by cutting the interest rate it charges banks to borrow from one another, which lowers the cost of borrowing for consumers and businesses and increases the supply of money. Alternatively, it can expand the money supply by purchasing financial instruments from the market. This is called “quantitative easing.” In the United States, for example, the Federal Reserve buys short-term securities (known as “treasury bills”) from dealers in exchange for cash. This adds reserves to the accounts that banks must keep at the central bank, thereby expanding the money supply.
A central bank can also influence the economy through its supervision of banks and financial institutions, by regulating the types of loans they lend and by making capital available to distressed firms. This is often a more indirect way of influencing economic activity, but it can have important implications for growth and poverty.
There is good evidence that high inflation reduces economic growth and engenders higher levels of unemployment. In times of economic distress, however, research suggests that a central bank should temporarily depart from its long-run inflation goal in order to boost economic activity and counter recessionary forces. It should also make clear its long-run commitment to low inflation so that it does not generate inflation expectations that are hard to dispel. It is particularly critical that central banks disclose their basic thinking on these issues to market participants so that they can better understand the considerations behind monetary policy choices.
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