Central banks issue national currencies, set interest rates on loans and bonds, regulate member banks, manage the country’s financial system, and provide a range of other services. They engage in contractionary monetary policy when they want to slow the economy and curb inflation, and expansionary monetary policy when they want to stimulate growth and increase employment.
The main tool a central bank has is its interest rate, which it sets through a variety of mechanisms. The Fed, for example, can change the discount rate it charges banks to borrow money on short-term contracts; set a cap on how much commercial banks must keep on hand as reserves, which reduces their liquidity; and buy or sell securities that are basically government IOUs in open market operations.
When a central bank lowers its interest rate, the money supply increases because commercial banks are willing to lend more. This bolsters economic activity, but can also fuel inflation. Central banks also set deposit and reserve requirements and provide a host of other services, such as managing the country’s foreign exchange reserves.
The biggest challenge facing most central banks is striking a balance between their three goals. A primary one is price stability (currently viewed as low inflation over the long-run period). To succeed, this goal requires credibility: people need to believe that the central bank will tighten if it detects an inflation threat. This goal is enhanced by good communication with the public.
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