Central banks exert influence over the money supply by either decreasing or raising interest rates and engaging in open market operations such as buying and selling government securities – this increases or decreases cash in circulation as bank reserves expand and contract accordingly.
Central banks must clearly explain their policy decisions, rationale and objectives to both the public and financial markets to manage expectations and maintain credibility.
The Reserve Requirement
A central bank may use reserve requirements to implement its monetary policy directly. An increase in reserve requirements forces banks to purchase temporary liquidity from the central bank at higher costs, thus decreasing lending activity and, ultimately, aggregate deposits. Conversely, reducing reserve requirements permits more loans to be extended thereby increasing aggregate deposits.
However, an excessive implicit tax on reserves could impede a central bank’s ability to manage prices and output effectively. Disintermediation caused by such taxes may weaken links between intermediate targets and ultimate objectives such as inflation and employment goals.
If a central bank wishes to maintain an environment of scarce reserves, one way of mitigating an implicit tax may be using longer measurement and maintenance periods. Longer measurement periods allow more accurate forecasts for base money demand while shorter maintenance periods will help lessen shocks impacting cash withdrawals from their daily schedules.
The Interest Rate
Central banks also influence or control general market lending rates through open market operations, specifically via short-term, often overnight rates banks charge each other for funds by setting their discount rate; an increase in this rate triggers higher money market and certificate of deposit (CD) rates offered to commercial banks by commercial banks to their most creditworthy customers.
Central banks traditionally used interest rates to regulate inflation and slow economic growth by applying brakes. But in light of recent global financial crises, central banks now recognize the need to use macroprudential tools as well to identify and contain risks to the financial system as a whole. As a result, many central banks now implement both monetary and macroprudential policies simultaneously while using forward guidance or other communication activities to express their stance on financial environment conditions.
The Monetary Policy
Monetary policy is the central bank’s tool for controlling money supply. This is accomplished by setting interest rates, controlling credit availability and overseeing financial markets.
Quantitative Easing The central bank can purchase large volumes of government-issued securities in order to increase its balance sheet and inject cash into the economy, also known as quantitative easing. This practice can have numerous detrimental effects on economic activity.
An expansionary monetary policy decreases borrowing costs, prompting consumers to spend more and businesses to invest more in capital goods – leading to greater economic activity and price inflation.
The Federal Reserve’s goal is to promote full employment while simultaneously containing inflation. Achieve this is often complicated by natural business cycles or events that disrupt economic activity, so the central bank must carefully weigh tradeoffs between short-term economic growth and unemployment, long-run price stability and inflation, which is why its staff remains large and independent of political considerations.
The Inflation Target
One of the central bank’s most powerful tools is their ability to control inflation. While controlling it has many benefits, changing your inflation target may have unintended repercussions.
At its core, changing inflation targets could cause inflation to become less anchored, making it harder for central banks to influence price developments and increasing unemployment. Furthermore, shifting target may confuse price-setters about what their intentions are while giving businesses more reason to pass along interest rate changes to consumers.
Paying interest on banks’ liquid reserves represents an unjustified transfer of the central bank’s monopoly profit (seignorage) to private institutions that have done nothing to earn it. Instead, this profit should go back to the government that granted the monopoly and would help strengthen the economy by lowering prices, increasing demand, encouraging investment and production, as well as creating higher economic growth, lower unemployment, and greater income equality.