What Is Central Bank Policy?

Central banks have a vital role to play in the economy. They must provide a stable currency, keep inflation low, and serve as lender of last resort. They must also be independent of government interference. This independence is crucial to the success of monetary policy.

Central bank policy is the set of actions a central bank takes to achieve its goals. Generally, a central bank targets interest rates and the money supply through open market operations. Interest rate changes affect the amount of money in the economy by changing the price of borrowing (the yield on a security) and thus the quantity of loans and investment. The money supply changes through purchases and sales of securities, which increase or decrease the monetary base (the total amount of currency in circulation plus the reserves that banks hold on deposit at the central bank).

The central banking system has evolved over time to meet the needs of the economy. At the outbreak of World War I, central banks developed a lender-of-last-resort function, as governments faced budget deficits to fund the war effort and needed more resources. This was the beginning of a gradual trend to central bank independence.

A key challenge for central banks is to ensure that the public understands their intentions. For policy to be successful, the public must believe that the central bank will tighten when inflation rises and this belief must be backed up by actions. This is difficult because of the lag between central bank actions and their effects on economic activity.