Central bank policy is a set of rules and tools that central banks use to influence financial conditions. Its goal is to achieve economic goals, such as maximum employment and stable prices, which create the conditions for moderate long-term interest rates. Central banks implement monetary policy through decisions that affect interest rates in the money market, and thereby a range of other interest rates, money supply, demand, and inflation.
For example, when a central bank lowers interest rates, it encourages consumers and businesses to spend more and invest more, which can spur economic growth. When a central bank raises interest rates, it makes borrowing more expensive, and this can discourage spending, investment, and savings and slow economic growth.
In addition to adjusting interest rates, a central bank may purchase or sell securities in the market to influence financial conditions. For example, the Federal Reserve uses a facility called the ON RRP to help control overnight interest rates by reinforcing the floor on the fed funds rate (the Fed’s target for the amount of reserves it holds). A central bank may also set required reserve levels, or require financial institutions to pledge certain assets as collateral to receive credit, to limit their risk and leverage.
A central bank’s policies must consider a variety of factors, including global financial stability and the sustainability of fiscal positions. Central banks are tasked with balancing these competing objectives and coordinating their policies in times of crisis.
