During the past decade or so, there has been much discussion of the evolution in views about appropriate ultimate objectives and strategic aspects of central bank policy. Less well recognized is the parallel evolution in thinking about how to operationally implement these policies. This relative neglect is problematic because it encourages the view that operating procedures are largely insignificant, but they can have substantial implications for how money and capital markets work and the volatility of asset prices.
The conventional view is that central banks exert influence over dimensions of economic activity like prices and output, or designated monetary aggregates, mainly by setting short-term interest rates. These rates then affect borrowing costs, which in turn influence consumer and business spending, investment, and production, as measured by demand and supply of the goods and services under consideration.
A further goal is to ensure that the financial system is able to function when there are crises. This can be accomplished by supplying ample liquidity to finance the banking and payments systems, as was done after the stock market crash of 1987 and during incipient crisis situations of the 1990s and 2000s. The approach has also been used after the 2008 global financial crisis.
A further concern is to control inflation. Achieving this goal requires that central banks communicate their intentions clearly, and if necessary, act more forcefully. One way to do this is by purchasing specific assets in the market, such as corporate commercial paper or mortgage-backed securities, thereby increasing the quantity of assets held by financial institutions.
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