Central bank policy refers to the actions a central bank takes to encourage or discourage borrowing, spending, business activity, hiring, economic growth and inflation. The tools used to implement monetary policy may include changing the interest rates that banks pay on their reserves, buying or selling government bonds and foreign exchange rates. It may also revise the amount of cash that banks are required to maintain as reserves.
During the financial crisis, one approach, called quantitative easing, expanded the size of a central bank’s balance sheet by purchasing assets such as commercial paper and mortgage-backed securities in order to pump liquidity into markets and drive down long-term interest rates. The increased size of the balance sheet meant that banks could receive additional reserves (the deposits they keep at a central bank).
However, there was an important trade-off between these objectives. Providing more funds to the economy lowered the cost of money for businesses and consumers, but it also led to higher inflation. Tightening monetary policy to raise interest rates might help control inflation, but it would also reduce economic growth and increase unemployment, all else being equal. This trade-off demonstrates why it is crucial that central banks have independence from elected political leaders and are free to pursue their own monetary policy goals.
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