Central bank policy is the set of tools a central bank uses to influence financial markets and the economy. It includes short-term interest rates and other policy instruments, such as credit easing.
The goal of most modern central banks is price stability, usually defined as low inflation over the long run. This goal requires credibility, because market agents need to believe that a central bank will tighten policy if inflation threatens. This belief can be influenced by good communication.
A second goal of central banks is to support the economic recovery in the aftermath of a crisis. This requires a more flexible approach than is typically used in normal times, since the impact of supply shocks on prices and growth is less clear-cut. This can be achieved with unconventional policies, such as quantitative easing and forward guidance.
Some central banks have experimented with explicitly setting targets for money supply growth (p) or the rate of change in the money supply (m). This has not become the norm, however, because there is a lower correlation between money and prices than previously thought.
Finally, many central banks are concerned about asset booms that can turn into busts, leading to economic downturns. Orthodox policy is to defuse booms before they turn into busts, for fear of triggering a recession, and to provide ample liquidity in the bust phase to ensure that payments and banking systems remain functioning. The aim is to help the economy recover from a crisis and, once the crisis has passed, return to its long-run price stability goals.
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