Central bank policy, in its many guises, involves adjusting the supply of money in an economy. One way of doing so is to purchase large quantities of financial instruments in the market. This expands the central bank’s balance sheet, which provides banks with additional reserves and increases the money supply. This is often referred to as quantitative easing.

Other tools involve altering the terms on which a central bank lends into markets. These may include establishing “floor” or “corridor” interest rates, which establish the spread between markets and the central bank’s target rate. These can affect the marginal opportunity costs to banks, influencing their incentives and behaviours.

Another important issue for monetary policymakers is managing asset booms and busts. Stock and housing market booms, for example, have often been followed by busts and economic slowdowns. The orthodox approach is to avoid defusing these booms in advance for fear of triggering a recession, and instead to respond to the bust by supplying ample liquidity. This is the policy followed, for instance, by the Fed after the stock market crash of 1987 and during the global financial crisis of 2007.

The key to success in this task depends on a combination of factors including credibility, communication, and the ability to quickly adjust policy. The current global financial crisis has highlighted these limitations, and a need for clearer communication of a clear policy stance is clearly required. In addition, it will be necessary to develop ways of responding more quickly to the next crisis, which may require a rapid shift in policy if it is to have the desired effect.