Central bank policy influences the money supply, short-term interest rates, long-term interest rates, exchange rates and a range of other economic variables. A key insight is that if the central bank commits to a path for financial conditions, this reduces their volatility. This in turn enlists arbitrageurs to trade more aggressively against noisy demand, stabilising markets before the central bank needs to act. This is how the Fed, for example, induced banks to invest in commercial paper and mortgage-backed securities in recent years, without having to identify which parts of the economy needed to be helped.
In some cases, the policy channel is blocked, and central banks need to tackle specific credit markets directly. This can involve setting up facilities such as the Federal Reserve’s purchase of commercial paper to ensure businesses have continued access to working capital or buying mortgage-backed securities to sustain housing finance. This approach is often politically sensitive, since a central bank has prerogative over the terms, eligibility and prices of the collateral it accepts, so its choice of who to infuse with cash by buying debt reflects political preferences.
It is also possible to use central bank policy to influence the size of the currency. This is done through open market operations (OMOs) to increase or decrease the amount of money in the system. It is important to note that, while OMOs can affect a range of variables in the economy, the primary objective of OMOs is to control inflation and keep prices stable.
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