Central Bank Actions and Economic Management

Definition and Purpose

A set of actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity. These actions aim to achieve macroeconomic stability, typically defined as price stability (controlling inflation), full employment, and sustainable economic growth.

Instruments

• Open Market Operations: Buying or selling government securities in the open market to increase or decrease the money supply and influence short-term interest rates. Purchasing securities injects reserves into the banking system, encouraging lending, while selling securities withdraws reserves.
• Reserve Requirements: The fraction of a bank's deposits that they are required to keep in their account at the central bank or as vault cash. Increasing reserve requirements reduces the amount of money banks can lend, while decreasing them allows banks to lend more.
• The Discount Rate: The interest rate at which commercial banks can borrow money directly from the central bank. Lowering the discount rate encourages banks to borrow more, increasing the money supply; raising it discourages borrowing.
• Interest on Reserves: The interest rate the central bank pays to commercial banks on the reserves they hold at the central bank. Raising this rate encourages banks to hold more reserves, reducing lending, while lowering it encourages lending.
• Quantitative Easing (QE): A non-conventional instrument where a central bank purchases longer-term securities, including government bonds and mortgage-backed securities, to lower long-term interest rates and increase liquidity when short-term rates are near zero.
• Forward Guidance: Communicating the central bank's intentions, what conditions would cause it to maintain a course of action, and what conditions would cause it to change course. This can influence market expectations and guide economic behavior.

Types

• Expansionary: Designed to stimulate economic activity during periods of recession or slow growth. This involves lowering interest rates, reducing reserve requirements, or buying government securities to increase the money supply and encourage borrowing and investment.
• Contractionary: Designed to curb inflation and cool down an overheated economy. This involves raising interest rates, increasing reserve requirements, or selling government securities to decrease the money supply and discourage borrowing and investment.

Relationship to Fiscal Policy

Distinct from fiscal policy, which involves government spending and taxation. While both aim to influence the economy, the former operates through the central bank and control of the money supply, while the latter operates through government budgetary decisions.

Targets and Indicators

Central banks typically monitor a range of economic indicators to inform their decisions, including:

• Inflation rates (CPI, PPI)
• Unemployment rate
• Gross Domestic Product (GDP) growth
• Interest rates
• Exchange rates
• Credit growth
• Asset prices

Challenges and Limitations

Effectiveness can be limited by:

• Time lags: The effects of changes may not be immediately apparent.
• Liquidity trap: Lowering interest rates may not stimulate borrowing if confidence is low.
• Global economic conditions: External factors can influence domestic economic conditions.
• Conflicting objectives: Balancing price stability and full employment can be challenging.
• Uncertainty: Predicting the exact impact of changes is inherently difficult.