What do central banks do?

The central bank (CB) is the monopoly producer of high-powered money (HPM), which makes up the monetary base. HPM comes in two flavors: (1) physical currency--paper notes, coins, etc.; (2) electronic bank reserves. In a typical developed economy, commercial banks must, by law, deposit some fraction of their customers' deposits into electronic vaults supervised by the CB. The funds put towards meeting this mandate constitute a bank's 'required reserves'. Any extra funds the bank deposits constitute its 'excess reserves'. The CB is the monopoly producer of HPM for two reasons: (1) it is the only entity legally permitted to create new physical currency; (2) it is the only entity legally permitted to electronically credit participating banks' reserves.

The CB is typically free to produce however much HPM it chooses, in either form. Additionally, HPM's cost of production is, approximately, zero. Consequently, the CB controls the supply of HPM in the relevant currency zone.

Why does HPM matter? The prices of goods and services are quoted in units of HPM--HPM is therefore the 'unit of account'. HPM is also what consumers use to buy goods and services--HPM is therefore the 'medium of exchange'. In equilibrium, the value of HPM is determined by the supply of, and demand for, HPM. Hence, in the long run the CB, through its management of the supply of HPM (its 'monetary policy'), determines the value of HPM, which is the flipside of the price level--the average price of goods and services. The higher the value of HPM, the fewer the units of HPM necessary to purchase a given bundle of goods and services. The lower the value of HPM, the greater the units of HPM necessary to purchase said bundle. As a result, monetary policy, executed by the CB, determines the price level, and therefore the rate of inflation (the rate of growth in the price level), in the long run.

If prices are perfectly flexible, then the economy equilibrates instantaneously, which means the CB determines the price level and the rate of inflation in the short run, too. Moreover, its policies are otherwise irrelevant to the evolution of the economy. Economists inclined towards a flexible-price view of the economy, therefore, believe that the sole objective of monetary policy ought to be 'price stability', usually defined to be a low and stable rate of inflation. If prices respond to shocks only sluggishly (that is, if prices are 'sticky'), however, then the economy takes time to equilibrate, which means that the CB plays a bigger role in the short-run evolution of the economy. Economists inclined towards a sticky-price view of the economy, therefore, believe that monetary policy ought to concern itself with more than mere price stability.

Suppose, for example, that the demand for HPM jumps (for whatever reason). This puts upward pressure on the value of HPM, meaning downward pressure on the price level. If prices are sticky, however, then many prices will remain too high in the face of this pressure. When the price of a good or service is too high, producers have the capacity to produce more than consumers want to consume. Producers react to this demand shortfall by contracting their output, rendering some of their inputs (e.g., labor) redundant. If wages are sticky, too, then redundant workers will continue to seek employment where there is none. As a consequence, output falls, while unemployment rises. If, in response, the CB expands the supply of HPM, this puts downward pressure on the value of money, meaning upward pressure on the price level. This offsets the downward pressure on prices, restoring the economy to equilibrium. As a consequence, output rises, while unemployment falls. Note that, in the process, the price level more or less stays put--monetary policy is impacting the economy without much impact upon price stability.

Considerations of such possibilities lead sticky-price economists to pin the blame for business cycles on the CB. When the CB does not provide the economy with enough HPM, it causes a recession. When it provides too much HPM, it causes high and/or unstable inflation. Monetary policy, therefore, has as its objective not only price stability in the long run, but also maximum output/employment in the short run.

What, then, do interest rates have to do with monetary policy? Interest is the price of a loan. A higher interest rate causes savers to save more, borrowers to borrow less. Savers make up the difference by building up their HPM reserves, expanding the demand for HPM, which (other things being equal) causes a recession. A lower interest rate causes savers to save less, borrowers to borrow more. Borrowers make up the difference by drawing down their HPM reserves, expanding the supply of HPM, which (other things being equal) stokes inflation. Thus, the stance of monetary policy may be equivalently characterized by either the supply of HPM, or a target for a benchmark interest rate. (The CB usually has no reason to interfere with the pricing of risk, so it typically manages a benchmark interest rate with reference to which financial markets fix other interest rates.) How, though, does the CB move the market rate of interest in line with its target?

An open market operation (OMO) is a transaction wherein the CB buys or sells assets in the marketplace, by drawing down or building up its HPM reserves. Since the CB can, in principle, expand the supply of HPM without limit, it can, in principle, buy or sell whatever quantity of assets is necessary to move the market rate of interest in line with its target. Because it can do this, however, it need not do this. If the CB declares a target for its policy rate (the benchmark interest rate it manages), market participants understand that there is no point doing battle with the CB. The CB always has more HPM than you, by design. Consequently, communication is usually enough to move interest rates towards the target, though the CB often engages in medium-scale OMOs to show its resolve.

The usual business of the CB, therefore, is to publicly set its target for the policy rate in a such a way as to maximize output/employment, while maintaining price stability over the long run. Sometimes, however, managing the policy rate isn't enough for the CB to fulfill its dual mandate. More on this issue to come...