Central bank policy is a set of tools that can be used to control the supply of money and credit in a country. The main tool is the interest rate, which central banks can change by buying or selling securities on the market. This has a direct effect on demand and, ultimately, inflation. Other tools include regulating the amount of reserves that banks must keep at the central bank, forward guidance, and open market operations.
A key challenge in modern times is to maintain stable growth and low unemployment. Orthodox central banking has historically given a higher priority to maintaining external stability (by focusing on gold reserves) than internal stability (by focusing on employment, real activity, and prices). This has changed since World War I, when many countries moved to a system of monetary sovereignty and began to focus on both external and domestic goals.
The guiding principle in this shift has been the importance of well-anchored inflation expectations. By communicating an explicit inflation target and delivering inflation consistent with that target, central banks can build credibility. This feedback loop between effective policy actions and communications, well-anchored expectations, and price stability short circuits the so-called second-round effects of supply shocks that can amplify and prolong economic downturns.
A related challenge has been to deal with financial booms and busts. Central banks have typically tried to avoid deflating asset booms before they turn into busts for fear of triggering recessions; instead, they have sought to provide ample liquidity during crisis periods and then withdraw it once the threat has passed. This approach has been criticized for encouraging excessive risk-taking and may have contributed to the recent subprime crisis, which was caused by the creation of new financial instruments that bundled mortgages of dubious quality into securities that could be sold on the markets.