A central bank’s primary tool for influencing the economy is the interest rate it targets. This rate influences the cost of short-term interbank credit by affecting how much banks earn on their reserves at the central bank (or at other deposit-taking financial institutions). Central banks usually adjust the target in order to change the money supply. They do so by buying or selling securities in open-market operations, adjusting the amount of cash they hold, and by adjusting the requirements that banks must maintain with them.
The traditional story is that changes in a central bank’s policy rate feed through to other, shorter-term market interest rates, which banks raise when reserves become more plentiful and less costly, and lower when they have less available reserve balances. While empirical evidence is mixed, it generally suggests that other interest rates do adjust to reflect changes in a central bank’s policy.
Historically, the vast majority of central banks were focused exclusively on external stability (as dictated by the gold standard to which most adhered). After 1914, however, a significant number of them began to place equal weight on goals such as stabilizing prices, real activity, and employment. The Fed, for example, is unique among major central banks in that it explicitly places its employment goal on an equal footing with its inflation target.
EMs face several challenges in achieving their inflation and growth goals, particularly during periods of high global uncertainty. In this context, it is important that they carefully assess the nature and duration of a supply shock, take steps to mitigate its impact, and keep inflation expectations anchored.