Central bank policy aims to stabilize inflation and growth. It involves using tools to increase or decrease money supply, including changing interest rates, limiting the amount of cash that banks are required to hold as reserves and conducting open market operations. Depending on the method, this can stimulate or depress borrowing and spending, increase or decrease economic activity, boost or slow business investment, reduce or raise prices and wages, and even control inflation expectations, which are self-fulfilling.
The most common tool used to change the money supply is the interest rate. When a central bank lowers the policy rate, banks loan more freely. Central banks also use other tools, such as buying or selling government bonds and foreign exchange interventions, to try to influence inflation expectations. During the financial crisis, many central banks cut their rates to near zero and continue to do so even after they have exhausted their traditional capacity for further reductions. They do so by making cheap loans to banks and increasing liquidity, which can boost economic activity and boost inflation expectations (though they do so without raising the overall price level).
A substantial empirical literature has sought to show that changing the policy rate induces changes in other market-determined interest rates. However, the relationship is complicated and hard to prove in real time. One important reason is that monetary policy does not directly affect prices and inflation, output and employment, or even designated monetary aggregates; these dimensions are influenced by a host of factors over which central banks have no direct control, such as the rate of business expansion and the supply of deposit money.