Central bank policy affects the money supply and, in turn, other economic variables such as inflation. Central banks have a variety of instruments for changing the amount of money in the economy, including open market operations. These involve buying or selling short-term government bonds in the private markets to change the supply of cash. For example, the Federal Reserve buys bonds to increase the money supply and sells them to decrease it. The Fed also manipulates the amount of cash banks have to keep with it through a system known as reserve requirements. Central banks may also set the exchange rate of their currency relative to foreign currencies, which can impact exports and imports.
Another way to influence the money supply is by changing the required collateral that financial institutions must hold. The Federal Reserve, for example, sets the minimum amount of assets that banks must pledge as a percentage of their deposits to obtain loans from the Fed. Central banks may also adjust a key interest rate, such as the discount rate. This rate can directly affect other interest rates such as those that commercial banks charge their customers.
A major challenge for central banks is to balance price and output goals. Many countries have a dual mandate for their central bank: to stabilize prices (usually viewed as low inflation over the long run) and promote growth by encouraging employment and investment. Achieving this goal requires credibility, and people need to believe that the central bank will tighten monetary policy if inflation becomes a problem. This belief can be bolstered by clear communication from the central bank.