🏦 The Role of the Central Bank
Definition: Central bank.
Key functions
- Setting interest rates — the main tool for monetary policy.
- Controlling inflation — most central banks have an inflation target (typically ~2%).
- Lender of last resort — provides emergency liquidity to banks facing short-term cash shortages.
- Managing the exchange rate — intervening in foreign exchange markets (in some countries).
- Supervising the banking system — ensuring financial stability.
Examples: The Federal Reserve (US), European Central Bank (eurozone), Bank of England (UK), Reserve Bank of India. Most are operationally independent — they set rates without political interference.
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🔧 Expansionary and Contractionary Monetary Policy
Expansionary (loose) monetary policy
- Central bank lowers interest rates → borrowing cheaper → C and I increase → AD shifts right.
- Used during recessions / deflationary gaps to boost demand, output, and employment.
- Can also involve quantitative easing (QE) — the central bank buys government bonds to inject money into the economy.
Contractionary (tight) monetary policy
- Central bank raises interest rates → borrowing more expensive → C and I decrease → AD shifts left.
- Used during inflationary gaps / overheating to cool demand and reduce inflation.
- Can also involve selling bonds to reduce the money supply.
Lower rates → AD right (expansionary). Higher rates → AD left (contractionary). This is the core mechanism — everything else follows from it.
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🎯 Inflation Targeting
Inflation targeting.
How it works
- Inflation above target → central bank raises rates → demand falls → inflation decreases.
- Inflation below target → central bank lowers rates → demand rises → inflation increases toward target.
- The target is usually symmetric — too-low inflation is also a problem (risk of deflation).
Benefits of inflation targeting
- Anchors expectations — businesses and workers plan around a stable, predictable inflation rate.
- Transparency — clear target makes the central bank accountable.
- Independence — reduces political pressure to keep rates low before elections.