Macroeconomics
Monetary policy

Central banks conduct monetary policy mainly by adjusting short-term interest rates. The actual method through which the interest rate is changed differs from central bank to central bank, but typically the implementation happens either directly via administratively changing the central bank's own offered interest rates or indirectly via open market operations.

Via the monetary transmission mechanism, interest rate changes affect investment, consumption, asset prices like stock prices and house prices, and through exchange rate reactions export and import. In this way aggregate demand, employment and ultimately inflation is affected. Expansionary monetary policy lowers interest rates, increasing economic activity, whereas contractionary monetary policy raises interest rates. In the case of a fixed exchange rate system, interest rate decisions together with direct intervention by central banks on exchange rate dynamics are major tools to control the exchange rate.

In developed countries, most central banks follow inflation targeting, focusing on keeping medium-term inflation close to an explicit target, say 2%, or within an explicit range. This includes the Federal Reserve and the European Central Bank, which are generally considered to follow a strategy very close to inflation targeting, even though they do not officially label themselves as inflation targeters. In practice, an official inflation targeting often leaves room for the central bank to also help stabilize output and employment, a strategy known as "flexible inflation targeting". Most emerging economies focus their monetary policy on maintaining a fixed exchange rate regime, aligning their currency with one or more foreign currencies, typically the US dollar or the euro.

Conventional monetary policy can be ineffective in situations such as a liquidity trap. When nominal interest rates are near zero, central banks cannot loosen monetary policy through conventional means. In that situation, they may use unconventional monetary policy such as quantitative easing to help stabilize output. Quantity easing can be implemented by buying not only government bonds, but also other assets such as corporate bonds, stocks, and other securities. This allows lower interest rates for a broader class of assets beyond government bonds. A similar strategy is to lower long-term interest rates by buying long-term bonds and selling short-term bonds to create a flat yield curve, known in the US as Operation Twist.
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