Central bank policy is a complex and varied endeavor. It encompasses both broad macroeconomic objectives such as inflation, output, and employment as well as more narrowly focused monetary policy goals such as interest rates and money supply growth. Moreover, there are numerous different tools central banks can employ to achieve those objectives. The most familiar tool is the monetary policy rate, which is typically a short-term, overnight rate that banks charge one another to borrow funds. The central bank can loosen policy by reducing this rate, or tighten it by raising it, by buying or borrowing securities to change the amount of funds in the system.
A common challenge in setting a policy rate is the fact that central banks do not control all dimensions of macroeconomic activity. For example, they do not control prices, wages, or the stock of wealth in their countries. Normally they exert whatever influence they can over those magnitudes through the setting of an interest rate, sometimes in conjunction with other policy instruments like exchange rates or designated monetary aggregates.
Before 1914, when most countries were still under the gold standard, central banks tended to attach greater weight to external stability (which required keeping an eye on the quantity of foreign reserves) than domestic economic stabilization goals. This changed after the Great Depression and World War II, as governments reverted to centralized control over their war-shattered economies.
Today, many central banks focus primarily on achieving their inflation stabilization objective through the setting of a policy interest rate. They usually do not use this as the only tool, but rather to complement it with other policy instruments such as the purchasing of assets from nonbanks and with a range of financial market operations.