The Role of Central Bank

The goals of any Central Bank are to simultaneously achieve:

1) price level stability (so predictable inflation)

2) maximized long term growth of real GDP

And maintaining a stable price level is believed to maximize the long term sustainable real GDP growth.

To control price level, US Fed Reserve uses the following tricks:

1) Change of discount rate (the rate banks borrow from Fed)

2) Change of Federal Fund Rate (the target rate Fed wants banks to borrow from each others, usually overnight)

3) Change of Bank reserve requirements

Note: Similar to FFR, in Australia and New Zealand it is called Cash Rate, in Canada it is called Overnight Rate and in UK system it is called repo rate.

To control price level, the central banks will set appropriate price level. If it realized that the growth is too high (unsustainable), it will, e.g. in US, increase the discount rate FFR and reserve requirements.

In some countries, they have inflation target. Therefore, the central bank will lower the inflation target in order to cool down the economy.