When inflation runs hot, central banks raise interest rates. When recession looms, they cut them. These decisions are monetary policy, the set of actions a central bank takes to control the money supply and the cost of credit. The goal is usually to keep inflation low and stable while supporting employment and growth. Getting the balance right is the hard part.

The tools have expanded over the years. Traditionally, central banks bought and sold government bonds to adjust the money supply, a process called open market operations. They also set reserve requirements for commercial banks and the discount rate at which banks borrow directly. Since 2008, many have used quantitative easing, buying large quantities of assets to push money into the financial system when rates hit zero.

Monetary policy works with a lag. A rate cut today may not affect spending for months. That makes timing difficult. Central banks must act on forecasts, and forecasts are often wrong. The Federal Reserve has been criticized for both moving too slowly before the 2008 crisis and for tightening too early in the 1930s, worsening the Great Depression.

Monetary tools

• Open market operations
• Reserve requirements
• Discount rate
• Quantitative easing
• Forward guidance