Central bank policy can take many forms, but it generally boils down to adjusting the supply of money to achieve some combination of inflation and output stabilization. Central banks also have other responsibilities that are less directly related to interest rates, such as financial stability. These include responding to banking crises and regulating margin lending, where individuals or companies borrow against pledged securities.
In the past, some central banks have operated primarily through the interest rate channel, but they have increasingly had to address other issues as well. For example, during the crisis, many specific credit markets became blocked, so the central bank needed to step in to provide liquidity. One option was to expand the size of its balance sheet through “quantitative easing”, which increases the amount of financial assets it owns and therefore the money supply. This has been a popular strategy since the financial crisis of 2008.
Another option is to buy commercial paper or mortgage-backed securities, which adds liquidity by providing a source of funds to companies and individuals that need them. In this way, the central bank provides liquidity to these markets without relying on the interest-rate channel. This is the approach currently used by the Federal Reserve and the Bank of Japan. This type of framework is often referred to as a “demand-driven” one, although it can be difficult to distinguish between the demand- and supply-driven operational frameworks, as most central banks offer a backstop lending facility to meet any additional need for reserves at a fixed price for eligible banks that can post collateral.