Central banks are a bit like national piggy banks. They keep a big stash of national savings in their vaults, and they supply money when needed. They also have some powerful tools at their disposal to steer national economies. Driving a country's economy is similar in many ways to driving a car, with the amount and the flow of money serving as the fuel. By stepping on the gas, an agency such as the Federal Reserve in the United States can prompt the economy to speed up. But expansion in the supply of money and an accelerating economy come with financial risks, including inflation.
Interest Rates and Money Supply
The Federal Reserve and other central banks control the money supply by setting interest rates. By deciding on a low target rate for federal funds in the United States, for example, the Fed makes money cheaper for banks and encourages more borrowing by businesses seeking to expand. The Federal Reserve is also responsible for printing money; more borrowing at lower rates set by the agency means more money in circulation. The trend in money supply is an important measure of whether a country is following an expansionary or restrictive monetary policy.
Another expansionary technique is quantitative easing, or QE. The central bank announces its intention to buy assets, such as government bonds. This supports demand for these bonds, which keeps their market price high. When the price of a bond rises, its interest rate falls, since the interest it pays now represents a smaller percentage of the bond's price.
The Federal Reserve pioneered this practice in the United States; the European Central Bank has also taken up QE to stimulate the stagnant economies in Europe. When QE is underway, the money supply expands. The goal is to "prime the pump" and get the economy moving ahead under its own steam. Eventually, QE comes to a halt; the central bank stops buying assets and putting new money into circulation. The growing economy, in theory, supports a high demand for loans and the circulation of money from lender to borrower and back again.
Expansionary policy carries some risks. When the money supply expands, prices tend to rise and currency loses its value. This happened in a big way during the 1920s in Germany and other European countries. Facing a crushing burden of World War I debts and reparations due by treaty to Great Britain and France, Germany began printing money to pay its bills. Expansion turned to hyperinflation, as the German currency lost all value and the price of a simple cup of coffee reached millions of German marks. The savings of German citizens were wiped out, and only people holding hard assets such as gold had a hope of financial survival. This traumatic experience still affects the country: Although it has the largest economy in Europe, Germany favors restrictive monetary policy, and its central bank aims to slow the rate of inflation by any means necessary.