A country�s central bank tries to keep the economy running smoothly. A central bank looks at economic data such as factory orders, housing, consumer credit, retail sales, manufacturing orders, construction activity, and
employment figures in an effort to keep the economy from dying and growing too fast.
Instead of taking deposits and making loans like normal banks, a central bank controls the economy by increasing or decreasing the country�s money supply. Every economy in the world is based on the use of money. Therefore,
each country�s money supply determines how quickly the economy can grow.
If the central bank increases the money supply, consumers and businesses have more money to spend on goods and services, which stimulates
economic activity. When businesses and individuals have less money at their disposal, economic activity slows down.
Central banks often limit money supply growth in order to slow down the economy and control inflation.Cranking up the printing presses is not the main way a central bank increases the country�s money supply though.
In the United States, the Fed usually prints only enough bills to replace worn-out money in circulation. So how then does a central bank control its country�s money supply?
There are several ways but the method that is most relevant to the foreign exchange market is by raising or lowering interest rates. When a central bank decides an economy is growing too slowly, it reduces the interest rate
it charges on its loans to banks, which results in cheaper loans to businesses and consumers. If an economy is growing too quickly, a central bank can increase the interest rates on its loans to banks, reducing the available
supply of money and putting the brakes on economic growth.
If the central bank allows the economy to expand too rapidly by keeping too much money in circulation, it may cause unwanted inflation. If it slows down the economy by removing too much money from circulation, it may
cause an economic recession, resulting in unemployment and reduced production.