Monetary policy is how a country controls its money supply. Central banks are typically in charge of monetary policy. If things aren’t going well—unemployment is high, growth is low—then more money flowing around the economy makes it easier for people to get loans to make big investments, which helps the economy get going again. This is called expansionary, or loose monetary policy.
But when things are going really well, there can sometimes be a problem of inflation, where prices for everything steadily increase. In these situations the central bank may want to pull some money out of the system. The idea is that with less money in the economy, each unit is more valuable. So by decreasing the money supply, a central bank can prop up the value of its money and stop inflation.
The main way central banks control money supply is buying and selling government debt in the form of short term government bonds. Economists call this ‘open market operations’, because the central bank is selling bonds on the open market. Central banks usually own a big portion of their county’s debt. When they want to shrink the money supply, they can sell some that debt to banks or investors. People hand over money to buy the debt, and money is taken out of the economy, as money that used to be floating from person to person disappears into the central bank. When the central bank wants to add more money to the economy it can buy debt, taking government debt out of the economy and replacing it with new money.
All this bond buying and selling affects the interest rate too. By shifting the supply and demand for debt, central banks can move the interest rate to affect how many people take new loans. Changing the interest rate allows central banks to also impact the money supply indirectly, because each loan a bank makes actually creates money.
Central banks have other tools to indirectly control the money supply, like requiring banks to keep more money on hand (called reserve requirements), or changing the interest rate at which they lend money to private banks. In recent years central banks have also experimented with a new policy called quantitative easing—basically a turbocharged version of buying bonds.