Up to this point in the book, the central bank has played a very simple role. In the short run, it has conducted exchange rate policy by intervening in the foreign exchange market in a very specific way, that is, by standing ready to buy or sell foreign exchange at the officially announced exchange rate, thereby making the market for foreign exchange. It has also conducted monetary policy by intervening in the domestic bond market with one of three objectives: to target the domestic interest rate, the stock of domestic credit (the quantity of domestic government bonds that it holds), or the money supply, thereby making one of these a policy-determined variable. Over the medium run, we described the central bank as expanding the stock of domestic credit to meet the government's financing needs and adjusting the officially determined nominal exchange rate proportionately to safeguard its stock of foreign exchange reserves.

In all this, the central bank has been treated as acting rather mechanically and passively. It is now time to examine the role of the central bank more closely. In Part 4 of the book, consisting of this chapter and the next, we will consider the institutional and policy frameworks for the conduct of monetary policy. The current chapter will consider the case for central-bank independence from the finance ministry, and in the chapter that follows, we will examine how an independent central bank should conduct monetary policy, that is, how the monetary policy regime should be chosen.