The monetary policy are directives issued by a nation’s central bank to influence and control money supply and credit, maintain price stability, influence output and unemployment and maintain a maximum sustainable growth.
The open market operations is effectively used by the central bank to control money supply and credit in the system in the short term. The central banks through its open market operations mechanism participates in trading of government securities thereby influencing inter-bank lending rates. Suppose the Central bank wants the rate to fall, it buys securities from the banks and then pays the banks for these securities, by increasing bank reserves. Now, the banks have more reserves and can lend these funds to another bank in the market (say at a rate, called the Fed rate in the US). Thus, the central bank’s open market purchase increases the supply of reserves to the banking system and the rate falls. The reverse is done in case the central bank wants to raise the funds rate.
Further, in the short term, when there is a fall in demand, and an onset of recession, the central bank may stimulate the economy (though temporarily) to a long run level of output by reducing interest rates. But this may not be possible always during recession! A continuous boost in stimulating the economy may pressurize on capacity and production constraints, thereby leading to a rise in inflation and higher price, without a drop in unemployment. More to say, it affects the domestic consumers who worry about rising inflation and its varying behaviour making capital intense business expansions more obscure. Tax - another component is not well indexed to the rise in inflation distorts domestic consumer welfare. So, moderately low inflation accompanied by ‘price stability’ makes it more vulnerable for business and economy to operate.
An effect of the implementation of the monetary policy can be seen on people, goods and services. A change in the real interest rates affects demand and finally the output, employment and inflation. A decrease in real interest rates lowers the cost of borrowing and hence promotes investment spending and consumer durables spending, availability of bank loans and foreign exchange rates. Lower interest rates make stock investments attractive than bonds, thus improving the performance of the market, Higher participation in the stock market and rise in stock prices facilitate further stock issuance avenues and expansion plans. This increase in demand across various products and services raises production and employment.
Some central banks in developing countries and emerging markets, to name a few, the People’s Bank of China, Reserve Bank of India, Central Bank of Brazil utilize the required reserve ratio or cash reserve ratio (CRR) as a tool to manage their framework. The cash reserve ratio is the
amount of minimum cash and reserves that the central bank requires commercial banks to hold (rather than lend out) as a proportion of customer deposits and notes. In essence, it limits how much the bank can lend; thus by altering the level of the ratio the central bank can influence the growth of credit which can be important in influencing the level of inflation and economic activity.
Another tool of the framework amidst the CRR is The Repurchase Agreement (commonly known as the Repo or discount rate). It is a transaction whereby eligible institutions (financial institutions, commercial banks) borrow money from the Central bank directly. It involves a sale of an asset (e.g. a bond) with the subsequent repurchase of that same asset for a slightly higher price. Repurchase operations are usually undertaken as a means of borrowing money; using the bond as collateral, as such the price differential is effectively the borrowing interest rate. Central banks frequently engage in repurchase (asset seller = borrower) and reverse repurchase (asset buyer = lender) transactions as part of their Open Market Operations; as a means of injecting or withdrawing liquidity from the system. Central banks often adjust their official/target repo and reverse repo rates as a means of influencing the costs/benefits of borrowing/lending by financial market participants and institutions.
The discount window is a key tool in promoting financial market and banking system stability, particularly when money markets tighten, as in times of crisis e.g. the US Federal Reserve discount window saw considerable use during the 2008-9 financial crisis. In the Eurozone, the European Central Bank (ECB) operates an equivalent mechanism called Standing Facilities; with the Marginal Lending Facility available for short-term bank funding and the Deposit facility as a means for depositing excess funds.
While we have understood that tools that constitute the framework of the monetary policy, it may not be true that the monetary policy stands a testimony to economic stability. However, a few thoughts on alternative ways (tools) may substitute in a better manner. The crisis of 2008 brought the financial system to a verge of systemic failure and showed signs of depression and deflation. Financial stability could be addressed mainly using macro-prudential policies. Central banks can mitigate the pro-cyclicality of systemic risk and the build-up of structural vulnerabilities. Macro-prudential tools include capital requirements and buffers, forward-looking loss provisioning, liquidity ratios, and prudent collateral valuation. All potentially systemic institutions and markets can be within the macro-prudential regulatory purview. Central banks should play a key role, whether or not they serve as the main regulator.
Price stability should be retained as the primary objective of the monetary policy. In normal economic times, price stability provides sufficient room for interest rate policy to react to short-run variations in economic activity. It’s only in rare occasions, say a crisis that may cause policy interest rates to reach the zero mark. Such crises usually arise from conditions that also make interest rates relatively ineffective in stimulating aggregate demand, while increases in risk aversion may well override the stimulus to consumption and investment of low real interest rates. In such circumstances, unconventional measures may prove to be more effective.
Broadly speaking, most central banks employ the same tools for their monetary policy framework. However, the order of importance in utilising these tools depends on the objective of the nation and charter of the government. The US Federal Reserve (Fed) follows a risk management approach in pursuit of its objectives of price stability and maximum employment. Under this approach, the Fed takes a policy view on interest rate on consideration of balance of risks to inflation and growth. On the other hand, the European Central Bank (ECB) has a single mandate of price stability. It is not an inflation targeting central bank. Its policy decisions are based on a “two pillars” strategy comprising of “economic analysis” and “monetary analysis”. Among the emerging markets, Reserve Bank of India (RBI) adopts a “multiple indicators approach” with a greater emphasis on rate channels for monetary policy formulation. Quantity variables such as money, credit, output, trade, capital flows and fiscal position as well as from rate variables such as rates of return in different markets, inflation rate and exchange rate are analysed for drawing monetary policy perspectives.
In conclusion, the task of monetary management has become more challenging. There is a need to raise awareness in the central banking community of the importance of monetary analysis and its implications, for economies individually and globally.
- www.imf.org (International monetary fund), World economic outlook, Central Banking lessons from crisis.
- www.federalreserve.gov ( US monetary Policy), Policy making process, structure and development.
- www.rbi.org.in (Reserve Bank of India), Multiple Indicator method of policy making.
- www.foreignpolicy.com (Foreign Policy), Financial crisis and after thoughts
- www.mckinseyquarterly.com : Miscellaneous articles.
- www.pbc.gov.cn (The People’s Bank of China), CRR as a tool of monetary policy.
- www.ecb.int (European Central Bank), Perspective of Monetary policy framework in Europe.
- www.cepr.org (Centre for Economic Policy Research), Articles on monetary policy.
Submitted by David BradyNovember 9, 2012 2:36 am
Submitted by Sara SalimAugust 31, 2015 6:01 pm
Submitted by Shuangmiao HanJuly 4, 2013 2:30 pm
Submitted by David BradySeptember 20, 2012 1:54 am
Submitted by Nagraj BaggonJanuary 17, 2013 6:35 am
Submitted by Radoslav DragovMarch 5, 2013 2:20 am