Monetary Policy

Implementation/Operations
LO1-Monetary Policy Operations
• Monetary policy operations refer to day to day working of SBP to
achieve its operational targets
• Monetary operations are conducted by using monetary policy tools
• Having chosen its intermediate targets, the SBP then seeks to affect
them by monetary policy operations using the monetary policy tools
in the Overnight interbank market
LO2-Monetary Policy Instruments

• Monetary policy instruments are generally classified as either direct or indirect

• Direct instruments operate under the regulatory authority granted to the
central bank. Direct instruments function according to regulations that directly
affect either interest rates or the volume of credit
• Indirect instruments operate as a function of the central bank's ability to issue
reserve money and the consequent impact of changes in reserve money on
money market conditions. Direct instruments function. indirect instruments
function by influencing market demand or supply conditions. Indirect
instruments are also termed "market-based instruments," since their use
affects the market determined price of bank reserves as the central bank
engages in transactions with both financial and nonfinancial institutions.
• There are three main types of indirect instruments: open market
• operations, central bank lending, and reserve requirements.
Monetary Policy Tools include
• Open Market Operations
• Discount Rate Operations
• Reserve Requirements
• Selective Credit Controls
• Credit Ceilings or directed lending
• individual bank credit ceilings
• Credit Planning
Direct Monetary Policy Tools
• Direct Monetry policy tools like interest rate controls have become increasingly ineffective as
markets and financial instruments develop.
• Typicaly, interest rate controls have been used when banking supervision is weak or when
information on borrowers is not adequate for judging their creditworthiness.
• They have also been used when monetary authorities are unable to achieve a target interest rate
through market mechanisms.
• Individual bank credit ceilings are effective instruments for controlling total domestic credit
growth. Like interest rate controls, however, they interfere with efficient credit allocation and lead
to disintermediation.
• Directed credits are restrictions placed on either central bank lending to banks or on commercial
bank lending whereby particular sectors of the economy receive a predetermined proportion of
the available bank credit. Directed credits are sometimes used to channel credit to public
enterprises, thereby bypassing the :fiscal accounts, or to promote certain "key" economic sectors.
The Market For Reserves and the overnight interbank Rate

• The demand and supply of commercial banks’ reserves determine the

equilibrium inter bank overnight rate which in turn affect the long
term interest rate .
• By using the monetary policy tools Central bank can change this rate
to implement its monetary policy
Demand for Reserves
• Banks demand reserves for two reasons:
They need required reserves
They keep excess reserves as precautionary reserves
TR(demand)=RR(required reserve demand)+ER(Excess reserve
demand)
RR(demand)=r(required reserve ratio) * D(Total deposits)
For example: given that D=$100bn and r=10%, RR=$10
Required Reserve Demand
Excess Reserve Demand
Demand in the Market for Reserves

• What happens to the quantity of reserves demanded by banks,

holding everything else constant, as the interbank rate changes?
• Excess reserves are insurance against deposit outflows
• The cost of holding these is the interest rate that could have been
earned minus the interest rate that is paid on these reserves.
• When the inter bank overnight rate is above the rate paid on excess
reserves, as the overnight interbank rate decreases, the opportunity
cost of holding excess reserves falls and the quantity of reserves
demanded rises.
Open Market Operations
• Open market operations consist of the central bank's purchases or sales of financial
instruments in the secondary market, although, when secondary markets are relatively
undeveloped, they also may be carried out in the primary market, frequently involving
transactions in central bank obligations.
• Instruments used for open market operations include treasury obligations, central bank
obligations, and prime commercial paper.
• The transactions involved in open market operations may be:
• outright purchases or sales, or
• a matched purchase and sale in which the purchase or the sale includes an accompanying obligation
to reverse the transaction after a specified period
• Outright purchases or sales are sometimes referred to as dynamic open market
operations, because they seek to affect the growth of reserve money permanently.
• Matched sale-purchase transactions, also known as repurchase or reverse repurchase
transactions, are referred to as defensive operations, because they are made with the
intention of smoothing out the path of reserve money growth.
Conventional Monetary Policy Tools

• During normal times, the Federal Reserve uses three tools of

monetary policy—open market operations, discount lending, and
reserve requirements—to control the money supply and interest
rates, and these are referred to as conventional monetary policy
tools.
• Central bank lending operations usually entail making loans or advances with short-term maturities. Depending
on the country, they take the form of outright loans on a collateralized basis, rediscounts of high-quality
financial assets (such as prime commercial paper or treasury obligations), or the extension of credit through
auctions.
• By changing the lending or discount rate, central banks create an announcement effect that can enhance the
transmission of monetary policy, and which is thought to be broader than the impact of an open market
operation, which is limited to the securities dealers or banks in a few financial centers.
• However, changing the rediscount rate is of somewhat limited use in monetary targeting, since access to the
rediscount window is at the initiative of the commercial banks. The central bank may also in fact be
implementing a selective credit policy by setting0 the criteria for eligible paper for rediscounting.
• Some countries,
• notably the United States, Japan, and Germany, set the rediscount rate below market interest rates, but their
central banks selectively determine
• which banks may use the facility. Most other countries set the rate above the market rate to discourage access.
• Although changes in reserve requirements are available as an instrument of monetary policy, they are only
infrequently used in practice because
• of their disruptive effects. TI1ey are not used for short-term liquidity management because frequent changes
disrupt portfolio
Open Market Operations

•  Dynamic open market operations

• Defensive open market operations
• Primary dealers
• TRAPS (Trading Room Automated Processing System)
• Repurchase agreements
• Matched sale-purchase agreements
Relative Advantages of the Different Monetary Policy Tools

• Open market operations are the dominant policy tool of the Fed since
it has complete control over the volume of transactions, these
operations are flexible and precise, easily reversed and can be quickly
implemented.
• The discount rate is less well used since it is no longer binding for
most banks, can cause liquidity problems, and increases uncertainty
for banks. The discount window remains of tremendous value given
its ability to allow the Fed to act as a lender of last resort.

•.
On the Failure of Conventional Monetary
Policy Tools in a Financial Panic
•
When the economy experiences a full-scale financial crisis,
conventional monetary policy tools cannot do the job, for two
reasons.
• First, the financial system seizes up to such an extent that it becomes
unable to allocate capital to productive uses, and so investment
spending and the economy collapse.
• Second, the negative shock to the economy can lead to the zero-
lower-bound problem
Nonconventional Monetary Policy Tools
During the Global Financial Crisis
•
Liquidity provision: The Federal Reserve implemented unprecedented
increases in its lending facilities to provide liquidity to the financial
markets
• Discount Window Expansion
• Term Auction Facility
• New Lending Programs
 Monetary Policy Tools of the European
Central Bank
• Open market operations
• Main refinancing operations
• Weekly reverse transactions
• Longer-term refinancing operations
• Lending to banks
• Marginal lending facility/marginal lending rate
• Deposit facility
 Monetary Policy Tools of the European Central Bank

• Reserve Requirements2% of the total amount of checking deposits

and other short-term deposits
• Pays interest on those deposits so cost of complying is low
Policy Rate
• The overnight market is the key market for finance and monetary policy.
• This market is very liquid, with a broad range of participants, the most active of which are deposit-taking
institutions and their investment dealer affiliates.
• The interest rate at which participants borrow and lend overnight funds to each other in the money
market is called the overnight interest rate.
• This rate is the shortest-term rate available and forms the base of any term structure of interest rates
relation.
• The Bank of Canada (as well as SBP) signals its monetary policy stance by announcing a target for the
overnight interest rate (the overnight interest rate is known as the reference rate).
• The target for the overnight rate, known as the policy rate, is the main tool the Bank uses to conduct
monetary policy.
• This rate refers to collateralized, market-based overnight transactions.
• The implementation of the stance of monetary policy is more successful when the reference rate is closer
to the policy rate; that is, the closer the overnight rate is to the target for the overnight interest rate
The Operating Band for the Overnight
Interest Rate
• Implementation of the monetary policy stance signaled through announcement of the
Policy (target) Rate, entails managing the day-to-day liquidity in the money market with
the objective to keep the short-term interest rates stable and aligned with the Policy
(target) Rate.
• The Bank of Canada (also SBP) implements monetary policy by changing the policy rate,
in order to influence other short-term interest rates and the exchange rate.
• In fact, in normal times the SBP’s operational objective is to keep the overnight rate
within an operating band (also known as a channel or corridor) of 200 basis points (2%)
• The lower reliance of banks on SBP and limited volatility in the overnight rate is
desirable to ensure smooth transmission of monetary policy signals to other market
interest rates. Excessive volatility in the overnight rate may distort the term structure of
interest rates by creating disconnect between short and long term rates.