Session-9

Monetary Policy
Implementation/Operations
Main Sources:
1. Chapter 8 , Section 8.3, of Meenai and Ansari
2. Chapter 15 , Monetary Policy Tools, The Economics of Money and Banking and
Financial Markets, Fredrick Mishkin
3. SBP website
Learning Objectives
OBJECTIVES
After studying this chapter you should be able to
1. what is meant by monetary policy operations
What are direct and indirect monetary policy tools
and what is the operational target of SBP
What is the Policy rate and what is the implication of the IRC
explain the market for reserves and the channel/corridor system for setting
the overnight interest rate in Pakistan
explain the various monetary policy tools and identify the impact of various
tools on the interbank rate
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.
Direct Monetary Policy Tools
• ;. 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.
• TypicaJJy, 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.
• Interest rate controls interfere with the market mechanism for credit allocation, and they promote
disintermediation.
• 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. In either case, directed credits restrict market-determined credit
allocation, thereby reducing the efficiency of intermediation, as well as creating incentives for disintermediation.
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
Total Reserve Demand

Repo Rate
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, ior.
• Since the fall of 2008 SBP pays interest on reserves at a level that is set at a fixed
amount below the repo rate target.
• When the inter bank overnight rate is above the rate paid on excess reserves, ior,
as the overnight interbank rate decreases, the opportunity cost of holding excess
reserves falls and the quantity of reserves demanded rises.
• Downward sloping demand curve that becomes flat (infinitely elastic) at Repo rate
Supply in the Market for Reserves

• Two components: non-borrowed (NBR) and borrowed reserves (BR)

• Cost of borrowing from the Central Bank is the discount rate (Reverse
Repo) in Pakistan
• If i(ior) < id, then banks will not borrow from the Central Bank and
borrowed reserves are zero -The supply curve will be vertical (NBR)
• As i(ior) rises above id, banks will borrow more and more at id, and
re-lend at Repo Rate-The supply curve is horizontal (perfectly elastic)
at id
Figure 1 Equilibrium in the Market for
Reserves
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.
How Changes in the Tools of Monetary
Policy Affect the Interbank Rate-OMOs
•
Effects of open an market operation depends on whether the supply
curve initially intersects the demand curve in its downward sloped
section versus its flat section.
• An open market purchase causes the interbank rate to fall whereas an
open market sale causes the interbank rate to rise (when intersection
occurs at the downward sloped section).
• Open market operations have no effect on the interbank rate when
intersection occurs at the flat section of the demand curve.
How Changes in the Tools of Monetary Policy Affect the
Interbank Rate-Discount Rate

• If the intersection of supply and demand occurs on the vertical

section of the supply curve, a change in the discount rate will have no
effect on the interbank rate.
• If the intersection of supply and demand occurs on the horizontal
section of the supply curve, a change in the discount rate shifts that
portion of the supply curve and the interbank overnight rate may
either rise or fall depending on the change in the discount rate.
How Changes in the Tools of Monetary
Policy Affect the Interbank Rate-Change
in RRs
• Open market operations and central bank lending operate by affecting
the level of reserve money, whereas reserve requirements are set and
changed according to regulation and thus contain an element of
direct control.
• However, since the effect of changes in reserve requirements is a
function of the demand for reserve money, changes in reserve
requirements are classified as an indirect instrument.
• Changes in reserve requirements generally will not change the
aggregate level of reserve money, but since they affect the money
multiplier, they will have an influence on the size of the money stock.
Application: How the Central Bank’s Operating
Procedures Limit Fluctuations in the inter bank Rate
• Supply and demand analysis of the market for reserves illustrates
how an important advantage of the Central Bank’s procedures for
operating the discount window and paying interest on reserves is that
they limit fluctuations in the federal funds rate.
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 rediscount 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
23 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
Nonconventional Monetary Policy Tools During the Global
Financial Crisis

• Large-scale asset purchases: During the crisis the Fed started three
new asset purchase programs to lower interest rates for particular
types of credit:
• Government Sponsored Entities Purchase Program
• QE2
• QE3
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. Moreover, it can also discourage
the development of financial market instruments (as most of them rely on well developed
yield curve
Fig 7.1-IRC Corridor
 IRC-SBP Reverse repo rate, repo rate and the
policy rate
• As Figure-1 shows, the upper limit of the operating band defines the bank rate or the Discount Rate (SBP’s
Reverse Repo Rate).
• The SBP’s Reverse Repo rate is the interest rate the SBP charges PRISM (Pakistan Real Time Interbank
Settlement Mechanism) participants that require an overdraft loan (advance) to cover negative settlement
balances on the books of the Bank at the end of the banking day.
• The Reverse Repo rate is the ceiling on the overnight rate in the money market for PRISM participants,
because they are unlikely to borrow overnight funds at a higher interest rate, since they can borrow at the
this rate from SBP
• The lower limit of the operating band is the rate SBP pays to PRISM participants with positive settlement
balances at the end of the day.
• If the overnight rate declines towards the lower limit of the operating band, then the Bank will accept
deposits from PRISM participants at the bank rate less 200 basis points, to put a floor on the overnight
rate.
• The REPO rate is the floor on the overnight rate because PRISM participants are unlikely to lend overnight
funds at a lower rate, since they can leave funds on deposit at this rate at SBP
• The midpoint of the operating band is SBP’s target for the overnight rate, the operating target of SBP’s
monetary policy.