Tools of Monetary Policy

Central banks implement the monetary policy using a number of instruments. These affect the aggregate demand through the supply of money, cost of money, and credit availability. The three main tools central banks use to implement monetary policies are open market operations, the central bank’s policy rate, and reserve requirements.

Open Market Operations

Open market operations refer to cases where a central bank buys and sells government bonds from and to commercial banks or designated market markers. For instance, when the central bank sells government bonds, the commercial bank’s reserves are decreased, and, therefore, they cannot be in a position to lend more to corporations and households. This leads to a decline in broad money growth through the money multiplier effect.

On the other hand, when recessionary forces get going in an economy, the central bank purchases government bonds, increasing the commercial banks’ reserves. Commercial banks then tend to lend more to households and corporations, who, in turn, invest more. In this way, broad money growth expands through the money multiplier mechanism.

Clearly, the central bank uses open market operations to set appropriate levels of commercial bank reserves or interest rates for the reserves.

The Central Bank’s Policy Rate

The policy rate, often referred to by various names depending on the central bank, is a primary tool that central banks use to convey their monetary policy intentions. Its main purpose is to influence both short-term and long-term interest rates, affecting real economic activity. Generally, the policy rate is the interest rate at which the central bank lends money to commercial banks.

A common mechanism for this is through repurchase agreements (repos), whose maturity ranges from overnight to two weeks. For instance, if the central bank wishes to increase money supply in the economy, it buys government bonds with an agreement to resell them in the future, effectively lending money to banks.

In essence, a repurchase agreement is a form of a loan to commercial banks, and the central bank (lender) earns a repo rate.

When a central bank raises its policy rate, commercial banks typically raise their base rates in response. The base rate of a commercial bank is a benchmark for its lending rates to various customers. Banks adjust their rates based on the central bank’s rate to avoid lending at rates lower than what the central bank charges them.

As such, when the policy rate rises, it becomes costlier for commercial banks to borrow. This typically leads them to decrease their lending activities, reducing the money supply.

On the other hand, a reduction in the policy rate makes borrowing cheaper for commercial banks. This often prompts them to increase their lending, consequently boosting the money supply.

Note that the central bank can compel commercial banks to take loans from it at a specific rate. This is made possible through its open market operations, which can deliberately induce a money deficit. Consequently, banks are nudged into selling bonds back to the central bank under the repurchase agreement. The repo rate is set in a way that ensures the central bank receives the standard refinancing rate from these deals.

In essence, by adjusting the policy rate, central banks can control the amount of money circulating in the market. A higher policy rate makes borrowing from the central bank costlier, potentially leading to reduced lending and slowed money growth in the broader economy.

Reserve Requirements

The law requires commercial banks to keep a certain percentage of their total deposits in the central bank as a reserve. When prices rise, the central bank raises the reserve ratios, and, therefore, commercial banks are left with less money to lend to the business community. Consequently, the volume of output, employment, and investment are adversely affected. Eventually, prices will fall.

The opposite is also true. Note that the higher the reserve requirement, the less money commercial banks can create. Hence, if the central bank wants to reduce the money creation power of commercial banks, it could easily increase the commercial bank’s reserve requirements.

Setting reserve requirements as a monetary policy is not commonly used in developed market economies. Varying reserve requirements are disruptive to the banks because a sudden increase can halt a bank’s lending if it lacks sufficient reserves.

However, central banks in emerging economies still use reserve requirements to manage lending.

The Monetary Transmission Mechanism

The monetary transmission mechanism is the process where a central bank’s interest rate is transmitted through the economy and ultimately affects the rate of increase of prices (inflation).

Consider a situation where a central bank increases its official interest rate. The implementation of the policy may be reflected on four connected channels: bank lending rates, asset prices, agents’ expectations or confidence and exchange rates.

Bank Lending Rates

When the central bank increases its official rate, commercial banks usually respond by increasing their base and interbank rates. This, in turn, amplifies the borrowing costs for both individuals and corporations across various time horizons. With heightened interest rates, there is a general trend among businesses and consumers to limit their borrowing activities.

Asset Prices

Higher short-term interest rates can lead to an increased discount rate for estimating future cash flows. Consequently, assets like bonds and the projected value of capital initiatives might witness a dip in their prices.

Agents’ Expectations/ Confidence

Market players might interpret elevated interest rates as a precursor to slower economic progress, diminished profits, and a contraction in asset-financing borrowings. The anticipation and interpretation of future interest rate trends can have a significant influence on economic decisions. If the market perceives the central bank’s move as the beginning of a series of rate hikes, this could lead to reduced consumption, borrowing, and a slump in asset prices.

Exchange rates

Increase in interest rates might make a country’s exchange rate to appreciate. This appreciation can make domestically produced goods expensive for international buyers, potentially reducing exporters’ earnings. This could further dampen the demand for local exports.

Overally, an increase in the central bank’s policy rate may lead to a decrease in both domestic demand and net external demand (export consumption less import consumption), which can be decreased by an increase in the central bank’s policy rate.

A weaker total demand would tend to push domestic inflation rates downward, as would a stronger currency, which would drive down the cost of imports. When these elements are considered collectively, the overall measure of inflation may start to experience negative pressure.

A monetary transmission can be represented in the following diagram:

Question

Which of the following elements is least likely to be a component of the monetary transmission mechanism?

1. Setting an inflation rate target.
2. Implementing a transfer payment program.
3. Adjusting the central bank’s official interest rate.

Solution

The correct choice is B.

Transfer payments are related to fiscal policy, not monetary policy.

A is not correct. Establishing an inflation rate target is an aspect of the monetary transmission mechanism, typically occurring later in the process.

C is not correct. Modifying the central bank’s official interest rate is usually the initial step in the monetary transmission mechanism.