Monetary policy objectives and relationship with financial markets

• There is a general consensus among academics and central bankers that monetary policy is best geared to achieve price stability.

• In some countries, central banks have additional mandates such as ensuring full employment, maximising growth and promoting financial stability.

• In order to meet these objectives, central banks intervene in financial markets to ensure that short-term interest rates (and exchange rates) and liquidity are maintained at appropriate levels, consistent with the objectives of monetary policy.

• Thus, monetary policy and financial markets are linked intrinsically.• Central banks conduct monetary policy by directly and indirectly

influencing financial market prices. • Financial market prices reflect the expectations of market

participants about future economic developments. These expectations, in turn, provide valuable information to central banks in setting the optimal course of monetary policy in the future.

• The transmission process from monetary policy to financial markets and finally to the real economy is typically triggered through the use of monetary policy instruments (reserve requirements, open market operations, policy rates and refinance facilities).

• For most central banks with floating exchange rates, the monetary policy instrument is a short-term interest rate.

• Under fixed exchange rate regimes, a particular exchange rate serves as the instrument.

• Similarly, under the monetary targeting regime, the operating target is

the quantity of central Bank money in the banking system.

Monetary Policy Transmission Process

• The interest rate channel is the primary mechanism of monetary policy transmission in conventional macroeconomic models.

• An increase in nominal interest rates, translates into an increase in the real rate of interest and the user cost of capital.

• These changes, in turn, lead to a postponement in consumption or a reduction in investment spending thereby affecting the working of the real sector, viz., changing aggregate demand and supply, and eventually growth and inflation in the economy. See the fig. on next slide.

• The money market forms the first and foremost link in the transmission of monetary policy impulses to the real economy.

• Policy interventions by the central bank along with its market operations influence the decisions of households and firms through the monetary policy transmission mechanism. The key to this mechanism is the monetary base.

• Among the constituents of the monetary base, the most important constituent is bank reserves, i.e., the claims that banks hold in the form of deposits with the central bank.

• Therefore, the daily functioning of a modern economy and its financial system creates a demand for central bank reserves which increases along with an expansion in overall economic activity

How Central Bank Conducts Monetary Policy!

• The most common procedure by which central banks influence the outstanding supply of bank reserves is through “open market operations” – that is, by buying or selling government securities in the market.

• When a central bank buys (sells) securities, it credits (debits) the reserve account of the seller (buyer) bank.

• This increases (decreases) the total volume of reserves that the banking system collectively holds.

• Expansion (contraction) of the total volume of reserves in this way matters because banks can exchange reserves for other remunerative assets.

Open Market Operations• Since reserves earn low interest, and in many

countries remain unremunerated, banks typically would exchange them for some interest bearing asset such as Treasury Bill or other short-term debt instruments.

• If the banking system has excess (inadequate) reserves, banks would seek to buy (sell) such instruments.

• If there is a general increase (decrease) in demand for securities, it would result in increase (decline) in security prices and decline (increase) in interest rates.

Open Market Operations

• Hence, an “expansionary” (contractionary) open market operation creates downward (upward) pressure on short-term interest rates not only because the central bank itself is a buyer (seller), but also because it leads banks to buy (sell) securities.

• In this way, the central bank can easily influence interest rates on short-term debt instruments.

• In the presence of a regular term structure of interest rates such policy impulses get transmitted to the longer end of the maturity spectrum, thereby influencing long-term interest rates, which have a bearing on household’s consumption and savings decisions and hence on aggregate demand.

Reserve Requirements : CRR, SLR

• There are alternative mechanisms of achieving the same objective through the imposition of reserve requirements and central bank lending to banks in the form of refinance facilities (Bank Rate).

• Lowering (increasing) the reserve requirement, and, therefore, reducing (increasing) the demand for reserves has roughly the same impact as an expansionary (contractionary) open market operation, which increases (decreases) the supply of reserves creating downward (upward) pressure on interest rates.

Bank Rate• Similarly, another way in which central banks can

influence the supply of reserves is through direct lending of reserves to banks.

• Central banks lend funds to banks at a policy rate (Bank Rate), which usually acts as the ceiling in the short-term market.

• Similarly, central banks absorb liquidity at a rate which acts as the floor for short-term market interest rates.

• This is important, since injecting liquidity at the ceiling rate would ensure that banks do not have access to these funds for arbitrage opportunities whereby they borrow from the central bank and deploy these funds in the market to earn higher interest rates.

• Similarly, liquidity absorption by the central bank has to be at the floor rate since deployment of funds with the central bank is free of credit and other risks.

Repo and Reverse Repo

• It is used when Central Bank wants to manipulate liquidity in the banking system for extremely short period

• Repo: This is a repurchase agreement to sell the government securities (TBs) with an agreement to buy back at later date. This is the short term Borrowing rate.

• Reverse Repo: Similarly the purchase of securities today with an agreement to sell back at later date is called Reverse Repo and decides the Short term Lending rate.

The Reverse Way of Doing The Same !!!

• While this mechanism outlines how central banks can influence short-term interest rates by adjusting the quantity of bank reserves, the same objective can be achieved by picking on a particular short-term interest rate and then adjusting the supply of reserves commensurate with that rate.

• In many countries, this is achieved by targeting the overnight inter-bank lending rate and adjusting the level of reserves which would keep the interbank lending rate at the desired level.

• Thus, by influencing short-term interest rates, central banks can influence output and inflation in the economy, the ultimate objectives of monetary policy.