Monetary policy objectives are classified into final and intermediate.
(a) Economic growth;
b) full-time employment;
c) price stability;
d) stable balance of payments.
(a) The money supply;
b) interest rate;
c) exchange rate.
Monetary policy instruments include:
a) credit limits; direct regulation of the interest rate;
b) changes in the rate of required reserves;
c) change in the discount rate (refinancing rate );
d) open market operations.
There is a distinction between direct (a) and indirect (b, c, d) regulatory instruments. The effectiveness of the use of indirect regulatory instruments is closely related to the degree of development of the money market. In transition economies, especially in the first stages of transformation, both direct and indirect instruments are used, with the former gradually displacing the latter.
The ultimate goals are realized by monetary policy as one of the directions of economic policy as a whole, along with fiscal, foreign exchange, foreign trade, structural and other types of policy. Intermediate goals are directly related to the activities of the Central (National) Bank and are implemented in a market economy with the help of mainly indirect instruments.
Consider the tools of indirect regulation of the monetary system.
Required reserves are part of the amount of deposits that commercial banks must keep as interest-free deposits with the Central Bank (forms of custody may vary by country). Required reserve ratios are set as a percentage of deposits. They differ in size depending on the types of deposits (for example, they are lower for term deposits than for demand deposits). In modern conditions, required reserves perform not so much the function of deposit insurance (this function is performed by specialized financial institutions to which banks deduct a certain percentage of deposits), but serve to carry out the control and regulatory functions of the Central Bank, as well as for interbank settlements.
Banks may also hold excess reserves – some amounts in excess of required reserves, for example, for unforeseen cases of increased need for liquidity. However, this deprives banks of the amount of income that they could receive by putting this money into circulation. Therefore, with an increase in the interest rate, the level of excess reserves usually decreases.
The higher the rate of required reserves set by the Central Bank, the smaller the share of funds can be used by commercial banks for active operations. An increase in the reserve ratio (rr) reduces the money multiplier and leads to a reduction in the money supply. Thus, by changing the rate of required reserves, the Central Bank has an impact on the dynamics of the money supply.
In practice, the norms of required reserves are rarely revised, since the procedure itself is cumbersome, and the strength of the impact of this tool through the multiplier is significant.
Another instrument of monetary regulation is the change in the discount rate (or refinancing rate) at which the Central Bank issues loans to commercial banks. If the discount rate rises, the volume of borrowing from the Central Bank decreases, and consequently, the operations of commercial banks to provide loans also decrease. In addition, receiving a more expensive loan, commercial banks increase their interest rates on loans. A wave of credit compression and appreciation of money is rolling throughout the system. The supply of money in the economy is declining. The reduction of the discount rate acts in the opposite direction.
The discount rate is usually lower than the interbank market rate. But obtaining a loan from the Central Bank may be associated with certain administrative restrictions. Often, the central bank acts as the last lender for commercial banks experiencing serious difficulties. However, not all banks are allowed to access the “accounting window” of the Central Bank: the nature of the borrower’s financial transactions or the reasons for seeking help may be unacceptable, from the point of view of the Central Bank.
Short-term loans are usually provided to replenish the reserves of commercial banks. Medium- and long-term loans of the Central Bank are issued for special needs (seasonal needs) or to overcome a difficult financial situation.
Unlike interbank credit, Central Bank loans, falling into the reserve accounts of commercial banks, increase the total reserves of the banking system, expand the monetary base and form the basis for a multiplicative change in the supply of money. It should be noted, however, that the volume of loans received by commercial banks from the Central Bank is usually only a small fraction of the funds raised by them. The change in the discount rate by the Central Bank should be considered rather as an indicator of the policy of the Central Bank. In many developed countries, there is a clear link between the central bank’s interest rate and the rates of private banks. For example, an increase in the discount rate by the Central Bank signals the beginning of a restrictive monetary policy. Following this, the rates in the interbank credit market are growing, and then the rates of commercial banks on loans provided by them to the non-banking sector. All these changes occur along the chain quite quickly.
Open market operations are the third way to control the money supply. It is widely used in countries with a developed securities market and is difficult in countries where the stock market is in the forming stage. This instrument of monetary regulation involves the purchase and sale by the Central Bank of government securities (usually in the secondary market, since the activities of the Central Bank in primary markets in many countries are prohibited or restricted by law). Most often these are short-term government bonds.
When the Central Bank buys securities from a commercial bank, it increases the amount in the reserve account of this bank (sometimes in a special account of a commercial bank in the Central Bank for such operations), respectively, additional “money of increased power” enters the banking system and the process of multiplicative expansion of the money supply begins. The scale of the expansion will depend on the proportion in which the increase in the money supply is distributed to cash and deposits: the more funds go into cash, the smaller the scale of monetary expansion. If the Central Bank sells securities, the process proceeds in the opposite direction.
Thus, by influencing the monetary base through open market operations, the Central Bank regulates the size of the money supply in the economy. Often, such operations are carried out by the Central Bank in the form of buyback agreements (REPO). In this case, the bank, for example, sells securities with the obligation to redeem them at a certain (higher) price after a certain period. The payment for the money provided in lieu of securities is the difference between the sale price and the buyback price. Buyback agreements are widespread in the activities of commercial banks and firms.
Along with indirect instruments, administrative methods of regulating the money supply can also be applied: direct limitation of loans, control over certain types of loans, etc. Direct limitation of loans consists in establishing an upper limit on credit emission, limiting the size of lending in certain industries, etc. The principle of limitation, as a rule, is used simultaneously with preferential lending to priority sectors of the economy.
Selective methods of monetary regulation include control over certain types of loans (mortgage, secured by exchange securities, consumer loans), the establishment of maximum limits on the accounting of bills for individual banks, etc. It should be emphasized that when implementing monetary policy, the central bank uses simultaneously a set of instruments.
There are two main types of monetary policy, each of which is characterized by certain goals and a set of regulatory tools. In the context of inflation, the policy of “expensive money” (the policy of credit restriction) is carried out. It is aimed at tightening conditions and limiting the volume of credit operations of commercial banks, i.e. at reducing the supply of money. The Central Bank, pursuing a restrictive policy, takes the following actions: sells government securities on the open market; increases the rate of required reserves; increases the discount rate. If these measures are not effective enough, the central bank uses administrative restrictions: lowers the ceiling on loans provided, limits deposits, reduces the amount of consumer credit, etc. The policy of “expensive money” is the main method of anti-inflationary regulation.
During periods of decline in production, a policy of “cheap money” (expansionary monetary policy) is carried out to stimulate business activity. It consists in expanding the scale of lending, weakening control over the growth of the money supply, increasing the supply of money. To do this, the central bank buys government securities, reduces the reserve rate and the discount rate. More favorable conditions are being created for the provision of loans to economic entities.
The central bank chooses one or another type of monetary policy based on the state of the country’s economy. When developing monetary policy, it is necessary to take into account that, firstly, a certain time passes between the implementation of an event and the appearance of the effect of its implementation; second, monetary regulation can only affect monetary factors of instability.
As noted, the central bank cannot fully control the supply of money. Thus, an increase in the interest rate in the money market can cause a decrease in excess reserves (a decrease in the coefficient , where R includes both mandatory and excess reserves), as well as encourage the population to keep relatively large funds on deposits and less in cash, which will affect the decrease in the cr coefficient (). As a result, the money multiplier and, accordingly, the supply of money will increase.
The choice of monetary policy options depends largely on the reasons for the change in demand for money. For example, if the growth in demand for money is associated with inflationary processes, a tight policy of maintaining the money supply, which corresponds to a vertical or steep money supply curve, will be appropriate. If it is necessary to isolate the dynamics of real variables from unexpected changes in the velocity of money circulation, then the policy of maintaining the interest rate associated directly with investment activity (horizontal or flat money supply curve LS) will probably be preferable. Depending on the angle of inclination of the LS curve, the change in demand for money will have a greater impact on either the money supply (Figure 7.1) or the interest rate (Figure 7.2).
Obviously, the Central Bank is not able to fix the money supply and the interest rate at the same time. For example, in order to maintain a relatively stable rate as the demand for money increases, the Central Bank will have to expand the supply of money to bring down the upward pressure on the interest rate from the increased demand for money (this will be reflected by shifting the LD curve to the right and moving the equilibrium point to the right along the LS curve).