Monetary policy instruments

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A country's monetary policy is driven by central banks. The best known (ECB, FED, BoJ and BoE) are independent, but some are directly linked to the government as is the case in China. There are three monetary policy instruments:

- Open market operations, which consist in acting on the money supply in circulation as well as on financial assets

- Standing facilities corresponding to the credit policy (setting of policy interest rates)

- Minimum reserves, which are also intended to control the money supply in circulation by limiting credit expansion.

Open Market operations

Open market operations (quantitative easing) play an important role in monetary policy, in steering interest rates, managing bank liquidity and indicating the direction of monetary policy. Open market operations are carried out at the initiative of the central bank, which chooses the instrument to be used and sets the terms and conditions of these operations. They may be carried out through standard tenders, quick tenders or bilateral procedures. The Eurosystem's open market operations can be divided into four categories:

- the main refinancing operations consist of reverse transactions (in the form of repurchase agreements), intended to provide liquidity on a regular basis, with weekly frequency and a maturity of two weeks. These operations are executed by the NCBs through standard tenders and according to a predefined schedule. The main refinancing operations play a pivotal role in achieving the objectives assigned to the Eurosystem's open market operations and constitute the main channel for refinancing the financial sector. Effectively, when an institution 'repurchases' securities, it temporarily transfers them to the central bank, which advances the funds to it and 'repurchases' the securities. Bank liquidity is thus increased. These refinancing operations may also be longer-term, with a monthly frequency and a maturity of three months to meet the financing needs of smaller structures.

- Refinancing operations may also be firm (i.e. final). This consists of the sale or purchase of securities, in particular treasury bills, by the central bank on the interbank market. The aim is also to influence bank liquidity, which will increase if the central bank buys securities and decrease if it sells them.

- fine-tuning operations are carried out on an ad hoc basis with a view to managing liquidity in the market and steering interest rates, in particular to mitigate the impact on interest rates of unexpected fluctuations in bank liquidity. Fine-tuning operations are mainly reverse transactions, but may also include outright transactions, currency swaps and fixed-term deposits. The instruments and procedures used in the conduct of fine-tuning operations are adapted to the types of transactions and the specific objectives pursued.

- Structural operations by issuing debt certificates and using reverse transactions or outright transactions. These operations are carried out when the central bank wishes to adjust the structural position of the Eurosystem in relation to the financial sector (on a regular or irregular basis), without necessarily influencing interest rates.

Policy rates

Standing facilities are used to provide or withdraw overnight liquidity, to indicate the general stance of monetary policy and to control overnight market rates.
They correspond to the credit policy (setting of policy interest rates). There are three of these policy rates:

- The refinancing rate used in open market operations. This rate therefore determines the cost of credit granted by central banks to commercial banks in exchange for eligible assets. Its cost will vary depending on the amounts of credit that the central bank wishes to distribute.

- The marginal lending rate, which counterparties can use to obtain overnight liquidity from central banks against eligible assets. The interest rate on the marginal lending facility normally constitutes a ceiling for the overnight market interest rate. Its rate is only be used in emergency situations as commercial banks only use it if the interbank market becomes illiquid (which was the case during the subprime crisis). This rate is therefore more important than the refinancing rate.

- The deposit rate for making overnight deposits with central banks. The interest rate on the deposit facility normally provides a floor for the overnight market rate. It therefore corresponds to the interest rate on commercial banks' deposits with the central bank. This rate is therefore lower than the refinancing rate. It should be noted that the FED does not remunerate the deposits of commercial banks in the same way as the ECB.

Policy rates are one of the most important instruments for regulating economic activity for a central bank. They enable it to support growth and fight inflation.
Effectively, the lower the policy rates, the more a commercial bank is able to offer its customers loans with low interest rates. Thus, the country's economic activity becomes stronger through an increase in liquidity in the financial circuit.
Conversely, an increase in policy rates aims to limit banks' demand for liquidity. Most often the aim is then to fight inflation to avoid an overheating of the economy.

It should also be noted that policy rates directly influence the value of a currency. Effectively, the more a currency is remunerated (a high policy rate), the greater the demand for that currency.

Mandatory reserves

Minimum reserves are liquidity reserves that financial institutions must deposit with the central bank. The purpose of the minimum reserve system is to stabilise money market interest rates, to create (or accentuate) a structural need for refinancing and to contribute, where appropriate, to the control of monetary growth. The amount of minimum reserves to be held by each institution is determined on the basis of a percentage of outstanding deposits.

For example, if a bank has €1 billion in deposits and the mandatory reserve rate is 10%, the commercial bank will have to deposit €100 million with the central bank.

Minimum reserves are remunerated at a rate corresponding to the average interest rate, over the maintenance period, of the main refinancing operations of the Eurosystem, i.e. 1% in 2010.

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