Definition: conventional monetary policy
What is conventional monetary policy?
Conventional monetary policy is a set ofinstruments available to a central bank to control the money supply level. These include instruments that have been used by all central banks since their inception.
Conventional monetary policy is structured around 3 axes: open market operations, standing facilities and minimum reserves.
Conventional monetary policy instruments
Open market operations: These are refinancing operations conducted by the central bank via invitations to tender with longer or shorter maturity terms. These tenders allow commercial banks to borrow money from the central bank. In exchange for these loans, banks use part of their assets (debt securities, treasury bills, etc.) as collateral. The policy rate serves as a reference for this conventional monetary policy tool. During the tender procedure, each bank gives a rate and the banks that offer the highest borrowing rate to the central bank win the bid. Each week, the amount to be distributed to commercial banks is defined in advance to control the level of the money supply.
There are several types of tenders: main refinancing operations (weekly tenders), longer-term operations (3-month tenders) and very long-term operations (up to 3 years). This is the main tool of conventional monetary policy that allows the central bank to manage the level of liquidity in the interbank market. For this reason, the level of policy interest rates is closely monitored by all financial market participants. A rise or fall in the policy interest rate is a strong policy signal (hawkish or dovish) of conventional monetary policy.
Standing facilities: There is not just one policy rate but three rates. The other two are the marginal lending rate and the deposit rate. These are less well-known, but they are widely used instruments in the context of conventional monetary policy. The marginal lending rate is the rate at which commercial banks can obtain very short-term financing (24-hour loans against a pledge of assets) from the central bank outside open market operations. The deposit rate is the interest rate on money deposited by commercial banks with the central bank.
Minimum reserves: All commercial banks are required to set aside funds with the central bank. As part of its conventional monetary policy, the central bank can therefore decide to increase or reduce the amount of its reserve requirements to influence the money supplylevel. These reserves may take the form of cash, debt securities or monetary instruments.
Consequences of non-conventional monetary policy
The central bank has a range of conventional instruments at its disposal to guide its monetary policy.
Increase in the money supply
If it wants to increase the level of the money supply, it can lower policy rate levels. As a result, commercial banks can borrow money from the central bank at a lower cost. With their additional funds, they can lend more to economic agents (households and businesses). Commercial banks are thus involved in money creation.
Also, in the context of conventional monetary policy instruments, the central bank may also reduce the funding requirements (minimum reserves) of commercial banks. These then have less money tied up and can lend more, thus increasing the money supply.
Reduction of the money supply
If the central bank wants to reduce the level of money supply, it can increase its policy rates. The cost of borrowing is then higher for commercial banks, households and businesses. The monetary creation mechanism is therefore reduced. The same applies if the central bank increases the level of reserve requirements.
If conventional monetary policy instruments are not enough to control the level of money supply and achieve the central bank's objectives (inflation and exchange rate control), boost economic activity, it can then use non-conventional monetary policy instruments such as negative interest rates, TLTROs and asset purchase programmes.