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Chapter 6

Goals and Tools of Monetary Policy

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Monetary Policy GoalsPrice Stability: Control inflation. Nominal

anchor is the inflation rate. Called inflation targeting. Current target of CBRT is 4% annual inflation rate.

Economic growth and reducing unemployment. Less emphasized in Turkey than inflation. In US, more important than Turkey.

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Rate of Change of CPI and Inflation Targets (Source: CBRT web)

02 03 04 05 06 07 08 09 10 11 12 13

  Targ

et 35 20 12 8 5 4 4 7,5 6,5 5,5 5 5

  Realizatio

n

29,7 18,4 9,3 7,7 9,6 8,4 10,1 6,5 6,4 10,4 - -

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Rate of Change of CPI and Inflation Targets (Source: CBRT web)

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Monetary Policy Tools:Interbank Overnight Rate Interbank overnight (O/N) rate (called Federal Funds Rate in

US) is the interest rate on overnight loans of reserves from one bank to another. It is the price of reserves in the market where banks borrow from each other overnight.

O/n rate is determined by demand for and supply of reserves in the interbank market.

CB targets a range for the o/n rate. This range is the primary instrument of CB’s monetary policy. Currently, (6.5%, 9%) in Turkey.

If o/n rate goes out of the policy range, the CB lends or borrows in the market to bring it back into the target range.

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Demand for Reserves Banks hold reserves. Reserves are made up of

two components: required reserves and excess reserves Excess reserves are insurance against deposit

outflows. The cost of holding excess reserves is the interbank o/n rate that could have been earned by lending to other banks.

As Interbank overnight rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded increases.

Think of interbank rate as the price of reserves. As price goes up, qty of reserves demanded goes down and vice versa.

Reserve demand curve is downward sloping

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Channel/Corridor SystemInterbank O/N rate

iMLR

iMBR

Rs

Rd

i*

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Supply of ReservesReserve supply is determined by the CB.

As long as the interbank rate stays in the target range, reserve supply is vertical.

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The Channel/Corridor System

System used in Turkey and the EU.CB stands ready to lend to banks at the

marginal lending rate. (MLR: currently 9% in Turkey)

The supply of reserves is horizontal (infinitely elastic) at the marginal lending rate because if the market O/N rate goes above 9%, banks can borrow from CB and lend to the market, make unlimited profits.

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The Channel/Corridor System (cont’d)CB has a second window that pays banks

the marginal borrowing rate (MBR: currently 6.5% in Turkey) on any reserves they would like to lend to the CB.

The supply of reserves is also horizontal (infinitely elastic) at the marginal borrowing rate because the market O/N rate cannot go below 6.5%.

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The Channel/Corridor System (cont’d)In between MLR and MBR, quantity of

reserves supplied is equal to the non-borrowed reserves; supply curve is vertical.

Shifts of the demand curve keeps overnight rate between marginal lending rate and marginal borrowing rate.

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Supply of Reserves Two components: non-borrowed (from CB) and

borrowed reserves If iMBR < iON < iMLR, then banks will not borrow

from or lend to the CB and borrowed reserves are zero. Supply of reserves is vertical and equal to nonborrowed reserves (NBR).

The supply curve is horizontal (perfectly elastic) at iMBR and iMLR .

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Tools of Monetary PolicyHow does the CB control the Interbank O/N rate?1. Open market operations

Change the quantity of nonborrowed reserves and the monetary base.

2. Changes in MLR and MBR: Changes the amount of borrowed reserves and the monetary base

3. Changes in reserve requirements Change the money multiplier

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How Does The CB Control The Interbank O/N Rate?1. Open market operations

An open market purchase shifts the supply curve to right and causes the interbank o/n rate to fall; an open market sale shifts the supply curve left and causes the interbank o/n rate to rise

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Open market purchaseInterbank O/N rate

iMLR

iMBR

Rs

Rd

i*

i**

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How Does The CB Control The Interbank O/N Rate?

2. Changes in m.lending and borrowing rates

Expansionary policy: To increase liquidity in the market, if the CB reduces the MLR and MBR

lends to banks at lower rates makes open market operations at lower rates or reverse repo (lending) operations at lowered

rate then the interbank market rate decreases

How Does The CB Control The Interbank O/N Rate?2. Changes in m.lending and borrowing rates Contractionary policy: To decrease liquidity

in the market, CB increases the MBR and MLR: Borrows from banks and pays higher MBR Makes OMO at higher rates Repo (borrowing) operations at higher rate Then interbank market rate increases

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How Does The CB Control The Interbank O/N Rate? Repo (repurchasing agreement): to sell treasury

bills & bonds now in order to buy it back at an agreed price a few days later: in order to borrow short-term liquidity

Reverse repo: to buy securities now with the promise of selling back at an agreed price in a few days: in order to lend excess liquidity

Central bank makes repo operation to temporarily reduce the money supply. In this operation CB uses the borrowing rate (MBR).

CB makes reverse repo to increase the money supply and uses the MLR.

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How Does The CB Control The Interbank O/N Rate?3. Changes in reserve requirements

When the CB raises the reserve requirement, banks need more reserves. This shifts the demand curve right and the Interbank O/N rate rises.

When the CB decreases the reserve requirement, this shifts the demand curve left and the Interbank O/N rate falls

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Increasing the reserve requirementInterbank O/N rate

iMLR

iMBR

Rs

Rd

i**

i*

R’d

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Discount PolicyCB acts as a lender of last resort (LLR) to

prevent financial panics (bank runs) Why do we need a LLR when we have deposit

insurance?Saving Deposit Insurance Fund (TMSF) funds may not

be enough. Then CBRT helps SDIF.Accounts above 50 000 TL not insured. Since a

majority of deposit accounts are above this amount, there is a risk of bank runs.

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Advantages and Disadvantages of Discount Policy

Advantages: Lender of last resort, prevents financial panics. Discount facility is used as a backup facility to prevent

the federal funds rate from rising too far above the target

Disadvantages: Amount cannot be controlled by the CB; the

commercial bank decides how much to borrow. Creates moral hazard problem. Banks take on more

risk when they know CB will come to rescue.