Chapter 6
Goals and Tools of
Monetary Policy
1
Monetary Policy Goals
Price 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.
2
Rate of Change of CPI and Inflation
Targets (Source: CBRT web)
Target
Realization
02
03
04
05
06
07
08
09
10
11
12
13
35
20
12
8
5
4
4
7,5
6,5
5,5
5
5
29,7
18,4
9,3
7,7
9,6
8,4
10,1
6,5
6,4
10,4
-
-
3
Rate of Change of CPI and Inflation
Targets (Source: CBRT web)
4
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.
5
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
6
Interbank
O/N rate
Channel/Corridor System
iMLR
Rs
i*
iMBR
Rd
7
Supply of Reserves
Reserve supply is determined by the CB.
As long as the interbank rate stays in the
target range, reserve supply is vertical.
8
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.
9
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%.
10
The Channel/Corridor System (cont’d)
In between MLR and MBR, quantity of
reserves supplied is equal to the nonborrowed reserves; supply curve is
vertical.
Shifts of the demand curve keeps
overnight rate between marginal lending
rate and marginal borrowing rate.
11
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 .
12
Tools of Monetary Policy
How 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
13
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
14
Interbank
O/N rate
Open market purchase
iMLR
Rs
i*
i**
iMBR
Rd
15
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
16
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
17
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.
18
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
19
Interbank
O/N rate
Increasing the reserve requirement
iMLR
Rs
i**
i*
iMBR
R’d
Rd
20
Discount Policy
CB 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.
21
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.
22