Dr Marek Porzycki
Chair for Economic Policy
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Basic function and purposes
Approaches – restrictive vs. expansionary
Monetary policy tools
Transmission mechanism
Unconventional tools applied during current
crisis
Communication of monetary policy
Sources and reading
Steering the money supply
- direct
influence on the monetary
base (M0)
- indirect impact on monetary
aggregates (M1 and above) via
the transmission mechanism
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price stability objective
price stability vs other goals of monetary
policy
economic growth
high employment
stability on financial markets
inflation targetting
Note: legal aspects of central bank mandate
will be discussed during the following courses
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Expansionary (loose) monetary policy – expansion
of money supply
aiming at higher inflation (or at least accepting it)
stimulating economic growth
lower interest rates = cheaper lending
„doves”
Restrictive (tight) monetary policy – reduction of
money supply
aiming to reduce inflation
cooling down overheated economy
higher interest rates = more expensive lending
„hawks”
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a specified fraction of deposits kept with a
commercial bank to be set aside in the central
bank as mandatory reserve
deposits set aside as reserve cannot be used to
finance lending  reduction of the money
multiplier
Current values (as of 2.4.2013):
Poland: 3,5 % - 500.000 EUR per credit
institution
euro area: 1% - 100.000 EUR per institution
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Starting from 18.01.2012, the ECB has
lowered the reserve requirement from
previous 2% to 1% as one of measures
intended to support bank lending (
expansionary monetary policy)
press release:
http://www.ecb.int/press/pr/date/2011/htm
l/pr111208_1.en.html
However, this move did not reach its intended
goal, as commercial banks preferred to
deposit excess reserves at the ECB using the
deposit facility.
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Central bank acts as „bank of banks” taking
deposits and extending loans to commercial
banks.
Central bank acts as „lender of last resort”
providing liquidity to disstressed (but solvent)
banks.
„standing” = can be used at the commercial
banks’ initiative
primary credit or regular short-term lending
(usually overnight)
- Eurosystem: marginal lending facility
- Fed: discount window
- NBP: lombard loans (kredyt lombardowy)
 in usual conditions interest rate applied to central
bank lending sets a ceiling on interbank interest
rates
 current rates (2.4.2013): 1,50% (ECB), 4.75% (NBP)
 to be distinguished from secondary lending or
liquidity support
 see below, unconventional tools
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overnight deposits with the central bank,
available to commercial banks
Interest rate on overnight deposits sets floor
to interbank lending rates, as the deposit
facility allows banks to „park” any amount of
money at the central bank at the deposit rate
Deposit rate is the lowest of central bank
interest rates. Current ECB interest rate on
deposit facility (as of 2.4.2013): 0,00%
Corresponding NBP rate: 1,75%
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initiated by the central bank
Basic form: purchases or sales of assets (mostly
Treasury bonds) from financial institutions
Purchases of assets  expansion of monetary base,
providing liquidity
Sales of assets  shrinking of monetary base,
absorbing liquidity
Dynamic vs. defensive open market operations
Repos (repurchase agreements) and reverse repos –
purchases/sales reversed on a specified time, subject
to specified interest rate
Outright transactions (purchase/sale without an
agreement to reverse the transaction)
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Other instruments used – collateralised loans,
issuance of debt certificates by the central
bank, swaps, fixed-term deposits
Difference in aims and regularity (Eurosystem
examples):
main refinancing operations
long-term refinancing operations (LTRO, see
also unconventional monetary policy)
fine-tuning operations (conducted on an ad
hoc basis)
structural operations
From the ECB website
Date: 28/03/2013
Action: Fine-tuning operation
Communication: [… T]he ECB conducts specific operations in order
to re-absorb the liquidity injected through the Securities Markets
Programme (SMP).
In this regard, the ECB will carry out a quick tender on 2 April at
11.30 in order to collect one-week fixed-term deposits with
settlement day on 3 April. A variable rate tender with a maximum
bid rate of 0.75% will be applied and the ECB intends to absorb an
amount of EUR 205.5 billion. […]. Fixed term deposits held with the
Eurosystem are eligible as collateral for the Eurosystem's credit
operations.
The ECB intends to carry out another liquidity-absorbing operation
next week.
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Lending by central banks should be based on adequate
collateral (assets submitted by commercial banks as
security).
 Treasury bonds and other marketable assets (e.g. credit
claims) are usually used as collateral.
 Central banks maintain a list of eligible collateral and
update it from time to time (example:
http://www.ecb.int/paym/coll/assets/html/list.en.html)
 Risky collateral, e.g. bonds with lower credit risk rating,
may be eligible under certain circumstances but
valuation haircuts may be applied to reflect higher risk.
Example: use of Greek sovereign bonds as collateral for
Eurosystem monetary policy operations
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Institutions allowed to contract with the central
bank within the monetary policy framework.
Broadly: commercial banks and similar
institutions.
Eurosystem eligibility criteria – eligible
institutions should be:
subject to minimum reserve requirement
in financially sound condition
subject to financial supervision by competent
authorities
fulfilling operational criteria
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Interest rates applied by central banks to
respective monetary policy instruments.
Announced by the central banks and changed
in reaction to monetary policy needs:
rate increase – tightening the monetary policy,
aimed at reduction of the money supply
rate decrease – easing the monetary policy,
aimed at expansion of the money supply
Influence on conditions on the money market
(interbank and between banks and the general
public) and in the general economy via the
transmission mechanism.
Examples:
 ECB
http://www.ecb.int/home/html/index.en.html
(„Key figures at a glance”)
http://www.ecb.int/stats/monetary/rates/html
/index.en.html
 NBP
http://www.nbp.pl/home.aspx?f=/srodek.htm
(„Stopy procentowe NBP”)
http://www.nbp.pl/home.aspx?f=/dzienne/sto
py.htm
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Reserve requirements - useful as a limit of
possible money creation but not suitable for
rapid changes in answer to changing
conditions on the market.
Standing facilities – useful to influence
interest rates on the market but not suitable
for reacting to daily fluctuations.
Open market operations – more flexible,
initiated by the central bank at any time and
with any volume needed. Easily reversible.
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function of „bank of banks”  central banks deal
directly only with commercial banks but not with the
general public.
Proper functioning of the monetary policy requires
transmission of measures taken by the central bank
through commercial banks to the economy.
Transmission channels include credit and deposit
businesses of the commercial banks, asset prices,
currency exchange rates and indirectly also wage and
price-setting resulting from supply and demand of
goods, services and labour.
Transmission mechanism is affected by events beyond
control of the central bank, such as global economic
developments, commodity prices, political events etc.
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Source: ECB,
http://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html
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Specific problems with transmission of expansive
monetary policy in periods of recession.
„Zero interest rate policy” („ZIRP”)  further
lowering of interest rates is not possible, as rates
cannot be negative.
Expanding the monetary base does not increase
money supply as long as banks do not start
credit expansion.
Monetary policy alone is not able to kick-start
economic growth.
compared to „pushing on a string”
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crisis-related, extremely expansive monetary
policy in order to stimulate economic growth
applied when interest rate cuts have failed to
stimulate monetary expansion („pushing on a
string”) and further cuts are impossible (zero
interest rates)
asset purchases - quantitative easing (QE)
open market operations – LTRO
liquidity support – e.g. Emergency Liquidity
Assistance (acting as „lender of last resort”)
commitment to further actions
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Central banks purchase large volume of assets
(mostly Treasury bonds) from banks, creating new
money to pay for them.
As banks buy Treasury bonds in order to re-sell them
to the central bank, QE is sometimes considered to
circumvent the prohibition on monetary financing
(lending by the central bank to the Treasury).
Purchases of Treasury bonds by the central bank are
legal if occuring on the secondary market, but
prohibited on primary market (directly from the
Treasury).
Result: large expansion of the monetary base (M0)
first applied in Japan since 2001, then by several
central banks after 2007
secondary lending or liquidity support
- Eurosystem: Emergency Liquidity Assistance
(ELA)
 providing liquidity to solvent banks experiencing
liquidity problems (e.g. withdrawal of deposits,
lack of access to interbank lending).
 function: preventing bank runs.
 Not applicable to insolvent banks which should
be subject to bank resolution tools or insolvency
proceedings.
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On 21.3.2013 the ECB announced that Emergency
Liquidity Assisstance to Cypriot banks would be
continued only until 25.3, unless a programme to
ensure their solvency is put in place.
http://www.ecb.int/press/pr/date/2013/html/pr130
321.en.html
On 25.3 a bailout deal was reached between Cyprus
and the Eurogroup (Eurozone finance ministers).
On 25.3 the ECB decided to continue providing ELA to
Cypriot banks, based on the assumption that the
bailout maintained their solvency.
http://www.ecb.int/press/pr/date/2013/html/pr130
325.en.html
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Function: sending signals to the markets
Example: speech by Mario Draghi, President of the
ECB, on 26.7.2012 „Within our mandate, the ECB is
ready to do whatever it takes to preserve the euro.
And believe me, it will be enough.”
http://www.ecb.int/press/key/date/2012/html/sp12
0726.en.html
Understood as commitment to unlimited asset
purchases.
Follow-up: launch of Outright Monetary Transactions
on 6.9.2012
http://www.ecb.int/press/pr/date/2012/html/pr120
906_1.en.html
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Does QE mean „printing money”?
QE and other forms of unconventional monetary
policy result in a large expansion of central banks’
balance sheets  expansion of monetary base (M0)
However, inflation results from the increase of total
money supply, including not only M0 but mostly
money created by commercial banks (M1, M2).
As banks mostly deposited additional funds
obtained from QE as deposits in the central banks
(excess reserves), lending expansion did not occur
and there was no increase in total money supply.
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As long as commercial banks do not start credit
expansion using the expanded monetary base,
overall money supply remains low and inflation
does not result.
Once credit expansion starts, central banks would
need to restrict monetary policy, including
shrinking the monetary base in order to avoid
inflation („exit strategy”).
Too early tightening of the monetary policy could
push the economy into deep recession.
In case of a too late tightening, inflation can result
from current expanded monetary base being used
to finance lending.
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In order to be efficient, monetary policy
needs to be predictable.
explaining monetary policy in detail to the
general public
publishing long-term strategies and policies
declaring „approaches” in monetary policy
regular meetings of the rate-setting bodies,
followed by press conferences
publication of minutes of discussion of the
rate-setting bodies
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„Monetary Policy Guidelines” – a yearly
strategy document by the NBP
http://www.nbp.pl/en/publikacje/o_polityce_
pienieznej/zal2013a.pdf
ECB communication channels explained:
http://www.ecb.int/mopo/strategy/comm/ht
ml/index.en.html
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F. Mishkin, The Economics of Money, Banking, and
Financial Markets, Pearson, 10th ed. 2013
monetary policy tools, p. 418-431
price stability and other goals: Chapter 17, p. 434-454
ECB website http://www.ecb.int/mopo/html/index.en.html
NBP website
http://www.nbp.pl/homen.aspx?f=/en/onbp/informacje/p
olityka_pieniezna.html
Fed website
http://www.federalreserve.gov/monetarypolicy/default.ht
m
For Polish readers: A. Sławiński (red.), Polityka pieniężna,
Warszawa 2011
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most comprehensive and detailed description
of the Eurosystem monetary policy
„The implementation of monetary policy in
the euro area. General documentation on
Eurosystem monetary policy instruments and
procedures” – set in annex to the ECB
Guideline of 20.9.2011 on monetary policy
instruments and procedures of the
Eurosystem (recast) (ECB/2011/14)
http://www.ecb.int/ecb/legal/pdf/02011o00
14-20130103-en.pdf
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Try yourself in monetary policy – €CONOMIA
- The Monetary Policy Game on the ECB
website:
http://www.ecb.europa.eu/ecb/educational/e
conomia/html/index.en.html