The Central Bank is the organ in charge of the monetary policy. In most countries, it is independent, in order to avoid that the government finances its projects by pumping more money into the economy, as it would lead to higher inflation.
The monetary policy focuses on money supply which is monopolized by the Central Bank (only the Central Bank can put new coins and banknotes into circulation). Now, money is essential to the economy, be it as a counting unit to fix prices and ease commerce or as reserve value unit (e.g. the money in bank accounts).
If the Central Bank wishes to raise the money supply, it implements an expansionary monetary policy. In the opposite situation, it is a restrictive monetary policy.
Rather than controlling the quantity of supplied money – it is difficult to assess perfectly the demand for money, in order to reach the equilibrium on the monetary market –, the Central Bank controls the “price” of the money, through the interest rates.
How does action on interest rates reflect on money supply?
When the Central Bank puts up interest rates, banks will provide less loans, that is less liquidity, as refinancing (i.e. borrowing money to other banks on the money markets or to the Central Bank) will become more expensive for them.
Let us also point out that creation of money / liquidity is not creation of wealth! Creation of money serves only to use more efficiently bank deposits – which would otherwise be “sleeping” money, unused, so unprofitable – but it does not increase the wealth of savers nor of borrowers.
Of course, monetary policy also influences the demand for money, but this will be addressed in another article.
Let us discuss the classical instruments of monetary policy. There are three of them: “open market” operations, facilities of deposit and lending and reserve requirements.
I/ Reserve requirements
Let us start with the easiest instrument: reserve requirements.
Each bank must put reserves at the Central Bank, proportionally to the amount of some deposits (mostly short-term ones) it holds. The current rate set by the European Central Bank (ECB) is 1% – before November 2011, it was 2% –, knowing that it can be fixed between 0 and 10%.
The role of this instrument of monetary policy is mainly to guarantee the stability of the money markets by forcing the banks to keep a safety margin. Indeed, when the rate is increased, banks have to constitute more reserves at the Central Bank, thus reducing money available for loans. I would like to make clear that the most risky loans (such as subprimes) are the first to be affected, so that the money markets remain more stable.
Lowering the rate of reserve requirements – as did the ECB in November 2011 – can help stimulate the economy when banks have troubles refinancing and are hesitating to lend money to households and businesses: it is the current situation in many EU countries.
II/ Open market operations
In the case of an expansionary monetary policy, the Central Bank buys securities (e.g. bank debt) or accepts to lend money against securities. This behaviour leads to a decrease of interest rates (as it increases demand for securities). Thus, banks own more liquid assets, enabling them to offer more loans.
Conversely, a restrictive monetary policy is a situation in which the Central Bank sells securities to recover liquid assets, retiring these from the markets. Interest rates increase as the offer securities rises while demand remains unchanged.
NB: We might imagine that the Central Bank buys public debt, thus contributing to finance the public budget deficit. But this is forbidden within the euro area, to avoid that all Member States using the single currency are forced to support the splurge of some members.
III/ Permanent lending and deposit facilities
The deposit facility allows banks to set up additional (i.e. not required) reserves at the Central Bank which remunerates them at an interest rate that constitutes the bottom rate on the money markets. Indeed, no bank will offer a lower rate; otherwise it will attract no deposits. Since July 2012, the bottom rate in the euro zone is 0%, because the ECB wants the banks to lend money to households and businesses instead of letting this money “sleep” in the Central Bank’s coffers.
The lending facility enables banks to borrow some money at the Central Bank. Usually, banks resort to the Central Bank only when strictly necessary, because the interest rate is higher than the one on money markets: it is the rate ceiling on the money markets. Indeed, no bank will ask for a higher interest rate; otherwise, nobody will borrow it money. Since July 2012, the ceiling rate in the euro area is 1.5%, so as to enable banks to refinance at a relatively low cost and not to weaken them.
For many months, or even years, key interest rates have been at 0% in many countries. This means that their Central Banks cannot use anymore classical instruments to try to stimulate the economy. This is why they use unconventional measures, which will be topic of a future article.