Lecture # 4
POLICY INSTRUMENTS
The main monetary policy instruments available to central banks are open market operation,
bank reserve requirement, interest-rate policy, re-lending and re-discount (including using
the term repurchase market), and credit policy (often coordinated with trade policy). While
capital adequacy is important, it is defined and regulated by the Bank for International
Settlements, and central banks in practice generally do not apply stricter rules.
To enable open market operations, a central bank must hold foreign exchange reserves
(usually in the form of government bonds) and official gold reserves. It will often have
some influence over any official or mandated exchange rates: Some exchange rates are
managed, some are market based (free float) and many are somewhere in between
("managed float" or "dirty float").
Interest Rates
By far the most visible and obvious power of many modern central banks is to influence
market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number.
Although the mechanism differs from country to country, most use a similar mechanism
based on a central bank's ability to create as much fiat money as required.
The mechanism to move the market towards a 'target rate' (whichever specific rate is used)
is generally to lend money or borrow money in theoretically unlimited quantities, until the
targeted market rate is sufficiently close to the target. Central banks may do so by lending
money to and borrowing money from (taking deposits from) a limited number of qualified
banks, or by purchasing and selling bonds. As an example of how this functions, the Bank
of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks
borrow from each other within this band, but never above or below, because the central
bank will always lend to them at the top of the band, and take deposits at the bottom of the
band; in principle, the capacity to borrow and lend at the extremes of the band are
unlimited. Other central banks use similar mechanisms.
It is also notable that the target rates are generally short-term rates. The actual rate that
borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity
and other factors. For example, a central bank might set a target rate for overnight lending
of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of
inverted yield curves, even below the short-term rate. Many central banks have one primary
"headline" rate that is quoted as the "Central bank rate." In practice, they will have other
tools and rates that are used, but only one that is rigorously targeted and enforced.
"The rate at which the central bank lends money can indeed be chosen at will by the central
bank; this is the rate that makes the financial headlines." - Henry C.K. Liu, in an Asia
Times article explaining modern central bank function in detail He explains further that
"the US central-bank lending rate is known as the Fed funds rate. The Fed sets a target for
the Fed funds rate, which its Open Market Committee tries to match by lending or
borrowing in the money market.... a fiat money system set by command of the central bank.
The Fed is the head of the central-bank snake because the US dollar is the key reserve
currency for international trade. The global money market is a US dollar market. All other
currencies markets revolve around the US dollar market." Accordingly the US situation isn't
typical of central banks in general.
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