Instruments of Monetary Policy

The instruments of monetary policy refer to the economic variables that the central bank is empowered to change at its discretion with a view to controlling and regulating the supply of and demand for money and the availability of credit.

In other words monetary policy instruments are the tools used by the central bank to reach its operational target. Central banks use mainly three such tools:

  1. open market operations,
  2. standing facilities, and
  3. reserve requirements.

Open Market Operations

Open market operations may be defined as central bank transactions with banks at the central bank’s initiative. Two subtypes can be distinguished:

  • outright purchases or sales of assets (normally debt securities);
  • lending (or ‘credit’, ‘reverse’, or ‘temporary’) operations, conducted for instance through an auction (or ‘tender’).

Standing Facilities

Standing facilities are central bank operations at the initiative of banks, on the basis of a commitment of the central bank to allow such operations under certain conditions.

Three variants can be distinguished, of which the first two are liquidity-providing and the third liquidity-absorbing.

  • A discount facility: banks can sell certain short-term paper to the central bank at any rate, whereby the discount rate specified by the central bank is applied to calculate the price on the basis of the securities’ cash-flows.
  • An overnight borrowing facility: banks can borrow at any time against the provision of eligible collateral at some rate specified by the central bank.
  • A deposit facility: banks can deposit at any time funds with the central bank on a specific account where it gets remunerated at a specific rate.

Reserve Requirements

Reserve requirements oblige banks to hold a certain minimum level of sight deposits on their account with the central banks and may apply to single day-ends, or to an average over e.g. a one-month period.

The fulfillment of reserve requirements is measured only on the basis of end-of-day snapshots (i.e. intra-day levels of reserves are not relevant). The requirement may apply to single day-ends, or to an average over e.g. a one-month period.

The size of the reserve requirement of a specific bank is normally set as a function of specific items of its balance sheet which need to be reported on a monthly basis. For example, in the case of the European Central Bank, the requirement for each bank amounts to 1% of its liabilities to non-banks with a maturity below two years.

The operational target of monetary is a variable with the following characteristics:
  • it can sufficiently be controlled by the central bank;
  • it is economically relevant, in the sense that it effectively influences the ultimate target of monetary policy (e.g. price stability);
  • it defines the stance of monetary policy, in the sense that it is set by the policy decision-making body of the central bank (e.g. the Federal Open Market Committee for the Federal Reserve or the Governing Council for the European Central Bank);
  • it gives the necessary and sufficient guidance to the monetary policy implementation officers in the central bank on what to do.

In a financial crisis Opens in new window, policy decision-makers will likely have to give guidance on more than one operational target variable, which makes policy decisions, communication, and implementation much more difficult.

Monetary policy implementation consists, first, in establishing an operational framework to control the selected operational target (e.g. setting up the instruments including legal documentation, selecting counterparties, defining a list of eligible collateral).

The second element of implementation is the use on day-by-day basis of open market operations and standing facilities to influence the scarcity of sight deposits of banks with the central bank, to achieve the operational target of monetary policy. This second element is often called central bank liquidity management.