Central Bank Monetary Policy Tools

What is a “stable economy”?

• Relatively low inflation
• High employment
• Steady economic growth

How can the interest rate influence other economic objectives?

• Low interest rates tend to stimulate economic growth, but can also lead to undesirable effects such as inflation and asset bubbles
• Higher interest rates tend to slow economic activity and increase unemployment, however, also curbing inflation

How can the overnight deposit rate be used to impact money supply?

This involves a central bank setting a target level, or range, for the rate on overnight uncollateralised deposits from commercial banks that are deposited with the central bank. Banks generally have excess reserves at the close of each business day. These liquid reserves are deposited overnight with the central bank or lent to other banks, so as to generate a return. Conversely, banks can borrow from its central bank or other member banks overnight at this rate in the event they are short of liquidity to meet their minimum reserve/capital requirements.

• A lower overnight interest rate discourages the deposits of excess cash, hence, banks try to minimise excess cash by making more loans. By doing this, the money supply increases and acts as an economic stimulus.
• A higher overnight rate encourages banks to deposit excess reserves to gain a greater return, so they have less liquidity and are likely to make fewer loans. This in essence shrinks the money supply, and slows economic growth.

What are Open Market Operations, and how do they impact the money supply in an economy?

Open Market Operations (OMOs) involves a central bank purchasing or selling domestic government securities in the secondary market to increase/decrease the money supply or, as is more common today, entering into overnight collateralised repurchase agreements with banks to absorb or provide liquidity. OMOs are used to ensure that the overnight deposit rate remains close to the target range established by the central bank.

• When a central bank wants to increase interest rates, it restricts the amount of money by selling treasuries or borrowing from banks via repo agreements.
• When a central bank wants to lower interest rates, it increases the amount of money in the system by buying treasuries or lending to banks via repo agreements.

How can the minimum reserve requirement be used to impact money supply?

Reserve requirements refer to the amount banks must retain as liquid assets, generally expressed as a percent of their deposit liabilities. These reserves, which must be held in cash or cash equivalents, serve as a buffer to meet unexpected calls on a bank’s assets, ensuring that enough liquidity is on hand to meet such calls.

• The higher the reserve requirement, the more cash that banks have to hold and the less they have to lend, overall lowering the money supply.

What is a negative overnight interest rate?

This means that banks with excess reserves must pay interest, rather than earn interest on excess liquidity placed overnight with their central bank. This is similarly an attempt to encourage lending as opposed to hoarding liquidity. The clear objective is to aggressively address deflationary pressures.

What is Basel III?

A global voluntary framework, widely used and respected for measuring and comparing liquidity and solvency of global banks. Basel III ratios include:

• Minimum capital ratios
• A minimum leverage ratio
• A minimum liquidity coverage ratio