Money market operations
MONETARY POLICY AND THE MONEY SUPPLY
Macro textbooks usually describe monetary policy as the central bank being able to change the money supply. Academic empirical research, although less so today than in the past, has also frequently assumed that monetary policy can be measured by observing changes in the money supply. Following this approach researchers examine the relationships between changes in money and for example changes in output and prices. This approach can be misleading and the assumption of monetary control is certainly wrong for short-term analysis such as a monthly or quarterly frequency. Many empirical “puzzles” appear to be the result of this confusion among economists. We must remember that central banks do not generally control the money supply over short periods of time (i.e. as part of operating procedures). However, at the same time, central banks do control, or are at least responsible for, the growth rate of the money supply over longer periods of time (i.e. result of the money multiplier model).
Some recent macro textbooks have started to describe monetary policy by focusing on changes in money market interest rates rather than changes in the money supply. These models (sometimes referred to as Taylor-Romer model or IS-AS-R model) ignore money as being simply endogenous to actual monetary policy (i.e. the interest rate). This new approach may turn out to be a mistake in the long run. For example, endogeneity of money is a matter of central bank choice, not a necessity. The Taylor-Romer model is not a general model, but relies on specific institutional behavior that may be relevant for today, but not for tomorrow. The debate continues.
THE MONEY MARKET AND CENTRAL BANK OPERATING PROCEDURES
What is the best way to think of how monetary policy works in practice? In fact, in practice, in the short run, central banks neither control money (multiplier model) nor do they control interest rates (interest rate model). The effects of central bank monetary policy are in general indirect: through its influence on demand and supply in the market for bank reserves. The market for bank reserves is special – not like other markets - because the central bank is essentially the only one able to create bank reserves. The central bank is a monopolist supplier in this market. Being a monopolist the central bank has very strong influence, and can in fact decide to control either price (interest rate) or quantity (bank reserves). In practice, usually, the influence of central banks is somewhere intermediate: a strong influence, but not exactly total control.
The real instruments of central banks
Neither money nor interest rate is the true instrument of monetary policy. The correct view is that they are so-called operating targets or intermediate targets. The real instruments of CB are divided into three categories:
a* Open market operations (OMOs). The CB can buy/sell or borrow/lend financial assets, usually government bonds and bills. The result is referred to as nonborrowed reserves.
Note that NBR is actually a misleading term derived from US textbooks. Sometimes open market operations are constructed as lending operations by the CB. For example, in the Euro area the ECB uses repurchase agreements (quasi collateralized loans) rather than outright purchases. One of the ‘official’ CB interest rates may refer to the interest rate at which the CB regularly supplies nonborrowed reserves (for example, official repo rate).
The ECB uses four categories of OMOs depending on purpose.
- Main refinancing operations (MRO): Weekly auction of repo contracts to supply reserves (1 or 2 week maturity). Auction using either fixed rate or variable rate tender.
- Longer-term refinancing operations (LRO): Monthly auction of repo contracts to supply reserves (3 month maturity). Auction using either fixed rate or variable rate tender.
- Fine-tuning operations: Ad hoc, short notice and for very short-term expansion or contraction of reserves. Multiple instruments: repos, currency swaps, outright sale/purchase.
- Structural operations: Ad hoc, for long-term expansion or contraction of reserves. Multiple instruments: repos, outright sale/purchase, issuing own debt paper.
b* Standing facilities (SFs). Facilities through which commercial banks have more or less unrestricted access to additional borrowed reserves from the CB or can reduce reserves by lending to the CB (i.e. putting reserves on deposit or buy central bank bills).
Note that discount window is a misleading term derived from US textbooks. The Federal Reserve has historically only used one standing facility, i.e. it allowed banks to borrow reserves if desired. Other CBs use two standing facilities. Also note that the crucial difference between OMOs and standing facilities is who initiates the transactions. OMOs are initiated by the CB, whereas the use of standing facilities is initiated by commercial banks (although sometimes subject to approval and restriction). The type of financial instrument is irrelevant. As mentioned earlier, supplying nonborrowed reserves can very well be done using repurchase agreements or special loans, i.e. lending/borrowing.
Eurozone banks have, when necessary, access to two ECB standing facilities.
- Marginal lending facility: Deficiencies in reserves can be borrowed (‘overnight’) from the ECB (actually from the various national central banks, NCBs) against the high marginal lending rate. (Viewed as positive borrowed reserves.)
- Deposit facility: Excess reserves can be placed on deposit (‘overnight’) with the ECB (in fact, the NCBs) earning a low deposit interest rate. (Viewed as negative borrowed reserves.)
c* Reserve requirements. CBs usually have the authority to require commercial banks to observe a minimum of reserves, calculated as a percentage of various categories of bank deposits and other liabilities. Sometimes these required reserves must be deposited into special reserve accounts with the central bank, but usually it refers to the average balance on normal current accounts of the banks held with the central bank.
Note that the reserve requirement system relevant to bank reserve market operations should not be confused with other types of "reserve" requirements such as liquidity requirements or capital requirements.
Eurozone banks:
- Reserve requirement: (a) 2% of deposits with maturity up to 2 years, debt paper (bonds) with maturities upt to 2 years, money market paper (CDs), (b) 0% of deposits with maturities over 2 years, repos, debt paper with maturities over 2 years. Liabilities to ESCB and other banks are not included. Reserve requirement is calculated using balance sheet of end of previous month. Thus, a system of lagged reserve requirements (i.e. requirement is predetermined and cannot be changed).
- Reserve maintenance: Average of daily deposits during the period from 24th of one month until the 23rd of the next month. Thus, possibility of ‘reserve averaging’ (i.e. daily fluctuations do not have extreme consequences for interest rates). Vault cash of banks does not count towards reserve maintenance.
- Remuneration: ECB pays interest on the minimum reserve requirement, equal to the average rate on ECB MROs. No interest rate paid on excess reserves. Interest rate penalty: Banks that have deficiencies in reserve maintenance must be the ECB a penalty interest rate for the deficiency.
d* Historically one may add a fourth category of CB instruments: quantitative credit and interest rate controls, i.e. restrictions applied to banks on the amount and type of lending they can do or the rate on loans and deposits. However, in the past this type of instrument turned out to be highly ineffective in the long run, and negative for economic efficiency. Today, no major developed country uses this type of instrument, although sometimes policymakers and politicians are tempted to reintroduce this type of control.
A simple model of the money market
The instruments of central banks are used to influence demand and supply in the money market or, more accurately the narrow money market for bank reserves. This is the market where commercial banks buy/sell, borrow/lend reserves from each other and from the central bank. Open market operations and standing facilities determine the supply of bank reserves by the central bank. We have TRs = NBR (nonborrowed reserves or open market operations) + BR (borrowed reserves or standing facilities). Reserve requirements determine the demand for bank reserves by the commercial banks, together with any excess reserves demanded. We have TRd = RR + ER.
Focus is on three essential and inter-related variables: 1 bank reserves, 2 money-market interest rate, 3 money stock.
A full schematic model of the money market consists of 3 components:
1* The market - demand and supply - for bank reserves
2* The money multiplier for bank reserves
3* The market - demand and supply - for money
The 3 components are related, but the relationships are not necessarily easy. For example, bank reserves and money supply are related, but the money multiplier is not a simple constant in the short term. The interest rate in the market for bank reserves and the interest relevant for money demand are related, but they are not the same.
Country-specific shapes of the money markets
The representation of the money market in the US or the Euro area cannot simply be transferred to other countries. Countries have different shapes of demand and supply in the money market.
Operating procedures
The static model of the market for bank reserves describes what the CB instruments look like. Monetary policy in practice is not static but dynamic, that is, central banks respond to shocks. How central banks respond to shocks is captured by a description of its operating procedures. Operating targets/procedures describe how the CB instruments are used.
Operating targets
For time frames of a few days or weeks a central bank decides on operating targets, in order to instruct its staff on how to respond to shocks when the CB monetary policy committee is between meetings. For example:
1) Interest-rate operating target (maintain a predetermined level of the money-market interest rate).
2) Total-reserves target (maintain a predetermined level of TR).
3) Non-borrowed-reserves target (maintain predetermined level of NBR).
4) Borrowed-reserves target (maintain predetermined level of BR).
Operating procedures determine what the effective supply of bank reserves and the effective supply of money look like to outside observers, i.e. economists analysing central bank behavior. For example, because the ECB normally intervenes in the reserves market once every week, the volume of NBR is essentially fixed during the week. The ECB only infrequently uses its fine-tuning operations. Therefore the daily interest rate fluctuates depending on shifts in the demand for reserves. Over periods longer than 1 week the ECB will adjust the volume of NBR to achieve a desired average level of the interest rate. Other central banks intervene in the reserves market on a daily basis, sometimes several times per day.
Policy reaction functions
For time frames of several weeks or months, the CB monetary policy committee meets regularly to discuss monetary policy and to decide on whether to change the stance of monetary policy (more restrictive, more expansionary, or neutral). A policy reaction function describes the systematic response of the CB to new information about economic variables such as inflation, exchange rate, economic growth, etc.
Note: Given what we know from the money-market model, it is not always easy to decide on which variable (interest rate, money stock, reserves, etc.) accurately describes the monetary policy decisions taken by the CB. CBs have more than one instrument to achieve a particular result.
Note on empirical research puzzles
A number of empirical “puzzles” have been identified in the literature on the effects of monetary policy. It appears that these puzzles occur when economists do not accurately identify the real or true shocks, changes in monetary policy. Due to the particular operating procedures, many changes in money and interest rates are the result of shocks to money/reserves demand rather than shocks to money/reserves supply. It should not be surprising that observed relationships are not exactly as expected in cases of wrongly identified monetary policy actions. See for example,
* Price puzzle: Balke and Emery (1994) Understanding the price puzzle, FRB Dallas Economic Review, Fourth Quarter: 15-26.
* Liquidity puzzle: Christiano and Eichenbaum (1992) Liquidity effects and the monetary transmission mechanism, American Economic Review, vol.82 (2): 346-53.
* Exchange rate puzzle: Kumah (1997) The effect of monetary policy on exchange rates: How to solve the puzzles, IMF paper
SUGGESTIONS FOR FURTHER READING
* FRBNY website Fed Education, http://www.federalreserveeducation.org/fed101/policy/
* FRBSF website US Monetary Policy, http://www.frbsf.org/publications/federalreserve/monetary/
* ECB, The Monetary Policy of the ECB (2nd ed) – Chapter 4: Monetary policy implementation, 2004.http://www.ecb.int/pub/pdf/other/monetarypolicy2004en.pdf
* Borio, C.E.V., ‘The implementation of monetary policy in industrial countries: A survey,’ BIS Economic Papers no.47 July 1997.
* Kneeshaw, J.T. and P. van den Bergh, ‘Changes in central bank money market operating procedures in the 1980s,’ BIS Economic Papers no.23 January 1989.
* Gilbert, R.A., ‘Operating procedures for conducting monetary policy,’ FRB St. Louis Review, vol.67 (2) February 1985: 13-21.
* Zha, T., ‘Identifying monetary policy: A primer,’ FRB Atlanta Economic Review, 2nd Quarter 1997: 26-43.
* Bernanke, B.S. and I. Mihov, ‘Measuring monetary policy’, Quarterly Journal of Economics, vol. 113 (3) August 1998: 869-902.
* Goodfriend, M., ‘A model of money stock determination with loan demand and a banking system balance sheet constraint,’ FRB Richmond Economic Review, January 1982:
* Bofinger, P., ‘The instruments of monetary policy,’ chapter 10 in Monetary Policy: Goals, Institutions, Strategies, and Instruments. Oxford Univ. Press, 2001.
* Walsh, C.E., ‘Monetary-policy operating procedures,’ chapter 9 in Monetary Theory and Policy. MIT Press, 1998.
* Romer, D., ‘Keynesian macroeconomics without the LM Curve’, Journal of Economic Perspectives, vol.14 2000, 149-169.
* Taylor, J.B., ‘Teaching modern macroeconomics at the principles level’, American Economic Review, vol. 90 2000, 90-94.
TECHNICAL NOTES
In almost all empirical research the identification of monetary policy 'shocks' or 'actions' is extremely important. However, there is not one method, but researchers have used various methods. Some methods are clearly wrong, other methods are subject to debate.
(1) M-POLICY IDENTIFICATION: NARRATIVE APPROACH
ROMER-ROMER (1989) DATES
• Examine minutes of FOMC meetings: Is there a shift towards more anti-inflationary stance?
• High inflation level assumed not to cause recessions (causality tests)
• Non-parametric: No modeling of operating procedures or financial system
BOSCHEN-MILLS (1991) INDEX
• Examine minutes of FOMC meetings: Policy stance rated from strongly expansionary (+2) to strongly contractionary (-2).
Weaknesses of the narrative approach: Subjective, difficult to distinguish between endogenous and exogenous components of policy changes, only discrete observations (FOMC meetings)
(2) MONEY MARKET MODELS: ALTERNATIVE IDENTIFICATION ASSUMPTIONS
Bernanke/Mihov (1998) provided a general money market model for the US and used it to discuss various identifying assumptions that have been used in the empirical literature.
TRd = - a iffr + nd demand for reserves
BR = b (iffr - idisc) + nb supply/demand for borrowed reserves (situation before 2003)
NBR = jd nd + jb nb + ns monetary policy using open market operations, responding to shocks
TRs = NBR + BR definition
TRs = TRd market equilibrium
Reduced-form equations for iffr, TR, NBR
Ignoring idisc (=constant?!) and assuming co-variances nd, nb, ns are zero
7 unknowns: a, b, jd, jb, nd, nb, ns
6 estimates: (co-) variances of movements in iffr, TR, NBR
We need one more identifying assumption for one of the unknowns. Several assumptions have been used in the literature.
Case 1: Bernanke/Blinder (1992) jd = 1, jb = -1
Federal funds rate targeting: Fed offsets shocks to total reserve demand and borrowing, there should be no effect on iffr
We find ns = -(a+b) iffr
Case 2: Christiano-Eichenbaum (1992) jd = 0, jb = 0
Nonborrowed reserves targeting: Fed keeps NBR constant and iffr reflects all other shocks.
We find ns = NBR
Case 3: Strongin (1995) a = 0, nb = 0
Assume vertical total reserves demand and no shocks to borrowing.
We find ns = - jd TR + NBR
Case 4: Borrowed reserves targeting jd = 1, jb = a/b
NBR are adjusted to accommodate shocks to total reserve demand and borrowing.
We find ns = -(1+a/b) BR
Case 5: Total reserves targeting jd = -b/a, jb = -1
We find ns = TR
Bernanke-Mihov (1998) argue that all cases with 2 restrictions are over-identified. We only need 1 restriction. They assume a = 0, i.e. a vertical function for total reserves demand.
IDENTIFICATION IN OPEN ECONOMIES
(1) MONETARY CONDITIONS INDEX
MCI = l1 (i – i*) + l2 (q – q*) + …
• movements in (real) exchange rates – and other financial variables, FCI – have similar effects on economy (exchange rate as a 2nd policy instrument), or
• effects of interest rate changes can be influenced by movements in exchange rates (exchange rate affects transmission mechanism).
(2) MONEY MARKET MODELS: ALTERNATIVE IDENTIFICATION ASSUMPTIONS
Allows for policy responses to exchange rate movements. For example,
NBR = jd nd + jb nb + je ne + ns
where je measures policy response to exchange rate shocks.