[see Borio (2001), section I]
The textbook explanation of monetary policy suggests that central banks control the supply of central bank money, alternatively referred to by names such as monetary base, bank reserves, high powered money. Through the so-called money multiplier mechanism, the control of the stock of central bank money is supposed to translate into control of the macroeconomic money supply, referred to by names such as narrow money (M1), broad money (M2, M3) or liquidity. In practice, this description of monetary policy is unreal, although it is sometimes useful as a construct to discuss long run monetary policy effects. As a stylized fact, central banks do determine by their actions the (long run) growth rate of money, therefore they are responsible, but the textbook multiplier model exaggerates the degree of short term control in practice.
In reality central banks operate by intervening in the short-term money markets. Specifically, in most cases, the interbank market for bank reserves. The tools of monetary policy (standing facilities, open market operations, reserve requirements) influence supply and demand in this market, causing the central bank to have a strong, dominant, even decisive influence over the quantity (volume of bank reserves) or price (the interest rate), depending on the chosen operating procedure.
Operating procedures
Operating procedures relate to what might be called the tactical level of policy implementation. Operating procedures cover the choice of monetary policy instruments and of monetary policy operating targets. Examples of policy instruments are official interest rates (for example, those on standing facilities such as the discount window, or deposit facilities), market operations (for example, repo tenders), reserve requirements, and, but mostly in the past, direct controls such as ceilings on bank credit growth and bank deposit and/or loan rates. Operating targets are variables which, being more proximate to the policy instruments in the causal chain, can be influenced quite closely by the authorities. Examples of operating targets are money market interest rates (for example, interbank overnight or call rate) and bank reserves (commercial banks' deposits with the central bank, plus vault cash). Operating procedures deal with the mainly daily or weekly implementation of policy.
The market for bank reserves
Currently, virtually all central banks in industrialized countries implement monetary policy through market-oriented instruments geared to influencing short-term interest rates as operating targets. They do so largely by determining the conditions that equilibrate supply and demand in the market for bank reserves. It is in this relatively unglamorous and even for economists often obscure corner of the financial markets that the ultimate source of the central banks' power to influence economic activity rests.
The market for bank reserves is a special market. On this market the central bank is a monopolist supplier of bank reserves (using open market operations - to create so-called non-borrowed reserves (NBR) - and standing facilities - to create so-called borrowed reserves (BR)). The central bank can also directly affect demand for reserves through the reserve requirement system. For example, the central bank can affect demand by setting reserve requirements ratios and by instituting reserve averaging facilities or by shaping the characteristics of key interbank (payment) settlement systems. Various elements also affect whether the reserve demand function is relative steep and little sensitive to interest rate changes, or relatively flat and very sensitive to interest rate changes.
Policy reaction functions
Policy reaction functions describe how monetary authorities actually adjust their operating targets and instruments to new information, such as an increase in expected or lagged inflation rates, high economic growth, depreciating exchange rate, excessive money growth. Policy reaction functions refer to changes on a mostly monthly or quarterly frequency and provide a link between short-horizon operating procedures and longer-horizon strategy objectives. Policy rules are in some sense closely related to policy reaction functions but different. A policy rule is in fact an economist's recommendation on what the best reaction function would be, considering the nature of the economic model (or rather, in many cases, the uncertainty that exists with respect to the true economic model among many competing economic models). A policy rule prescribes the relevant economic indicators and also the required response coefficients.
Market interest rates and official interest rates
Measuring monetary policy stance and actions is difficult. Traditionally economists have relied on changes in money aggregates (M0, M1, M2, ...) to "measure" monetary policy, but this is inaccurate, at least in the short run, because in practice central banks never really use the supply of money as an actual instrument of monetary policy. That would require making it a target and making the actual value in any given period equal to or at least very close to the target value. Most central banks focus on influencing a short-term interest rate instead, and their influence is usually indirect (demand and supply) and control is usually imperfect (limited market intervention during each day/week). There are many interest rates for different market segments, and different financial instruments. Central banks' leverage over interest rates varies depending on the type of interest rate (market rate, official rate), depending on the maturity of the interest rate (money market, capital market), and depending on the policy operating procedure implemented by the central bank (point target or target zone, continuous market interventions or only periodic interventions). To complicate matters even further, names, procedures, and practices differ across countries and across time periods.
Borio (1997 Table 1) provides the following elements of any summary of policy rates:
* Key policy rate (indicator of policy changes)
- Key signals provided by: * target announcement, * OMO tender rate, * standing facility rate, or * other
* Operating target
- Name of the market interest rate and its maturity (days)
* Open market operations
- Characteristics: maturity of contracts to supply or withdraw funds from the market, frequency of operations (daily, weekly, ...; regular or ad hoc)
In addition: main types of market interest rates depending on availability of liquid (secondary) markets and availability of types of financial instruments.