Monetary policy objectives and relationship
with financial markets
There is a general consensus among academics and central
bankers that monetary policy is best geared to achieve price
In some countries, central banks have additional mandates such as
ensuring full employment, maximising growth and promoting
In order to meet these objectives, central banks intervene in
financial markets to ensure that short-term interest rates (and
exchange rates) and liquidity are maintained at appropriate levels,
consistent with the objectives of monetary policy.
Thus, monetary policy and financial markets are linked intrinsically.
Central banks conduct monetary policy by directly and indirectly
influencing financial market prices.
Financial market prices reflect the expectations of market
participants about future economic developments. These
expectations, in turn, provide valuable information to central banks
in setting the optimal course of monetary policy in the future.
The transmission process from monetary policy to financial markets
and finally to the real economy is typically triggered through the use of
monetary policy instruments (reserve requirements, open market
operations, policy rates and refinance facilities).
For most central banks with floating exchange rates, the monetary
policy instrument is a short-term interest rate.
Under fixed exchange rate regimes, a particular exchange rate serves
as the instrument.
Similarly, under the monetary targeting regime, the operating target is
the quantity of central Bank money in the banking system
Monetary Policy Transmission Process
• The interest rate channel is the primary mechanism of
• An increase in nominal interest rates, translates into an
increase in the real rate of interest and the user cost of
• These changes, in turn, lead to a postponement in
consumption or a reduction in investment spending
thereby affecting the working of the real sector, viz.,
changing aggregate demand and supply, and eventually
growth and inflation in the economy. See the fig. on next
• The money market forms the first and foremost link in the
transmission of monetary policy impulses to the real
• Policy interventions by the central bank along with its
market operations influence the decisions of households
and firms through the monetary policy transmission
mechanism. The key to this mechanism is the
• Among the constituents of the monetary base, the most
important constituent is bank reserves, i.e., the claims that
banks hold in the form of deposits with the central bank.
• Therefore, the daily functioning of a modern economy
and its financial system creates a demand for central
bank reserves which increases along with an
expansion in overall economic activity
How Central Bank Conducts Monetary
• The most common procedure by which central banks
influence the outstanding supply of bank reserves is
through “open market operations” – that is, by buying or
selling government securities in the market.
• When a central bank buys (sells) securities, it credits
(debits) the reserve account of the seller (buyer) bank.
• This increases (decreases) the total volume of reserves
that the banking system collectively holds.
• Expansion (contraction) of the total volume of reserves in
this way matters because banks can exchange reserves
for other remunerative assets.
Open Market Operations
• Since reserves earn low interest, and in many
countries remain unremunerated, banks typically
would exchange them for some interest bearing
asset such as Treasury Bill or other short-term
• If the banking system has excess (inadequate)
reserves, banks would seek to buy (sell) such
• If there is a general increase (decrease) in
demand for securities, it would result in increase
(decline) in security prices and decline
(increase) in interest rates.
Open Market Operations
• Hence, an “expansionary” (contractionary) open market
operation creates downward (upward) pressure on shortterm interest rates not only because the central bank
itself is a buyer (seller), but also because it leads banks
to buy (sell) securities.
• In this way, the central bank can easily influence interest
rates on short-term debt instruments.
• In the presence of a regular term structure of interest
rates such policy impulses get transmitted to the
longer end of the maturity spectrum, thereby
influencing long-term interest rates, which have a
bearing on household’s consumption and savings
decisions and hence on aggregate demand.
Reserve Requirements : CRR, SLR
• There are alternative mechanisms of achieving
the same objective through the imposition of
reserve requirements and central bank
lending to banks in the form of refinance
facilities (Bank Rate).
• Lowering (increasing) the reserve requirement,
and, therefore, reducing (increasing) the
demand for reserves has roughly the same
impact as an expansionary (contractionary) open
market operation, which increases (decreases)
the supply of reserves creating downward
(upward) pressure on interest rates.
• Similarly, another way in which central banks can
influence the supply of reserves is through direct lending
of reserves to banks.
• Central banks lend funds to banks at a policy rate (Bank
Rate), which usually acts as the ceiling in the short-term
• Similarly, central banks absorb liquidity at a rate which
acts as the floor for short-term market interest rates.
• This is important, since injecting liquidity at the ceiling
rate would ensure that banks do not have access to
these funds for arbitrage opportunities whereby they
borrow from the central bank and deploy these funds in
the market to earn higher interest rates.
• Similarly, liquidity absorption by the central bank has to
be at the floor rate since deployment of funds with the
central bank is free of credit and other risks.
Repo and Reverse Repo
is used when Central Bank wants to
manipulate liquidity in the banking system for
extremely short period
• Repo: This is a repurchase agreement to sell the
government securities (TBs) with an agreement
to buy back at later date. This is the short term
• Reverse Repo: Similarly the purchase of
securities today with an agreement to sell back
at later date is called Reverse Repo and decides
the Short term Lending rate.
The Reverse Way of Doing The
• While this mechanism outlines how central banks can
influence short-term interest rates by adjusting the
quantity of bank reserves, the same objective can be
achieved by picking on a particular short-term
interest rate and then adjusting the supply of
reserves commensurate with that rate.
• In many countries, this is achieved by targeting the
overnight inter-bank lending rate and adjusting the level
of reserves which would keep the interbank lending rate
at the desired level.
• Thus, by influencing short-term interest rates, central
banks can influence output and inflation in the economy,
the ultimate objectives of monetary policy.