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
stability.
In some countries, central banks have additional mandates such as
ensuring full employment, maximising growth and promoting
financial stability.
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).
Typically, the monetary policy instrument is a financial
market price, which is directly set or closely controlled by
the central bank.
For most central banks with floating exchange rates, the
monetary policy instrument is a short-term interest rate.
Changes in the short-term policy rate provide signals to
financial markets, whereby various segments of the
financial system respond by adjusting their rates of return
on various instruments, depending on their sensitivity and
the efficacy of the transmission mechanism.


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.

The interest rate channel is the primary mechanism of monetary
policy transmission in conventional macroeconomic models where an
increase in nominal interest rates, translates into an increase in the
real rate of interest and the user cost of capital.

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


Real Interest Rate!
The nominal current interest rate minus
the rate of inflation. For example, an
investor holding a 10% certificate of
deposit during a period of 6% annual
inflation would be earning a real interest
rate of 4%. The real interest rate is a more
valid measure of the desirability of an
investment than the nominal rate is.
How Central Bank Conducts
Monetary Policy!!!!!!!!
The central banks power to conduct monetary policy stems from its
role as a monopolist, as the sole supplier of bank reserves, in the
market for bank reserves.
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.
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 debt
instruments.
If the banking system has excess
(inadequate) reserves, banks would seek
to buy (sell) such instruments.
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.
Hence, an expansionary (contractionary)
open market operation creates downward
(upward) pressure on short-term interest
rates. A signal for accelerating economic
growth.

Another Way For Central Bank!
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.
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.
Still Another Way!
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, which usually acts as the
ceiling in the short-term market.
Summary of Monetary
Instruments
Net loans to central government (i.e. open
market operations)
Net purchase of foreign currency assets
Change in cash reserve ratio
Changes in repo rate and reverse repo
rate
Bank rate
What is Repo?

A repo or repurchase Agreement is an
instrument of money market. Usually
reserve bank (federal bank in U.S or RBI
in INDIA) and commercial banks involve in
repo transactions but not restricted to
these two. Individuals, banks, financial
institutes can also participate in
repurchase agreement.

REPO
Repo is a collateralized lending i.e. the banks
which borrow money from Reserve Bank to meet
short term needs have to sell securities, usually
bonds to Reserve Bank with an agreement to
repurchase the same at a predetermined rate
and date.
In this way for the lender of the cash (usually
Reserve Bank) the securities sold by the
borrower are the collateral against default risk
and for the borrower of cash (usually commercial
banks) cash received from the lender is the
collateral.

REPO-REVERSE REPO
Reserve bank charges some interest rate on the
cash borrowed by banks. This rate is usually less
than the interest rate on bonds as the borrowing
is collateral.
This interest rate is called repo rate. The lender
of securities is said to be doing repo whereas the
lender of cash is said to be doing reverse repo.
In a reverse repo Reserve Bank borrows money
from banks by lending securities. The interest
paid by Reserve Bank in this case is called
reverse repo rate.