1 Chapter 6 Goals and Tools of Monetary Policy

2 Monetary Policy Goals  Price Stability: Control inflation. Nominal anchor is the inflation rate. Called inflation targeting. Current target of CBRT is 4% annual inflation rate.  Economic growth and reducing unemployment. Less emphasized in Turkey than inflation. In US, more important than Turkey.

3 Rate of Change of CPI and Inflation Targets (Source: CBRT web) Target ,56,55,5 55 Realization 29,718,49,37,79,68,410,1 6,5 6,4 10,4 --

4 Rate of Change of CPI and Inflation Targets (Source: CBRT web)

5 Monetary Policy Tools: Interbank Overnight Rate  Interbank overnight (O/N) rate (called Federal Funds Rate in US) is the interest rate on overnight loans of reserves from one bank to another. It is the price of reserves in the market where banks borrow from each other overnight.  O/n rate is determined by demand for and supply of reserves in the interbank market.  CB targets a range for the o/n rate. This range is the primary instrument of CB’s monetary policy. Currently, (6.5%, 9%) in Turkey.  If o/n rate goes out of the policy range, the CB lends or borrows in the market to bring it back into the target range.

6 Demand for Reserves  Banks hold reserves. Reserves are made up of two components: required reserves and excess reserves Excess reserves are insurance against deposit outflows. The cost of holding excess reserves is the interbank o/n rate that could have been earned by lending to other banks. As Interbank overnight rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded increases. Think of interbank rate as the price of reserves. As price goes up, qty of reserves demanded goes down and vice versa.  Reserve demand curve is downward sloping

7 Channel/Corridor System Interbank O/N rate i MLR i MBR RsRs RdRd i*

8 Supply of Reserves  Reserve supply is determined by the CB. As long as the interbank rate stays in the target range, reserve supply is vertical.

9 The Channel/Corridor System  System used in Turkey and the EU.  CB stands ready to lend to banks at the marginal lending rate. (MLR: currently 9% in Turkey)  The supply of reserves is horizontal (infinitely elastic) at the marginal lending rate because if the market O/N rate goes above 9%, banks can borrow from CB and lend to the market, make unlimited profits.

10 The Channel/Corridor System (cont’d)  CB has a second window that pays banks the marginal borrowing rate (MBR: currently 6.5% in Turkey) on any reserves they would like to lend to the CB.  The supply of reserves is also horizontal (infinitely elastic) at the marginal borrowing rate because the market O/N rate cannot go below 6.5%.

11 The Channel/Corridor System (cont’d)  In between MLR and MBR, quantity of reserves supplied is equal to the non- borrowed reserves; supply curve is vertical.  Shifts of the demand curve keeps overnight rate between marginal lending rate and marginal borrowing rate.

12 Supply of Reserves  Two components: non-borrowed (from CB) and borrowed reserves  If i MBR < i ON < i MLR, then banks will not borrow from or lend to the CB and borrowed reserves are zero. Supply of reserves is vertical and equal to nonborrowed reserves (NBR).  The supply curve is horizontal (perfectly elastic) at i MBR and i MLR.

13 Tools of Monetary Policy How does the CB control the Interbank O/N rate? 1.Open market operations Change the quantity of nonborrowed reserves and the monetary base. 2.Changes in MLR and MBR: Changes the amount of borrowed reserves and the monetary base 3.Changes in reserve requirements Change the money multiplier

14 How Does The CB Control The Interbank O/N Rate? 1.Open market operations An open market purchase shifts the supply curve to right and causes the interbank o/n rate to fall; an open market sale shifts the supply curve left and causes the interbank o/n rate to rise

15 Open market purchase Interbank O/N rate i MLR i MBR RsRs RdRd i* i**

16 How Does The CB Control The Interbank O/N Rate? 2.Changes in m.lending and borrowing rates  Expansionary policy: To increase liquidity in the market, if the CB reduces the MLR and MBR lends to banks at lower rates makes open market operations at lower rates or reverse repo (lending) operations at lowered rate then the interbank market rate decreases

How Does The CB Control The Interbank O/N Rate? 2.Changes in m.lending and borrowing rates  Contractionary policy: To decrease liquidity in the market, CB increases the MBR and MLR: Borrows from banks and pays higher MBR Makes OMO at higher rates Repo (borrowing) operations at higher rate Then interbank market rate increases 17

18 How Does The CB Control The Interbank O/N Rate?  Repo (repurchasing agreement): to sell treasury bills & bonds now in order to buy it back at an agreed price a few days later: in order to borrow short-term liquidity  Reverse repo: to buy securities now with the promise of selling back at an agreed price in a few days: in order to lend excess liquidity  Central bank makes repo operation to temporarily reduce the money supply. In this operation CB uses the borrowing rate (MBR).  CB makes reverse repo to increase the money supply and uses the MLR.

19 How Does The CB Control The Interbank O/N Rate? 3.Changes in reserve requirements  When the CB raises the reserve requirement, banks need more reserves. This shifts the demand curve right and the Interbank O/N rate rises.  When the CB decreases the reserve requirement, this shifts the demand curve left and the Interbank O/N rate falls

20 Increasing the reserve requirement Interbank O/N rate i MLR i MBR RsRs RdRd i** i* R’ d

21 Discount Policy  CB acts as a lender of last resort (LLR) to prevent financial panics (bank runs) Why do we need a LLR when we have deposit insurance?  Saving Deposit Insurance Fund (TMSF) funds may not be enough. Then CBRT helps SDIF.  Accounts above TL not insured. Since a majority of deposit accounts are above this amount, there is a risk of bank runs.

22 Advantages and Disadvantages of Discount Policy  Advantages: Lender of last resort, prevents financial panics. Discount facility is used as a backup facility to prevent the federal funds rate from rising too far above the target  Disadvantages: Amount cannot be controlled by the CB; the commercial bank decides how much to borrow. Creates moral hazard problem. Banks take on more risk when they know CB will come to rescue.