1. 1 Chapter 6 Goals and Tools of Monetary Policy

2. 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 high employment. Less emphasized in Turkey than inflation. In US, more important than Turkey.

3. 3 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’s accounts at the CB overnight. Primary instrument of CB’s monetary policy.

4. 4 Source: Erdem Başçı, “Dollarization: Consequences and Policy Options”, 14-15 December 2006, Istanbul

5. 5 Demand for Reserves  What happens to the quantity of reserves demanded, holding everything else constant, as the Interbank overnight rate changes?  Two components: required reserves and excess reserves Excess reserves are insurance against deposit outflows. The cost of holding excess reserves is the interest rate that could have been earned  As Interbank overnight rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded increases  Reserve demand curve is downward sloping

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7. 7 The Channel/Corridor System  System used in Turkey and the EU.  CB stands ready to loan overnight any amount banks want to borrow at the marginal lending rate. (MLR: currently 19.25% in Turkey)  The supply of reserves is horizontal (infinitely elastic) at the marginal lending rate because if the market O/N rate goes above 19.25%, banks can borrow from CB unlimited and lend to the market, make unlimited profits.

8. 8 The Channel/Corridor System (cont’d)  CB has a second window that pays banks the marginal borrowing rate (MBR: currently 15.25% in Turkey) on any deposits they would like to keep at 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 15.25%.  In between MLR and MBR, quantity of reserves supplied is equal to the non-borrowed reserves; supply curve is vertical.  Figure 6: Shifts of the demand curve keeps overnight rate between marginal lending rate and marginal borrowing rate.

9. 9 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.

10. 10 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: Changes the amount of borrowed reserves and the monetary base 3.Changes in reserve requirements Change the money multiplier

11. 11 How Does The CB Control The Interbank O/N Rate? 1.Open market operations An open market purchase shifts the supply curve right and causes the federal funds rate to fall; an open market sale shifts the supply curve left and causes the federal funds rate to rise

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13. 13 How Does The CB Control The Interbank O/N Rate? 2.Changes in MLR (discount rate)  If the intersection of supply and demand occurs on the vertical section of the supply curve, a change in the discount rate will have no effect on the Interbank O/N rate. Because there is no borrowing from CB in this region. But in practice there may be a downward effect on expectations. This is the typical case.  If the intersection of supply and demand occurs on the horizontal section of the supply curve, a change in the discount rate shifts that portion of the supply curve and the Interbank O/N rate either rises or falls together with the discount rate. This case is not very common in practice.

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15. 15 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

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17. 17 Discount Policy  Lender of last resort to prevent financial panics 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 50 000 YTL not insured.

18. 18 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.