ECB: Instruments of Monetary Policy

1. ECB: Instruments of Monetary Policy Before the foundation of the currency union the monetary instruments of the national central banks were similar but not identical, and the importance of the instruments and the weights given to them were different. Therefore, a decision was necessary which instruments should be passed over to ECU and which weight should be attributed to them. 1

2. E.g., one instrument which was one of the two most important for the short-term control of the quantity of the monetary base, vanished completely, namely trade bills. In Germany and Austria it had been quite usual to pay for ship-ments neither in cash nor by cheque but by a bill. The bill, being a means of payment and 3-month credit at the same time, was given to the supplier and normally handed out to the commercial bank of the latter against immediate payment of the nominal value minus discount („Wechseldiskont“). The commercial bank then had to decide whether to keep the bill or pass it over to the central bank against re-discount. Eventually, when after 3 months the bill was due, the debtor had to pay the total amount to the commercial or central bank, resp.. 2

3. Another instrument, the minimum reserve requirement, was carried over to the ECU, but weakened considerably. The minimum reserve ratio, to be held by commercial banks in the form of monetary base as percentage of demand deposits, had values of 10% and even more for many decades. It had been a means to control a minimum liquidity of the banks. It was an important brake in the money multiplier. In the ECU the minimum reserve ratio is only about 2% and not very important. Especially, it makes the money supply process less controllable, since it widenes the possibility of (private) money creation. 3

4. Monetary instruments of the ECB: Deposit facility: Commercial banks have the possibility to transfer their excess liquidity overnight on their accounts with the ECB. Such overnight deposits earn as interest the deposit rate. It is the lower bound of the short term interest band of the inter-bank market. For the time being it is 1%. If commercial banks use the overnight deposit facility it is a signal for th ECB, that they are too liquid. 4

5. 2. Lombard facility (marginal lending): This is an overnight credit facility. If commercial banks have a short-term lack of liquidity they can borrow from the ECB and pay as interest the lombard rate. The latter is the upper bound of the interest band of the interbank market. If commercial banks use this instrument it is a signal to the ECB that the banks find themselves in a difficult liquidity position. The first two instruments are standing facilities, meaning that the initiative to use it is with the banks. Deposit and Lombard facility form a corridor within which interbank interest rates are planned to stay. 5

6. 3. Open market transactions: In principle, purchases of securities by the central bank increase the quantity of central bank money (=monetary base) hold by commercial banks. This results in credit entries on CB accounts in favour of the commercial banks, which is central bank money. Sales of securities by the central bank reduce the quan-tity of money in circulation since this results in debit en-tries on CB accounts of commercial banks. This „destroys“ CB money (=monetary base). The instruments are working as follows: 6

7. a) Fixed period transactions (duration 2 weeks, weekly frequency): Lombard transaction: credit on mortgage basis „Pension“ transaction (or re-purchase agreement): a combination of spot and forward transaction (actually a „swap“): Spot transaction: one party commits itself to take the object of the trans-action (e.g. short-term government bonds) into „pension“ (storage) against credit entry, reduced by a discount. Forward transaction: The other party commits itself to take the bonds back at maturity and for nominal value. The interest equivalent of the discount = pension rate The procedural method is an auction (=„tender“) 7

8. b) outright transactions: The ECB is permitted to buy and to sell securities on the markets for the purpose of fine tuning and steeering the liquidity structure. c) Emisssion of bonds. The ECB may issue bonds (max. duration 12 months) in order to absorb excess liquidity of the commercial banks. The ECB d) The ECB is allowed to carriy out foreign exchange swaps, buying spot and selling forward or vv. This is another instru-ment of fine-tuning the liquidity supply of the economy. buying spot and selling forward is a short-term increase, Selling spot and buying forward is a short-term decrease of lquidity. e) with permission of the ECB the national CBs may offer time deposits to commercial banks in order to absorb liquidity. 8

9. 4. Minimum reserve requirements Commercial banks have to keep minimum reserves as a certain percentage (about 2 %) of the demand deposits of their customers. The minimum reserve is held as positive balance on the ECB account of the commercial bank. the excess of reserves beyond the minimum reserve may be lent out. It is reasonable to expect the banks to hold much more than the minimum reserve in order to be ready not only to bear liquidity shortages but also to carry out transactions in theri own interest. 9