Monetary Theory and Polıcy (ENG) — Ünite 4 Soru-Cevap

Direct policy tools directly intervene in the decisions of the financial system. Direct monetary policy tools encompass various measures aimed at regulating deposits and credits, such as interest rate and credit growth restrictions through the implementation of interest rate and quantity ceilings. Central banks utilize these tools to directly influence and intervene in deposit and credit markets. In the case of an interest rate ceiling, the central bank establishes maximum interest rates for deposit and/or loan rates, thereby exerting control over the prevailing interest rates in the market. Financial institutions are required to adhere to these specified rates.

However, these tools involved substantial intervention in the private sector, which conflicts with the principles of a market-based economy and modern central banking. As countries increasingly embraced market-based, or free market, economies, the utilization of these direct monetary policy tools waned over time.

Indirect monetary policy tools to provide liquidity are Repo, Lending deposits and Outright purchases.

Repo: This term refers to repurchase agreement, commonly known as repo. Repos are short-term borrowing instruments involving two parties: one party holds securities but requires liquidity, while the other party possesses surplus liquidity available for lending.

Outright Purchase: In the case of an outright purchase, the central bank buys government bonds from banks, thereby providing permanent liquidity to the banks. During this transaction, banks transfer the government bonds to the central bank, and in return, the central bank pays the bank the bond value at the prevailing market price.

Lending Deposits : This instrument is similar to a repo transaction. Central banks lend liquidity to banks for a short period against specific collateral. While banks sell a particular government bond to the central bank in a repo transaction, they provide government bonds, gold, or foreign currency as collateral in deposits lending.

Indirect monetary policy tools to withdraw liquidity are Reverse Repo, Borrowing deposits, Outright sales and Central Bank liquidity bills.

Reverse Repo: This term is just used for the reverse case of repo (repurchase agreement). Just the seller and buyer parties’ change. In the monetary policy case, the central bank withdraws liquidity from the banks for a short period, usually from overnight to 3 months, through reverse repo. At the transaction date, the central bank sells government bonds to the banks, and buys back at maturity. The interest rate is usually determined by the central bank for shorter term reverse repos.

Borrowing Deposits : This instrument is akin to a reverse repo. Central banks borrow liquidity from banks for a short period. However, the central bank does not provide any collateral to the banks in deposits borrowing.

Outright Sale: In this case, the central bank sells  government  bonds  from  its  portfolio  to the banks, effectively withdrawing permanent liquidity. During the transaction, the central bank transfers the government bonds to the banks, and in return, the banks pay the central bank the value of the bonds at the prevailing market price.

Central bank liquidity bills: Central banks may issue short-term bills with maturities of up to, for example, 3 months to withdraw liquidity from  banks.  In  this  scenario,  the  central  bank issues liquidity bills to the banks, and in return, the banks pay the central bank. Upon reaching the maturity date, the banks transfer the bills back to the central bank, and the central bank pays the face.

Purposes of Reserve Requirements tool are "Buffer Function”, “Liquidity Management Function” and “Income or Tax Function”.

"Buffer Function”:  Central  banks  aim  to keep banks liquid by requiring them to maintain a  portion  of  their  deposits  in  the  required reserves account. This helps banks meet deposit withdrawals promptly.

“Liquidity Management Function”: Adjusting the required reserve ratio can serve as a means to control the money supply. When the ratio is increased, banks are compelled to hold more funds in the central bank, reducing the amount of money available for lending and vice versa.

“Income or Tax Function”: Required reserve ratios may also serve as a source of revenue for the central bank if it does not pay interest rates or offers lower rates compared to the deposit rates.

Liquidity management refers to the systematic control and regulation of available funds in the financial system by a central bank with the objective of achieving a targeted short-term policy rate. Through the use of various monetary policy instruments central banks aim to influence the level of liquidity in the market, thereby effectively steering short-term interest rates towards their desired policy rate.

The primary function of the discount window facility is to provide short-term liquidity to banks, helping  them  meet  their  immediate  liquidity needs. Under this facility, the central bank specifies (i) the borrowing rules, (ii) eligible securities, and (iii) the discount rate. Eligible securities typically include short-term government or private sector bills. When a bank requires liquidity, it sells these securities to the central bank, and in return, the central bank provides funds to the bank at the announced discount rate. Furthermore, through this facility, central banks can also extend credit to  the  real  sector  through  the  banking  system. The process works as follows: firms issue bills to the banks, and the banks use these bills to obtain liquidity from the central bank.

The implementation of monetary policy involves two main elements: (i) signalling the desired policy stance and (ii) conducting operations using the central bank’s balance sheet to effectively implement the monetary policy stance (liquidity management). In modern central banking, policy stance is signalled through explicitly announcing the policy rate. When the policy stance is signalled through the policy rate, liquidity management becomes a purely technical operation aimed at achieving the targeted policy rate, particularly if central banks use short-term interest rates as their primary instrument.

Central banks typically prefer to use “very” short- term interest rates as their operating target rather than longer-term rates. In practice, central banks often select the overnight (O/N) rate or one week repo/reverse repo rates as their operating target. For example, the CBRT prefers one week repo rate as the operating target.

For very short-term transactions, central banks determine interest rates and usually announce the quantity of the auction. However, for longer-term monetary policy tools, the market determines the interest rates. In this case, central banks typically announce the participants of the auctions and allow the market to determine the quantity and interest rate. Note that, central banks control very short-term interest rates in monetary policy implementation, and longer term interest rates are determined in the market.

Interest Rate Corridor: The interest rate corridor refers to a framework wherein the central bank establishes boundaries for the market interest rate by publicly stating the lower limit (borrowing interest rate) and upper limit (lending interest rate) associated with overnight interest rates.

There are numerous banks with varying levels of liquidity in their free deposit accounts. Some banks may have excess liquidity, while others may need liquidity. Banks facing liquidity shortages must close the gap by borrowing from other banks, while those with excess liquidity need to lend it out to earn interest. To facilitate this process, an interbank money market is essential, where short- term money market interest rates are determined through borrowing and lending activities among banks.

A liquidity trap refers to a scenario in the field of economics when conventional monetary policy measures prove to be ineffectual in encouraging economic expansion and mitigating deflationary forces. This phenomenon arises when nominal interest rates reach exceedingly low levels or approach zero.

The concept of the liquidity trap was popularized by British economist John Maynard Keynes during the Great Depression of the 1930s.

As the transmission channels of monetary policy were significantly damaged and lost their effectiveness, traditional   monetary   policy   measures   could not effectively impact the real economy. In this situation, central banks had two options: they could  lower  nominal  interest  rates  much  more than expected or intervene directly in transmission channels using unconventional monetary policy tools. The fact that interest rates had already approached the zero limit made monetary policy implementers need to evaluate unconventional instruments during this period.

Common unconventional monetary policy tools are;

- Negative Interest Rate Policy (NIRP)

- Asset Purchase Programs (APPs)

- Expanded Lending Operations (LOs)

- Forward Guidance.

Forward Guidance: Forward guidance involves communication by the central bank about the current position and direction of monetary policy. By sharing their future trajectory of monetary policy explicitly, central banks aim to influence market participants and the public. Forward guidance can be based on either a predetermined time frame or specific economic conditions that need to be met before any policy changes occur.

Expanded Lending Operations (LOs): Conventional central bank lending practices may prove inadequate during a crisis, necessitating innovative solutions. LOs involve measures to ensure an abundant supply of liquidity to a broader range of financial institutions. These operations have more relaxed conditions, such as accepting lower- quality collateral, offering longer repayment timeframes, and potentially lowering borrowing costs. LOs play a critical role in preventing financing market deterioration, stabilizing leverage reduction, and enabling financially strained intermediaries to continue supplying credit to the real economy.

Items on the Asset Side of the CBRT Balance Sheet are;

Foreign Assets: It shows all foreign currency assets of CBRT. We can also describe this item as the foreign currency reserves of CBRT for this chapter.

Domestic Assets: It shows all TL assets of the CBRT. It has many sub items.

Revaluation Account: It shows unrealized profit or losses of the CBRT stemming from changes in foreign currency assets and liabilities when exchange rate changes.

Liability Side of the CBRT Balance Sheet are;

Total Foreign Liabilities: It shows total foreign currency liabilities of CBRT.

Central Bank Money: It shows all TL liabilities of the CBRT including net open market operations and public sector TL deposits in the CBRT

Reserve Money item on the balance sheet of CBRT is one of the main items in the money creation process. It includes following items.

Currency Issued: It shows the quantity of banknotes issued by CBRT. All banknotes in the market; in the banks’ vault or our hands are included.

Deposits of Banking Sector: It shows the total TL deposits of banks, including required reserves and free reserves accounts.

Extra Budgetary Funds: It shows the TL accounts of some public funds. Its amount is negligible.
Deposits of Non-Bank Sector: In fact, it is also negligible. CBRT collects deposits
from only Treasury and public institutions and banks. There are a very small number of non-bank institutions approved by the CBRT to hold TL accounts at the CBRT.

You will see that at the end of this case, nothing will change in the CBRT balance sheet. However, during the steps, there will be some liquidity impacts. Firstly, the Treasury borrows from the banks by issuing bonds and receives TL 100. The Treasury’s TL account at CBRT increases by TL 100 (Table 4.9). Note that, since this account is, in fact, a liability of CBRT and its sign is negative, any increase in it is recorded as a “decline.” Banks pay this money from their free deposits. Therefore, free deposits of banks decline by TL 100.

Now, assume that the Treasury makes a TL 100 payment to the markets. The Treasury’s TL accounts at CBRT decline by TL 100, while Banks’ free deposits increase by TL 100.
At the end of these transactions, NDA and RM do not change. What does that mean? If the Treasury borrows in the domestic currency, it withdraws liquidity from the market, and RM, and consequently NDA, decline. But when the Treasury pays back for its expenses, RM, and consequently NDA, increases. At the end of the transactions, nothing changes in the CBRT balance sheet. Therefore, if the Treasury finances its budget deficit through domestic borrowing, liquidity conditions do not change.