Monetary policy of India

Monetary policy is the process by which monetary authority of a country, generally a central bank controls the supply of money in the economy by exercising its control over interest rates in order to maintain price stability and achieve high economic growth.[1] In India, the central monetary authority is the Reserve Bank of India (RBI). is so designed as to maintain the price stability in the economy. Other objectives of the monetary policy of India, as stated by RBI, are: Price Stability Price Stability implies promoting economic development with considerable emphasis on price stability. The centre of focus is to facilitate the environment which is favourable to the architecture that enables the developmental projects to run swiftly while also maintaining reasonable price stability. Controlled Expansion Of Bank Credit One of the important functions of RBI is the controlled expansion of bank credit and money supply with special attention to seasonal requirement for credit without affecting the output. Promotion of Fixed Investment The aim here is to increase the productivity of investment by restraining non essential fixed investment. Restriction of Inventories Overfilling of stocks and products becoming outdated due to excess of stock often results is sickness of the unit. To avoid this problem the central monetary authority carries out this essential function of restricting the inventories. The main objective of this policy is to avoid over-stocking and idle money in the organization Promotion of Exports and Food Procurement Operations Monetary policy pays special attention in order to boost exports and facilitate the trade. It is an independent objective of monetary policy. Desired Distribution of Credit Monetary authority has control over the decisions regarding the allocation of credit to priority sector and small borrowers. This policy decides over the specified percentage of credit that is to be allocated to priority sector and small borrowers. Equitable Distribution of Credit The policy of Reserve Bank aims equitable distribution to all sectors of the economy and all social and economic class of people To Promote Efficiency It is another essential aspect where the central banks pay a lot of attention. It tries to increase the efficiency in the financial system and tries to incorporate structural changes such as deregulating interest rates, ease operational constraints in the credit delivery system, to introduce new money market instruments etc. Reducing the Rigidity RBI tries to bring about the flexibilities in the operations which provide a considerable autonomy. It encourages more competitive environment and diversification. It maintains its control over financial system whenever and wherever necessary to maintain the discipline and prudence in operations of the financial system.

how does monetary policy affect inflation? Wages and prices will begin to rise at faster rates if monetary policy stimulates aggregate demand enough to push labor and capital markets beyond their long-run capacities. In fact, a monetary policy that persistently attempts to keep short-term real rates low will lead eventually to higher inflation and higher nominal interest rates, with no permanent increases in the growth of output or decreases in unemployment. As noted earlier, in the long run, output and employment cannot be set by monetary policy. In other words, while there is a trade-off between higher inflation and lower unemployment in the short run, the trade-off disappears in the long run. Policy also affects inflation directly through people's expectations about future inflation. For example, suppose the Fed eases monetary policy. If consumers and businesspeople figure that will mean higher inflation in the future, they'll ask for bigger increases in wages and prices. That in itself will raise inflation without big changes in employment and output. Doesn't U.S. inflation depend on worldwide capacity, not just U.S. capacity? In this era of intense global competition, it might seem parochial to focus on U.S. capacity as a determinant of U.S. inflation, rather than on world capacity. For example, some argue that even if unemployment in the U.S. drops to very low levels, U.S. workers wouldn't be able to push for higher wages because they're competing for jobs with workers abroad, who are willing to accept much lower wages. The implication is that inflation is unlikely to rise even if the Fed adopts an easier monetary policy. This reasoning doesn't hold up too well, however, for a couple of reasons. First, a large proportion of what we consume in the U.S. isn't affected very much by foreign trade. One example is health care, which isn't traded internationally and which amounts to nearly 15% of U.S. GDP. More important, perhaps, is the fact that such arguments ignore the role of flexible exchange rates. If the Fed were to adopt an easier policy, it would tend to increase the supply of U.S. dollars in the market. Ultimately, this would tend to drive down the value of the dollar relative to other countries, as U.S. consumers and firms used some of this increased money supply to buy foreign goods and foreigners got rid of the additional U.S. currency they did not want. Thus, the price of foreign goods in terms of U.S. dollars would go upeven though they would not in terms of the foreign currency. The higher prices of imported goods would, in turn, tend to raise the prices of U.S. goods.

The Tools of Monetary Policy

1. Open Market Operations 2. Discount Loans 3. Changes in Reserve Requirements Before working through Mishkins Chapter 17, on the Tools of Monetary Policy, it is helpful to state a definition that clarifies what is meant by the term monetary policy in the first place. We can find such a definition in Chapter 1 of Mishkins book, on page 12: Monetary policy = the management of money and interest rates.

Next, it is useful to recall from our analysis of the money supply process that M = m MB, where M is the money supply, MB is the monetary base, and m, the money multiplier, is determined as m= 1+c r+e+c . These equations reveal that the Fed can manage the money supplythat is, conduct monetary policy, in three ways: By changing the monetary base through open market operations. By changing the monetary base through discount lending. By changing the money multiplier by changing the required reserve ratio. Thus, the Fed has three tools of monetary policy: Open market operations. Discount loans. Changes in reserve requirements. Which of these tools is most effective? Mishkins Chapter 17 helps us answer this question.

OpenMarketOperations
We have already distinguished between two types of open market operations: Open market purchases = Fed buys US government securities to increase the monetary base. Open market sales = Fed sells US government securities to decrease the monetary base. Thus, the Fed conducts open market operations by buying and selling US government securitiesespecially US Treasury bills. Since the market for US Treasury bills is so active, the Fed can make large purchases and sales quickly and easily, without disrupting the market. Although the FOMC makes decisions on how open market operations are to be conducted, the trades themselves are executed at the Open Market Desk at the Federal Reserve Bank of New York. Open market purchases and sales have permanent affects on the monetary base, but sometimes the Fed will want to change the monetary base only temporarily. At these times, it engages in two other types of transactions: Repurchase Agreement (repo) = The Fed purchases US government securities will an agreement that the seller will buy them back (repurchase them) at a specified price on a specified date, usually within two weeks. A repo is therefore like a temporary open market purchase, temporarily increasing the monetary base. Matched Sale-Purchase Transaction (reverse repo) = The Fed sells US government securities with an agreement that the buyer will sell them back at a specified price on a specified date, again usually within two weeks. A reverse repo is therefore

like a temporary open market sale, temporarily decreasing the monetary base. Hence, in conducting monetary policy, open market operations have a number of advantages: They are under the direct and complete control of the Fed. They can be large or small. They can be easily reversed. They can be implemented quickly. 2

2 Discount Loans
When a bank receives a discount loan from the Fed, it is said to have received a loan at the discount window. The Fed can affect the volume of discount loans by setting the discount rate: A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discount loans. A lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discount loans. Discount lending is most important during financial panics: When depositors lose confidence in the financial system, they will rush to withdraw their money. This large deposit outflow puts the banking system in great need of reserves. The Fed stands ready to supply these reserves by making discount loans. In such situations, the Fed acts as a lender of last resort. Hence, in October 1987 and again in September 2001, the Fed made it clear that it would supply additional reserves to the financial system, as necessary, through the discount window. Advantage of discount loans: They allow the Fed to act as a lender of last resort during a financial panic. Disadvantages of using discount loans as a tool for monetary policy during normal times: The volume of discount loans can be influenced by the Fed, but not completely controlled: The Fed cannot be sure how many banks will request discount loans at any given interest rate. Changes in the discount rate must be proposed by the Federal Reserve Banks before being approved by the Board of Governors. Hence, they are neither quickly made nor easily reversed.

Changes in Reserve Requirements

By affecting the money multiplier, changes in the required reserve ratio can lead to changes in the money supply. Disadvantages to using changes in reserve requirements as a tool for monetary policy: Large changes in reserves must be approved by Congress. Hence, large changes cannot be made quickly and easily. Also, if a bank holds only a small amount of excess reserves and the required reserve ratio is increased, the bank will have to quickly acquire reserves by borrowing, selling securities, or reducing its loans. Each of these three options is costly and

disruptive. Hence, changes in reserve requirements can cause problems for banks by making liquidity management more difficult.

Goals of Monetary Policy

The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. Stable prices in the long run are a precondition for maximum sustainable output growth and employment as well as moderate long-term interest rates. When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are undistorted by inf lation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living. Moreover, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inf lationand the need to guard against such lossesare minimized, households are encouraged to save more and businesses are encouraged to invest more. Although price stability can help achieve maximum sustainable output growth and employment over the longer run, in the short run some tension can exist between the two goals. Often, a slowing of employment is accompanied by lessened pressures on prices, and moving to counter the weakening of the labor market by easing policy does not have adverse inf lationary effects. Sometimes, however, upward pressures on prices are developing as output and employment are softening especially when an adverse supply shock, such as a spike in energy prices, has occurred. Then, an attempt to restrain inf lation pressures would compound the weakness in the economy, or an attempt to reverse employment losses would aggravate inf lation. In such circumstances, those responsible for monetary policy face a dilemma and must decide whether to focus on defusing price pressures or on cushioning the loss of employment and output. Adding to the difficulty is the possibility that an expectation of increasing inf lation might get built into decisions about prices and wages, thereby adding to inf lation inertia and making it more difficult to achieve price stability.

Beyond inf luencing the level of prices and the level of output in the near term, the Federal Reserve can contribute to financial stability and better economic performance by acting to contain financial disruptions and preventing their spread outside the financial sector. Modern financial systems are highly complex and interdependent and may be vulnerable to wide-scale systemic disruptions, such as those that can occur during a plunge in stock prices. The Federal Reserve can enhance the financial systems resilience to such shocks through its regulatory policies toward banking institutions and payment systems. If a threatening disturbance develops, the Federal Reserve can also cushion the impact on financial markets and the economy by aggressively and visibly providing liquidity through open market operations or discount window lending.

How Monetary Policy Affects the Economy

The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve Banks. Depository institutions have accounts at their Reserve Banks, and they actively trade balances held in these accounts in the federal funds market at an interest rate known as the federal funds rate. The Federal Reserve exercises considerable control over the federal funds rate through its inf luence over the supply of and demand for balances at the Reserve Banks. The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments. A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect other short-term interest rates, longer-term interest rates, the foreign exchange value of the dollar, and stock prices. In turn, changes in these variables will affect households and businesses spending decisions, thereby affecting growth in aggregate demand and the economy. Short-term interest rates, such as those on Treasury bills and commercial paper, are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Federal Reserve surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Federal Reserve was going to be holding the federal funds rate lower than had been anticipated. Similarly, short-term inter.

The Effects of Monetary Policy on the Economy

Central banks are the national authorities responsible for providing currency and implementing monetary policy. Monetary policy is a set of actions through which the monetary authority determines the conditions under which it supplies the money that circulates in the economy. Monetary policy therefore has an effect on short-term interest rates. Setting monetary policy goals has been a defining issue for economists and public opinion since the consolidation of central banks as the entities responsible for providing the economies with domestic currency and for implementing monetary policy. Parallel with academic progress and experience in this matter, the understanding of monetary policy has advanced significantly over the last few decades. Currently, it is clear that in both academic circles and among the worlds monetary authorities, monetary policys best contribution to sustained growth is to foster price stability. For that reason, in recent years, the central banks of many countries, including Mexico, have reoriented their monetary policy objectives, setting price stability as their main goal. This goal has been formalized, in most cases, by establishing low-level inflation targets. The central bank does not control prices directly because these are determined by the supply and demand of many goods and services. Nevertheless, through monetary policy the central bank can influence the price-determination process and thus attain its inflation target. The latter suggests the extreme need for the monetary authority to identify the effects that its actions have on the general economy and, particularly, on the price-determination process. The study of the channels by which these effects take place is known as the

monetary policy transmission mechanism. Flow Chart 1 details this mechanism in general terms.

est rates would increase if the Federal Reserve surprised market participants by announcing an increase in the federal funds rate, or if some event prompted market participants to believe that the Federal Reserve was going to be holding the federal funds rate at higher levels than had been anticipated. It is for these reasons that market participants closely follow data releases and statements by Federal Reserve officials, watching for clues that the economy and prices are on a different trajectory than had been thought, which would have implications for the stance of monetary policy.

Changes in short-term interest rates will inf luence long-term interest rates, such as those on Treasury notes, corporate bonds, fixed-rate mortgages, and auto and other consumer loans. Long-term rates are affected not only by changes in current short-term rates but also by expectations about short-term rates over the rest of the life of the long-term contract. Generally, economic news or statements by officials will have a greater impact on short-term interest rates than on longer rates because they typically have a bearing on the course of the economy and monetary policy over a shorter period; however, the impact on long rates can also be considerable because the news has clear implications for the expected course of short-term rates over a long period. Changes in long-term interest rates also affect stock prices, which can have a pronounced effect on household wealth. Investors try to keep their investment returns on stocks in line with the return on bonds, after allowing for the greater riskiness of stocks. For example, if long-term interest rates decline, then, all else being equal, returns on stocks will exceed returns on bonds and encourage investors to purchase stocks and bid up stock prices to the point at which expected risk-adjusted returns on stocks are once again aligned with returns on bonds. Moreover, lower interest rates may convince investors that the economy will be stronger and profits higher in the near future, which should further lift equity prices. Furthermore, changes in monetary policy affect the exchange value of the dollar on currency markets. For example, if interest rates rise in the United States, yields on dollar assets will look more favorable, which will lead to bidding up of the dollar on foreign exchange markets. The higher dollar will lower the cost of imports to U.S. residents and raise the price of U.S. exports to those living outside the United States. Conversely, lower interest rates in the United States will lead to a decline in the exchange value of the dollar, prompting an increase in the price of imports and a decline in the price of exports. Changes in the value of financial assets, whether the result of an actual or expected change in monetary policy, will affect a wide range of spending decisions. For example, a drop in interest rates, a lower exchange value of the dollar, and higher stock prices will stimulate various types of spending. Investment projects that businesses believed would be only marginally profitable will become more attractive with lower financing costs. Lower consumer loan rates will elicit greater demand for consumer goods, especially bigger-ticket items such as motor vehicles. Lower mortgage rates will make housing more affordable and lead to more home purchases. They will also encourage mortgage refinancing, which will reduce ongoing housing costs and enable households to purchase other goods. When refinancing, some homeowners may withdraw a portion of their home equity to pay for

other things, such as a motor vehicle, other consumer goods, or a long-desired vacation trip. Higher stock prices can also add to household wealth and to the ability to make purchases that had previously seemed beyond reach. The reduction in the value of the dollar associated with a drop in interest rates will tend to boost U.S. exports by lowering the cost of U.S. goods and services in foreign markets. It will also make imported goods more expensive, which will encourage businesses and households to purchase domestically produced goods instead. All of these responses will strengthen growth in aggregate demand. A tightening of monetary policy will have the opposite effect on spending and will moderate growth of aggregate demand. If the economy slows and employment softens, policy makers will be inclined to ease monetary policy to stimulate aggregate demand. When growth in aggregate demand is boosted above growth in the economys potential to produce, slack in the economy will be absorbed and employment will return to a more sustainable path. In contrast, if the economy is showing signs of overheating and inf lation pressures are building, the Federal Reserve will be inclined to counter these pressures by tightening monetary policyto bring growth in aggregate demand below that of the economys potential to producefor as long as necessary to defuse the inf lationary pressures and put the economy on a path to sustainable expansion. While these policy choices seem reasonably straightforward, monetary policy makers routinely face certain notable uncertainties. First, the actual position of the economy and growth in aggregate demand at any point in time are only partially known, as key information on spending, production, and prices becomes available only with a lag. Therefore, policy makers must rely on estimates of these economic variables when assessing the appropriate course of policy, aware that they could act on the basis of misleading information. Second, exactly how a given adjustment in the federal funds rate will affect growth in aggregate demandin terms of both the overall magnitude and the timing of its impactis never certain. Economic models can provide rules of thumb for how the economy will respond, but these rules of thumb are subject to statistical error. Third, the growth in aggregate supply, often called the growth in potential output, cannot be measured with certainty. Key here is the growth of the labor force and associated labor input, as well as underlying growth in labor productivity. Growth in labor input typically can be measured with more accuracy than underlying productivity; for some time, growth in labor input has tended to be around the growth in the overall population of 1 percentage point per year. However, underlying productivity growth has varied considerably over recent decades, from approximately 1 percent or so per year to somewhere in the neighborhood of 3 percent or even higher, getting a major boost during the mid- and late 1990s from applications of information technology and advanced management systems. If, for example, productivity growth is 2 percent per year, then growth in aggregate supply would be the sum of this amount and labor input growth of 1 percentthat is, 3 percent per year. In which case, growth in aggregate demand in excess of 3 percent per year would result in a pickup in growth in employment in excess of that of the labor force and a reduction in unemployment. In contrast, growth in aggregate demand below 3 percent would result in a softening of the labor market and, in time, a reduction in inf lationary pressures.

Limitations of Monetary Policy

Monetary policy is not the only force acting on output, employment, and prices. Many other factors affect aggregate demand and aggregate supply and, consequently, the economic position of households and businesses. Some of these factors can be anticipated and built into spending and other economic decisions, and some come as a surprise. On the demand side, the government inf luences the economy through changes in taxes and spending programs, which typically receive a lot of public attention and are therefore anticipated. For example, the effect of a tax cut may precede its actual implementation as businesses and households alter their spending in anticipation of the lower taxes. Also, forward-looking financial markets may build such fiscal events into the level and structure of interest rates, so that a stimulative measure, such as a tax cut, would tend to raise the level of interest rates even before the tax cut becomes effective, which will have a restraining effect on demand and the economy before the fiscal stimulus is actually applied. Other changes in aggregate demand and supply can be totally unpredictable and inf luence the economy in unforeseen ways. Examples of such shocks on the demand side are shifts in consumer and business confidence, and changes in the lending posture of commercial banks and other creditors. Lessened confidence regarding the outlook for the economy and labor market or more restrictive lending conditions tend to curb business and household spending. On the supply side, natural disasters, disruptions in the oil market that reduce supply, agricultural losses, and slowdowns in productivity growth are examples of adverse supply shocks. Such shocks tend to raise prices and reduce output. Monetary policy can attempt to counter the loss of output or the higher prices but cannot fully offset both. In practice, as previously noted, monetary policy makers do not have up-to-the-minute information on the state of the economy and prices. Useful information is limited not only by lags in the construction and availability of key data but also by later revisions, which can alter the picture considerably. Therefore, although monetary policy makers will eventually be able to offset the effects that adverse demand shocks have on the economy, it will be some time before the shock is fully recognized andgiven the lag between a policy action and the effect of the action on aggregate de-mandan even longer time before it is countered. Add to this the uncertainty about how the economy will respond to an easing or tightening of policy of a given magnitude, and it is not hard to see how the economy and prices can depart from a desired path for a period of time. The statutory goals of maximum employment and stable prices are easier to achieve if the public understands those goals and believes that the Federal Reserve will take effective measures to achieve them. For example, if the Federal Reserve responds to a negative demand shock to the economy with an aggressive and transparent easing of policy, businesses and consumers may believe that these actions will restore the economy to full employment; consequently, they may be less inclined to pull back on spending because of concern that demand may not be strong enough to warrant new business investment or that their job prospects may not warrant the purchase of big-ticket household goods. Similarly, a credible antiinf lation policy will lead businesses and households to expect less wage and price inf lation; workers then will not feel the same need to protect themselves by demanding large wage increases, and businesses will be less aggressive in raising their prices, for fear of losing sales and profits. As a result, inf lation will come down more rapidly, in keeping with the policy-related slowing in growth of aggregate demand, and will give rise to less slack in product and resource markets than if workers and businesses continued to act as if inf lation were not going to slow.

Objective of monetary policy

To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty on the Functioning of the European Union, Article 127 (1). "Without prejudice to the objective of price stability", the Eurosystem shall also "support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union". These include inter alia "full employment" and "balanced economic growth". The Treaty establishes a clear hierarchy of objectives for the Eurosystem. It assigns overriding importance to price stability. The Treaty makes clear that ensuring price stability is the most important contribution that monetary policy can make to achieve a favourable economic environment and a high level of employment. These Treaty provisions reflect the broad consensus that

the benefits of price stability are substantial (see benefits of price stability). Maintaining stable prices on a sustained basis is a crucial pre-condition for increasing economic welfare and the growth potential of an economy . the natural role of monetary policy in the economy is to maintain price stability (see scope of monetary policy). Monetary policy can affect real activity only in the shorter term (see the transmission mechanism). But ultimately it can only influence the price level in the economy.

The Treaty provisions also imply that, in the actual implementation of monetary policy decisions aimed at maintaining price stability, the Eurosystem should also take into account the broader economic goals of the Union. In particular, given that monetary policy can affect real activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in output and employment if this is in line with the pursuit of its primary objective.

Transmission mechanism of monetary policy

This is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level. The chart below provides a schematic illustration of the main transmission channels of monetary policy decisions.

Change in official interest rates

The central bank provides funds to the banking system and charges interest. Given its monopoly power over the issuing of money, the central bank can fully determine this interest rate.
Affects banks and money-market interest rates

The change in the official interest rates affects directly money-market interest rates and, indirectly, lending and deposit rates, which are set by banks to their customers.
Affects expectations

Expectations of future official interest-rate changes affect medium and long-term interest rates. In particular, longer-term interest rates depend in part on market expectations about the future course of short-term rates. Monetary policy can also guide economic agents expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility firmly anchors expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation.

Affects asset prices

The impact on financing conditions in the economy and on market expectations triggered by monetary policy actions may lead to adjustments in asset prices (e.g. stock market prices) and the exchange rate. Changes in the exchange rate can affect inflation directly, insofar as imported goods are directly used in consumption, but they may also work through other channels.
Affects saving and investment decisions

Changes in interest rates affect saving and investment decisions of households and firms. For example, everything else being equal, higher interest rates make it less attractive to take out loans for financing consumption or investment. In addition, consumption and investment are also affected by movements in asset prices via wealth effects and effects on the value of collateral. For example, as equity prices rise, shareowning households become wealthier and may choose to increase their consumption. Conversely, when equity prices fall, households may reduce consumption. Asset prices can also have impact on aggregate demand via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks.
Affects the supply of credit

For example, higher interest rates increase the risk of borrowers being unable to pay back their loans. Banks may cut back on the amount of funds they lend to households and firms. This may also reduce the consumption and investment by households and firms respectively.
Leads to changes in aggregate demand and prices

Changes in consumption and investment will change the level of domestic demand for goods and services relative to domestic supply. When demand exceeds supply, upward price pressure is likely to occur. In addition, changes in aggregate demand may translate into tighter or looser conditions in labour and intermediate product markets. This in turn can affect price and wagesetting in the respective market.
Affects the supply of bank loans

Changes in policy rates can affect banks marginal cost for obtaining external finance banks differently, depending on the level of a banks own resources, or bank capital. This channel is particularly relevant in bad times such as a financial crisis, when capital is scarcer and banks find it more difficult to raise capital. In addition to the traditional bank lending channel, which focuses on the quantity of loans supplied, a risk-taking channel may exist when banks incentive to bear risk related to the provision of loans is affected. The risk-taking channel is thought to operate mainly via two mechanisms. First, low interest rates boost asset and collateral values. This, in conjunction with

the belief that the increase in asset values is sustainable, leads both borrowers and banks to accept higher risks. Second, low interest rates make riskier assets more attractive, as agents search for higher yields. In the case of banks, these two effects usually translate into a softening of credit standards, which can lead to an excessive increase in loan supply.

Monetary policy instruments

Operational Framework
In order to achieve its primary objective, the Eurosystem uses a set of monetary policy instruments and procedures. This set forms the operational framework to implement the single monetary policy (see instruments).

Monopoly supplier of monetary base

The Eurosystem is the sole issuer of banknotes and bank reserves in the euro area. This makes it the monopoly supplier of the monetary base, which consists of

currency (banknotes and coins) in circulation, the reserves held by counterparties with the Eurosystem, and recourse by credit institutions to the Eurosystems deposit facility.

These items are liabilities in the Eurosystems balance sheet. Reserves can be broken down further into required and excess reserves. In the Eurosystems minimum reserve system, counterparties are obliged to hold reserves with the national central banks (NCBs). Beyond that, credit institutions usually hold only a small amount of voluntary excess reserves with the Eurosystem. By virtue of its monopoly, a central bank is able to manage the liquidity situation in the money market and influence money market interest rates.

Signalling the monetary policy stance

In addition to steering interest rates by managing liquidity, the central bank can also signal its monetary policy stance to the money market. This is usually done by changing the conditions under which the central bank is willing to enter into transactions with credit institutions.

Ensuring proper functioning of the money market

In its operations, the central bank also aims to ensure a proper functioning of the money market and to help credit institutions meet their liquidity needs in a smooth manner. This is achieved by

providing both regular refinancing to credit institutions and facilities that allow them to deal with end-of-day balances and to cushion transitory liquidity fluctuations.

Guiding principles
The operational framework of the Eurosystem is based on the principles laid down in the Treaty on the Functioning of the European Union. Article 127 of that Treaty states that in pursuing its objectives, the Eurosystem "() shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources ()". In addition to the principles set out in the Treaty on the Functioning of the European Union, the operational framework follows several guiding principles.
Operational efficiency

The most important principle is operational efficiency. It can be defined as the capacity of the operational framework to enable monetary policy decisions to feed through as precisely and as fast as possible to short-term money market rates. These in turn, through the monetary policy transmission mechanism, affect the price level.
Equal treatment and harmonisation

Another principle is that credit institutions must be treated equally irrespective of their size and location in the euro area. The harmonisation of rules and procedures helps to ensure equal treatment by trying to provide identical conditions to all credit institutions in the euro area in transactions with the Eurosystem.
Decentralised implementation

One principle specific to the Eurosystem is the decentralised implementation of monetary policy. The ECB coordinates the operations and the national central banks (NCBs) carry out the transactions.
Simplicity, transparency, continuity, safety and cost efficiency

Simplicity and transparency ensure that the intentions behind monetary policy operations are correctly understood. The principle of continuity aims at avoiding major changes in instruments and procedures, so that central banks and their counterparties can draw on experience when participating in monetary policy operations. The principle of safety requires that the Eurosystems financial and operational risks are kept to a minimum. Cost efficiency means keeping low the operational costs to both the Eurosystem and its counterparties arising from the operational framework.

How Does Monetary Policy Impact the Economy?

The Transmission Mechanism
What Is the Monetary Policy Transmission Mechanism?

Because of the impact monetary policy has on financing conditions in the economy (not just the costs, but also the availability of credit or banks willingness to assume specific risks) but also because of its influence on expectations about economic activity and inflation, monetary policy can affect the prices of goods, asset prices, exchange rates as well as consumption and investment. Interest rate cuts, for example, lower the cost of borrowing, which results in higher investment activitiy and the purchase of consumer durables. The expectation that economic activity will strengthen may also prompt banks to ease lending policy, which in turn enables businesses and households to boost spending. In a low interest-rate environment, shares become a more attractive buy, raising households financial assets. This may also contribute to higher consumer spending, and makes companies investment projects more attractive. Lower interest rates also tend to cause currencies to depreciate: Demand for domestic goods rises when imported goods become more expensive. All of these factors raise output and employment as well as investment and consumer spending. However, this stepped-up demand may cause prices and wages to rise if goods and labor markets are fully utilized. The process through which monetary policy decisions impact on an economy in general and the price level in particular is known as the monetary policy transmission mechanism. The individual links through which monetary policy impulses proceed are known as transmission channels. The main channels of monetary policy transmission are set out in a simplified, schematic form in the chart.

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The Impact of Monetary Policy Impulses on the Economy

Every monetary policy impulse (e.g. an interest rate change by the central bank, change in the monetary base resulting from changes in the minimum reserve rate) has a lagged impact on the economy. Moreover, it is uncertain how exactly monetary policy impulses are transmitted to the price level or how real variables develop in the short and medium term. The difficulty of the analysis is to adjust the effects of the individual channels for external factors. The effect of such external factors e.g. supply and demand shocks, technical progress or structural change may be superimposed on the effect of central bank measures, and it is difficult to isolate monetary policy effects on various variables for analytical purposes. Moreover, the time lag in the reaction of the real sector to monetary measures renders the analysis more difficult. Hence, monetary policy must be forward looking. The individual transmission channels are described in detail below: Interest rate channel: An expansion of the money supply by the central bank feeds through to a reduction of short-term market rates through this channel. As a result, the real interest rate and capital costs decline, raising investment. Additionally, consumers save less and opt for current consumption over future consumption. This, in turn, causes demand to strengthen. However, this

stepped-up demand may cause prices and wages to rise if goods and labor markets are fully utilized. Credit channel: The credit channel in effect breaks down into two different channels:
1. Bank lending channel: Central banks monetary policy decisions influence commercial banks refinancing costs; banks are inclined to pass the changes on to their customers. If financing costs diminish, investment and consumer spending rise, contributing to an acceleration of growth and inflation. However, following an increase in interest rates, the risk that some borrowers cannot pay back their loans in due course may increase so much that banks will not grant loans to these borrowers. As a result, borrowers would be forced to cut back on planned expenditure. 2. Balance sheet channel: Monetary policy may have a direct impact on corporate policy, because companies may borrow to improve return on equity as long as the return on debt in effect the lending rate is lower than the return on assets. Hence, the return on assets is a weighted arithmetic mean of the return on equity and the lending rate, which are respectively weighted by the share of equity and debt in total assets. Consequently, lower interest rates improve the return on equity. For this reason, nonprofitable enterprises may show a positive return on equity. However, this may reinforce the influence of interest rates on investment behavior, which is referred to as the financial accelerator effect. Exchange rate channel: Expansionary monetary policy affects exchange rates because deposits denominated in domestic currency become less attractive than deposits denominated in foreign currencies when interest rates are cut. As a consequence, the value of deposits denominated in domestic currency declines relative to that of foreign currency-denominated deposits and the currency depreciates. This depreciation makes domestic goods cheaper than imported goods, causing demand for domestic goods to expand and aggregate output to augment. This channel does not operate if a country has a fixed exchange rate; conversely, the more open an economy is, the stronger this channel is. Exchange rate fluctuations may also influence aggregate demand by affecting the balance sheets of banks and companies whose balance sheets include a large share of foreign currency-denominated debt. Interest rate reductions that entail a depreciation of the national currency raise the debt of domestic banks and companies which have foreign currency-denominated debt contracts. Since assets are typically denominated in domestic currency and therefore do not increase in value, net worth declines automatically. If balance sheets deteriorate, the risk that some borrowers cannot pay back their loans in due course may increase so much that banks will not grant loans to these borrowers. As a result, borrowers would be forced to cut back on planned expenditures. Wealth channel: Monetary policy impulses are also transmitted through the price of assets such as stocks and real estate. Fluctuations in the stock or real estate markets that are influenced by monetary policy impulses have important impacts on the aggregate economy. The expansionary monetary policy effects of lower interest rates make bonds less attractive than stocks and result in increased demand for stocks, which bids up stock prices. Conversely, interest rate reductions make it cheaper to finance housing, causing real estate prices to go up. There are three different types of transmission mechanisms involving asset prices:

1. Investment effects: Tobins q theory explains an important mechanism through which movements in stock prices can affect the economy. Tobins q is defined as the market value of firms divided by the replacement cost of capital. If q is high, the market price of firms is high relative to the replacement cost of capital, and new plant and equipment capital is cheap relative to the market value of firms. Companies can then issue stock and get a high price for it relative to the cost of the facilities and equipment they have bought. Investment spending will rise because firms can now buy a relatively large amount of new investment goods with only a small issue of stock. An interest rate cut entailing a rise in stock prices will therefore reduce companies capital costs and consequently boost investment spending. 2. Wealth effects: Modiglianis life cycle model states that consumption is determined by the lifetime resources of consumers. These life cycle resources consist primarily of financial assets, mostly stock, and real estate. Interest rate cuts entail a rise in stock and real estate prices and accordingly boost household wealth. At the same time, consumers life cycle resources expand, in turn lifting consumer spending and aggregate demand. 3. Balance sheet effects: A rise in stock and real estate prices improves corporate and household balance sheets alike. Higher net worth translates into higher collateral for lending to companies and households. This in turn increases lending, investment spending and hence higher aggregate spending.