LECTURE FIVE:

THE TOOLS OF MONETARY POLICY

BY
MR. B. M. SIMAUNDU
INTRODUCTION

 The Monetary Policy is a process whereby the monetary authority, generally the
central bank controls or regulates the money supply in the economy.
 The central bank uses several instruments of monetary policy, referred to as
monetary variables at its discretion, to regulate the credit availability and liquidity
(money supply) in a manner that controls inflation and at the same time stimulate the
growth of the economy.
 The instruments of monetary policy are also called as “weapons of monetary policy”.
These instruments can be categorized as:
CONT’D
QUANTITATIVE MEASURES

 These are the traditional measures of monetary control. All the quantitative methods
affect the entire credit market in the same direction. This means their impact on all
the sectors of the economy is uniform.
 But however it does not take into consideration the objectives of credit control. The
quantitative measure includes the following methods:
 Open Market Operations
 Bank Rate or Discount Rate
 Cash Reserve Ratio
SELECTIVE CREDIT CONTROLS

 Since the objectives of credit control are not served by the quantitative methods, the
economists rely on selective control methods to fulfill the purpose. The credit
objectives may include rationing the credit, directing the flow of credit from least
important sectors to the most important sectors, controlling a speculating tendency
based on the availability of bank credit. Thus, these objectives are very well served by
the
 selective control methods. It includes the following monetary measures:
 Credit Rationing
 Change in Lending Margins
 Moral Suasion
CONT’D

 In addition to these measures, the central bank uses a Liquidity Adjustment Facility,
Repo Rate, and Reverse Repo Rate, to control and regulate the money supply in the
economy.
 The Repo Rate is the rate at which commercial banks borrow from Central Bank
while the Reverse Repo Rate is the opposite of Repo rate.
 It is the rate at which Central Bank borrows from the commercial banks against the
government securities.The Central keeps changing these rate at its discretion.
 The Repo Rate increases the money supply while the Reverse Repo Rate decreases
the money supply in the economy.
RESERVE REQUIREMENTS

 By law, deposit money banks are obliged to hold a specified proportion of

their deposits in cash or near-cash assets known as reserve requirements.
 Banks are prohibited from using such reserves to extend loans to customers.
An increase in this requirement would limit the amount of loans that a bank is
able to extend to its clients, whereas a reduction would increase the amount
of funds available for lending.
 The Central Bank then, is able to influence the supply of money by either
increasing or decreasing this requirement.
CONT’D

 There are two types of reserve requirements employed by the Bank.

 In accordance with the Central Bank, banks are required to maintain
primary reserves referred to as the 'Statutory Reserve', against
their domestic currency liabilities.
 The Central Bank is also empowered to impose a secondary reserve,
called the Liquid Asset Ratio (LAR), which mandates banks to maintain an
average ratio of liquid assets in relation to their Kwacha deposit
liabilities.
DISCOUNT RATE (BANK RATE)

 Discount (Bank) Rate and how does it relate to Discount Policy?

 The Discount or Bank Rate, which is set by the Central Bank, is the interest rate charged by the Bank
on loans to banks. Commercial banks usually respond to changes in the Discount Rate with
proportionate changes in their Prime Lending Rate.
 The Discount Rate is an instrument of Discount Policy, and is used by the Bank to influence the flow
of money and credit in a desired direction.
 For instance, since people's borrowing decisions, whether for investment or consumption purposes, is
influenced by the interest rate charged on that borrowing, an increase(decrease) in the
 Discount Rate signals a desire by the Bank to slow(quicken) the rate of increase in credit expansion,
since higher(lower) interest rate charges are likely to discourage(encourage) new borrowing.
CONT’D

 The Bank Rate also called as a Discount Rate is the rate at which the commercial bank rediscounts
their bills of exchange from the central bank.
 The bank rate is the standard rate at which the bank buys or rediscounts the bills of exchange and
other commercial papers that can be purchased. Only the approved bills and first-class bills of
exchange can be produced for rediscounting.
 Why do commercial banks get their bills of exchange rediscounted? Whenever the commercial banks
are faced with the shortage of cash reserves, they approach the central bank to borrow money by
discounting their bills of exchange.
 The central bank rediscounts the commercial papers or bills of exchange because it is the function of
the central bank- it is the lender of the last resort. The central bank charges a rate for rediscounting
the bills of exchange; this rate is traditionally called as a Bank Rate and more appropriate name used
today is Discount Rate.
CONT’D

 The central bank can raise or reduce the bank rate at its discretion, based on whether
the commercial bank’s flow of credit is to be increased or decreased. Such as, if the
central bank wants to increase the credit creation capacity of the banks, will reduce the
bank rate and vice-versa.
 This action of the central bank is termed as bank rate policy or discount rate policy.
 The working of the bank rate policy is quite simple. When the central bank changes the
discount rate, the commercial banks also change their discount rates. Such as, if the
central bank increases the discount rate the commercial bank also increases the discount
rate and vice-versa.
 Often, the central bank rate is one percentage point higher than the commercial bank
discount rate.
CONT’D

 Let us see how the change in the bank rate affects the availability of credit.
Suppose the central bank seeks to control the flow of credit and to achieve this
objective it raises the discount rate.The flow of credit will be reduced in three ways:
 1. The net worth of the government securities reduces with an increase in
the discount rate against which the commercial banks borrow money
from the central bank.
 This reduces the bank’s capacity to borrow funds and as a result, the commercial
banks find it difficult to maintain a high cash reserve.
 Ultimately, the credit creation capacity of the commercial banks is reduced and as a
consequence, the flow of credit to the market is also reduced.
CONT’D

 2. As the central bank raises the discount rate, the commercial banks also increase the
discount rate due to which the business sectors get discouraged to get their bills of
exchange discounted.
 Besides, a rise in the bank rate leads to an upward shift in the interest structure. This rise in the
interest rate discourages the borrowings or the demand for funds reduces. Such policy is therefore
called as “dear money policy”.
 3. The lending rate is quickly adjusted to deposit rates and hence a rise in the bank rate
causes an increase in the deposit rate. As a result, the borrowers become depositors and the
savings flow into the banks in the form of deposits.This is known as a “deposit mobilization effect”.
 Thus, the bank rate is the rate that the central bank charges against the lending to the commercial
banks.
OPEN MARKET OPERATIONS (OMOS)

 Open market operations (OMO) refers to the buying and selling of government
securities in the open market in order to expand or contract the amount of money
in the banking system, facilitated by the Central Bank.
 Purchases inject money into the banking system and stimulate growth, while sales of
securities do the opposite and contract the economy. The Central Bank's goal in
using this technique is to adjust and manipulate the BOZ funds rate, which is the rate
at which banks borrow reserves from one another.
 The Open Market Operations refers to the sale and purchase of government
securities and treasury bills by the central bank of the country with a view to
regulate the supply of money in the economy.
CONT’D
 When the central bank wants to increase the money supply in the economy, it purchases
the government securities, i.e., bills, and bonds.
 On the other hand, the central bank sells the government bonds and securities if the
money supply is to be curtailed. The open market operations are one of the most widely
used measures of monetary control.
 The central bank carries out its open market operations through the commercial banks,
i.e. it does not deal directly with the public.
 The major buyers of government bonds comprise of commercial banks, financial
institutions, big business corporations, and individuals with high savings.
 These buyers hold their respective accounts in the banks and on the purchase of the
government bonds the money gets transferred to the Central Bank account.
CONT’D

 Thus, the open market operations affect the bank’s deposits and reserves and their ability to create
credit.
 For example, when the central bank plans to reduce the money supply and the availability of credit to
the public, will offer the government bonds and securities for sale through the commercial banks. The
sale of government securities will affect both the supply of and demand for credit.
 As regard the supply of credit gets adversely affected in the following ways:
 1. The buyers of government bonds and securities often pay through a cheque drawn on the
commercial bank in the favor of the central bank. Thus, at the time of a sale of government security,
the money is transferred from the buyer’s account to the central bank account. This reduces the
deposits and reserves of the commercial banks. Due to which the credit creation capacity of the
commercial bank reduces. As a consequence, the flow of credit to the society from the commercial
bank also reduces.
CONT’D

 2. When the commercial bank buys the government bonds and securities themselves,
their cash reserves reduces. This further reduces their credit creation capacity and as a result, the
flow of credit to the society further reduces.
 3. As regards the demand for credit, when the central bank sells the government bond
and securities, their prices go down, and the rate of interest goes up. As a result, there is an
upward shift in the interest rate structure. With an increased rate of interest the demand for credit
decreases. Thus, the open market operations affect not only the supply of but also the demand for
credit.
 4. On the other hand, if the central bank decides to increase the money supply will buy
back the government securities, then the money will flow out from the central bank
account to the people’s account with the commercial banks. As a consequence, the deposits
and the reserves of the commercial banks increases. This enhances their credit capacity and as a result,
the flow of credit from the banks to the public also increases.
ADVANTAGES OF OPEN MARKET OPERATIONS

Open market operations have several advantages over the other tools of monetary policy.
 1 . Open market operations occur at the initiative of the Fed, which has complete control
over their volume. This control is not found, for example, in discount operations, in which
the Fed can encourage or discourage banks to borrow reserves by altering the discount rate
but cannot directly control the volume of borrowed reserves.
 2. Open market operations are flexible and precise; they can be used to any extent. No
matter how small a change in reserves or the monetary base is desired, open market
operations can achieve it with a small purchase or sale of securities. Conversely, if the
desired change in reserves or the base is very large, the open market operations tool is
strong enough to do the job through a very large purchase or sale of securities.
CONT’D

 3. Open market operations are easily reversed. If a mistake is made in conducting an

open market operation, the Fed can immediately reverse it. If the trading desk
decides that the federal funds rate is too low because it has made too many open
market purchases, it can immediately make a correction by conducting open market
sales.
 4. Open market operations can be implemented quickly; they involve no
administrative delays. When the trading desk decides that it wants to change the
monetary base or reserves, it just places orders with securities dealers, and the
trades are executed immediately.
CASH RESERVE RATIO (CRR)

 Banks in Zambia are required to hold a certain proportion of their deposits in the form of
cash. However Banks don't hold these as cash with themselves, they deposit such cash (aka currency
chests) with Bank of Zambia, which is considered as equivalent to holding cash with themselves. This
minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the BOZ and
is known as the CRR or Cash Reserve Ratio.
 When a bank's deposits increase by K100, and if the cash reserve ratio is 9%, the banks will have to
hold K9 with BOZ and the bank will be able to use only K91 for investments and lending, credit
purpose.
 Therefore, higher the ratio, the lower is the amount that banks will be able to use for lending and
investment. This power of Bank of Zambia to reduce the lendable amount by increasing the CRR,
makes it an instrument in the hands of a central bank through which it can control the amount that
banks lend.Thus, it is a tool used by BOZ to control liquidity in the banking system.
CONT’D

 The objective of maintaining the cash reserve is to prevent the shortage of funds in meeting
the demand by the depositor. The amount of reserve to be maintained depends on the bank’s
experience regarding the cash demand by the depositors. If there had been no government
rules, the commercial banks would keep a very low percentage of their deposits in the form
of reserves.
 Since cash reserve is non-interest bearing, i.e. no interest is paid on the deposits, therefore,
the commercial banks often keep the reserve below the safe limits. This might lead to a
financial crisis in the banking sector.
 Thus, in order to avoid such uncertainty the central bank imposes a cash reserve ratio or
CRR on commercial banks. The central bank has the legal power to change the CRR any
time at its discretion. The cash reserve ratio is a legal requirement and therefore it is also
called as a Statutory Reserve Ratio (SRR).
CONT’D

 Through a cash reserve ratio, the central bank can change money supply in the economy.
Such as, when the economy demands a Contractionary Monetary Policy the central bank
will raise the CRR. On the other hand, when the economic conditions, demand for an
Expansionary Monetary Policy the central bank cuts down the CRR.
 The effect on the supply of money and credit due to the change in CRR is explained
below:
 Suppose a commercial bank has total deposits of K150 million and CRR is 20%. It means
a bank can loan K120 million (150*20/100 = 30 million), and the credit of deposit
multiplier is equal to Five (deposit multiplier, Dm = 1/CRR = 1/0.20). This means a bank
can create, through a credit multiplier a total credit of K750 million (150 *5) or an
additional credit of K600 million (120*5).
CONT’D

 Now, if the central bank decides to curb the supply of money to the public raises the CRR to 25%. The
credit multiplier will go down to Four (1/0.25). By doing so, the commercial bank can now only give a
loan of K112.5 million (150 * 0.25 = 37.5 million).
 Thus, the total credit created by the commercial bank will go down to K600 million (150*4), and the
additional credit goes down to K450 million (112.5 * 4). A fall in the bank credit by K150 million will
have a great impact on the money market.
 The cash reserve ratio method is more handy and effective where the open market operations and
bank rate policy proves to be ineffective.
 However, its efficiency with respect to its impact on the capital market depends on the banking credit
share in the credit market. In addition to CRR, the central bank has imposed another kind of reserve
called as Statutory Liquidity Ratio (SLR).
STATUTORY LIQUIDITY RATIO (SLR)
 The Statutory Liquidity Ratio (SLR) refers to the proportion of deposits the
commercial bank is required to maintain with them in the form of liquid assets in
addition to the cash reserve ratio.
 Every bank is required to maintain at the close of business every day, a minimum
proportion of their Net Demand and Time Liabilities as liquid assets in the form of
cash, gold and un-encumbered approved securities.
 The ratio of liquid assets to demand and time liabilities is known as Statutory
Liquidity Ratio (SLR).
 Bank of Zambia is empowered to increase or decrease this ratio. An increase in SLR
also restricts the bank's leverage position to pump more money into the economy.
CONT’D

 Net Demand Liabilities - Bank accounts from which you can withdraw your money at
any time like your savings accounts and current account.
 Time Liabilities - Bank accounts where you cannot immediately withdraw your
money but have to wait for certain period. E.g. fixed deposit accounts.
 In the definition, the liquid assets are the assets readily convertible into cash, includes
government bonds, or government approved securities, gold, and cash reserve.
 The objective of statutory liquidity ratio is to prevent the commercial banks from
liquidating their liquid assets during the time when CRR is raised.
CONT’D

 The statutory liquidity ratio is determined by the central bank as the percentage of total
demand and time liabilities. The time liabilities refer to the liabilities of a bank which is to
be paid to the customer anytime the demand arises and are the deposits of the
customers which are to be paid on demand.
 The statutory liquidity ratio is determined and maintained by the central bank to control
the bank credit, ensure the solvency of commercial banks and compel banks to invest in
the government securities. By changing the SLR, the flow of bank credit in the economy
can be increased or decreased. Such as, when the central bank decides to curb the bank
credit so as to control the inflation will raise the SLR. On the contrary, when the
economy faces recession, and the central bank decides to increase the bank credit will
cut down the SLR.
CONT’D

 A penalty at a rate of 3% per annum above the bank rate is imposed if

any commercial bank fails to maintain the statutory liquidity ratio.
 Further, a penalty at a rate of 5% per annum above the bank rate is
imposed on a defaulter bank if it continues to default on the next
working day.
 The central bank imposes such a restriction on the commercial banks so
that the funds are readily made available to the customers on their
demand.
MORAL SUASION

 A moral suasion is a persuasion tactic used by an authority (i.e. Bank of Zambia) to influence and
pressure, but not force, banks into adhering to policy.
 Tactics used are closed-door meetings with bank directors, increased severity of inspections, appeals
to community spirit, or vague threats.
 When a government or central bank uses persuasion rather than regulatory coercion to convince
financial sector participants to take a particular course of action.
 Monetary policy governmental guidance as a tool to persuade financial institutions to follow suggested
guidelines on the availability and cost of credit, instead of law-making power to mandate.
 Before mandatory compliance through statutory regulations, moral suasion plays through policy
announcements to induce a desired response.
CONT’D
 Moral Suasion refers to a method adopted by the central bank to persuade or convince the
commercial banks to advance credit in accordance with the directives of the central bank in the
economic interest of the country.
 Simply, the process in which the central bank requests or persuade the commercial banks to comply
with the general monetary policy of the central bank is called a moral suasion.
 Moral suasion is applied in addition to the quantitative and other selected methods, especially in the
situations where these methods prove to be less effective.
 The central bank relies heavily on this method where there are a large number of commercial banks,
with a view to accomplishing the objectives.
 Also, the central bank can request or convince the commercial banks to not to advance additional
credit to the public or finance the nonpriority industrial sectors.
CONT’D

 Under this method, the central bank writes letters or hold meetings with the
commercial banks with an aim to persuading banks to act according to the directives
regarding the money and credit matters of the central bank in the economic interest
of the country as a whole.
 The moral suasion develops a more psychological effect as the central bank makes an
appeal to the bank’s nationalism spirit.
 Thus we can say that the moral suasion is a psychological phenomenon of controlling
the credit in the economy.
 It is not subject to any law as it is purely informal and involves personal interaction
between the central bank and the commercial banks.
CONT’D

 The moral suasion is a more lenient method than other forms of

selective credit control methods as it does not involve any punitive
action or administration threat.
 Thus, it helps the central bank to gain the willing cooperation of the
commercial banks.
 The moral suasion proves to be effective only when the central bank
gets a full cooperation and respect for its directives from the commercial
banks.
PRUDENTIAL GUIDELINES

 The Central Bank may in writing require the Deposit Money

Banks to exercise particular care in their operations in order
that specified outcomes are realized.
 Key elements of prudential guidelines remove some discretion
from bank management and replace it with rules in decision
making.
CREDIT RATIONING

 Definition: The Credit Rationing is a measure undertaken by the central bank to limit
or deny the supply of credit based on the investor’s creditworthiness and an
increased loan demand.
 In other words, a situation where the central bank denies credit to the borrowers
who want funds and are willing to pay a higher interest rate is called a credit
rationing.
 This situation arises because of market imperfection or market failure as in spite of a
demand for funds at a current rate the lender is not either willing to loan more funds
or increase the interest rates.
CONT’D

 Credit rationing is often applied in the situations where there is a shortage of institutional credit
available for the business sector, the big and financially strong institutes try to capture a larger portion
of the institutional credit.
 As a result of which, the priority sector often the weaker, but essential industries are deprived of
necessary funds, mainly because the bank credit is given to the non-priority sectors.
 In order to control this situation, the central bank resorts to credit rationing measures.
 Typically, three measures are adopted:
 Imposing an upper limit on the credit available to the big firms or industries.
 Charging a higher and progressive interest rate on the loan amount after a certain limit.
 Offering credit to the weaker sectors at lower internal rates.
CONT’D

The Central Bank can direct Deposit Money Banks on the maximum
percentage or amount of loans (credit ceilings) to different economic
sectors or activities, interest rate caps, liquid asset ratio and issue credit
guarantee to preferred loans.
In this way the available savings is allocated and investment directed in
particular directions.
CONT’D

 All these measures are mainly undertaken with a view to making the credit available to the weaker industries.
 The credit rationing results not necessarily due to a credit shortage, but also due to asymmetric information.
 The forms of credit rationing can be distinguished as;
 (i) Rationing arising when the investor is not able to provide sufficient collateral,
 (ii) When specific group members, sharing the identifiable traits cannot obtain credit because of the supply of
loanable funds, but can be obtained if the supply is increased. These group members will not get loans even if they
pay a higher interest rate.This situation is called as Redlining,
 (iii)Pure credit rationing is a situation where the group members with indistinguishable traits, some obtain credit
while some do not and will not get it even if they pay a higher interest rate,
 (iv) Disequilibrium credit rationing is a feature of the market occurred due to some friction preventing the
clearance of the credit.
LENDING MARGIN

 The Lending Margin refers to the gap between the value of the property mortgaged, against which the
loan is borrowed, and the actual amount advanced to the borrower.
 In the above definition, Margin denotes the collateral that the investor has to deposit with a bank so as
to cover some or all the credit risk as posed on the banks by the borrower.
 The risk arises if the holder has borrowed funds from the bank, entered into the derivative contract
or has sold the financial instruments short.
 The banks often lend money against a mortgage of property Viz., Building, land, shares, the stock of
goods, jewelry, etc. Only a certain percentage of the value of a mortgaged property is provided in the
form of a loan.
 For example, if the value of a building is K50 million and the amount advanced is only K30 million, the
lending margin is 40 percent (50-30/50 * 100).
CONT’D

 The central bank has the power to increase or decrease the lending
margin with a view to increasing or decrease the bank credit.
 Such as, when the central bank decides to reduce a bank credit to
overcome the inflation, raises the lending margin.
 On the contrary, when the central bank decides to increase the bank
credit cuts down the lending margin.
QUANTITATIVE EASING (QE)
 What Is Quantitative Easing (QE)?
 Quantitative easing (QE) is a form of unconventional monetary policy in which a central
bank purchases longer-term securities from the open market in order to increase the money
supply and encourage lending and investment.
 Buying these securities adds new money to the economy, and also serves to lower interest
rates by bidding up fixed-income securities. It also expands the central bank's balance sheet.
 When short-term interest rates are either at or approaching zero, the normal open market
operations of a central bank, which target interest rates, are no longer effective. Instead, a
central bank can target specified amounts of assets to purchase.
 Quantitative easing increases the money supply by purchasing assets with newly-created
bank reserves in order to provide banks with more liquidity.
CONT’D

 To execute quantitative easing, central banks increase the supply of money by buying government
bonds and other securities.
 Increasing the supply of money lowers the cost of money—the same effect as increasing the supply of
any other asset in the market. A lower cost of money leads to lower interest rates. When interest
rates are lower, banks can lend with easier terms.
 Quantitative easing is typically implemented when interest rates are approaching zero because, at this
point, central banks have fewer tools to influence economic growth.
 If quantitative easing itself loses effectiveness, a government's fiscal policy may also be used to further
expand the money supply.
 As a method, quantitative easing can be a combination of both monetary and fiscal policy; for example,
if a government purchases assets that consist of long-term government bonds that are being issued in
order to finance counter-cyclical deficit spending.
THE DRAWBACKS OF QUANTITATIVE EASING

 If central banks increase the money supply too quickly, it can cause inflation.
 This happens when there is increased money but only a fixed amount of goods available
for sale when the money supply increases.
 A central bank is an independent organization responsible for monetary policy, and is
considered independent from the government.
 This means that while a central bank can give additional funds to banks, they can't force
the banks to lend this money to individuals and businesses.
 If this money does not end up in the hands of consumers, the lending to the banks will
not impact the money supply, and therefore will be ineffective at stimulating the economy.
CONT’D

 Another potentially negative consequence is that quantitative easing generally

causes depreciation in the value of the home country's currency.
 Depending on the country, this can be a negative. It is good for a country's
exports, but bad for imports, and can result in the country's residents having to
pay more money for imported goods.
 Example: Quantitative easing is considered an unconventional monetary policy, but
it has been implemented a lot in recent times.
 Following the global financial crisis of 2007-08, the U.S. central bank, the Federal
Reserve, implemented several rounds of quantitative easing. More recently, the Bank
of Japan and the European Central Bank have implemented QE.
THE USE OF INTERMEDIATE TARGETS AS METHODS OF
MONETARY CONTROL

Overnight rate
 The overnight rate is generally the interest rate that large banks use to
borrow and lend from one another in the overnight market.
 In some countries (the United States of America, for example), the
overnight rate may be the rate targeted by the central bank to influence
monetary policy.
 In most countries, the central bank is also a participant on the overnight
lending market, and will lend or borrow money to some group of banks.
CONT’D

 There may be a published overnight rate that represents an average of the rates at which banks lend
to each other; certain types of overnight operations may be limited to qualified banks.
 The precise name of the overnight rate will vary from country to country.
 Throughout the course of a day, banks will transfer money to each other, to foreign banks, to large
clients, and other counterparties on behalf of clients or on their own account.
 At the end of each working day, a bank may have a surplus or shortage of funds (or a shortage or
excess reserves in fractional reserve banking).
 Banks that have surplus funds or excess reserves may lend them (often at a multiple of their legal
reserve ratio, if any) or deposit them with other banks, who borrow from them. The overnight rate is
the amount paid to the bank lending the funds.
CONT’D

 Banks will also choose to borrow or lend for longer periods of time, depending
on their projected needs and opportunities to use money elsewhere.
 Most central banks will announce the overnight rate once a month.
 In Canada, for example, the Bank of Canada sets a target bandwidth for the
overnight rate each month of +/- 0.25% around its target overnight rate: the Bank
of Canada does not interfere in the overnight market so long as the overnight
rate stays within its target band, but the Bank will use its reserves to lend or
borrow in the overnight market to ensure that the overnight rate stays within its
announced bandwidth.
MEASURE OF LIQUIDITY

 Overnight rates are a measure of the liquidity prevailing in the economy.

 In tight liquidity conditions, overnight rates shoot up.
 Overnight rates may also shoot up due to lack of confidence amongst banks, as was
observed in the liquidity crunch of 2008. In order to measure liquidity situation, the spread
between risk-free rates and overnight rates is considered.
 The TED spread is a liquidity indicator for the U.S., which is the difference between LIBOR
and Treasury bills. The TED spread is the difference between the interest rates on interbank
loans and on short-term U.S. government debt. TED is an acronym formed from T-Bill and
ED, the ticker symbol for the Eurodollar futures contract. The TED spread is an indicator of
perceived credit risk in the general economy, since T-bills are considered risk-free while
LIBOR reflects the credit risk of lending to commercial banks
CENTRAL BANK POLICY RATE

 The central bank policy rate (CBPR) is the rate that is used by central bank to
implement or signal its monetary policy stance.
 It is most commonly set by the central bank’s policy making committees (e.g. Fed
Open Market Committee in the US and the monetary policy Committee in Zambia).
 The underlying financial instrument of the CBPR varies per country and is explained
in the metadata.
 For instance, in some countries the CBPR is the discount rate while in others it is a
repurchase agreement rate
OPERATING TARGET OF MONETARY POLICY

 To achieve the price stability objective, reflected in low and stable inflation, the BoZ uses the monetary
policy framework in which the Policy Rate is the key interest rate in signaling the monetary policy
stance.
 The Policy Rate, introduced in April 2012, also provides a credible and stable anchor to financial
market participants in setting their own interest rates.
 The Monetary Policy Committee (MPC) of the Bank of Zambia meets quarterly to decide on the
Policy Rate.
 However, the MPC can meet at any other time during the year should conditions warrant a change in
the monetary policy stance.
 A press release is issued a day after the MPC Meeting to explain the MPC decision on the Policy Rate.
Changes to the Policy Rate are guided by a comprehensive set of economic indicators that inform
short- and medium-term risks to price stability.
CONT’D

 The Policy Rate is expected to influence the overnight interbank rate (operating
target) which in turn impacts on inflation through changes in market interest rates
which are transmitted via the expectations, exchange rate and/or credit channels.
 To effectively manage the overnight interbank rate, the BoZ conducts open market
operations to either supply or withdraw liquidity from the banking system in volumes
required to keep the overnight interbank rate within the corridor of +/- 2
percentage points around the Policy Rate.
 However, the interbank rate may be allowed to move outside the Policy Rate
corridor in exceptional circumstances.
CONT’D

 The Policy Rate corridor defines the band within which the overnight interbank
rate is allowed to fluctuate in line with the inflation target set by the Government.
 If the overnight interbank rate moves above the upper limit of the corridor, the BoZ
supplies funds to commercial banks in order to influence the overnight interbank
rate downwards towards the Policy Rate.
 Conversely, the BoZ withdraws funds from the banking system when the interbank
rate falls below the corridor in order to drive it up towards the Policy Rate.
CONT’D
CONT’D

 The BoZ may use other monetary policy instruments

such as the statutory reserve ratio and Overnight
Lending Facility to provide short-term liquidity
assistance to commercial banks to influence liquidity
conditions and ultimately the overnight interbank rate.
THE END QUESTIONS???