The policy objectives, tactics and instruments of central banks are normally the least visible facet of their operations. Academic and public attention tends to focus on issues such as whether price stability should be the sole ultimate objective, or whether a target should be set for inflation, output, or designated monetary aggregates. Operating procedures, however, can be just as important for a central bank’s success.
These operating procedures, in turn, affect the monetary transmission mechanism through which a central bank’s interest rate decision reaches financial markets and changes the money supply. Central banks typically manage the distribution of liquidity through open market operations. They stipulate the amount of cash that commercial banks must keep on hand to avoid running a risk of collapsing the payments and banking system; they set the interest rate they charge for short-term loans and buy and sell securities, mainly government IOUs.
Central bankers, like their counterparts in the private sector, often have different opinions on how best to achieve these operational objectives. One view, which was popular before the crisis, is that central banks should use the operation of the money market to achieve their policy objectives by adjusting the overall supply of central bank money. This approach has two boundaries: an upper limit on the overnight (O/N) money market interest rate, and a lower limit on the rate paid on reserves, if there is a remuneration for excess deposits.
This approach reflects a belief that the interbank money market can distribute money effectively and efficiently without the intervention of central bank facilities, which can cause disruptions in specific credit markets. Alternatively, some scholars argue that central banks should use their facilities to target specific markets, such as the purchase of commercial paper or mortgage-backed securities, to ensure that financial intermediation remains functioning during crises.
