How Are Open Market Operations Related to Other Monetary Instruments?

How Are Open Market Operations Related to Other Monetary Instruments?

Open market operations affect the money supply and related financial measures through their impact on the reserve base of the banking system. As a matter of monetary policy tactics in controlling these reserves, open market operations can be conducted in one of two ways: actively, by aiming for a given quantity of reserves and allowing the price of reserves (that is, the interest rate) to fluctuate freely; or passively, by aiming at a particular interest rate, allowing the amount of reserves to fluctuate. Industrial countries, with well-developed and sensitive markets, normally employ a passive approach, although there have been exceptions. A passive approach also appears to be the norm in emerging markets that have reached a certain level of sophistication. There are advantages to a more active approach in developing countries, however. In such countries, the absence of efficient secondary or interbank markets--to transmit the influence of monetary policy--might be one reason for an active approach. Another might be that the active approach allows the central bank to define its policies more clearly, especially when control of inflation is the overriding goal. Such an approach is embodied in a number of programs supported by the International Monetary Fund for particular countries.

If open market operations are to become the principal policy instrument, other monetary instruments obviously need to be given less importance, particularly the central bank's discount window, where the banking system can obtain reserves on its own initiative simply by borrowing from the central bank. Other adjustments may also be needed, depending in part on the particular strategy adopted for conducting day-to-day open market operations.

Discount Window Policy

For open market operations to be effective, limitations need to be placed on the access of banks to borrowing from the central bank at the discount window. Without such limitations, open market operations could not be used as the principal monetary instrument for controlling bank reserves and overall financial conditions. The discount window should therefore be designed to make access to the central bank's credit less attractive in one way or another, perhaps through a high penalty rate or restrictive guidelines. Some countries, such as Germany, employ a dual rate structure, comprising a basic discount rate and a penalty Lombard rate, to discourage overuse of this facility.

Restrictions on the discount window need, however, to be handled with care. If a penalty rate is set well above current market conditions, the system might not react quickly enough to unanticipated liquidity demands. Guidelines that restrict access to the window ought to permit smooth adjustment when reserve shortages occur. In a tight money period, borrowing from the central bank for very limited periods allows banks to make more orderly portfolio adjustments. Such short-term borrowing at the discount window should be differentiated from longer-term structural borrowing at the window, which, among other things, allows emergency long-term advances to institutions in severe operating difficulties.

Reserve Requirements

In addition to use of the discount window, imposing reserve requirements has traditionally been used by central banks as a means of monetary control. The ability to vary the proportion of assets that banks are required to hold in reserve is an obvious means of controlling the money supply. Reserve requirements can be regarded as either an alternative to open market operations or a way of enhancing their effectiveness for monetary control purposes. Since the use of open market operations has become more widespread, central banks have, in fact, had less recourse to changes in reserve requirements, which are a relatively crude tool. In many countries, they have also gradually been lowered and, in some cases, eliminated, since such requirements can place banks at a significant competitive disadvantage to other institutions providing similar services.

A minimum binding level of reserve requirements may be useful in helping to gauge the impact of open market operations on interest rates and the money supply. The experience of some countries that do not impose reserve ratios, such as the United Kingdom, may suggest that they are not really necessary. On the other hand, the financial crisis at the end of 1994 in Mexico, which had abolished reserve requirements, raises questions about whether such requirements--and the ability to vary them--could still play a useful role. They may be particularly useful in circumstances where bank liquidity needs to be adjusted rapidly in markets that are thin, and where the central bank needs to give clear, swift, and unambiguous signals