I Overview

Bernard Laurens
Published Date:
December 2005
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Central bankers around the world generally agree on the benefits for the economy of using market-based instruments to implement monetary policy. Following a trend initiated in the 1970s in industrial countries, central banks in most developing countries and emerging market economies have attempted to regulate overall liquidity conditions in the economy through financial operations in the domestic money markets. The objective of these central banks has been to influence the underlying demand and supply conditions for central bank money. The move was the parallel in the monetary area of the trend toward enhancing the role of price signals in the economy in general. It aimed at improving domestic savings mobilization and strengthening their market allocation.

The process was not without difficulties in those countries that did not succeed in developing their money markets. A survey of country experiences shows that failure to establish a clear separation between money creation and government funding needs often limited the effectiveness of money market operations, as did limited market participation and the lack of an effective framework to determine the timing and size of the central bank’s money market operations.

The experience of countries at different stages of money market development shows that the timing and speed of moving toward reliance on money market operations to conduct monetary policy must be tailored to each country’s particular circumstances. A stylized sequencing can be mapped into a four-stage process:

  • Stage zero refers to the situation of post-conflict countries. Financial reforms involve reestablishing key functions in those areas where a central bank typically has responsibilities.
  • Stage one in the process involves developing financial intermediation. Monetary policy relies on rules-based instruments—that is, instruments based on the regulatory power of the central bank, such as reserve requirements or deposit or refinance facilities available to the banks on demand, under certain preset conditions.
  • Stage two involves fostering interbank market development. Money market operations can be introduced at this stage, but rules-based instruments retain an important role. Countries with limited market participation—for instance due to the small size of their economy—may not progress beyond stage two.
  • Stage three involves the diversification of markets. At the end of stage three, liquidity management can fully rely on money market instruments.

This paper supports the close integration of the work of the International Monetary Fund’s area departments (i.e., surveillance or use of resources) with the Fund’s technical assistance in monetary policy design and implementation. This integration is particularly relevant for countries in transition to market-based frameworks for the implementation of monetary policy.

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