Abstract

With the increased integration of world financial markets, developments in these markets are exerting more influence on exchange rate movements. Indeed, models of exchange rate determination usually include interest rates as one of the primary explanatory variables.1 Consequently, an understanding of the operation of financial markets in general, and the factors determining interest rates in particular, is essential for analyzing the behavior of exchange rates. Furthermore, monetary policies in the major industrial countries have a significant impact on financial markets. It is thus important to be able to identify these monetary policy actions in order to interpret the economic and financial ramifications of the actions. This paper contributes to the understanding of financial and exchange market developments by examining and comparing the instruments and procedures for implementing monetary policy in the short run that are currently employed by the central banks of the five major industrial countries—France, the Federal Republic of Germany, Japan, the United Kingdom, and the United States. Such an investigation of the procedures for implementing monetary policy helps to distinguish movements in variables that reflect changes in the current stance of monetary policy from those that do not, and thereby provides a better understanding of monetary policy actions and their links to exchange market developments.

With the increased integration of world financial markets, developments in these markets are exerting more influence on exchange rate movements. Indeed, models of exchange rate determination usually include interest rates as one of the primary explanatory variables.1 Consequently, an understanding of the operation of financial markets in general, and the factors determining interest rates in particular, is essential for analyzing the behavior of exchange rates. Furthermore, monetary policies in the major industrial countries have a significant impact on financial markets. It is thus important to be able to identify these monetary policy actions in order to interpret the economic and financial ramifications of the actions. This paper contributes to the understanding of financial and exchange market developments by examining and comparing the instruments and procedures for implementing monetary policy in the short run that are currently employed by the central banks of the five major industrial countries—France, the Federal Republic of Germany, Japan, the United Kingdom, and the United States. Such an investigation of the procedures for implementing monetary policy helps to distinguish movements in variables that reflect changes in the current stance of monetary policy from those that do not, and thereby provides a better understanding of monetary policy actions and their links to exchange market developments.

Monetary policy is implemented to achieve the ultimate goals of the monetary authorities, which tend to focus on output and inflation objectives. However, these variables are not directly controllable by the central banks. Moreover, because of the lack of timely and accurate information on output and prices, as well as because monetary policies affect prices and output with a lag, monetary authorities generally use intermediate target variables that are closely related to output and prices but that are more controllable by the central bank and for which more timely information is available. Since the mid-1970s, a number of central banks have used the growth of a monetary aggregate as an intermediate target. However, as the relationship between monetary aggregates and economic activity has become less predictable, especially in the 1980s, and hence, as monetary aggregates have become less reliable indicators of monetary conditions, monetary authorities have placed greater emphasis on short-term interest rates and exchange rates as intermediate targets than on monetary aggregates.

The exchange rate mechanism of the European Monetary System (EMS) provides clear evidence of the role of exchange rates in influencing monetary policy; the commitment of EMS participants to maintain their exchange rates within agreed limits has often led them to undertake policy measures aimed at exchange rate objectives. Moreover, the intensified economic policy coordination among the Group of Seven countries,2 initiated by the Plaza Agreement in September 1985, has enhanced the role of exchange rates as a guide for policy in all of the major industrial countries. Thus, the monetary policy measures and operating procedures described below may indeed be undertaken in order to achieve particular exchange rate objectives.

Implementation of Operating Procedures in the Interbank Market

Whichever intermediate target is chosen by a central bank, it must implement an operating procedure that enables it to achieve the desired level of the targeted variable. For the central banks of the five major industrial countries, it is useful to focus on the control of the reserves (or liquidity) of the banking system as the central component of their operating procedures. This is both because bank reserves are a liability item in a central bank’s balance sheet and hence can be easily and precisely controlled and because changes in bank reserves influence the ability of banks to extend credit and hence affect both short-term interest rates and growth in the monetary aggregates.

An operating procedure using bank reserves can be characterized, at the two ends of the spectrum, as setting either the price (that is, the interest rate) or the quantity of reserves so as to achieve the intermediate target. In particular, given banks’ demand for reserves (determined primarily by the economy’s demand for credit and for money balances held both for transaction and saving purposes), a central bank can, at one extreme, choose to supply whatever amount of reserves is demanded by banks (usually through the sale or purchase of securities) at an interest rate deemed to be consistent with its intermediate and ultimate objectives. In this case, as shown in Figure 1, the short-run supply of reserves would be infinitely elastic, as indicated by S1, at the desired interest rate shown by i*; the quantity of reserves provided to the banking system would depend entirely on the position of the demand for reserves, shown by D1. Alternatively, at the other extreme, a central bank could supply the particular quantity of reserves thought to be consistent with its policy objectives and allow the short-run interest rate to be determined by the banks’ demand for reserves. As a result, the short-run supply of reserves would be completely inelastic, as indicated by S2, at the desired level of reserves, R*, and the interest rate prevailing in the interbank market would depend entirely on the demand for reserves.

Figure 1.
Figure 1.

Operating Procedures and the Market for Bank Reserves

Whether the management of reserves should be directed toward maintaining a particular quantity or a particular interest rate depends importantly on the nature of the shocks that affect the demand for reserves.3 On the one hand, if a rise to D2 in the level of reserves that banks wish to hold reflects an unanticipated increase in economic growth that is above that desired or anticipated by the central bank, then accommodating this enlarged demand by supplying reserves along S1 will tend to involve some acceleration in the growth of monetary aggregates, which could ultimately place upward pressure on prices and jeopardize the inflation objective of the central bank. If, however, the monetary authority does not accommodate this increased demand and instead supplies only R* of reserves, that is, the supply curve is S2, interest rates will rise, thereby dampening the tendency toward faster economic growth and greater inflation pressures and helping to keep the economy on the growth and inflation paths desired by the central bank.

On the other hand, if the increased demand for reserves is generated by an unanticipated increase in the demand for money associated with a concomitant decrease in demand for other financial assets, including those denominated in foreign currencies, and this larger demand is accommodated by supplying reserves along S1, then sufficient reserves will become available to support the higher desired level of the money stock, and domestic output and inflation will not be affected. However, if the increased reserve demand is not accommodated and only R* reserves are supplied, then interest rates will rise and output and employment will decline below the levels desired by the central bank. To summarize, central banks can more easily achieve their ultimate objectives regarding output, employment, and inflation by maintaining a relatively inelastic supply of bank reserves when shocks to reserves reflect predominantly economic growth, whereas if shocks are primarily to the demand for money, they can more easily achieve their objectives by maintaining a relatively elastic supply of reserves.4

To the extent that shocks to the demand for money have become more prevalent in the 1980s, operating procedures have tended to focus more on dampening fluctuations in short-run interest rates.5 While moderating large fluctuations in short-term interest rates is a common element in the operating procedures of the monetary authorities in the five major industrial countries, these procedures do not attempt to regulate or rigidly control interest rates, but rather to influence what are primarily market-determined variables.

The Convergence of Operating Procedures

It is important to note that even though the procedures employed by the five major industrial countries for implementing monetary policy have become more similar, their evolution has been quite dissimilar. In the United Kingdom and the United States, where capital markets are already well developed and open market operations have been the major instrument of monetary policy, changes in operating procedures over the past decade or so have not involved major modifications to existing techniques of monetary control. In the early 1980s, the United Kingdom discontinued the use of the minimum lending rate and intensified the role of open market operations, in order to provide additional interest-rate flexibility so that financial markets could respond to shocks in a more timely manner. Since these changes were introduced, however, little adjustment has been made to the operating procedures even though several different intermediate targets have been used since the early 1980s.

In the United States, the only significant change in the implementation of policy during the past decade has involved the variable that is the primary focus of the implementation procedures. During most of the 1970s, the Federal Reserve conducted open market operations to maintain the federal funds rate—the overnight interbank rate—within relatively narrow bands and in 1979 switched to a nonborrowed reserves operating target, with greater emphasis on monetary aggregates as intermediate targets, primarily to enhance its ability to reduce the rate of inflation. As the financial innovation and deregulation of the early 1980s rendered this approach less effective and as inflation subsided, the Federal Reserve changed its operating objective to borrowing by banks from the Federal Reserve, a procedure that involves greater smoothing of short-term interest rate fluctuations and hence is very similar to targeting the federal funds rate.

In contrast to the changes in the United Kingdom and the United States, the adjustments to operating procedures during the last decade in the Federal Republic of Germany, France, and Japan have been much more far-reaching. Prior to the 1980s, the Deutsche Bundesbank controlled the liquidity of the banking system primarily through the provision of central bank credit and changes in the minimum reserve ratios. During the 1980s, however, the scope for further increases in rediscount quotas became more limited, there was virtually no room for reducing minimum reserve ratios, and the Lombard window, because of excessive use, was losing its role as a last-resort source of reserves. Consequently, the Bundesbank began to employ open market operations—particularly, security-based repurchase agreements—as the major instrument for liquidity management. In addition, in 1985 it raised, and has maintained, the Lombard rate so that it exceeded short-term market rates and thereby effectively became a penalty rate.

The substantial liberalization that occurred in financial markets in France and Japan necessitated major changes in the implementation of monetary policy in these countries. Before 1985, financial markets in France were highly segmented and monetary policy was implemented primarily through quantitative credit allocations. This system, which imposed extremely high financial intermediation costs on the French economy, resulted in a loss in international competitiveness as French financial institutions were increasingly unable to meet the needs of a domestic economy faced with growing international competition. In part to alleviate this problem, the French financial system was significantly restructured by consolidating and liberalizing financial markets and replacing credit allocations with open market operations as the primary instrument of monetary policy.

In Japan, the changes were similar, although less dramatic. In the early to mid-1970s, corporations did not have direct access to credit markets and hence were almost completely dependent for financing on banks, especially the large, dominant city banks. Within this environment, the Bank of Japan conducted monetary policy by allocating credit through its discount window. As corporations gained direct access to capital markets during the late 1970s and restrictions on international capital flows were reduced in 1980, corporations became less dependent on bank credit. In response, the Bank of Japan reduced the role of quantitative credit allocation and placed more emphasis on influencing short-term interest rates through interbank market operations as the main channel for implementing monetary policy. These operations are conducted in the interbank market because the secondary market for short-term government securities is still very underdeveloped in Japan.

This paper employs the analytical framework presented above to describe and to analyze the operating procedures currently employed by each of the five major industrial countries. A brief overview of the salient features of each country’s operating procedures is given in Tables 13. Table 1 describes the official and key money market interest rates that are integral to the implementation of monetary policy. As market operations are the major instruments of policy in all of the major industrial countries, Table 2 presents the types of instruments exchanged in these operations and the types of transactions made.6 Table 3 lists reserve requirements and maintenance periods. Although limited use is now made of changes in reserve requirements to manage reserves, these requirements still play an important technical role in most countries for the daily implementation of policy. Moreover, since interbank market interest rates frequently behave differently around the end of a reserve maintenance period, knowledge of these periods prevents misconstruing interest rate behavior associated with the end of a maintenance period as a change in policy.

Table 1.

Five Major Industrial Countries: Official and Key Money Market Interest Rates

article image

Literally translated as “rate on tender for repurchase agreement.”

Table 2.

Five Major Industrial Countries: Types of Financial Instruments Used in Central Bank Market Operations

article image

Legend:

GS = Government securities

CD = Certificates of deposit

CP = Commercial paper

CBB = Bills issued by central bank

PB = Private bills

FXS = Foreign exchange swaps

Includes securities issued by government-owned enterprises.

Consists of bills accepted by banks whose acceptances are eligible for discount at the Bank of England.

Includes, inter alia, commercial and industrial bills, promissory notes, and export and import bills.

May also include short-term credits to private enterprises with a maturity of two years or less.

Foreign exchange operations designed to manage the reserves of the banking system, not to influence the exchange rate.

Table 3.

Five Major Industrial Countries: Reserve Requirement Ratios1 and Maintenance Periods

(In percent)

article image

Requirements expressed as percent of reservable liability.

There are no reserve requirements for the purpose of conducting monetary policy. Some liquidity requirements are maintained for prudential purposes.

The first $3.2 million of reservable liabilities at each depository institution is not subject to reserve requirements.

Maximum requirement on demand deposits exceeding DM 100 million; requirements are lower for smaller demand deposit totals.

Maximum requirement on demand deposits exceeding ¥ 1.2 trillion; requirements are lower on smaller demand deposit totals.

Maximum requirement in 1990 on demand deposits exceeding $41.5 million with this critical amount changed annually. On deposits equal to or less than $41.5 million, the requirement is 3 percent.

On time deposits; on savings deposits the ratio is 4.15 percent.

Maximum requirement on time deposits exceeding ¥ 2.5 trillion; requirements are lower on smaller time deposit totals.

Requirement on nonpersonal time deposits with an original maturity of less than one and one half years. No requirement on personal time and saving deposits or on nonpersonal time deposits with an original maturity of more than one and one half years.

Small requirements (0.5 percent or less) on foreign currency liabilities to nonresidents and on certain trusts.

On Eurocurrency liabilities.

The paper examines the operating procedures from the point of view of their influence on the banking system’s liquidity and on money market interest rates. The analysis includes a description of the time frame within which monetary policy is implemented, the instruments that are employed and their use, and the variables that can be construed as signals of a change in the policy stance of central banks.7 The paper concludes with a section that compares and contrasts the operating procedures of the five countries.

1

See, for example, Isard (1988) for a discussion and references.

2

The five major industrial countries plus Canada and Italy.

3

The demand and supply curves for reserves are continuously subjected to small, day-to-day, frequently offsetting shocks that the monetary authorities in the five major industrial countries typically accommodate. The following analysis involves shocks that are large enough and are sustained long enough that they may affect the monetary authorities’ ability to achieve their objectives.

4

See Poole (1970) and Sellon and Teigen (1981) for a more complete and rigorous discussion.

5

For a discussion of how financial innovation during the 1980s has generated increased shocks to the demand for money, see Bank for International Settlements (1984).

6

Market operations are primarily open market operations (that is, conducted in markets with varied participants and various financial instruments) in France, Germany, the United Kingdom, and the United States. In contrast, market operations in Japan are conducted largely in the interbank market, that is, only between banks.

7

Kneeshaw and Van den Bergh (1989) provide a good discussion of the instruments employed in daily money market intervention by the monetary authorities in the ten major industrial countries. The analysis here, however, emphasizes the way in which the procedures for implementing monetary policy function and how monetary authorities signal changes in policy.

instruments and Operations Procedures: Occa Paper No.70
  • Axilrod, Stephen H., “U.S. Monetary Policy in Recent Years: An Overview,” Federal Reserve Bulletin (Washington), Vol. 71 (January 1985), pp. 1424.

    • Search Google Scholar
    • Export Citation
  • Bank for International Settlements, Financial Innovation and Monetary Policy (Basle: Bank for International Settlements, 1984).

  • Bank of England, “Annex 3—Bank of England Dealings in the Sterling Money Market: Operational Arrangements,” Bank of England Quarterly Bulletin (London), Vol. 28 (August 1988), pp. 403409.

    • Search Google Scholar
    • Export Citation
  • Bank of France, “Instruction Réglementaire de la Banque de France Relative aux Actions sur le Marché Monétairé,” No. 586 (Paris, November 1986).

    • Search Google Scholar
    • Export Citation
  • Batten, Dallas S., and Daniel L. Thornton, “Discount Rate Changes and the Foreign Exchange Market,” Journal of International Money and Finance, Vol. 3 (December 1984), pp. 27992.

    • Search Google Scholar
    • Export Citation
  • Board of Governors of the Federal Reserve System, “Monetary Policy Report to Congress,” Federal Reserve Bulletin (Washington), Vol. 74 (August 1988), pp. 51733.

    • Search Google Scholar
    • Export Citation
  • Board of Governors of the Federal Reserve System, “Record of Policy Actions of the Federal Open Market Committee,” Federal Reserve Bulletin (Washington), Vol. 76 (February 1990), pp. 5560.

    • Search Google Scholar
    • Export Citation
  • Bruneel, Didier, “Recent Evolution of Financial Structures and Monetary Policy in France,” paper presented at Conference on Domestic and International Aspects of Macroeconomic Policy, University of Illinois, September 12–14, 1986.

    • Search Google Scholar
    • Export Citation
  • Cargill, Thomas F., “Japanese Monetary Policy, Flow of Funds, and Domestic Financial Liberalization,” Economic Review, Federal Reserve Bank of San Francisco (San Francisco), Summer 1986 (No. 3), pp. 2132.

    • Search Google Scholar
    • Export Citation
  • Coleby, A.L., “Changes in Money-Market Instruments and Procedures in the United Kingdom,” in Bank for International Settlements, Changes in Money-Market Instruments and Procedures: Objectives and Implications (Basle: Bank for International Settlements, 1986).

    • Search Google Scholar
    • Export Citation
  • Deutsche Bundesbank, “The Bundesbank’s Transactions in Securities Under Repurchase Agreements,” Monthly Report (Frankfurt-am-Main), Vol. 35 (May 1983), pp. 2330.

    • Search Google Scholar
    • Export Citation
  • Deutsche Bundesbank, “Recent Developments with Respect to the Bundesbank’s Securities Repurchase Agreements,” Monthly Report (Frankfurt-am-Main), Vol. 37 (October 1985), pp. 1824.

    • Search Google Scholar
    • Export Citation
  • Deutsche Bundesbank, The Deutsche Bundesbank: Its Monetary Policy Instruments and Functions, Deutsche Bundesbank Special Series, No. 7 (Frankfurt-am-Main: Deutsche Bundesbank, 2nd ed., October 1987).

    • Search Google Scholar
    • Export Citation
  • Deutsche Bundesbank, “Methodological Notes on the Monetary Target Variable ‘M3’,” Monthly Report (Frankfurt-am-Main), Vol. 40 (March 1988), pp. 1821.

    • Search Google Scholar
    • Export Citation
  • Dudler, Hermann-Joseph, “Changes in Money-Market Instruments and Procedures in Germany,” in Bank for International Settlements, Changes in Money-Market Instruments and Procedures: Objectives and Implications (Basle: Bank for International Settlements, 1986).

    • Search Google Scholar
    • Export Citation
  • Fukui, Toshihiko, “The Recent Development of the Short-Term Money Market in Japan and Changes in the Techniques and Procedures of Monetary Control Used by the Bank of Japan,” in Bank for International Settlements, Changes in Money-Market Instruments and Procedures: Objectives and Implications (Basle: Bank for International Settlements, 1986).

    • Search Google Scholar
    • Export Citation
  • Gilbert, R. Alton, “Operating Procedures for Conducting Monetary Policy,” Review, Federal Reserve Bank of St. Louis (St. Louis), Vol. 67 (February 1985), pp. 1321.

    • Search Google Scholar
    • Export Citation
  • Heller, H. Robert, “Implementing Monetary Policy,” Federal Reserve Bulletin (Washington), Vol. 74 (July 1988), pp. 41929.

  • Hutchison, Michael M., “Japan’s ‘Money Focused’ Monetary Policy,” Economic Review, Federal Reserve Bank of San Francisco (San Francisco), Summer 1986 (No. 3), pp. 3345.

    • Search Google Scholar
    • Export Citation
  • Icard, André (1987a), “La Réforme du Marché Interbancaire, Premières Impressions,” Banque (Paris), No. 468 (January 1987), pp. 7781.

    • Search Google Scholar
    • Export Citation
  • Icard, André (1987b), “Les Instruments de la Politique des Taux,” Banque (Paris), No. 474 (July—August 1987), pp. 698702.

  • Isard, Peter, “Exchange Rate Modeling: An Assessment of Alternative Approaches,” in Empirical Macroeconomics for Interdependent Economies, ed. by Ralph C. Bryant and others (Washington: The Brookings Institution, 1988).

    • Search Google Scholar
    • Export Citation
  • Ito, Takatoshi, “The Recent Evolution of Monetary Control Techniques: The Case of Japan,” paper presented at Seminar on Central Banking, International Monetary Fund, Washington, November 1988.

    • Search Google Scholar
    • Export Citation
  • Johnson, Manuel H., “Current Perspectives on Monetary Policy,” in Dollars, Deficits, & Trade, ed. by James A. Dorn and William A. Niskanen (Boston: Kluwer Academic Publishers, 1989).

    • Search Google Scholar
    • Export Citation
  • Johnson, Manuel H., “Perspectives on the Implementation of Monetary Policy,” in Monetary Policy for a Changing Financial Environment, ed. by William Haraf and Phillip Cagan (Washington: American Enterprise Institute, 1990).

    • Search Google Scholar
    • Export Citation
  • Kanzaki, T., “Determination of the Short-Term Money Market Interest Rates: Comparison of Monetary Adjustment in the United States and Japan,” (in Japanese) (unpublished working paper, Bank of Japan, Institute for Monetary and Economic Studies, March 24, 1988).

    • Search Google Scholar
    • Export Citation
  • Kneeshaw, J. T., and P. Van den Bergh, Changes in Central Bank Money-Market Operating Procedures in the 1980’s, BIS Economic Papers, No. 23 (Basle: Bank for International Settlements, 1989).

    • Search Google Scholar
    • Export Citation
  • Madigan, Brian F., and Warren T. Trepeta, “Implementation of U.S. Monetary Policy,” in Bank for International Settlements, Changes in Money-Market Instruments and Procedures: Objectives and Implications (Basle: Bank for International Settlements, 1986).

    • Search Google Scholar
    • Export Citation
  • Neumann, Manfred J. M., “Implementation of Monetary Policy in Germany,” in Financial Sectors in Open Economies: Empirical Analysis and Policy Issues, ed. by Peter Hooper and others (Washington: Board of Governors of the Federal Reserve System, 1990, forthcoming).

    • Search Google Scholar
    • Export Citation
  • Poole, William, “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model,” Quarterly Journal of Economics, Vol. 84 (May 1970), pp. 197216.

    • Search Google Scholar
    • Export Citation
  • Sellon, Gordon H., Jr., and Ronald L. Teigen, “The Choice of Short-Run Targets for Monetary Policy,” Economic Review, Federal Reserve Bank of Kansas City (Kansas City), Vol. 66 (April 1981), pp. 316.

    • Search Google Scholar
    • Export Citation
  • Shimamoto, Reiichi, “Monetary Control in Japan,” in Central Bank Views on Monetary Targeting, ed. by Paul Meek (New York: Federal Reserve Bank of New York, 1983).

    • Search Google Scholar
    • Export Citation
  • Suzuki, Yoshio, “Monetary Control Mechanism in Japan,” in Financial Sectors in Open Economies: Empirical Analysis and Policy Issues, ed. by Peter Hooper and others (Washington: Board of Governors of the Federal Reserve System, 1990, forthcoming).

    • Search Google Scholar
    • Export Citation
  • Takagi, Shinji, “Recent Developments in Japan’s Bond and Money Markets,” Journal of the Japanese and International Economies, Vol. 2 (March 1988), pp. 6391.

    • Search Google Scholar
    • Export Citation
  • Thornton, Daniel L., “The Discount Rate and Market Interest Rates: Theory and Evidence,” Review, Federal Reserve Bank of St. Louis (St. Louis), Vol. 68 (August/September 1986), pp. 521.

    • Search Google Scholar
    • Export Citation
  • Thornton, Daniel L., “The Borrowed-Reserves Operating Procedure: Theory and Evidence,” Review, Federal Reserve Bank of St. Louis (St. Louis), Vol. 70 (January/February 1988), pp. 3054.

    • Search Google Scholar
    • Export Citation
  • Truquet, J., “The Development of Central-Bank Intervention on the Money Market in France: Changes in Instruments and Procedures Since 1972,” in Bank for International Settlements, Changes in Money-Market Instruments and Procedures: Objectives and Implications (Basle: Bank for International Settlements, 1986).

    • Search Google Scholar
    • Export Citation
  • Wallich, Henry C., “Recent Techniques of Monetary Policy,” Economic Review, Federal Reserve Bank of Kansas City (Kansas City), Vol. 69 (May 1984), pp. 2130.

    • Search Google Scholar
    • Export Citation
  • Wenninger, J., “Federal Reserve Operating Procedures and Recent Experience with Monetary Targeting,” in Bank for International Settlements, Changes in Money-Market Instruments and Procedures: Objectives and Implications (Basle: Bank for International Settlements, 1986).

    • Search Google Scholar
    • Export Citation