The Conduct of Monetary Policy

Nowadays the Central Bank of a country is the monopoly supplier of legal tender currency. The commercial banks are committed to making their deposits convertible at par into such currency. So the banks need to keep reserves in the form of currency and deposits at the Central Bank. The Central Bank primarily conducts its policy by buying and selling financial securities, e.g. Treasury bills or foreign exchange, in exchange for its own liabilities, i.e. open market operations. Academic economists generally regard such operations as adjusting the quantitative volume of the banks’ reserve base, and hence of the money stock, with rates (prices) in such markets simultaneously determined by the interplay of demand and supply. Central Bank practitioners, almost always, view themselves as unable to deny the banks the reserve base that the banking system requires, and see themselves as setting the level of interest rates, at which such reserve requirements are met, with the quantity of money then simultaneously determined by the portfolio preferences of private sector banks and non-banks. This difference in perceptions is discussed again in section 6.4.