Conducting the borrowed reserves. This means that the

Conducting monetary policy is themost important objective of the Central Banks. Through it, the Central Banksets the short-term interest rates and the money supply in the economy, whichis equal to the total of the quantity of money circulating in the hands of thepublic and the reserves. Reserves can be of two types; required reserves andexcess reserves. Required reserves are the percentage of deposits thatcommercial banks are obliged to keep at the Central Bank. Excess reserves areadditional reserves that are kept by the commercial banks.

Standard Monetary Policy MeasuresNormally, the Central Bank uses 3standard measures to adjust money supply or interest rates in the economy. Thefirst tool used by the Central Bank is open market operations, where itpurchases and sells government securities to affect the reserves and themonetary base in the economy. The second tool is changing the borrowed reserves.This means that the central bank gives out loans to commercial banks or thecommercial banks repay the Central Bank for any loans that were borrowed.Changes in borrowed reserves affect the monetary base and thus the moneysupply. The last standard measure used by the Central Bank is the requiredreserve ratio.

Best services for writing your paper according to Trustpilot

Premium Partner
From $18.00 per page
4,8 / 5
4,80
Writers Experience
4,80
Delivery
4,90
Support
4,70
Price
Recommended Service
From $13.90 per page
4,6 / 5
4,70
Writers Experience
4,70
Delivery
4,60
Support
4,60
Price
From $20.00 per page
4,5 / 5
4,80
Writers Experience
4,50
Delivery
4,40
Support
4,10
Price
* All Partners were chosen among 50+ writing services by our Customer Satisfaction Team

By increasing or decreasing the required reserve ratio, theCentral Bank affects the required reserves that commercial banks are obliged tokeep and the money multiplier. By using these 3 measures theCentral Bank controls the overnight interbank rate, meaning the rate at whichcommercial banks borrow money from each other. This will result in a change inthe interest rates on deposits and loans that are set by the commercial banks. Theeffects of the tools on the interbank rate can be observed in the market forreserves, which shows the relationship between the overnight interbank rate andthe quantity of reserves demanded and supplied. When the Central Bank makes useof the 3 tools a shift in either the demand or supply for reserves occurs.Although the Central Bank hasthese tools at hand to control the monetary policy and inflation in the economy,during the financial crisis of 2008 it had to resort to other tools as it wasnot able to control the price stability.Financial CrisisThe financial crisis of 2008occurred due to the mismanagement of financial innovation in the subprimeresidential mortgage market and the bursting of the house pricing bubble. Datamining allowed the evaluation of credit risk ratings for subprime mortgages,mortgages for borrowers with a higher default-risk.

Computer technology loweredtransaction costs and thus smaller loans could be bundled in standard debtsecurities. Therefore, mortgages were being financed through mortgage-backedsecurities. Collateralised debt obligations (CDOs) paid out cash flows fromsubprime mortgage-backed securities in different tranches.

By 2007 the subprimemortgage market was worth over a trillion dollars. Subprime borrowers wereunlikely to default because they could sell their house to pay off the debt,making investors feel more secure. As the subprime mortgage market grew, thedemand for houses continued to increase and this fuelled the house pricingbubble.Subprime mortgages were firstsold to mortgage brokers, who would then distribute them to investors. Themortgage brokers did not have any incentives to ensure that the mortgage is agood credit risk because they still earned their broker fees.

This led to theprincipal-agent problem. Risk-loving investors could obtain loans to acquirehouses that would generate high returns if the house prices increased.Households were also encouraged to take loans that they could not afford or to commitfraud by falsifying information to be able to get higher mortgages causingadverse selection.

Furthermore, regulation did not require information to bedisclosed to borrowers. Investment banks such as Lehman Brothers, who underwrotemortgage-backed securities and CDOs, had little incentives to ensure that theultimate security holders would be paid off, thus engaging in moral hazard. The complications in themortgage-backed securities made it difficult to determine who the actual ownerof the asset was. Moreover, riskier borrowers were able to obtain mortgageswith a higher loan-to-value ratio as their default risk was not assessedproperly. When most borrowers started to default since they were not able to repaytheir loans, house prices stumbled drastically and the house pricing bubbleburst. Credit agencies downgraded themortgage-backed securities and investors tried to sell their assets. This ledthe market to seize as the value of mortgage-backed securities collapsedresulting in a deterioration in the institutions’ balance sheets.

Banks triedto sell off assets and restricted the availability of credit. Although theEuropean Central Bank and the Federal Reserve injected liquidity into thesystem, commercial banks were unwilling to lend money to each other. In fact,they increased interest rates in the interbank market. This led to the firstmajor bank failure in the UK, Northern Rock. In March 2008, Bear Stearns, whichhad invested heavily in mortgage-backed securities was bought by JPMorgan for avalue less than 5% of its previous year’s value. Additionally, Lehman Brotherssuffered huge losses in the subprime market and filed for bankruptcy inSeptember 2008. Several other investment banks and insurance companies such asMerrill Lynch and AIG also suffered huge losses and were either bought by otherinvestment banks or bailed out by the government.

Many companies from all over theworld that had invested money with Lehman Brothers and other financialinstitutions lost their money. The failure of these institutions also resultedin market uncertainty that was reflected with a 40% decline in the stockmarket. Investors and banks in Europebecame nervous that some Eurozone countries would not be able to repay theirdebts. This caused the bond and stock markets to become very volatile resultingin a Sovereign Debt crisis and the EU had to bail out the affected economies,particularly Greece, Ireland, Italy, Portugal and Spain because the governmentswere not able to repay their debts.

When these countries joined the Eurozone,they got access to lower interest rates. Financial institutions lent hugeamounts of money that could not be repaid. Regulators failed to notice thiscredit boom that weakened banks’ balance sheets. As a result, when LehmanBrothers collapsed, house prices began to decline and losses on loansaccumulated, driving down the net worth of the European banks. Due to this,banks were unwilling to participate in the interbank market, and the spreadbetween the three-month Euribor and the overnight interest rate EONIA reached156 basis points, causing a financial crisis. This caused financial markets todry up and investors to lose their confidence.Unconventional Monetary Policy MeasuresIn order to achieve the goal ofprice stability during the financial crisis, the European Central Bank (ECB)had to use unconventional monetary policy tools.

They were needed because thenominal interest rates had to be brought down to zero, the zero-lower bound,after a powerful economic shock. At this rate it would not be possible to cutpolicy rates further and thus unconventional monetary policy tools need to beused to stimulate the monetary system. This can be achieved by guiding mediumto long-term interest rate expectations, changing the composition of centralbanks’ balance sheets and by expanding the size of the central banks’ balancesheets. Furthermore, unconventional monetary policy is used when the monetarytransmission process is impaired. In this case, central banks could reduce theshort term nominal interest rate even further than in normal conditions and actdirectly on the transmission process by using unconventional measures. One of the tools of unconventionalmonetary policy is enhanced credit support.

This is split into five buildingblocks. Firstly, the ECB provided unlimited liability through fixed ratetenders with full allotment. This was adopted for all refinancing operationsduring the crisis.

Banks had unlimited access to the Central Bank’s liquidityat the main refinancing rate subject to adequate collateral. Secondly, the listof eligible collateral was extended allowing banks to use a larger proportionof assets to obtain liquidity. This was an effective remedy to liquidityshortages caused by the sudden halt in interbank lending.

Thirdly, the ECBextended the maturity of long-term refinancing operations. After LehmanBrothers collapsed, the maturity of loans increased from 6 to 12 months inorder to encourage banks to continue providing credit to the economy and keepinterest rates at low levels. The ECB also engaged in currency swap agreements,providing liquidity in foreign currency at various maturities to support bankswith foreign currency shortfalls. Furthermore, the ECB purchased €60 billioneuro-dominated covered bonds in 2009 and another €40 billion in 2011 becausethe covered bonds market had dried up in liquidity, issuance and spreads.Therefore, it revived the covered bonds market which is the primary source offunding for banks. The ECB also engaged in a SecuritiesMarkets Programme due to the tensions in the sovereign bonds market in 2010. Itintervened in euro-area public and private debt securities markets to ensuredepth and liquidity in dysfunctional market segments and to restore themonetary transmission mechanism.

Therefore, it limited the purchases ofgovernment bonds to secondary markets and to ensure that liquidity conditionsare not affected, all purchases were neutralised through liquidity-absorbingoperations.  Further unconventional measuresinclude longer-term refinancing operations (LTROs), where loans were given amaturity of 3 years. This was an attractive way to fund current and newbusinesses. Another measure is Outright Monetary Transactions (OMTs) in thesecondary sovereign bond markets. Moreover, liquidity was provided to thosebanks which extend credit to the private sector through Targeted Longer-TermRefinancing Operations (TLTROs).In January 2015, the ECB implementedQuantitative Easing to restore the banks’ balance sheets and prevent adeflationary spiral.

The ECB bought assets in the banks’ balance sheets toexpand their size. Traditional quantitative easing was more focused on buyinglong-term government bonds from banks. This would decrease the yields onprivate securities relative to the government bonds. Furthermore, the lowerlong-term interest rates would stimulate longer-term investments and thusaggregate demand.

It would also maintain price stability. Quantitative easingis successful when conducted at the zero lower bound, when the short-terminterest rates on deposits are very low. This would discourage banks fromdepositing excess reserves at the central bank and instead they would lend themoney, keeping it in the financial system. In March 2015 the ECB announced thatit would purchase up to €60 billion of public and private sector securitieseach month up to the end of September 2016 to boost confidence and restorefinancial markets.One can see how in order toachieve the ECB’s main goal of price stability during the global financialcrisis, monetary policy had to be taken into new paths as the conventionalmeasures were not effective due to the uncertainty and instability of thefinancial markets.