Conducting the borrowed reserves. This means that the

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

Standard Monetary Policy Measures

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Normally, the Central Bank uses 3
standard measures to adjust money supply or interest rates in the economy. The
first tool used by the Central Bank is open market operations, where it
purchases and sells government securities to affect the reserves and the
monetary 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 the
commercial banks repay the Central Bank for any loans that were borrowed.
Changes in borrowed reserves affect the monetary base and thus the money
supply. The last standard measure used by the Central Bank is the required
reserve ratio. By increasing or decreasing the required reserve ratio, the
Central Bank affects the required reserves that commercial banks are obliged to
keep and the money multiplier.

By using these 3 measures the
Central Bank controls the overnight interbank rate, meaning the rate at which
commercial banks borrow money from each other. This will result in a change in
the interest rates on deposits and loans that are set by the commercial banks. The
effects of the tools on the interbank rate can be observed in the market for
reserves, which shows the relationship between the overnight interbank rate and
the quantity of reserves demanded and supplied. When the Central Bank makes use
of the 3 tools a shift in either the demand or supply for reserves occurs.

Although the Central Bank has
these 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 was
not able to control the price stability.

Financial Crisis

The financial crisis of 2008
occurred due to the mismanagement of financial innovation in the subprime
residential mortgage market and the bursting of the house pricing bubble. Data
mining allowed the evaluation of credit risk ratings for subprime mortgages,
mortgages for borrowers with a higher default-risk. Computer technology lowered
transaction costs and thus smaller loans could be bundled in standard debt
securities. Therefore, mortgages were being financed through mortgage-backed
securities. Collateralised debt obligations (CDOs) paid out cash flows from
subprime mortgage-backed securities in different tranches. By 2007 the subprime
mortgage market was worth over a trillion dollars. Subprime borrowers were
unlikely to default because they could sell their house to pay off the debt,
making investors feel more secure. As the subprime mortgage market grew, the
demand for houses continued to increase and this fuelled the house pricing

Subprime mortgages were first
sold to mortgage brokers, who would then distribute them to investors. The
mortgage brokers did not have any incentives to ensure that the mortgage is a
good credit risk because they still earned their broker fees. This led to the
principal-agent problem. Risk-loving investors could obtain loans to acquire
houses that would generate high returns if the house prices increased.
Households were also encouraged to take loans that they could not afford or to commit
fraud by falsifying information to be able to get higher mortgages causing
adverse selection. Furthermore, regulation did not require information to be
disclosed to borrowers. Investment banks such as Lehman Brothers, who underwrote
mortgage-backed securities and CDOs, had little incentives to ensure that the
ultimate security holders would be paid off, thus engaging in moral hazard.

The complications in the
mortgage-backed securities made it difficult to determine who the actual owner
of the asset was. Moreover, riskier borrowers were able to obtain mortgages
with a higher loan-to-value ratio as their default risk was not assessed
properly. When most borrowers started to default since they were not able to repay
their loans, house prices stumbled drastically and the house pricing bubble

Credit agencies downgraded the
mortgage-backed securities and investors tried to sell their assets. This led
the market to seize as the value of mortgage-backed securities collapsed
resulting in a deterioration in the institutions’ balance sheets. Banks tried
to sell off assets and restricted the availability of credit. Although the
European Central Bank and the Federal Reserve injected liquidity into the
system, commercial banks were unwilling to lend money to each other. In fact,
they increased interest rates in the interbank market. This led to the first
major bank failure in the UK, Northern Rock. In March 2008, Bear Stearns, which
had invested heavily in mortgage-backed securities was bought by JPMorgan for a
value less than 5% of its previous year’s value. Additionally, Lehman Brothers
suffered huge losses in the subprime market and filed for bankruptcy in
September 2008. Several other investment banks and insurance companies such as
Merrill Lynch and AIG also suffered huge losses and were either bought by other
investment banks or bailed out by the government.

Many companies from all over the
world that had invested money with Lehman Brothers and other financial
institutions lost their money. The failure of these institutions also resulted
in market uncertainty that was reflected with a 40% decline in the stock

Investors and banks in Europe
became nervous that some Eurozone countries would not be able to repay their
debts. This caused the bond and stock markets to become very volatile resulting
in a Sovereign Debt crisis and the EU had to bail out the affected economies,
particularly Greece, Ireland, Italy, Portugal and Spain because the governments
were not able to repay their debts. When these countries joined the Eurozone,
they got access to lower interest rates. Financial institutions lent huge
amounts of money that could not be repaid. Regulators failed to notice this
credit boom that weakened banks’ balance sheets. As a result, when Lehman
Brothers collapsed, house prices began to decline and losses on loans
accumulated, driving down the net worth of the European banks. Due to this,
banks were unwilling to participate in the interbank market, and the spread
between the three-month Euribor and the overnight interest rate EONIA reached
156 basis points, causing a financial crisis. This caused financial markets to
dry up and investors to lose their confidence.

Unconventional Monetary Policy Measures

In order to achieve the goal of
price stability during the financial crisis, the European Central Bank (ECB)
had to use unconventional monetary policy tools. They were needed because the
nominal 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 cut
policy rates further and thus unconventional monetary policy tools need to be
used to stimulate the monetary system. This can be achieved by guiding medium
to long-term interest rate expectations, changing the composition of central
banks’ balance sheets and by expanding the size of the central banks’ balance
sheets. Furthermore, unconventional monetary policy is used when the monetary
transmission process is impaired. In this case, central banks could reduce the
short term nominal interest rate even further than in normal conditions and act
directly on the transmission process by using unconventional measures.

One of the tools of unconventional
monetary policy is enhanced credit support. This is split into five building
blocks. Firstly, the ECB provided unlimited liability through fixed rate
tenders with full allotment. This was adopted for all refinancing operations
during the crisis. Banks had unlimited access to the Central Bank’s liquidity
at the main refinancing rate subject to adequate collateral. Secondly, the list
of eligible collateral was extended allowing banks to use a larger proportion
of assets to obtain liquidity. This was an effective remedy to liquidity
shortages caused by the sudden halt in interbank lending. Thirdly, the ECB
extended the maturity of long-term refinancing operations. After Lehman
Brothers collapsed, the maturity of loans increased from 6 to 12 months in
order to encourage banks to continue providing credit to the economy and keep
interest rates at low levels. The ECB also engaged in currency swap agreements,
providing liquidity in foreign currency at various maturities to support banks
with foreign currency shortfalls. Furthermore, the ECB purchased €60 billion
euro-dominated covered bonds in 2009 and another €40 billion in 2011 because
the covered bonds market had dried up in liquidity, issuance and spreads.
Therefore, it revived the covered bonds market which is the primary source of
funding for banks.

The ECB also engaged in a Securities
Markets Programme due to the tensions in the sovereign bonds market in 2010. It
intervened in euro-area public and private debt securities markets to ensure
depth and liquidity in dysfunctional market segments and to restore the
monetary transmission mechanism. Therefore, it limited the purchases of
government bonds to secondary markets and to ensure that liquidity conditions
are not affected, all purchases were neutralised through liquidity-absorbing

Further unconventional measures
include longer-term refinancing operations (LTROs), where loans were given a
maturity of 3 years. This was an attractive way to fund current and new
businesses. Another measure is Outright Monetary Transactions (OMTs) in the
secondary sovereign bond markets. Moreover, liquidity was provided to those
banks which extend credit to the private sector through Targeted Longer-Term
Refinancing Operations (TLTROs).

In January 2015, the ECB implemented
Quantitative Easing to restore the banks’ balance sheets and prevent a
deflationary spiral. The ECB bought assets in the banks’ balance sheets to
expand their size. Traditional quantitative easing was more focused on buying
long-term government bonds from banks. This would decrease the yields on
private securities relative to the government bonds. Furthermore, the lower
long-term interest rates would stimulate longer-term investments and thus
aggregate demand. It would also maintain price stability. Quantitative easing
is successful when conducted at the zero lower bound, when the short-term
interest rates on deposits are very low. This would discourage banks from
depositing excess reserves at the central bank and instead they would lend the
money, keeping it in the financial system. In March 2015 the ECB announced that
it would purchase up to €60 billion of public and private sector securities
each month up to the end of September 2016 to boost confidence and restore
financial markets.

One can see how in order to
achieve the ECB’s main goal of price stability during the global financial
crisis, monetary policy had to be taken into new paths as the conventional
measures were not effective due to the uncertainty and instability of the
financial markets.