4. Monetary-Policy Instruments

Ricardo, David, 1809: The price of gold, Letter contributed to the Morning chronicle, p. 14.

A thorough discussion of the different forms of seigniorage can be found in Baltensperger, Ernst, and Thomas Jordan, 1997: Principles of Seigniorage, Swiss Journal of Economics and Statistics. A textbook discussion on seigniorage can be found in Walsh, Carl E., 2017: Monetary Theory and Policy, MIT Press, Ch. 4.

The difference between short-term (e.g. those on money markets) and long-term (e.g. those on capital markets) interest rates is reflected in their term structure. Across various points in time, the observed term structure of interest rates can be positive (meaning that long-term rates are relatively higher), or negative. The positive slope is deemed normal in the sense that it is the most common scenario, because investors typically want to be compensated for the higher level of uncertainty when holding an asset that pays out in the distant future.

The acronym ‘Libor’ stands for London interbank offered rate, which is an indicative (i.e. non-binding) reference rate for short-term interbank loans denominated in various currencies between the major banks in the London financial market. Owing to London’s leading position in international financial affairs, the Libor provides the basis for a range of key commercial interest rates around the world. Because the Libor is a subjective assessment of the borrowing costs of large banks, it is prone to manipulations. Therefore, there are currently attempts to replace the Libor with a benchmark based on money-market interest rates on actual financial transactions. See Duffie, Darrell, and Jeremy C. Stein, 2015: Reforming LIBOR and Other Financial Market Benchmarks, Journal of Economic Perspectives 29, 191–212.

This expression was coined by John Maynard Keynes to explain why monetary policy was, arguably, ineffective during the Great Depression of the 1930s. In principle, a liquidity trap can arise whenever banks, firms, or households hoard central-bank money. However, the incentives to do so are particularly large when the opportunity costs of holding money are low, that is, when nominal interest rates are close to zero.

A prominent exception is the People’s Bank of China, which routinely changes the reserve requirements of commercial banks. However, the Chinese financial system still differs markedly from those of Europe and North America, as it encompasses only a small number of state-controlled banks. Arguably, this distinction facilitates the implementation of monetary policy via reserve requirements.

In this regard, a special situation has occurred in the euro area, where no government bonds (so-called ‘euro bonds’) are currently issued by the central government (i.e. the European Union). Therefore, the ECB conducts its open-market operations partly with government bonds of the member states. Doing so gives rise to the risk of creating distributional effects when, for economic or political reasons, the bonds of certain member states are preferred over others.

A recent example of private asset purchases involved so-called ‘mortgage-backed securities’ (MBS). These securities were at the centre of the Global Financial Crisis as they provided the vehicle which transmitted the losses from decreasing real-estate prices in the United States to other parts of the banking and financial system. To prevent a destabilising cascade of potential bank failures, in 2008, the Federal Reserve System introduced rescue programmes including, among other things, the purchase of substantial amounts of MBS.

For a state-of-the-art discussion on capital controls, see International Monetary Fund, 2011: Recent Experiences in Managing Capital Inflows—Cross-Cutting Themes and Possible Policy Framework.