Monetary Policies And The Control Of Levels Of Interest Rates

Running head: MONETARY POLICES 1

Monetary Policies and the Control of Levels of Interest Rates

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MONETARY POLICES 2

Monetary Policies and the Control of Levels of Interest Rates

Monetary policies are the actions of a country’s central bank or any other regulatory

committee that is mandated by a state to control the quantity and growth rates of the money

supply. Such policies are maintained through a wide range of actions such as the modification of

the interest rates, peddling of federal bonds and restructuring the number of bank reserves

(Overview of the Federal Reserve System,” n.d.). The policies can be either expansionary or

contractionary. Expansionary monetary policies are aimed at creating employment opportunities

and improving borrowing rates and consumer spending with the aim of stimulating the economic

growth. On the other hand, contractionary monetary policies slows down the money supply rates

to control inflation. This policy reverses the financial gains realized by expansionary fiscal

policies. As demonstrated in the actions of People’s Bank of China and the Federal Reserve

Bank of the USA, central banks can use discount rates, open market operations, and reserve

requirements to achieve the required monetary policy.

Agencies Responsible for Monetary Policy in the USA and China

The US Federal Reserve Bank (Fed) is mandated to increase the employment rates and

address inflation as well as ensuring the interest rates are maintained low. Fed regulates financial

institutions and plays the role of a last resort financial lender to the banks while providing

liquidity to the banks with liquidity to save them from financial shocks in the industry. The Fed

aims at keeping the inflation at between 2 and 3 % and employment rates at 5% (“Overview of

the Federal Reserve System,” n.d.). Fed’s Open Market Committee (FOMC) buys and sells US

resources in open market operations to increase money supply with the aim of lowering the

interest rates, setting the rates that banks with healthy credit ratings pay on overnight loans, and

establishing the reserve requirement. The FOMC is comprised of the Fed’s Board of Governors,

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New York Fed’s President, and four of the rest of 11 presidents of regional reserve banks, who

serve on a rotational basis.

In China, People's Bank of China (PBOC) is mandated to formulate the monetary policy,

and it is equivalent to the USA’s Fed. It controls and supervises the domestic financial sector and

the banking system. PBOC represents China in global financial organizations such as the

International Monetary fund (IMF) the World Bank, and The Asian Development Bank (ADB).

The functions of the PBOC’s Monetary Policy Committee include the formation of credit plans,

setting of interest rates, regulation of the financial market, issuance of Renmimbi, control of the

interbank bond market, and management of foreign exchanges. PBOC performs these

responsibilities with the aim of maintaining financial stability and stimulating economic growth.

The committee is composed of the Governor and Deputy Governors of PBOC, vice ministers of

the State Development and Reform Commission and Finance, the President of the China

Association of Banks, the National Bureau of Statistics Commissioner, and chairpersons of

China Banking Regulatory Commission, Securities Regulatory Commission, and Insurance

Regulatory commission (PBOC, n.d.). Other members include the State Administration of

Foreign Exchange’s Administrator and an academic expert.

Instruments Used by the Agencies

Fed Role

Fed uses the open market operations, the discount rates, and reserve requirements tools to

implement monetary policy. While the Fed’s Board of Governors is responsible for the discount

rate and reserve requirements, FOMC is mandated to oversee open market operations, which

directly affect the rates at which the depository institutions lend each other, also known as the

Federal Funds (FF) rates (Thornton, 2004). The FOMC also oversees the operations undertaken

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by the Fed in the foreign exchange markets and the currency swap programs in different foreign

central banks.

The Fed has managed the short-term rates since the 1970s through open market

operations (Thornton, 2004). Fed reduces the supply of reserves through a free market sale,

which leads to a reduction of interest rates through the acquisition of securities. This action

affects the Federal Funds (FF) rate and short-term rates. Analysts have questioned the

effectiveness of open market operations in managing the short-term interest rates. Some have

even suggested development of a model driven by private agents to determine the interbank rates

to the levels desired by the Fed and FOMC. This school of though regulates the money market

operations and creates a formidable relationship between the interest rates changes and the

financial processes initiated by financial institutions. Since the open market policy affects the

availability of reserves, FF rates are affected in the process. The long-term rates are subject to

markets’ dependence on FF rate (Thornton, 2004). With this direct impact on the reserves, it can

be deduced that Fed through FOMC controls the FF rates. The ability of the FOMC to influence

the short-term rates is a challenge since the Fed open market operations are relative to the market

rates. Due to this reason, the required open markets to absorb the economic shocks may be

bigger than it is practical, since the banks depend on the reserves to meet their daily needs. To

address such problems, FOMC must allow Fed to regulate the fund's rate in times of shocks that

lead to considerable changes in short-term rates.

The Role of PBOC

In the last three decades, China has made remarkable progress towards achieving market-

oriented, interest rate systems. Currently, the interest rates can be grouped into central bank

operations, banking products, bond markets, and other financial markets (He, Wang, & Yu,

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2015). PBOC controls the interest rates in the banking sector. Bank rates are at low levels to

extract subsidies from the households to the corporate sector, primarily the State Owned

Enterprises (SOEs). However, PBOC acknowledges that the low interest rates require the

primary stakeholders to exercise self-discipline in their pricing strategies (He et al., 2015). At the

national level, when the bond markets are underdeveloped, PBOC controls the interest rates

through direct control rates.

Regardless of the policies, PBOC relies on the quantity-based instruments to achieve its

interest rates control goals. Tools such as aggregate credit quotas and reserve requirement ratios

are used to constrain credit supply (He et al., 2015). The bank also uses the lending rate floor to

curb the loans demand. This analysis is a clear indication that the changes precipitated by the

price regulations can only be addressed by aggregate credit quotas or reserve requirement ratios

(He et al., 2015). PBOC must maintain a benchmark or policy interest at equilibrium levels

In most cases, the PBOC relies on the reserve requirement rate to effect control interest

rates. The reserve requirement rate is a top-down monetary policy instrument that requires banks

to keep a proportion of their deposits in the reserve. PBOC varies the rate based on the three

types of financial institutions in the country: small and medium banks are expected to comply

with 17.4%, large banks at 19.5%, and credit cooperatives at 16% (Gehringer, 2015). As such,

due to the important role played by the banks in the Chinese economy, the effectiveness of this

instrument in influencing the money supplied to the economy has increased its use by the PBOC

(Gehringer, 2015).

Effects of FF Rate Change on Money Market Rates and Yield Curve

FF rates are influential in the money market, since they are the overnight market cost of

credit in the USA. The Fed policy shapes up the FF market and the market growth (Goodfriend

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& Whelpley, 1998). The FF rates are short-term borrowings of urgently available money. The FF

rates can only be accessed by financial institutions recognized under the Monetary Control Act

of 1980 to hold their reserves with Fed. FF rate is also different from other borrowings because it

is exempt from both reserve requirements and interest rate ceilings.

The Fed has a dominant influence on the determination of the FF rates to which other

money market rates are anchored. Participants in money market determine the rates according to

the existing and future FF rates. Banks raise funds through overnight borrowing (Goodfriend &

Whelpley, 1998). Any corporation considering buying a treasury bill can acquire its resources

over the term of the bill, which is mostly tied to the FF rate. The choice depends on the

alternative that gives highest returns. Such considerations by market participants make the

existing Fed policy towards the FF rates a critical determinant of the money market rates.

However, the money markets are also subject to Fed’s monetary policy and economy-wide

variables, such as unemployment and inflation ( “Overview of the Federal Reserve System,”

n.d.). With the movements of the FF rates, which are subject to movements in short-term interest

rates, FF rates are likely to change the yield curve.

Impacts of PBOC’s Short-Term rate on Money Market and Yield Curve

In the last decade, studies have prioritized the monetary policy strategies in China. Areas

of focus include the short-term rates and long-term bond rates (Garcia-Herrero, Girardin, &

Lunven, 2011). Bond rates are dependent on the future systems, and therefore, the effectiveness

of monetary policy depends on the deformations of the yield curve, which is an indication of the

direction of the future fiscal policies.

Existing literature shows that monetary policies have a significant impact on the yield

curve (Garcia-Herrero et al., 2011). The slope of the curve is dependent on the nature of the

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future inflation. An inverted yield curve is an indication of a reducing rate of interest in future.

Contractionary policy shocks are also known to trigger positive responses in the short-term

interest rates.

Conclusion

Both Fed and PBOC play critical roles in controlling the interest rates to promote the

economic growth of the USA and China respectively. These institutions have instituted policies

that have improved the economic growth by fostering growth, controlling the interest rates, and

formulating fiscal policies. These institutions will continue to be essential regulators of monetary

policy in their countries with the view of creating sustainable economies. There is the need for

the governments to continue supporting these institutions in efforts to have effective monetary

policies through can use discount rates, open market operations, and reserve requirements.

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References

Garcia-Herrero, A., Girardin, E., & Lunven, S. (2011, Dec.). Monetary policy transmission on

the yield curve in China during the financial crisis. Retrieved from http://www.edge-

page.net/jamb2012/papers/Lunven.pdf

Gehringer, A. (2015, Jan. 7). Monetary policy made in China. Retrieved from http://www.fvs-

ri.com/files/monetary_policy_made_in_china.pdf.

Goodfriend, M., & Whelpley, W. (1998). Chapter 2: Federal Funds. Retrieved from

https://www.richmondfed.org/~/media/richmondfedorg/publications/research/special_rep

orts/instruments_of_the_money_market/pdf/chapter_02.pdf.

He, D., Wang, H., & Yu, X. (2015). Interest rate determination in China: Past, present, and

future. International Journal of Central Banking, 11(4), 255-277.

Overview of the Federal Reserve System. (n.d.). Retrieved from

https://www.federalreserve.gov/aboutthefed/files/pf_1.pdf.

The People’s Bank of China [PBOC]. (n.d.). Monetary Policy Committee. Retrieved from

http://www.pbc.gov.cn/english/130727/130873/index.html.

Thornton, D. L. (2004). The Fed and short-term rates: Is it open market operations, open mouth

operations or interest rate smoothing? Journal of Banking & Finance, 28(3), 475-498.

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