Central Banking: Theory and Practice in Sustaining Monetary and Financial Stability

Chapter 7Monetary Policy ImplementationFinancial Market Operations

Learning Objectives

• Distinguish between the financial sector and the real sector.
• Define money market.
• Describe how central banks can influence conditions and interest rates in the money market.
• Explain how changes in money market interest rates can affect long-term interest rates.

Monetary policy implementation refers to ways in which the central bank could act to influence money conditions in the economy in order to achieve its mandate, whether the mandate is monetary stability, financial stability, or employment (the latter applies particularly to the case of the United States). In the previous chapter, we have discussed monetary policy rules, or monetary policy regimes, which modern central banks might choose to adopt. The regime that the central bank has chosen to adopt would dictate how the central bank might implement its monetary policy decisions in the pursuit of its mandate.

In practice, modern monetary policy is often conducted through operations in the financial markets.¹ Such operations often involve transactions with financial institutions, which will affect money conditions before affecting real economic activity such as consumption, investment, and net exports, which are components of aggregate demand. Generally speaking, changes in aggregate demand will then affect the output gap and inflation. In practice, however, changes in expectations following an announcement of the central bank’s monetary ...