Central banking : back to the future

Release date
01/09/2001
Reference
DP2001/05
Author
Bruce D. White
Main file
Most textbook models explain the operation of monetary policy in terms of how the central bank influences the market rate of interest by managing the supply of its liabilities relative to the demand for them. Yet some central banks no longer operate that way and, instead, set an interest rate for their own liabilities. This raises the question of how under that modus of operation the central bank's rate is transmitted to the financial markets. Another question concerns whether advances in information technology may erode the demand for central bank money and hence threaten the ability of central banks to implement monetary policy. There are, however, some simple answers to these conundrums. In an open and efficient financial system, the central bank can determine the market rate of interest by standing in the market at its own rate, and rely on interest rate arbitrage to transmit that rate to the market. It follows that even if advances in information technology result in a diminished use of, and thus reduced demand for, a stock of central bank money, that need not undermine a central bank's capacity to implement monetary policy.