Adopting Indirect Instruments of Monetary Policy - Finance & Development - March 1996 - William E. Alexander, Tomas J.T. Balino, and Charles Enoch

In the late 1970s, industrial countries began moving toward full reliance on indirect instruments, such as open market operations, rediscount facilities, and reserve requirements. Many developing and transition economies have followed suit. Indirect instruments are more effective than direct instruments in today’s increasingly open economic environment. N IMPLEMENTING monetary policy, a central bank can act directly, using its regulatory powers, or indirectly, using its influence on money market conditions as the issuer of reserve money (currency in circulation and deposit balances with the central bank). The term “direct” refers to the one-to-one correspondence between the instrument (such as a credit ceiling) and the policy objective (such as a specific amount of domestic credit outstanding). Direct instruments operate by setting or limiting either prices (interest rates) or quantities (amounts of credit outstanding) through regulations, while indirect instruments act through the market by, in the first instance, adjusting the underlying demand for, and supply of, bank reserves. The greater use of indirect monetary instruments can be seen as the counterpart in the monetary area of the widespread movement toward enhancing the role of price signals in the economy. Both aim to improve market efficiency. In addition, the adoption of indirect instruments is taking place in an increasingly open economic environment characterized by widespread adoption of current account convertibility and progress in moving to full external account convertibility. In such an environment, direct instruments have become increasingly ineffective, leading to inefficiencies and disintermediation. The most common direct instruments are interest rate controls, credit ceilings, and directed lending (lending at the behest of the authorities, rather than for commercial reasons). The three main types of indirect instrument are open market operations, reserve requirements, and central bank lending facilities.