Monetary policy and the central bank's securities

Abstract

Open market operation (OMO) is one of the major instruments of conducting the monetary policy in both developing and developed countries. Using this instrument requires a well-developed secondary financial market. OMO can be implemented by using either government or central bank (CB) securities. Developing countries are using the second which raises a question about CB profits and the effect on the economy. This study, through evidence from a small developing country, Jordan, shows that issuing CB securities causes losses which affect the monetary policy continuity. Moreover, the paper extends a model introduced by Walsh (1998) to study the impact of the CB losses on some macroeconomic variables. The model shows that if the CB profits are part of the objective function then inflation, output and growth of the money supply tend to have a positive bias.

Notes

¹ For more details about the advantages of OMO see Mishkin (2003).

² For more details see McCallum (1989).

³ Calculation based on data from the federal reserve bank of Saint Louis web site.

⁴ For more details see Quintyn (1994).

⁵ The prices are set either by the government or the central bank.

⁶ This is the case of direct control.

⁷ In October 1995, the monetary authority adopted a fixed exchange rate with the US dollar.

⁸ The period 1988 to 1992 is excluded because during this period the economy has a negative shock in the banking system causing an economic crisis.

⁹ Walsh's model includes output and inflation.

¹⁰Peel (1999) shows the implications of uncertainty in the weight the CB attaches to output for inflation.

¹¹ Equation 4 has aggregate demand shifting factor, the purpose of such a form is to start the analysis from an expansionary position which requires a contractionary monetary policy.

¹² Or income statement.

¹³ Based on Equation 6 the CB should adopt values for aλ and γ less than the original ones. This makes Δm negative.

¹⁴ This equation tells an interesting story the inflation doesn’t rely on the aggregate demand shock (d), but it relies on the weight the CB places over the value (aλ + γ).