Interest rate policy or monetary base policy: implications for a central bank’s balance sheet

The article discusses the relationship between the central bank balance sheet, the monetary base, monetary aggregates and credit in the euro area. In particular, it looks at the choice of the operational procedures available to the central bank, and for this purpose it compares the current interest rate policy to a hypothetical monetary base policy. In the latter case, monetary policy would be transmitted primarily via the monetary aggregates which are already monitored by the ECB as part of its monetary analysis. The analysis points out, however, that the euro area conditions favour an interest rate policy rather than a monetary base policy. The reason is that the uncertainty created in the very short run by money demand shocks and unstable money multipliers exceeds that created by global demand shocks. This explains why central banks of countries with developed financial markets follow an interest rate policy. Such a choice is not at odds with the fact that money plays a fundamental role in the monetary policy strategy of the Eurosystem, as the comparative advantage of the monetary analysis pertains to the medium to long term. Finally, the authors point out that an interest rate policy implies an endogenous central bank balance sheet, where changes in base money demand are passed on to the balance sheet. Therefore, extra interventions, as for example those during the summer of 2007, by a central bank aiming to stabilise the official rate do not signal a change in monetary policy stance.