The global financial crisis of 2007/08 made a policymaker to rethink the traditional monetary policy instruments, where the interest rate is fully deregulated, and the provision of reserve requirement such as CRR and SLR, which are based on deposits.
However, the Global Financial Crisis made the policymakers and academics realize that financial liberalization of the 1990s had some limitations because fully deregulated interest rate leads to interest rate volatility and uncertainty.
Similarly, the cost of BFIs increases due to the reserve requirement policy, and it encourages them for aggressive lending, which may ultimately lead to a financial crisis.
So, they advocated some alternative policy instruments to be used in the normal situation in order to minimize the risk of crisis.
And some other policy instruments that can be used if the economy is in crisis.
Alternative Policy Instruments for Normal Situation
1) Interest Rate Channel:
This is an alternative instrument of monetary policy suggested after the global financial crisis. It argues that the full deregulation of interest rates makes it more volatile and may lead to a banking sector crisis.
So, the central bank should regulate the interest rate by defining the interest rate channel (corridor).
It means the central bank should make the lower and upper limits of the interest rate public and should regulate the interest rate to maintain it within the floor and limit.
This helps to maintain the optimum interest rate and stabilize the market.
2) Interest on Reserve Requirement:
This alternative instrument suggests that the central bank should pay the interest rate to the BFIs for the compulsory reserve requirement (CRR). When the BFIs maintain the CRR, their unit cost increases because some part of their deposits or funds is held with the central bank.
Then they have to cover the cost as well as earn some profit from the remaining fund. It makes them aggressive in lending, which may lead to a crisis.
So, the central bank provides the interest rate for the reserve requirement, reduces its cost, and provides some leverage for investing in better quality assets, avoiding their aggression.
3) Assets-Based Reserve Requirement:
The traditional framework of monetary policy is based on a deposit-based reserve requirement, which does not take into account the quality of assets of the BFIs.
Since the financial market is highly interdependent, the crisis of one leads to the crisis of the whole system. So, this alternative instrument is suggested to minimize such a crisis.
Under this instrument, the banks are required to maintain a reserve based on the quality of the assets, where the reserve requirement is higher for the BFIs with a higher proportion of poor-quality assets.
This discourages the BFIs from being aggressive and controlling the credits in poor-quality assets.
These are alternative policy instruments to be incorporated by the existing monetary policy framework during the normal period in order to minimize the risk of a crisis.
However, if there is already a crisis, then the unconventional monetary policy can be used as an alternative. The unconventional monetary policy instruments are
- Quantity easing
- Forward guidance
- Negative interest rate
- Targeted lending
- Assets purchase by central bank
These are the alternative frameworks in general, and there may be some specific targeting frameworks of the monetary policy, such as:
1. Inflation targeting:
There is an explicit target of inflation, and the monetary policy instruments are designed and used to maintain the inflation within the target.
2. Exchange Rate targeting:
Under this framework, the exchange rate is pegged, which is considered to be the nominal anchor of the monetary policy, and the central bank is fully committed to maintaining the fixed exchange rate.
3. Monetary targeting:
In this framework, the money supply growth rate is targeted to achieve price stability, and the central bank tries to maintain such a money supply growth rate to maintain the desired inflation and growth target.