czech monetary vibhav

8/2/2019 Czech Monetary Vibhav

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Monetary Policy Analysis

OF

Czech Republic

Submitted by -

Name : Vibhav Shukla

Class : PG-IB

Batch : 2011-13

Roll No. : 55



Objective

The CNB´s monetary policy objective is set forth in Article 98 of the Constitution of the

Czech Republic and in Article 2 of Act No. 6/1993 Coll., on the Czech National Bank. Inparticular, the CNB is required to maintain price stability. The central banks of most

democratic nations with market economies have a similar objective. The objective of

maintaining price stability, i.e. of fostering a stable environment for the development of

entrepreneurial activity, reflects the central bank's responsibility for sustainable economic

growth.

The CNB endeavours to fulfil this objective within a monetary policy regime known as

inflation targeting. In the pursuit of its objective, it uses several monetary policy instruments.

Price stability

Like most central banks, the CNB focuses on stability of consumer prices. In practice, price

stability does not literally mean unchanging prices, it means moderate growth in prices. The

level of inflation corresponding to price stability should encompass the upward statistical

deviations that arise in the measurement of inflation, and should also allow sufficient room

for the small changes in relative prices that occur constantly in every economy with an

effective price system.

High and volatile inflation has adverse implications for economic growth. This is confirmedby the long-term empirical experience from the world economy. High inflation erodes the

value of incomes and savings and leads to high nominal interest rates. As a rule, it also

implies considerable inflation volatility, which substantially increases the costs of inflation.

This is because high inflation increases the uncertainty about future relative prices and about

the price level, and so domestic and foreign financial markets require a higher risk premium

as compensation for this increased uncertainty. When inflation is high in the long term,

inflation and depreciation expectations generally become fixed in the decision-making of

economic agents. Because of the greater inflation volatility, investors focus more on short-

term financial investments (speculative activities) and on hedging against inflation, and less

on longer-term investment projects in the real economy. These stimulate inflow of short-term

risk capital, which has a range of direct and indirect adverse effects.

Inflation targeting in the Czech Republic

In the pursuit of its primary monetary policy objective , i.e. maintaining price stability, the

central bank can opt for any one of several monetary policy regimes. The four basic types of

regime are:



(1) a regime with an implicit nominal anchor,

(2) money targeting,

(3) exchange rate targeting,

(4) inflation targeting.

The main features of inflation targeting are its medium-term focus, the use of an inflation

forecast and the explicit public announcement of an inflation target or sequence of targets. In

its monetary policy decision-making the CNB Bank Board assesses the latest

CNB forecast and evaluates the risks of non-fulfilment of this forecast. Based on these

considerations the Bank Board then votes on whether and how to change the settings of

monetary policy instruments. By changing these instruments the central bank seeks to offset

excessive inflationary or disinflationary pressures which are deviating future inflation from

the inflation target or from the tolerance band around this target. For example, an increase in

the repo rate generally leads, via the transmission mechanism, to a weakening of aggregate

demand, which in turn causes inflation to fall. Lowering the repo rate generally has the

opposite effect. If the central bank expects that inflationary effects deviating inflation above

the targeted value will prevail in the future, this is a signal that monetary policy should be

tighter, i.e. that the repo rate should be raised.

Instruments of monetary policy

The main instruments of monetary policy are -

Open market operations

Automatic facilities

Extraordinary facilities

Minimum reserves

Open market operations

Open market operations are used for steering interest rates in the economy. Open market

operations are mostly executed in the form of repo operations (based on a general agreement

on trading on the financial market). With regard to their aim and regularity, the CNB's open

market operations can be divided into the following categories:

The main monetary policy instrument takes the form of repo tenders. The CNB accepts

surplus liquidity from banks and in return transfers eligible securities to them as collateral.

The two parties agree to reverse the transaction at a future point in time, when the CNB as

borrower repays the principal of the loan plus interest and the creditor bank returns the

collateral to the CNB. The basic duration of these operations is 14 days; the two-week repo

rate (2W repo rate) is therefore considered to be of key importance in terms of monetary

policy. Repos with shorter maturities are executed from time to time depending on the

forecasts of banking sector liquidity. Owing to the systemic liquidity surplus in the Czech

banking sector, 2W repo tenders are currently used exclusively for absorbing liquidity.



The CNB conducts variable rate tenders, which means that the declared repo rate serves as

the maximum limit rate at which banks' bids can be satisfied in the tender. The bids are

ranked using the American auction procedure, i.e. those with the lowest interest rate are

satisfied as having priority and those with successively higher rates are accepted until the

total predicted liquidity surplus for the day is exhausted. If the volume ordered by the banks

exceeds the predicted surplus, the CNB either completely refuses the bids at the highest rate

or reduces them pro rata. Repo tenders are usually announced three times a week at around

9.30 a.m. Banks may submit their orders - i.e. the amounts of money and the interest rates at

which they want to enter into transactions with the CNB - within a prescribed time. The

minimum acceptable volume is CZK 300 million. Bids exceeding the minimum must be

expressed as multiples of CZK 100 million.

Fine-tuning instruments (foreign exchange operations and securities operations) are used ad

hoc, mainly to smooth the effects on interest rates caused by unexpected liquidity fluctuations

in the market. These instruments are rarely

Automatic facilities

Automatic facilities are used for providing and depositing liquidity overnight. As, from the

banks' point of view, these represent standing facilities for depositing or borrowing money,

the interest rates applied to them form the corridor for short-term money market rates (as well

as for the two-week repo rate).They are done with help of deposit facility and marginal

lending facility.

Extraordinary facilities

In autumn 2008, the CNB introduced extraordinary liquidity-providing repo operations with

two-week and three-month maturities aimed at fostering the functioning of the government

bond market. From January 2011, only the liquidity-providing repo operation with two-week

maturity remains in place.

Minimum reserves

Every bank, building society and foreign bank branch that has a banking licence in the Czech

Republic or intends to operate in the Czech Republic on the basis of the "Single Licence" is

required to hold a pre-specified volume of liquid funds - known as minimum reserves - on its

account with the CNB. At present, each bank holds its minimum reserves on its account with

CNB Clearing ("payment system account") and also on a deposit and withdrawal account if

such an account has been opened. The reserve requirement is 2% of the base used for

calculating the minimum reserves.



Transmission Mechanism

The bank investigate the evolution of the monetary policy transmission mechanism in the

Czech Republic over the 1996 –

2010 period by employing a time-varying parametersBayesian vector autoregression model with stochastic volatility. It evaluate whether the

response of GDP and the price level to exchange rate or interest rate shocks changes over

time, with a focus on the period of the recent financial crisis. Furthermore, it augment the

estimated system with a lending rate and credit growth to shed light on the relative

importance of financial shocks for the macroeconomic environment. The results suggest that

output and prices have become increasingly responsive to monetary policy shocks, probably

reflecting financial sector deepening, more persistent monetary policy shocks, and overall

economic development associated with disinflation. On the other hand, exchange rate pass-

through has weakened somewhat over time, suggesting improved credibility of inflation

targeting in the Czech Republic with anchored inflation expectations. They find that credit

shocks had a more sizeable impact on output and prices during the period of bank

restructuring with difficult access to credit. In general, the results shows that financial shocks

are less important for the aggregate economy in an environment of a stable financial system.

czech monetary vibhav

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