The Eurosystem uses a set of monetary policy instruments and procedures to achieve its primary objective of maintaining price stability, and these form the operational framework for the single monetary policy.
Monopoly supplier of the monetary base
The Eurosystem is the sole issuer of banknotes and sets the reserve requirements for the commercial banks, which means that it is the monopoly supplier of the monetary base.
The monetary base consists of
- currency in circulation in the form of banknotes and coins;
- the reserves held with the Eurosystem by counterparties; and
- the money held by credit institutions in the deposit facility.
The components of the monetary base are recorded as a liability on the balance sheet of the Eurosystem. Reserves can be broken down further into mandatory reserves and excess reserves. In the Eurosystem's minimum reserve system, credit institutions have to hold reserves as deposits and loan collaterals on accounts at the national central banks. The reserve requirement is currently 1% for liabilities with maturity of up to two years. Beyond that, credit institutions usually hold only small amounts on their accounts at central banks, as those amounts do not earn income with the Eurosystem.
This means that the Eurosystem as the monopoly supplier of the monetary base can manage liquidity in the money market and steer the money market interest rates.
Signalling the monetary policy stance
The central bank not only steers liquidity management through interest rates, but can also signal its monetary policy stance to the money market by changing the conditions under which it is willing to enter into transactions with credit institutions.
Ensuring the functioning of the money market
The central bank also uses its monetary policy operations to ensure that the money market functions properly and to help credit institutions meet their liquidity needs smoothly. This is done by giving regular refinancing to credit institutions by providing them with tools that allow them to cushion transitory liquidity fluctuations.
The principles of the Eurosystem's monetary policy framework are laid down in Article 127 of the Treaty on the Functioning of the European Union, which states that in pursuing its objectives, the Eurosystem "shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources and in compliance with the principles set out in Article 119". The operational framework follows several other guiding principles as well as this.
The most important principle is operational efficiency, which can be defined as the capacity of the operational framework to transmit monetary policy decisions as precisely and as fast as possible to short-term money market rates.
Equal treatment and harmonisation
Another key principle is that credit institutions in the euro area must be treated equally irrespective of their size and location. The harmonisation of rules and procedures helps to ensure equal treatment by providing identical conditions for all credit institutions in the euro area in transactions with the Eurosystem.
Decentralised implementation of monetary policy
The Eurosystem follows the principle of decentralised implementation of monetary policy. This means that the minimum reserve requirement and the size of regular refinancing operations, meaning the total amount of short-term loans granted to credit institutions in the Eurosystem, are set by the Governing Council of the European Central Bank, but monetary policy transactions are the responsibility of the national central banks.