In order to achieve its primary objective - maintaining price stability - the Eurosystem uses a set of monetary policy instruments and procedures, which form the operational framework to implement the single monetary policy.
Monopoly supplier of monetary base
The central bank is the sole issuer of banknotes and bank reserves, which means that it is the monopoly supplier of the monetary base in the euro area. The monetary base consists of
- currency (banknotes and coins) in circulation;
- the reserves held by counterparties with the Eurosystem, and
- recourse by credit institutions to the Eurosystem's deposit facility.
These items are liabilities on the Eurosystem's balance sheet. Reserves can be broken down further into required and excess reserves. In the Eurosystem's minimum reserve system, counterparties are obliged to hold reserves with the national central banks (NCBs) as deposits and reserves as loan collaterals. The 2% reserve requirement currently applies to liabilities with maturity up to two years on the credit institutions' balance sheet. Beyond that, credit institutions usually hold only a small amount of voluntary excess reserves, because voluntary reserves do not earn income with the Eurosystem.
The Eurosystem as the monopoly supplier of the monetary base is thus able to manage liquidity on the money market and steer money market interest rates.
Signalling the monetary policy stance
In addition to steering interest rates by managing liquidity, the central bank can also signal its monetary policy stance to the money market, which is usually done by changing the conditions under which the central bank is willing to enter into transactions with credit institutions.
Ensuring proper functioning of the money market
In its operations, the central bank also aims to ensure a proper functioning of the money market and to help credit institutions meet their liquidity needs in a smooth manner. This is achieved by providing both regular refinancing to credit institutions and facilities that allow them to deal with end-of-day balances and to cushion transitory liquidity fluctuations.
The operational framework of the Eurosystem's monetary policy is based on the principles laid down in Article 127 of the Treaty on 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". In addition to the principles set out in the Treaty on European Union, the operational framework follows several guiding principles.
The most important principle is operational efficiency, which can be defined as the capacity of the operational framework to enable monetary policy decisions to feed through as precisely and as fast as possible to short-term money market rates.
Equal treatment and harmonisation
Another principle is that credit institutions must be treated equally irrespective of their size and location in the euro area. The harmonisation of rules and procedures helps to ensure equal treatment by trying to provide identical conditions to all credit institutions in the euro area in transactions with the Eurosystem.
One principle specific to the Eurosystem is the decentralised implementation of monetary policy. This means that the required reserve limit and the volume of regular refinancing operations, i.e. the total amount of short-term loans granted to credit institutions in the Eurosystem, are determined by the Eurosystem, but monetary policy transactions are intermediated by national central banks.