CHAPTER 17
Tools of Monetary Policy
The Big Idea
Every day, banks lend spare cash to each other overnight — this is called the interbank market. The interest rate on these loans (the
interbank call money rate in Bangladesh) matters a lot, because it feeds through to the rates banks charge on loans and pay on deposits
across the whole economy. Central banks control the economy mainly by steering this one rate. Bangladesh Bank (BB) does this using
four tools, explained below with simple examples.
1. Open Market Operations (OMO) — the main, everyday tool
This is simply BB buying or selling government securities (like Treasury bills) in the open market. It is the tool BB uses most often,
because it is fast, flexible, and easy to reverse the next day if needed.
• Buying securities: BB pays banks with new cash, so banks suddenly have more reserves. More reserves means banks are keener to
lend, so they lower their rates. Net effect: money supply rises, interest rates fall.
• Selling securities: banks hand over cash to buy the securities, so they have fewer reserves left. With less spare cash, banks compete
harder to attract deposits, pushing rates up. Net effect: money supply falls, interest rates rise.
• Bangladesh example: before Eid, people withdraw large amounts of cash from banks to spend and travel. This drains reserves out
of the banking system. If BB does nothing, banks could suddenly feel short of cash. So BB often buys securities around this time —
this is called a defensive operation, because BB isn't trying to change policy, just replacing the cash that temporarily left the system.
2. Discount Lending — the emergency window
Sometimes a bank runs short of cash unexpectedly — maybe more customers withdrew money than expected. Instead of panicking, that
bank can borrow directly from Bangladesh Bank through the Standing Lending Facility (SLF), pledging government securities as
collateral.
• Why it costs more: the SLF rate is set above BB's normal policy rate on purpose. This way, banks only use it as a last resort, after
trying to borrow more cheaply from other banks first.
• Why it matters: this role — being ready to lend to any bank in trouble — is called being the "lender of last resort." It stops a single
bank's cash problem from turning into a full-blown bank run or panic.
• The trade-off: if this safety net is too easy or too cheap to use, banks might take bigger risks knowing BB will bail them out.
Economists call this moral hazard.
3. Interest on Reserves — the safety floor
Banks keep some of their spare cash sitting with Bangladesh Bank rather than lending it all out. BB pays interest on this — currently
through the Standing Deposit Facility (SDF).
Think of it from a bank's point of view: why would you ever lend your spare cash to another bank overnight for less interest than you
could earn safely by just parking it with BB? You wouldn't. So no bank accepts a rate below the SDF rate, which means the SDF rate
becomes a floor — the lowest the interbank rate can go, no matter how much extra cash BB pumps into the system.
4. Reserve Requirements — the background rulebook
By law, every bank must keep a minimum share of deposits safe and not lend all of it out. Bangladesh uses two related rules:
• Cash Reserve Ratio (CRR): a minimum share of deposits that must be kept as actual cash with Bangladesh Bank.
• Statutory Liquidity Ratio (SLR): a broader rule — a minimum share of deposits kept as cash, gold, or safe government securities.
This is a powerful tool — even a small change affects every single bank at once — but it is also blunt and disruptive, a bit like using a
jackhammer where a scalpel would do. So Bangladesh Bank changes CRR and SLR rarely, usually only during serious stress, and relies
on OMO for everyday fine-tuning instead.
How the Four Tools Fit Together
Tool (textbook name) Bangladesh Bank version What it does
Open Market Operations Repo / Reverse Repo, T-bill & T-bond auctions Main tool. Adds or removes cash from banks
daily.
Discount Lending Standing Lending Facility (SLF) Emergency borrowing window for banks
short of cash.
Interest on Reserves Standing Deposit Facility (SDF) Safe parking spot for banks' spare cash; sets a
floor rate.
Reserve Requirements CRR & SLR Minimum cash/liquid assets every bank must
keep.
Key Takeaway
SDF sets the floor, SLF sets the ceiling, and BB's policy repo rate (set through OMO) is the target in between. This "corridor" keeps
Bangladesh's interbank rate stable, while CRR/SLR stay in the background as a backup safety rule.