Scholars believe that as the interest rate approaches zero or near zero monetary policy cannot operate or becomes ineffective if further stimulus needed to boost the economy or to rescue it from any prolonged economic stagnation. (Sellon, 2003)The monetary policy of the central bank operates through the alteration of price and volume of the reserve and settlement balances those other banks and financial institutions keep in the hold at the central bank. If the central bank supplies more reserve at the current rate of interest then this will push the rate of interest down. this follows a simple demand-supply interaction and is the result of the excess supply of a commodity (reserve) at the current price (interest rate). Central bank’s prime objective is price stability and sustainable economic growth and to achieve that it increases the supply of money to that extent that will allow the desired level of inflation and fulfill its growth objectives. (Sellon, 2003. Froyen, 2002. Branson, 1995)This is known as quantitative targeting and nowadays seldom practiced by the central banks. In recent time most of the central banks have shifted to interest rate targeting from quantitative targeting and that on valid ground. Quantitative targeting requires a clear knowledge on the exact demand for money of the economy along with the banking behavior. Owing to financial deregulation and innovation in banking sector both the demand for money and banking behavior has undergone considerable transformations in recent time and therefore involves significant risks in terms of quantitative targeting of the reserves. Interest rate targeting is technically much easier and it comes with much clarity.
Monetary Policy when ShortTerm Interest Rates are Close at Zero