Monetary Policy

Monetary policy

Malta officially adopted the euro as its national currency on 1 January 2008. As a result, the Central Bank of Malta became a member of the Eurosystem.

The Eurosystem’s primary objective is to maintain price stability, in accordance with the Treaty on the Functioning of the European Union and the Statute of the European System of Central Banks (ESCB) and of the European Central Bank (ECB).

The Central Bank of Malta contributes to monetary policy decisions affecting the euro area through the participation of the Governor in the Governing Council of the ECB. The Bank is also responsible for the implementation of these decisions in Malta, using a range of monetary policy instruments approved by the Governing Council of the ECB.

The main objective of monetary policy - price stability

The primary objective of monetary policy in the euro area is price stability, which implies avoiding prolonged inflation and deflation.  Price stability is an important precondition for business certainty and the sustainable growth of an economy. It supports investment and employment, while also increasing economic welfare. In the euro area, price stability is defined as an inflation rate of below, but close to, 2% over the medium term. 

The ECB seeks to maintain price stability through changes in interest rates, which affect saving and investment decisions of households and firms. The ECB’s Governing Council of normally sets three key interest rates for the euro area:

  • The main refinancing rate

The rate on the main refinancing operations, which normally provide the bulk of liquidity to the banking system.

  • The marginal lending facility rate 

The marginal lending rate is the interest rate on the Eurosystem's marginal lending facility, which credit institutions may use to obtain overnight credit from the Eurosystem.

  • The deposit facility rate

The deposit rate is the interest rate paid on the liquidity that credit institutions may deposit overnight with the Eurosystem.

In addition, since 2009, the ECB has implemented several non-standard monetary policy measures, involving forward guidance, targeted longer-term refinancing operations and asset purchase programmes, to complement its standard monetary policy measures, particularly when nominal interest rates approached zero.

Read more about monetary policy instruments here.

The transmission mechanism of monetary policy

The transmission mechanism is the process through which monetary policy decisions affect the economy in general, and the price level in particular. 

In theory – given its monopoly power to issue money – a central bank can fully determine the interest rate at which it provides funds to the banking system. This, in turn, influences bank lending and deposit rates, as well as other variables.  Generally speaking, a rise in interest rates will discourage spending as higher interest rates make it more costly for economic agents to borrow, while encouraging saving. Although with a time lag, the resulting restraint in expenditure weakens aggregate demand and thus dampens inflation. 

Monetary policy decisions also affect expectations about inflation in the future, as well as asset prices and exchange rates. Interest rates, asset prices, the exchange rate and expectations all have a bearing on saving and investment decisions, on the supply of credit, and on aggregate demand. In turn, when aggregate demand exceeds aggregate supply, this generates upward pressure on prices and vice-versa.

In practice, the transmission mechanism is a complex web of economic interactions. Consequently, it is difficult to quantify the precise effects of monetary policy decisions on the economy and the price level. 

Central banks need to determine what policy stance is needed at present to maintain price stability in the future. Given the lags in the transmission process, monetary policy changes made today will only affect the price level after months or even years. This means that monetary policy must be forward-looking. 

Furthermore, given the complexity of the transmission process, there is always a large element of uncertainty surrounding the timing and size of adjustment triggered by changes in the monetary policy stance. In this regard, a medium-term orientation to monetary policy is desirable to avoid excessive and unnecessary volatility in the real economy.

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