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 consists of the European Central Bank (ECB) and the national central banks of those EU member states that have adopted the euro.

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 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 the sustainable growth of an economy. It supports investment and employment, while also increasing economic welfare. 

Following the conclusion of the monetary policy strategy review in July 2021, the Governing Council has defined price stability as an inflation rate of 2% over the medium term.  The Governing Council’s commitment to this target is symmetric, meaning that both negative and positive deviations from the target are equally undesirable. 

The ECB seeks to maintain price stability primarily through changes in interest rates.  

The ECB’s Governing Council sets three key interest rates for the euro area:

  • The main refinancing rate

The rate on the main refinancing operations.

  • 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, given that nominal interest rates are subject to an effective lower bound, the Governing Council also uses other  monetary policy measures, in particular forward guidance, asset purchases and longer-term refinancing operations, as appropriate.

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 principle, 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, reducing aggregate demand in the economy.  Conversely, a reduction in interest rates encourages borrowing and makes saving less attractive, raising aggregate demand.   

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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