Published: 15.06.2023

In a market economy, monetary policy decisions affect the price level through a number of different transmission channels, and a combination of such channels is called the transmission mechanism of monetary policy.

In the first monetary policy transmission stage, the Eurosystem sets the terms and conditions for the amount, price, maturity and time of granting the funding to monetary policy counterparties, i.e. credit institutions. The conditions for central bank funding, as a rule, can crucially influence the interest rate formation in the interbank market, as the euro area credit institutions need such central bank funding to meet the public demand for euro banknotes and coins and to hold minimum reserves with national central banks. This process of steering the interbank interest rates is known as the implementation of monetary policy.

A national central bank is the sole issuer of banknotes, holder of credit institutions' minimum reserves and monopoly supplier of monetary base. The euro area monetary base is made up of the most liquid resources: currency in circulation (banknotes and coins), minimum reserves of counterparties held with the Eurosystem, and funds deposited under the deposit facility. These are liabilities items in the Eurosystem balance sheet, while loans granted via market operations to credit institutions as well as investment on the asset side, including foreign exchange reserves, constitute a major part of national central bank assets.

Simplified Eurosystem balance sheet

Assets (supply of national central bank financing)

Liabilities (funds at the disposal of national central bank)

Market operations

Credit institution deposits

Lending constraints

Overnight deposits

Investment assets

Currency in circulation

Managing liquidity or predicting the central bank's balance sheet item developments as well as the framework for credit institution refinancing are essential for the implementation of monetary policy. In a normal situation, an adequate amount of financing for credit institutions to meet the minimum reserve requirement is secured via market operations. Deviations from this equilibrium status are reflected as overnight deposits under the central banks' deposit facility (in the event of market operations providing excess financing) and as lending constraints (recourse to central bank lending facility; when credit institutions need additional financing to meet the minimum reserve requirement). Extensive use of standing facilities or a simultaneous recourse to the marginal lending facility and deposit facility testify to malfunctioning or fragmentation of the money market, as, in the interbank market, credit institutions are unable to mutually smooth out their financing needs.