How is the Monetary Policy implemented in Colombia?

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As for the monetary policy instruments available to achieve the inflation target, Banco de la República performs auctions of REPO operations to provide liquidity to the banking system by granting one-day loans (sometimes at longer maturities) so that the one-day Reference Banking Indicator (IBR) be close to the policy interest rate set by the Board of Directors. Banks support these loans with government bonds (mainly TES), with repurchase agreements according to the terms agreed. In some cases, when the economy presents an excess in the market of primary liquidity, the Central Bank uses the auctions of Remunerated Deposits not Constitutive of Reserves (DRNCE) to drain these excesses. In both cases, the policy interest rate set by the Board serves as a reference for these operations.

The Board of Directors meets eight times a year to make monetary policy decisions: January, March, April, July, September, October and December. In preparation for these meetings, the technical staff of the Office for Monetary Policy and Economic Information meets with the Board to discuss the current situation of the economy and the macroeconomic forecasts of the technical staff. The technical staff presents a summary of the information delivered to the Board of Directors in the Inflation Report to the public.

How does monetary policy affect the economy?

Whenever the Central Bank modifies the benchmark interest rate, it sets in motion a series of forces that, with some lag, affect market interest rates at different periods of time, as well as the exchange rate and inflation expectations. These variables in turn influence: 

  • The cost of credit.
  • Agents’ decisions on spending, production and employment.
  • The exchange rate and asset prices.
  • The inflation rate. 

The process by which monetary policy decisions affect the various economic variables is known as transmission mechanism, which should ultimately lead to results in growth and inflation. The Bank assesses the effect of monetary policy on the economy through various transmission mechanisms and is alert to introduce necessary changes in its policy so as to achieve the targets proposed.

These are two general examples of how the transmission mechanism operates: 

When projected inflation is below the target range:

 

 

When projected inflation is above the target range:

 

 


Why is it important to have a low and stable inflation?

A low and stable inflation improves the well-being of the population. This takes place in several ways: 

  • Low inflation promotes the efficient use of productive resources. On the contrary, when inflation is high, the people’s time and the resources of the economy are partly invested in the search for mechanisms to defend themselves against it.
  • Low inflation reduces uncertainty and gives more certainty about the future performance of investment. It has been observed that economies with high inflation rates also suffer from a more volatile inflation. Greater uncertainty can negatively affect the expected return on investment and thus affect long-term growth. High uncertainty also implies that relative prices lose their informative content regarding the relative scarcity or abundance of goods and factors in the economy. This prevents an efficient allocation of resources, consequently reducing economic growth.
  • Lower inflation encourages investment. Usually, the most important economic decisions taken by individuals and companies are for the long-term, such as building a factory, starting a company, education, or buying a house. These decisions crucially depend on the degree of uncertainty about the future. A low and stable inflation is an indicator of macroeconomic stability that helps people and companies to make investment decisions with confidence.
  • Low inflation prevents arbitrary redistribution of income and wealth, especially against the poorest population. Employees and retirees have fewer mechanisms to protect their income from the inflationary erosion. The lower their income, people are more likely to have less defense mechanisms against inflation, such as savings or real estate. For this reason, an increasing inflation rate means a redistribution of income against the poorest population.