Operational framework of the Estonian monetary policy

The monetary policy operational framework includes the monetary policy tools used to meet the aims of the monetary policy. The Estonian monetary system which is based on the currency board arrangement, is characterised by the absence of active monetary policy, which sets constraints on the choice of possible monetary policy instruments. The monetary policy instruments used in Estonia have been created with the goal of fostering the operation of markets and generating sufficient liquidity buffers for the financial sector.

Eesti Pank's primary monetary policy instrument is the standing facility of buying/selling foreign currency (the forex window) for commercial banks. With the purpose of supplementing the kroon reserve, the forex window allows commercial banks to sell unlimited foreign currency to Eesti Pank against Estonian kroons and vice versa. Each foreign currency transaction between the central bank and a commercial bank is accompanied by an equivalent change in the base money[1] and in the foreign currency reserves, ensuring the nominal exchange rate between the kroon and the euro.

Besides the forex window, another important monetary policy tool is the reserve requirement, for credit institutions, which obligates commercial banks to keep a certain percentage of their liabilities in reserve as financial assets. The reserve requirement ensures that a share of commercial banks' financial means is liquid and can be immediately used at all times. In addition, Eesti Pank offers commercial banks the deposit facility, which is the possibility of earning interest on the average monthly balance in excess of the reserve requirement.

Along with the development of the financial environment, Eesti Pank has been gradually updating the monetary policy operational framework (see Table). The monetary policy operational framework was thoroughly reviewed in 2000, when the operational framework reform of the monetary policy was approved. The document describes the step-by-step process of changing the operational framework until joining the European Economic and Monetary Union. The objective of the gradual reforming of the monetary policy operational framework is ensuring the functioning of the fixed exchange rate regime within the framework of the currency board arrangement and, in longer term, smooth operational convergence with the Eurosystem.

The Estonian monetary policy operational framework has delivered a monetary policy environment and liquidity management conditions fairly similar to those of the Eurosystem, creating preconditions for successful integration with the monetary policy environment of the European System of Central Banks. Until Estonia becomes a full member of the monetary union, the country will preserve some specific characteristics in respect of its monetary policy instruments.

[1] The central bank's liabilities used as a means of payment. Mostly cash and banks' accounts (reserves) with the central bank. Also called the central bank money or the monetary aggregate M0.