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MONETARY POLICY
What is Monetary Policy?
Monetary policy is a short-run tool used by the central bank to persist sustainable economic growth (in the long-run) by controlling the money supply through open market operations, discount lending and reserve requirements.
Before focusing on the significance for and affects of monetary policy on the economy of the country, first we discuss what monetary policy is? And how it is used by the central bank?
Monetary policy is the process of managing a nation's money supply to achieve specific goalssuch as constraining inflation, achieving full employment or more well-being. Monetary policy can involve setting interest rates, margin requirements, capitalization standards for banks or even acting as the lender of last resort or through negotiated agreements with other governments.
A wide variety of policy systems are possible to conduct monetary policy operations, but in the current international scenario, we have two broad groups of countries:
The first one is the group of those countries (like Hong Kong, Zambia, and China, etc.), whose monetary policies are focused primarily on the exchange rate. They either have exchange rates fixed to a major international currency (usually U.S. dollar) or in some kind of target band and monetary policy involve the management of that exchange rate.
The second is the group of countries with floating exchange rates (like the United States of America, Japan, Pakistan and Australia, etc.) and monetary policy involves the management of short-term interest rates by central banks to pursue the macroeconomic objectives of the economy.
The central bank uses monetary policy in two ways: that is contractionary monetary policy or expansionary monetary policy.
The Central Bank designs Contractionary policy in order to constrain the growth of money (i.e. increasing inflation) and credit in the economy. This is done by an increase in interest rates and a decrease in bond prices, such that higher interest rates lead to lower levels of capital investments, and leading the demand for bonds (domestic) to rise. The appreciation of domestic currency causes exchange rate to rise so there would be an increase in the demand for domestic currency and fall in demand for foreign currency. Thus a higher exchange rate causes a decline in exports and the imports get dearer in the country.
In the present international scenario, due to hike in inflation internationally, most of the countries adopted contractionary policy, like Pakistan recently has increased interest rate by 0.5 percent and set 10 percent short-term interest rates, and it is expected that the Reserve Bank of Australia (RBA) would increase short-term interest rates from 6.25 percent to 6.50 percent.
On the other hand Expansionary policy is used as a tool by the central bank to broaden the monetary base and credit in the economy by reduction in interest rates and increase in bond prices. The reduced interest rates attract capital investments and increased bond prices reduces its demand and the demand for foreign bonds to rise. The exchange rate also lowers down as a result of fall in the demand for domestic currency and a rise in demand for foreign currency leading currency to depreciate, resulting imports to decline and export to accelerate.
In 1999, Ecuador adopted the expansionary monetary policy in, but failed to achieve the required economic growth.
Objectives of Monetary Policy:
Price stability,
Maintenance of full employment, and
The economic prosperity and welfare of the people of the economy.
Price stability, that is controlled price level, is the imperative condition for the constant economic growth, once accomplished leads to full employment and economic prosperity. Price stability develops investors confidence boosting investments, causing acceleration of economic activity and achievement of full employment.
Thus, the significance of monetary policy is to achieve the inflation target (set by the central bank for required economic growth), and as a consequence, to accelerate strong and sustainable economic growth. Achievement of inflation target directs strong currency valuation in terms of other foreign currencies, resulting as favorable balance of payments.
Tools of Monetary Policy:
In order to attain the objectives discussed above, the central bank uses three tools: open market operations, the discount rate and reserve requirements.
Open Market Operations: The most effective and major tool the central bank uses to affect the monetary supply in the economy is open market operations that is, the buying and selling of government securities (usually bonds or T-bills) by the central bank.
If the central bank decides to increase monetary base in the economy it buys securities from the open market and pays for these securities by crediting the reserve amounts of banks involved in selling. This will increase the reserve amount the banks hold, such that banks have more money to lend, interest rates my fall, leading to increase investment spending and as a result economic growth.
Conversely, in order to tighten the monetary base in the economy, the central bank sell the government securities, as a result collect payments from banks by reducing their reserve accounts. Having less money in these reserve accounts the opportunity cost of lending money decline, such that interest rates may increase, resulting a drop of investment spending, that is the slow down of economic activity.
The Discount Rate: the rate at which financial institutions may borrow funds for short-term directly from the central bank.When the central bank reduces the discount rate, financial institutions must pay to borrow from the central bank; financial institutions become more willing to borrow, to make more money available for lending to businesses and households at low interest rates. This would initiate more consumption and investment spending and generate economic activity in the economy. The reverse would be the effect in case of increased discount rate.
Reserve Requirements: the proportion of the total assets that banks must hold in reserve with the central bank. Financial institutions only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets (like loans and mortgages). The monetary policy can be implemented by altering the proportion of these required reserves. Increasing the proportion of total assets to be held as liquid cash increases the amount of money available to banks as loanable funds, thus mean the broader monetary base in the economy, vice versa.
How does Monetary Policy affect the economy of a country?
After having discussed the objectives and tools of monetary policy, let us now talk about how policy affects the economy:
Consumption, Saving and Investment:
Changes in the real interest rates affect the demand for consumption and savings of the people and also change the investment pattern of the businesses.
For instance, a reduction in real interest rate lowers the cost of borrowing, encouraging people to borrow in order to consume (durable items like, electronic items, automobiles etc.). Moreover stimulating banks willingness to lend more and investors to invest more, on the other side discourage saving, resulting to increase spending and aggregate demand.
Lower real interest rates also make stocks and other such investments more desirable than bonds, resulting stock prices to rise. People are likely to increase their stock of wealth.
Foreign Exchange, Imports and Exports:
Short-run changes lower interest rate result as currency depreciation, which means lower prices of home-produced goods selling abroad, making exports dearer and discourage imports, reducing the gap between imports and exports and having favorable balance of trade. Again this leads to higher aggregate spending on goods and services produced in the country.
Output and Employment:
The increase in aggregate demand for the output boosts up the production cycle; generating employment, as a result increase investment spending on the existing industrial capacity. Which accelerate the consumption further due to more incomes earned, thus attaining the multiplier effect of Keynes.
How does Monetary Policy affect Inflation?
Monetary policy affects inflation in two ways. First, affecting indirectly, if monetary policy able to achieve multiplier effect, it boosts up economic activity. Initiating labor and capital markets to raise outputs beyond there capacities and creating an upward pressure on wages, thus resulting inflation to rise (that is cost-push inflation). Thus there would be a trade-off between higher inflation and lower unemployment in the short-run which further accelerate inflation. As wages and prices start to rise they are hard to bring down back, stressing the need for early policy measures to be taken.
Secondly, monetary policy can directly affect inflation via future expectations. Like if people expect the rise in prices in future, they persuade to increase in wages, which in turn affect the prices, resulting higher inflation.
Conclusion:
The results show that mostly developing countries fail to attain the desired goals of monetary policy. The basic hurdles are the deep debt burdens on government, and inflation pressures. Like, Pakistan, although adopted tight monetary policy, stood at actual inflation rate of 7.7% (FY 2006-07), against the inflation target of 6.5% (in FY 07). However, the monetary policy plays effective role to control the money supply in economy in the short-run for a sustainable prosperous long-term growth of developed countries.
Thanks to Sources:
www.forexpk.com
Source:
TD Waterhouse - Private Investment Counsel - Glossary
Wikipedia, the free encyclopedia
State Bank of Pakistan - The Central Bank
Statistics Division, Government of Pakistan
RBA: Education-Monetary Policy
Buzzle Web Portal: Intelligent Life on the Web
EconEdLink - a premier source of classroom-tested, Internet-based economic education lesson plans for K-12 teachers and their students
The Federal Reserve Bank of San Francisco: Economic Research, Educational Resources, Community Development, Consumer and Banking Information
Miller, Roger LeRoy and D.Var Hoose, David (1993): Modern Money and Banking. Mcgraw-Hill International Editions. ISBN 0-07-112741-0
What is Monetary Policy?
Monetary policy is a short-run tool used by the central bank to persist sustainable economic growth (in the long-run) by controlling the money supply through open market operations, discount lending and reserve requirements.
Before focusing on the significance for and affects of monetary policy on the economy of the country, first we discuss what monetary policy is? And how it is used by the central bank?
Monetary policy is the process of managing a nation's money supply to achieve specific goalssuch as constraining inflation, achieving full employment or more well-being. Monetary policy can involve setting interest rates, margin requirements, capitalization standards for banks or even acting as the lender of last resort or through negotiated agreements with other governments.
A wide variety of policy systems are possible to conduct monetary policy operations, but in the current international scenario, we have two broad groups of countries:
The first one is the group of those countries (like Hong Kong, Zambia, and China, etc.), whose monetary policies are focused primarily on the exchange rate. They either have exchange rates fixed to a major international currency (usually U.S. dollar) or in some kind of target band and monetary policy involve the management of that exchange rate.
The second is the group of countries with floating exchange rates (like the United States of America, Japan, Pakistan and Australia, etc.) and monetary policy involves the management of short-term interest rates by central banks to pursue the macroeconomic objectives of the economy.
The central bank uses monetary policy in two ways: that is contractionary monetary policy or expansionary monetary policy.
The Central Bank designs Contractionary policy in order to constrain the growth of money (i.e. increasing inflation) and credit in the economy. This is done by an increase in interest rates and a decrease in bond prices, such that higher interest rates lead to lower levels of capital investments, and leading the demand for bonds (domestic) to rise. The appreciation of domestic currency causes exchange rate to rise so there would be an increase in the demand for domestic currency and fall in demand for foreign currency. Thus a higher exchange rate causes a decline in exports and the imports get dearer in the country.
In the present international scenario, due to hike in inflation internationally, most of the countries adopted contractionary policy, like Pakistan recently has increased interest rate by 0.5 percent and set 10 percent short-term interest rates, and it is expected that the Reserve Bank of Australia (RBA) would increase short-term interest rates from 6.25 percent to 6.50 percent.
On the other hand Expansionary policy is used as a tool by the central bank to broaden the monetary base and credit in the economy by reduction in interest rates and increase in bond prices. The reduced interest rates attract capital investments and increased bond prices reduces its demand and the demand for foreign bonds to rise. The exchange rate also lowers down as a result of fall in the demand for domestic currency and a rise in demand for foreign currency leading currency to depreciate, resulting imports to decline and export to accelerate.
In 1999, Ecuador adopted the expansionary monetary policy in, but failed to achieve the required economic growth.
Objectives of Monetary Policy:
Price stability,
Maintenance of full employment, and
The economic prosperity and welfare of the people of the economy.
Price stability, that is controlled price level, is the imperative condition for the constant economic growth, once accomplished leads to full employment and economic prosperity. Price stability develops investors confidence boosting investments, causing acceleration of economic activity and achievement of full employment.
Thus, the significance of monetary policy is to achieve the inflation target (set by the central bank for required economic growth), and as a consequence, to accelerate strong and sustainable economic growth. Achievement of inflation target directs strong currency valuation in terms of other foreign currencies, resulting as favorable balance of payments.
Tools of Monetary Policy:
In order to attain the objectives discussed above, the central bank uses three tools: open market operations, the discount rate and reserve requirements.
Open Market Operations: The most effective and major tool the central bank uses to affect the monetary supply in the economy is open market operations that is, the buying and selling of government securities (usually bonds or T-bills) by the central bank.
If the central bank decides to increase monetary base in the economy it buys securities from the open market and pays for these securities by crediting the reserve amounts of banks involved in selling. This will increase the reserve amount the banks hold, such that banks have more money to lend, interest rates my fall, leading to increase investment spending and as a result economic growth.
Conversely, in order to tighten the monetary base in the economy, the central bank sell the government securities, as a result collect payments from banks by reducing their reserve accounts. Having less money in these reserve accounts the opportunity cost of lending money decline, such that interest rates may increase, resulting a drop of investment spending, that is the slow down of economic activity.
The Discount Rate: the rate at which financial institutions may borrow funds for short-term directly from the central bank.When the central bank reduces the discount rate, financial institutions must pay to borrow from the central bank; financial institutions become more willing to borrow, to make more money available for lending to businesses and households at low interest rates. This would initiate more consumption and investment spending and generate economic activity in the economy. The reverse would be the effect in case of increased discount rate.
Reserve Requirements: the proportion of the total assets that banks must hold in reserve with the central bank. Financial institutions only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets (like loans and mortgages). The monetary policy can be implemented by altering the proportion of these required reserves. Increasing the proportion of total assets to be held as liquid cash increases the amount of money available to banks as loanable funds, thus mean the broader monetary base in the economy, vice versa.
How does Monetary Policy affect the economy of a country?
After having discussed the objectives and tools of monetary policy, let us now talk about how policy affects the economy:
Consumption, Saving and Investment:
Changes in the real interest rates affect the demand for consumption and savings of the people and also change the investment pattern of the businesses.
For instance, a reduction in real interest rate lowers the cost of borrowing, encouraging people to borrow in order to consume (durable items like, electronic items, automobiles etc.). Moreover stimulating banks willingness to lend more and investors to invest more, on the other side discourage saving, resulting to increase spending and aggregate demand.
Lower real interest rates also make stocks and other such investments more desirable than bonds, resulting stock prices to rise. People are likely to increase their stock of wealth.
Foreign Exchange, Imports and Exports:
Short-run changes lower interest rate result as currency depreciation, which means lower prices of home-produced goods selling abroad, making exports dearer and discourage imports, reducing the gap between imports and exports and having favorable balance of trade. Again this leads to higher aggregate spending on goods and services produced in the country.
Output and Employment:
The increase in aggregate demand for the output boosts up the production cycle; generating employment, as a result increase investment spending on the existing industrial capacity. Which accelerate the consumption further due to more incomes earned, thus attaining the multiplier effect of Keynes.
How does Monetary Policy affect Inflation?
Monetary policy affects inflation in two ways. First, affecting indirectly, if monetary policy able to achieve multiplier effect, it boosts up economic activity. Initiating labor and capital markets to raise outputs beyond there capacities and creating an upward pressure on wages, thus resulting inflation to rise (that is cost-push inflation). Thus there would be a trade-off between higher inflation and lower unemployment in the short-run which further accelerate inflation. As wages and prices start to rise they are hard to bring down back, stressing the need for early policy measures to be taken.
Secondly, monetary policy can directly affect inflation via future expectations. Like if people expect the rise in prices in future, they persuade to increase in wages, which in turn affect the prices, resulting higher inflation.
Conclusion:
The results show that mostly developing countries fail to attain the desired goals of monetary policy. The basic hurdles are the deep debt burdens on government, and inflation pressures. Like, Pakistan, although adopted tight monetary policy, stood at actual inflation rate of 7.7% (FY 2006-07), against the inflation target of 6.5% (in FY 07). However, the monetary policy plays effective role to control the money supply in economy in the short-run for a sustainable prosperous long-term growth of developed countries.
Thanks to Sources:
www.forexpk.com
Source:
TD Waterhouse - Private Investment Counsel - Glossary
Wikipedia, the free encyclopedia
State Bank of Pakistan - The Central Bank
Statistics Division, Government of Pakistan
RBA: Education-Monetary Policy
Buzzle Web Portal: Intelligent Life on the Web
EconEdLink - a premier source of classroom-tested, Internet-based economic education lesson plans for K-12 teachers and their students
The Federal Reserve Bank of San Francisco: Economic Research, Educational Resources, Community Development, Consumer and Banking Information
Miller, Roger LeRoy and D.Var Hoose, David (1993): Modern Money and Banking. Mcgraw-Hill International Editions. ISBN 0-07-112741-0
