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Monetary Policy Assignment

Monetary policy involves controlling the supply, availability, and cost of money in order to achieve economic objectives like growth and stability. It can be expansionary, increasing the money supply to combat unemployment, or contractionary, decreasing the supply to combat inflation. Central banks use tools like open market operations and interest rate adjustments to target variables such as inflation, price levels, monetary aggregates, exchange rates, or a mix. Political realities may favor monetary policy for inflation and fiscal policy for unemployment. Once interest rates hit zero, monetary policy alone may be insufficient to stimulate the economy.

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5K views

Monetary Policy Assignment

Monetary policy involves controlling the supply, availability, and cost of money in order to achieve economic objectives like growth and stability. It can be expansionary, increasing the money supply to combat unemployment, or contractionary, decreasing the supply to combat inflation. Central banks use tools like open market operations and interest rate adjustments to target variables such as inflation, price levels, monetary aggregates, exchange rates, or a mix. Political realities may favor monetary policy for inflation and fiscal policy for unemployment. Once interest rates hit zero, monetary policy alone may be insufficient to stimulate the economy.

Uploaded by

api-3810664
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Monetary Policy

Monetary policy is the process by which the government, central bank, or monetary
authority of a country controls (i) the supply of money, (ii) availability of money, and
(iii) cost of money or rate of interest, in order to attain a set of objectives oriented
towards the growth and stability of the economy
Monetary policy is generally referred to as either being an expansionary policy, or
a contractionary policy, where an expansionary policy increases the total supply of
money in the economy, and a contractionary policy decreases the total money supply.
Expansionary policy is traditionally used to combat unemployment in a recession by
lowering interest rates, while contractionary policy involves raising interest rates in order
to combat inflation.

Types of monetary policy


In practice, all types of monetary policy involve modifying the amount of base currency
in circulation. This process of changing the liquidity of base currency through the open
sales and purchases of (government-issued) debt and credit instruments is called open
market operations.
Constant market transactions by the monetary authority modify the supply of currency
and this impacts other market variables such as short term interest rates and the exchange
rate.
The distinction between the various types of monetary policy lies primarily with the set
of instruments and target variables that are used by the monetary authority to achieve
their goals.

Monetary Policy: Target Market Variable: Long Term Objective:


Interest rate on overnight
Inflation Targeting A given rate of change in the CPI
debt
Price Level Interest rate on overnight
A specific CPI number
Targeting debt
Monetary The growth in money
A given rate of change in the CPI
Aggregates supply
Fixed Exchange The spot price of the
The spot price of the currency
Rate currency
Low inflation as measured by the gold
Gold Standard The spot price of gold
price
Mixed Policy Usually interest rates Usually unemployment + CPI change

1) Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition
such as Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central Bank interest
rate target. The interest rate used is generally the inter bank rate at which banks lend to
each other overnight for cash flow purposes.
The interest rate target is maintained for a specific duration using open market operations.
Typically the duration that the interest rate target is kept constant will vary between
months and years. This interest rate target is usually reviewed on a monthly or quarterly
basis by a policy committee..

2) Price level targeting


Price level targeting is similar to inflation targeting except that CPI growth in one year is
offset in subsequent years such that over time the price level on aggregate does not move.
Something similar to price level targeting was tried by Sweden in the 1930s, and seems to
have contributed to the relatively good performance of the Swedish economy during
the Great Depression. As of 2004, no country operates monetary policy based on a price
level target.

3) Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the money
supply. This approach was refined to include different classes of money and credit.
This approach is also sometimes called monetarism. While most monetary policy focuses
on a price signal of one form or another, this approach is focused on monetary quantities.

4) Fixed exchange rate


This policy is based on maintaining a fixed exchange rate with a foreign currency. There
are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid
the fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a
fixed exchange rate but does not actively buy or sell currency to maintain the rate.
Instead, the rate is enforced by non-convertibility measures (e.g. capital controls,
import/export licenses, etc.). In this case there is a black market exchange rate where the
currency trades at its market/unofficial rate.

5) Gold standard
The gold standard is a system in which the price of the national currency as measured in
units of gold bars and is kept constant by the daily buying and selling of base currency to
other countries and nationals. (i.e. open market operations, cf. above). The selling of gold
is very important for economic growth and stability.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate"
policy. And the gold price might be regarded as a special type of "Commodity Price
Index".
Today this type of monetary policy is not used anywhere in the world, although a form of
gold standard was used widely across the world prior to 1971.

6) Mixed policy
In practice, a mixed policy approach is most like "inflation targeting". However some
consideration is also given to other goals such as economic growth, unemployment and
asset bubbles.
This type of policy was used by the Federal Reserve in 1998.
Importance of Monetary Policy
The growing importance of monetary policy and the diminishing role played by fiscal
policing economic stabilization efforts may reflect both political and economic realities.
Fighting inflation requires government to take unpopular actions like reducing spending
or raising taxes, while traditional fiscal policy solutions to fighting unemployment tend to
be more popular since they require increasing spending or cutting taxes. Political
realities, in short, may favor a bigger role for monetary policy during times of inflation.
One other reason suggests why fiscal policy may be more suited to fighting
unemployment, while monetary policy may be more effective in fighting inflation. There
is a limit to how much monetary policy can do to help the economy during a period of
severe economic decline, such as the States encountered during the 1930s. The monetary
policy remedy to economic decline is to increase the amount of money in circulation,
thereby cutting interest rates. But once interest rates reach zero, the Fed can do no more.
The United States has not encountered this situation, which economists call the "liquidity
trap," in recent years, but Japan did during the late 1990s. With its economy stagnant and
interest rates near zero, many economists argued that the Japanese government had to
resort to more aggressive fiscal policy, if necessary running up a sizable government
deficit to spur renewed spending and economic growth.

Summary of Monetary Policy in Pakistan


Government has explained the circumstances and developments both on domestic and
international front that led to the unsustainable imbalances. As far as monetary policy is
concerned, it has rightly pointed to fiscal developments diluting the effectiveness of
monetary policy to contain inflation.
The governor, after analyzing the causes of excessive demand in the economy – like
consumption increasing currently at 8.5 per cent while GDP growth is lower than this
figure, leading to decline in domestic savings, has emphasized the need to contain this
demand which should make a dent on the twin deficits which at present are unsustainably
large.
In concrete terms, the governor has increased the discount rate by 1.0 per cent (100 basis
points) to 13 per cent, clearly stating that this would be effective in containing demand
for credit. This is possible, provided the government lives up to their policy commitment
of retiring Rs84 billion of borrowing from the State Bank during the year i.e. Rs21 billion
every quarter. While stating this she said that during the first 25 days of current month
(July) the government had already borrowed Rs32.9 billion – which means they would
need to retire at least of Rs53.9 billion by 30th September. This looks highly unlikely. For
as stated by the governor, a targeted increase of 24 per cent in tax revenue during 2008-
09 is extremely difficult to achieve which during the past few years on the average has
been 12.8 per cent. It needs to be mentioned that one per cent increase in fiscal deficit
over the targeted figure of 4.7 per cent of GDP would necessitate mobilizing an
additional amount of Rs100 billion.
The governor and the members of board of directors of SBP have emphasized the need
for the fiscal authorities to contain the fiscal deficit at 4.7 per cent of GDP and have
emphases retirement SBP debt in the amount of Rs84 billion.

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