MONETARY POLICY

TARGETS/OBJECTIVES OF MONETARY POLICY:

1.Control over the Growth of Money supply.

2.Control over interest rates levels.
3.Growth in the volume of Credit.
4.The Exchange Rate.
5.Growth in Money GNP or GDP.

DETAILED INTRODUCTION:

1. CONTROL OVER THE GROWTH IN MONEY STOCK:

It is an obvious medium term target according to the Monetarists.

Link b/w MS and Prices, incomes and expenditure is reasonably predictable and stable i.e.
V=constant so that money incomes and money expenditures are directly affected by change
in MS.

If the link is not reliable, monetary policy cannot be implemented with such predictability.

SHORT-TERM EFFECT:

In short-term, monetary policy cannot be miracles cure for economy i.e. only a medium
term policy.
The short-term effect is unpredictable because:

i.The effect on interest rates could be erratic.

ii.Time lag may be involved.
iii.There is difficulty in selecting a Monetary Aggregate.

2. CONTROL OVER THE INTEREST RATES:

It is appropriate to consider it as an intermediate target if there is a direct relationship b/w

1Interest rates and the level of expenditure in economy; or
2Interest rates and the rate of inflation.

CAUSES OF RAISING INTEREST RATES:

i.Rates of returns decreases.

ii.Investment plans curtailed.
iii.Corporate profits fall.
iv.There is a reduction in stock level.
v.Private consumption is reduced.

The connection between interest rates and investment is not so much stable.
It only affects after a considerable time lag.

ADVANTAGE:
The interest rates policy can be more fairly implemented.

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3. GROWTH IN THE VOLUME OF CREDIT:

I.CREDIT SQUEEZED.

Lower credit lowers the amount of borrowing; hence decrease the aggregate
expenditure, so also NI.

II.HIGHER LENDING:

Higher lending will increase the amounts of funds available to consumers, firms to be
spent, so there is an increase in the aggregate expenditure i.e. increase in GNP i.e. NI.

However it is not a serious option in today’s highly competitive market economy and in the
absence of exchange controls.

4. EXCHANGE RATES TARGET:

This target cannot be achieved unless inflation at home is controlled which ensures the
chances of Appreciation/Devaluation.

The following measures are available to government:

I.DEVALUATION OF DOMESTIC CURRENCY.

Exports become competitive as Import Prices rises.

II.APPRECIATION OF DOMESTIC CURRENCY.

Exports become expensive as Import Prices falls.

EFFECT OF DEVALUATION/APPRECIATION:
The overall affect will depend upon the Elasticity of demand for Exports at abroad and
Elasticity of demand for Imports at home.

5. GROWTH IN MONEY SUPPLY:

Theoretically this is the most appropriate monetary policy target, but cannot be practical
because of out datedness of available information.

This Government might set target levels for NI.

It may be growth in NI/GDP/GNP of X% p.a. for Y years.

MONETARY INDICATORS: ECONOMIC INDICATORS:

i. Size of Money Stock M1 or M2. Economic Indicators provide information about

ii. Interest rates e.g. Banks base economic conditions and might be used as a
Rates, LIBOR, Treasury bills rate, way of judging the performance of
etc. Government.
iii. Exchange Rate of Rupee Vs $
iv. Size of PSBR. TYPES:
v. PSBR as a percentage of GDP.
•1 Leading Indicator (Future).
•2 Coincident Indicator (Present).
• 3 Lagging Indicator (Past).
 INSTRUMENTS OF MONETARY POLICY

1.CONTROL OVER THE LEVEL AND STRUCTURE OF INTEREST RATES:

(Controls inflation and exchange rate only)

SHORT-TERM (OPEN MARKET OPERATION IN DISCOUNT MARKET)

Buying and selling of local currency.

The short-term measure is to cure inflation and exchange rate, not to control Money supply.

LONG-TERM MEASURES (CHANGING THE SIZE OF PSBR)

1Through Government funding policy

2Issuing Gilts edged securities

2. RESERVES REQUIREMENT ON BANKS:

(Controls Growth in Money Supply)

In order to control the growth in Money Supply, a special reserve requirement is set by the
SBP on Banks.
There is always a minimum reserve ratio, which reduces the size of credit multiplier
(D=C/r), hence control growth in MS.

DRAWBACKS:

i.Reserve requirement should be equally imposed on all financial institutions.

ii.Restrictions on domestic banks and no restrictions on foreign banks will give a
competitive disadvantage to the local banks.

3. SPECIAL DEPOSITS:
(Controls interest rates and MS Growth)

SBP might call Sp. Deposits from banks. Interest is paid on them. Sp. Deposits are tied up
and hence are illiquid.

WORKING:

Liquidity of the banks is decreased.

This applies an upward pressure on the interest rates.
Ability to lend at higher interest rates is hence squeezed.

4. EXCHANGE RATE CONTROLS:

(Affects the BoP, interest rates and Economic growth)

Exchange rates affect the BoP, inflation and economic growth so Government might seek to
achieve a target exchange rate for domestic currency.

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5. DIRECT CONTROLS ON BANKS LENDING:
(Controls growth in Money supply)

I.QUALITATIVE CONTROLS:

The purpose is to keep check on bank lending as a result of:

1Change in banks deposits;
2Imposing a lending ceiling.

ADVANTAGE:

A way of bridging the time lag before other policies can be implemented.

DISADVANTAGES:

a. Qualitative controls might be more permanent, hence unsuccessful because

escape is possible for some financial intermediaries.

b. It may be proved to be inefficient if lending capability can be redirected into other

NBFIs such as retained earnings.

c. Direct controls tend to divert financial flows into other, often less efficient,
channels i.e. leakages are inevitable.

EFFECTIVENESS:
Direct controls are therefore rarely effective in dealing with the source rather than the
symptom.

II.QUALITATIVE CONTROLS:

Qualitative Controls may be:

MANDATORY: difficult to impose without the cooperation of all banks

MORAL SUASION: frequently used. (A temporary form of control)

Government told SBP its policy and SBP issues:

1Orders;
2Suggestions; or
3Requests;
To:
1Restraint lending;
2Lending to priority sectors of economy; or/and
3Say no to private sector lending at all.

III.PRUDENTIAL CONTROLS:

The authorities oversight the banks and other FIs to ensure that they have adequate
capital structure, adequacy, liquidity (asset portfolio) and Foreign exchange
exposure.