Monetary Policy

Tools & Affects

Assignment for:
Money & Banking

Written by:
Muhammad Qasim
BM-26464
Contents
INTRODUCTION ....................................................................................................................................... 3
MONETARY POLICY ................................................................................................................................. 3
Definition ............................................................................................................................................ 4
Types of monetary policy .................................................................................................................... 4
Objectives of Monetary Policy: ........................................................................................................... 5
Instruments of Monetary Policy ......................................................................................................... 5
State Bank uses tools of Monetary Policy:.......................................................................................... 5
Use Open Market Operations to change the monetary base.................................................... 6
Changing the Discount Rate:...................................................................................................... 6
Changing the reserve Requirements (CRR & SLR): .................................................................... 7
Affecting a change in nominal interest rate: ........................................................................... 10
MONETARY POLICY AND ITS EFFECTS ON ECONOMY:.......................................................................... 12
How does Monetary Policy affect the economy of a country? ........................................................ 14
Consumption, Saving and Investment: .................................................................................... 14
Foreign Exchange, Imports and Exports: ................................................................................. 15
Output and Employment: ........................................................................................................ 15
INTRODUCTION

Monetary policy is one of the tools that a Government uses to influence its economy. Using its
monetary authority to control the supply and availability of money, a government attempts to
influence the overall level of economic activity in line with its political objectives. Usually this goal is
"macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of
external payments. Monetary policy is usually administered by a Government appointed "Central
Bank" like the State Bank of Pakistan. Pakistan’s monetary policy is concerned with how much
money circulates in the economy, and what that money is worth. The ultimate objective of
monetary policy is to promote solid economic performance and higher living standards for
Pakistani’s. The best way to achieve that objective is to keep inflation low, stable, and predictable.

State bank play a highly important role in the international financial systems today. With the right
monetary policy they are able to bring about economic growth and financial stability in a country.
Conditions in different countries are diverse; therefore the structure of a State bank can also be
quite different.

One of the functions of a State Bank is to ensure the health of the economy of the country. It does so
by setting monetary policies, managing foreign exchange and reserves, setting interest rate and
money supply to mange inflation among others. However the function that a State bank is most
associated with is setting monetary policies. It mainly influences the economy of a country by
controlling the money supply, and one of its main policy instruments is interest rate. Interest rates
set by the State bank affects the borrowing by commercial bank and other market institutions,
hence affecting the other interest rates in the market.

The relationship between the State Bank and the Government is an extremely important and equally
sensitive area. They share virtually the totality of policy framework where by Ministry of Finance
manages the fiscal policy while the State Bank organizes the monetary and exchange rate.

MONETARY POLICY
Monetary policy is what central banks use to manage the amount of liquidity in the economy.
Liquidity is the total amount of money, including cash, credit and money market mutual funds. The
important part of liquidity is credit, which includes loans, bonds, mortgages, and other agreements
to repay.
Central banks, including the State Bank of Pakistan, manage the money supply to guide economic
growth. Monetary policy rests on the relationship between the rates of interest in an economy, that
is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses
a variety of tools to control one or both of these, to influence outcomes like economic growth,
inflation, exchange rates with other currencies and unemployment. Where currency is under a
monopoly of issuance, or where there is a regulated system of issuing currency through banks which
are tied to a central bank, the monetary authority has the ability to alter the money supply and thus
influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes
from the late 19th century, where it was used to maintain the gold standard.
Monetary policy is a short-run tool used by the State 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 discuss what monetary policy is? And how it is used by the State bank?

“Monetary policy is the process of managing a nation's money supply to achieve specific goals such
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
developing countries with floating exchange rates (like Pakistan etc.) and monetary policy involves
the management of short-term interest rates by central banks to pursue the macroeconomic
objectives of the economy.

Definition

“Monetary policyis the process by which the monetary authority of a country controls the supply of
money, often targeting a rate of interest for the purpose of promoting economic growth and
stability.”

Types of monetary policy

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.

 Inflation Targeting
 Price Level Targeting
 Monetary Aggregates
 Fixed Exchange Rate
 Gold Standard
 Mixed Policy
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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 investor’s 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 State 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.

Instruments of Monetary Policy

Fiduciary or paper money is issued by the Central Bank on the basis of computation of estimated
demand for cash. Monetary policy guides the Central Bank’s supply of money in order to achieve the
objectives of price stability (or low inflation rate), full employment, and growth in aggregate income.
This is necessary because money is a medium of exchange and changes in its demand relative to supply,
necessitate spending adjustments. To conduct monetary policy, some monetary variables which the
Central Bank controls are adjusted-a monetary aggregate, an interest rate or the exchange rate-in order
to affect the goals which it does not control. The instruments of monetary policy used by the Central
Bank depend on the level of development of the economy, especially its financial sector.

State Bank uses tools of Monetary Policy:

The State Bank is also in charge of conducting monetary policy which means changing the supply of
money in the economy. In order to attain the objectives discussed above, the State bank uses tools of
the monetary policy which are:

1. Open market operations.

2. The discount rate.
3. Reserve requirements
4. Nominal interest rate

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Use Open Market Operations to change the monetary base (OMO): The most effective and major tool the
State bank uses to affect the monetary supply in the economy is open market operations. The bank
would buy and sell government securities (usually bonds or T-bills) in exchange of hard currency.

If the State 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.

Conversely, in order to tighten the monetary base in the economy, the State 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.

An open market operation (OMO) is an activity by a central bank to give (or take) liquidity in its currency
to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds in the
open market (this is where the name was historically derived from) or, which is now mostly the
preferred solution, enter into a repo or secured lending transaction with a commercial bank: the central
bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as
collateral. A central bank uses OMO as the primary means of implementing monetary policy. The usual
aim of open market operations is - aside from supplying commercial banks with liquidity and sometimes
taking surplus liquidity from commercial banks - to manipulate the short-term interest rate and the
supply of base money in an economy, and thus indirectly control the total money supply, in effect
expanding money or contracting the money supply. This involves meeting the demand of base money at
the target interest rate by buying and selling government securities, or other financial instruments.
Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this
implementation.
To increase the money supply in the market, the SBP will purchase securities from banks. The funds that
the banks acquire from the sale can be used as loans to individuals and businesses. The more money
that is available in the market for lending, the lower the rates on these loans become, which causes
more borrowers to access cheaper capital. This easier access to capital leads to greater investment and
will often stimulate the overall economy.

Changing the Discount Rate: Banks borrow money from the State Bank by cashing or discounting credit
instruments, such as bills of exchange. By raising the discount rate SBP discourages bank to borrow
money. If and when the goal is to increase the money supply, the Bank lowers its discount rate to
encourage borrowing by the banks and thus helps increasing the money supply. Also by calling in
existing loans or extending new loans, the monetary authority can directly change the size of the money
supply.

The discount rate is the interest rate charged to commercial banks and other depository institutions on
loans they receive from their regional State Bank of Pakistan Bank's lending facility--the discount
window. The State Bank of Pakistan Banks offer three discount window programs to depository
institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All
discount window loans are fully secured.

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Under the primary credit program, loans are extended for a very short term (usually overnight) to
depository institutions in generally sound financial condition. Depository institutions that are not eligible
for primary credit may apply for secondary credit to meet short-term liquidity needs or to resolve severe
financial difficulties. Seasonal credit is extended to relatively small depository institutions that have
recurring intra-year fluctuations in funding needs, such as banks in agricultural or seasonal resort
communities.

The discount rate charged for primary credit (the primary credit rate) is set above the usual level of
short-term market interest rates. (Because primary credit is the State Bank of Pakistan's main discount
window program, the State Bank of Pakistan at times uses the term "discount rate" to mean the primary
credit rate.) The discount rate on secondary credit is above the rate on primary credit. The discount rate
for seasonal credit is an average of selected market rates. Discount rates are established by each
Reserve Bank's board of directors, subject to the review and determination of the Board of Governors of
the State Bank of Pakistan System. The discount rates for the three lending programs are the same
across all Reserve Banks except on days around a change in the rate.

Setting a high discount rate tends to have the effect of raising other interest rates in the economy, since
it represents the cost of borrowing money for most major commercial banks and other depository
institutions. This could be considered contractionary monetary policy. Exactly how much a high discount
rate affects the economy as a whole depends on the relationship between the discount rate and the
normal market rate of interest for loans to banks.
In part, interest rates represent the cost of borrowing money. When it is less expensive for banks to
borrow money from the State Bank of Pakistan, they can subsequently charge less interest on their own
loans. This has a ripple effect on the demand for loanable funds everywhere, unless the market rate of
interest is equally as high.
Interest rates also coordinate savings in the economy. When too few actors want to save money, banks
entice them with higher interest rates. Between savings and loans, interest rates help coordinate
economic activity between different actors and different points in time. Savings represent a preference
for future consumption over present consumption, while the opposite is true for borrowing. If the
discount rate is raised too high, it could throw this coordinating mechanism out of balance.
More immediate impacts are felt from a high discount rate. Loans are more expensive, and borrowers
have to work to pay off loans more quickly. This has the effect of taking money out of the economy,
which could also cause prices to decline. Individuals are encouraged to save more. This leads to an
increase in capital funding. Whether this helps or harms the economy depends on many other factors
and is very difficult to gauge.

Changing the reserve Requirements (CRR & SLR): the proportion of the total assets that banks must hold
in reserve with State bank. Banks 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
loan able funds, thus mean the broader monetary base in the economy. This act as a change in the
money supply.

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Cash reserve ratio is the amount of cash that the banks have to keep up with the central bank. This ratio
is basically to secure the solvency of banks and to drain out the excessive money from the banks. If the
central bank decides to increase the percent of this, the available amount with the banks come down ,
and if the central bank reduces the CRR then the available amount with banks increased and they are
able to lend more.
This serves two purposes. First, it ensures that some bank deposits are totally risk-free and second it
enables the central bank to control liquidity in the system, and thereby, inflation by restricting lending of
money.

SLR and CRR are reserve requirements set by the central bank of a state to regulate liquidity in the
market. The purpose and use of these requirements vary from country to country. In some countries
they are merely used as a tool to ensure ability of bank to pay its current liabilities i.e. withdrawals
by depositors. But in most countries like Pakistan, India and China, they are also used as a tool for
monitory policy and to control inflation along with liquidity broadening the usability of these
requirements.

State Bank of Pakistan sets SLR and CRR in Pakistan which apply to all banks and DFIs here. They are
changed as and when needed, by SBP. These reserve requirements are the part of monitory policy
of State Bank of Pakistan used as a tool to control liquidity and inflation. A tight requirement will
result in low liquidity in the market and downward change in inflation and vise-versa.

Although both SLR and CRR are reserves, main difference between the two is that CRR is kept with
State Bank of Pakistan while SLR is kept by banks with themselves.

Having two requirements provide SBP flexibility to choose between two options to regulate liquidity
in the market. Recently SBP lowered the CRR and exempted time liabilities from SLR to maintain
liquidity level and meet the credit requirements.

Maintaining Liquidity
As discussed before, these reserves are used to control liquidity in the market. When SBP feels that
liquidity should be lower, it tightens the requirement and when it feels that market needs more
currency in circulation, it softens the requirement. The effect of these requirement is that if banks
have 100 rupees in deposits and reserve requirement is 10%they can generate credit of
maximum1000 rupees (100/10%). Because first bank will lend 90 rupees and if lent money is again
deposited, that bank will lend 81 rupees and so on (100+90+81…..=1000) so if the requirements is
soften to 8%, banks will be able to generate credit of maximum1250 rupees out of the same 100
rupees deposit.

Controlling Inflation
Another thing that is being controlled by SBP using these requirements is inflation. This is done by
controlling money supply and credit. The relationship can be best understood through this formula:

MV = PQ

Where:

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M = Money supply
V = Velocity (number of times a rupee is spent) in the year
P = Average price of all goods and services sold in the year
Q = Quantity of goods, services and assets sold during the year

P represents the inflation which is effected by the other variables and controlling them, SBP controls
the inflation (P)

SLR

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CRR

Affecting a change in nominal interest rate:The contraction of the monetary supply can be achieved
indirectly by increasing or decreasing the nominal interest rates. By changing the discount rate and by
conducting open market operations a change in money supply would affect the nominal interest rates. A
tight money supply tends to increase nominal interest rates while an increase in money supply can help
bring down the interest rates. A change in the nominal interest rates influences the overall economic
activity, rate of inflation, GDP and economic growth.

Nominal interest rate refers to the interest rate before taking inflation into account. Nominal can also
refer to the advertised or stated interest rate on a loan, without taking into account any fees or
compounding of interest. Finally, the federal funds rate, the interest rate set by the SBP, can also be
referred to as a nominal rate.

“Nominal interest rates exist in contrast to real interest rates and effective interest rates. Real interest
rates tend to be important to investors and lenders, while effective rates are significant for borrowers as
well as investors and lenders.”

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Unlike the nominal rate, the real interest rate takes the inflation rate into account. The equation that
links nominal and real interest rates can be approximated as: nominal rate = real interest rate + inflation
rate, or nominal rate - inflation rate = real rate.

A nominal interest rate is the interest rate that does not take inflation into account. It is the interest rate
that is quoted on bonds and loans. The nominal interest rate is a simple concept to understand; for
example, if you borrow $100 at a 6% interest rate, you can expect to pay $6 in interest without taking
inflation into account. The disadvantage of using the nominal interest rate is that it does not adjust for
the inflation rate.

A real interest rate is the interest rate that does take inflation into account. As opposed to the nominal
interest rate, the real interest rate adjusts for the inflation and gives the real rate of a bond or a loan. To
calculate the real interest rate, you first need the nominal interest rate. The calculation used to find the
real interest rate is the nominal interest rate minus the expected or actual inflation rate. This rate gives
the real rate that lenders or investors are receiving after inflation is factored in; it gives them a better
idea of the rate at which their purchasing power is increasing or decreasing.

The nominal interest rate (or money interest rate) is the percentage increase in money you pay the
lender for the use of the money you borrowed. For instance, imagine that you borrowed $100 from your
bank one year ago at 8% interest on your loan. When you repay the loan, you must repay the $100 you
borrowed plus $8 in interest—a total of $108.

But the nominal interest rate doesn’t take inflation into account. In other words, it is unadjusted for
inflation. To continue our scenario, suppose on your way to the bank a newspaper headline caught your
eye stating: “Inflation at 5% This Year!” Inflation is a rise in the general price level. A 5% inflation rate
means that an average basket of goods you purchased this year is 5% more expensive when compared
to last year. This leads to the concept of the real, or inflation-adjusted, interest rate. The real interest
rate measures the percentage increase in purchasing power the lender receives when the borrower
repays the loan with interest.. In our earlier example, the lender earned 8% or $8 on the $100 loan.
However, because inflation was 5% over the same time period, the lender actually earned only 3% in
real purchasing power or $3 on the $100 loan.

The diagram below illustrates the relationship between nominal interest rates, real interest rates, and
the inflation rate. As shown, the nominal interest rate is equal to the real interest rate plus the rate of
inflation.

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To avoid purchasing power erosion through inflation, investors consider the real interest rate, rather
than the nominal rate. One way to estimate the real rate of return is to observe the interest rates on
Treasury Inflation-Protected Securities (TIPS). The difference between the yield on a Treasury bond and
the yield on TIPS of the same maturity provides an estimate of inflation expectations in the economy.

MONETARY POLICY AND ITS EFFECTS ON ECONOMY:

In the short run, monetary policy influences inflation and the economy-wide demand for goods and
services--and, therefore, the demand for the employees who produce those goods and services--
primarily through its influence on the financial conditions facing households and firms. During normal
times, the State Bank of Pakistan has primarily influenced overall financial conditions by adjusting the
federal funds rate--the rate that banks charge each other for short-term loans. Movements in the
federal funds rate are passed on to other short-term interest rates that influence borrowing costs for
firms and households. Movements in short-term interest rates also influence long-term interest rates--
such as corporate bond rates and residential mortgage rates--because those rates reflect, among other
factors, the current and expected future values of short-term rates. In addition, shifts in long-term
interest rates affect other asset prices, most notably equity prices and the foreign exchange value of the
dollar. For example, all else being equal, lower interest rates tend to raise equity prices as investors
discount the future cash flows associated with equity investments at a lower rate.

In turn, these changes in financial conditions affect economic activity. For example, when short- and
long-term interest rates go down, it becomes cheaper to borrow, so households are more willing to buy
goods and services and firms are in a better position to purchase items to expand their businesses, such
as property and equipment. Firms respond to these increases in total (household and business) spending
by hiring more workers and boosting production. As a result of these factors, household wealth
increases, which spurs even more spending. These linkages from monetary policy to production and
employment don't show up immediately and are influenced by a range of factors, which makes it
difficult to gauge precisely the effect of monetary policy on the economy.

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Monetary policy also has an important influence on inflation. When the federal funds rate is reduced,
the resulting stronger demand for goods and services tends to push wages and other costs higher,
reflecting the greater demand for workers and materials that are necessary for production. In addition,
policy actions can influence expectations about how the economy will perform in the future, including
expectations for prices and wages, and those expectations can themselves directly influence current
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.

 Inflation is the rise over time in the prices of goods and services usually measured as an annual
percentage, just like interest rates.
 Inflation is the natural byproduct of a robust, growing economy.
 No inflation or deflation (the lowering of prices), is actually a much worse economic indicator.
Also, in a healthy economy, wages rise at the same rate as prices.
 Interest rates is just one factor(but a major driver) affecting the inflation.
 The picture explains the relation between interest rates and economy.

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Relation between inflation and economy

Inflation and interest rates are linked, and frequently referenced in macroeconomics. Inflation refers to
the rate at which prices for goods and services rises. In the United States, interest rates are determined
by the State Bank of Pakistan (sometimes called "the Fed"). In general, as interest rates are lowered,
more people are able to borrow more money. The result is that consumers have more money to spend,
causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates.
As interest rates are increased, consumers tend to save as returns are higher. With less disposal income
to spend as a result of the increase in savings, the economy slows and inflation decreases.

How does Monetary Policy affect the economy of a country?

After having discussed the objectives and tools of monetary policy, 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 bank’s willingness to lend more and investors to invest more, on the other
side discourage saving, resulting to increase spending and aggregate demand.

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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.

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