The Ultimate Guide to Understanding Monetary Policy: History, Tools, and Objectives

This document include:
1) What is monetary policy. history, who made this and why?
2) Why Government use Monetary Policy ?
3) Objectives of monetary policy.
4) Types of monetary policy
5) Quantitative tools of monetary policy.
6) Quantitative tools of monetary policy
7) Qualitative monetary policy

And much more

1. Presentation Monetary policy

2. Topic What is monetary policy. history, who made this and why?

3. Monetary-policy “Monetary policy is concerned with deciding how much money-the economy should have or perhaps more correctly deciding whether to increases or decrease the purchasing power of money.”

4. According to Macconal : “Changing the money supply to assist the economy to achieve a full employment” The central bank , which has a monopoly over the supply of many usually undertakes this policy. It is maintained through actions such as increasing the interest rate , or changing the amount of money banks need to keep in the bank reserve.

5. History The Bank of England in 1699, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established. Gold standard Breeton Woods IMF and World Bank Floating Rate system Gold has no role in present system while it treads any other metal in commodities market .

6. State Bank of Pakistan ( SBP ) State bank of Pakistan is the central bank of Pakistan. The headquarters are located in the financial capital of Pakistan ,in Karachi with its second headquarter in the capital , Islamabad.

7. Various Monetary policy of SBP in-different years In 2000-01 With the free fall of the Rupee in mid-September 2000, SBP had to tighten its monetary policy to defend the exchange rate In 2001-02 The tight monetary discipline visible in FY01 was-perceptibly eased in FY02. In2002-03 a substantial increase in the annual external account surplus and the easier monetary stance of the SBP left the money market wash with liquidity during FY03.

8. 2013-2014 In the monetary policy statement of February 2013, the SBP highlighted two main challenges for monetary policy: to manage the balance of payment position and to contain the possible increase in inflation. A cumulative decline of 450 basis points in the policy rate of SBP since the beginning of FY12 has played a role in this uptick. Moreover, an analysis of the balance sheets of the main sectors supports this assessment. In conclusion, given the risks to the balance of payments.

9. Inflation Inflation is the rise in general level of prices of goods and services in an economy over a period of time. When he price level rises , each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate. When prices rise the value of money fall.

10. Issue of New currency During inflation the SBP will issue new currency notes replacing many old notes. This will reduce the supply of money in economy.

11. Why Government use Monetary Policy ?????

12. Monetary policy use to manage economic growth, unemployment, and inflation.  It does this to influence production, prices, demand, and employment. Expansionary monetary policy increases the growth of the economy, while contractionary policy slows economic growth.  The three objectives of monetary policy are controlling inflation, managing employment levels, and maintaining long term interest rates . 

13. Cont.. The Fed implements monetary policy through open market operations, reserve requirements, discount rates, the federal funds rate, and inflation targeting. The most important is to manage inflation. And to reduce unemployment, but only after controlling inflation. Also it use is to promote moderate long-term interest rates.

14. Conclusion SBP has encountered difficulties to targeting the inflation, economic growth, employment and interest rate objectives. but still there are certain difficulties which are a huge hindrance in the way of Economic Policy. so SBP can control all hurdles with some suitable policies………..

15. Cont… (a) improve its capacity to forecast liquidity conditions and actively preempt inflationary pressures (b) develop a greater understanding of the channels of transmission of monetary policy (c) have an increasingly transparent policy framework

16. Topic Objectives of monetary policy

17. Objectives of monetary policy 1. Price stability 2. Rapid economic growth 3. Full employment 4. Exchange rate stability 5. Maintenance of equilibrium in BOP 6. To control business cycle 7. Reduction of inequality in income and wealth

18. 1. Price stability To control problems of Inflation Deflation Inflation: increase in price of services and goods in market Deflation: decrease in price of services and goods in market To stable price in average Level Income Demand Price Inflation

19. 2. Rapid economic growth Control interest rate for rapid economic growth Interest rate money supply If we want to increase money supply then we must reduce interest rate and vice versa Reduce interest rate High loan level High investment Rapid economic growth

20. Pakistan’s interest rates in some few last years Date Key rates 6/26/2020 7.00% 5/18/2020 8.00% 4/17/2020 9.00% 3/25/2020 11.00%

21. 3. Full employment By providing various jobs to different sectors like Business sector Health sector Educational sector ,etc. It is useful tool to provide economic and social welfare of the community. To a greater extent, this policy solves the problem of business fluctuations.

22. Topic Objectives of monetary policy

23. 4. Exchange rate stability Exchange rate is the price of home currency expressed in terms of any foreign currency. State bank is the custodian of foreign exchange reserve. Thus state bank is responsible to maintain stability in exchange rate. Forex Central Bank Exchange Rate Checked by Checked by

24. Cont… Stable exchange rate plays a key role in international trade. If exchange rate is very fluctuating, the international community might lose confiden-ce in our economy. Causes disequilibrium in BOP. So monetary policy aims to maintain the relative stability in exchange rate.

25. 5. Maintenance of equilibrium in BOP BOP stands for “Balance of payment”. BOP: Difference between export revenue and imports expenditures in a particular period. Equilibrium in BOP: when BOP equal to zero. Disequilibrium in BOP: surplus/deficit Surplus: BOP>0 Deficit: BOP<0

26. Cont… Many developing countries like Pakistan suffers from disequilibrium in BOP. Developed countries tries to maintain equilibrium. State Bank through its monetary policy tries to maintain equilibrium in BOP.

27. 6. To control business cycle Boom and depression are the main phases of business cycle. In period of boom economic growth is high. In period of recession and depression economic growth is low. If condition of economy is bad( recession and depression ) causes inflation, unemployment, deficit of BOP, instability in price and exchange rate.

28. 7. Reduction of inequality in income and wealth Inequality in income and wealth due to right of private property and law of inheritance is common feature of capitalist and mixed economy. As result society is divided into two classes, rich and poor. Poor class is generally exploited by rich class. The objective of monetary policy is to reduce the inequalities of income and wealth.

29. Topic Types of monetary policy

30. Types of monetary policy There are two types of monetary policy: Expansionary monetary policy Contractionary monetary policy

31. Expansionary monetary policy This type of policy is used to increase the amount of money circulating throughout the economy. The goal of this policy is to reduce the unemployment.

32. Cont… To increase the money supply the federal government can: Lower the interest rates Lower the reserve ratio Buy government bonds(open market purchase)

33. Example of a car If you want to buy a car and you want to buy it by taking loan from the bank. Consider the economy interest rates of a loan car is 12%. You think that the interest rate of this loan is very high I will not take it. You will not buy the car. But if the interest rate decreases to 8% now you can afford it you will buy a car.

34. Cont… This will increase in demand of car and when many people take this decision. The company will make more cars so more workers will be needed for the work. Hence the economy of the country will rise.

35. Merits of expansionary monetary policy It urges the economic growth during a economic decline or recession. By adding money to the economic system lowers interest rates and eases credit restriction that banks apply to loan applications. It means businesses can borrow money more easily which leads them to spend more money.

36. Demerits of expansionary monetary policy Consumption and investment are not completely dependent on interest rates. If the interest rate is very low then it can be reduced more thus making it ineffective. The main problem of this policy is time lag which comes after several months.

37. Contractionary monetary policy This type of policy is used to decrease the amount of money circulating throughout the economy. It is the complete opposite of expansionary monetary policy. The goal of this policy is to reduce inflation. Therefore the tool would be decrease in the money supply.

38. Cont… To decrease the money supply the federal government can: Lower the interest rates Raise the reserve ratio Sell government bonds(an open market sell)

39. Example of a car If we want to buy a car by taking loan from a bank. The interest rates we consider are 8% and are affordable we will buy the car but if the interest rates are high consider 12 % we cannot afford the loan we will not buy the car. Hence when many people not buy the car the car companies will not make more cars.

40. Cont… Hence they will not hire more workers but instead of hiring they will kick out the workers so it will cause unemployment so the economy of country decreases.

41. Merits of contractionary monetary policy It slows down the expansion or rampant inflation of a booming economy. The government uses several methods to decrease of money supply. By increasing the interest rates to make the money more expensive and hard to borrow which leads the consumer not to spend much money.

42. Demerits of contractionary monetary policy The production is reduced in the economy as a by product of slowing the economic engine. More expensive capital expenses and a reduced demand for products and services are responsible for this. Once companies started down production, it can take years to rise it again.

43. Topic Quantitative tools of monetary policy

44. Tools of monetary policy There are two types of tools: Quantitative tools Qualitative tools

45. Quantitative tools Also known as General tools of monetary policy It affects the amount of credit Designed to control the total volume of bank credit in the economy

46. Quantitative tools They are: Cash reserved ratio Statutory liquidity ratio Open market operation

47. Cash reserved ratio CRR is the amount of cash that the banks have to keep with RBI. This ratio is basically to secure solvency of the bank & to drain out of the excessive money from the banks. For example; if you deposit Rs. 100 in your bank, then bank can’t use the entire Rs. 100 for lending or investment purpose

48. Cash reserved ratio No interest Low CRR = happy banks Current CRR is 5%

49. Effects When RBI increases the CRR less funds are available with banks as they have to keep large portion of their cash in hand with RBI When RBI decreases the CRR more funds are available with banks as they have to keep small portion of their cash in hand with RBI

50. How CRR affects the economy? When the CRR is Hiked Lowered

51. Statutory liquidity ratio It is the minimum percentage of deposits that a bank has to maintain in form of gold, cash or other approved securities. Give interests Current SLR is 25%

52. Effects When RBI increases the SLR less funds are available with banks as they have to keep large portion of their cash in hand with RBI When RBI decreases the SLR more funds are available with banks as they have to keep small portion of their cash in hand with RBI

53. How does SLR affect economy? When the SLR is: Hiked Lowered

54. Open market operation It refers to buying & selling of government securities in open market in order to expand or contract the amount of money in banking system

55. Topic Quantitative tools of monetary policy

56. Liquidity Adjustment Facility (LAF) It is a monetary policy tool used by RBI to control short term money supply or inflation in the economy. Two tools used under LAF Repo rate Reverse repo rate

57. Repo rate Repo is a short term borrowing for dealers or commercial banks in government securities. The dealers can be any financial institution or bank. They sells the securities to investors on an overnight basis or weekly basis and buys them back on a higher rate. The rate at which the securities are bought back is called as repo rate . It is also known as repurchase agreement and sale-purchase agreement.

58. Commercial bank/seller Govt. securities 10 Cr. Rs Govt. securities Commercial bank RBI RBI/buyer 10 Cr. + repo interest

59. Reverse repo rate Reverse repo is a short term borrowing for investor(RBI) or banks in government securities. The investor can be any financial institution or bank. They sells the securities to dealers on an overnight basis or weekly basis and buys them back on a higher rate. The rate at which the securities are bought back is called as reverse repo rate.

60. Commercial bank/buyer RBI/seller 10 Cr. Rs Govt. securities Commercial bank RBI Govt. securities 10 Cr. + reverse repo interest

61. Inflation VS growth Repo and Reverse repo rates help RBI to control inflation. Nov 2020 Repo rate 4.0% Reverse repo rate 3.35% Control inflation Repo rate Reverse repo 4.5% 3.65% Interest rate Loans Money supply Demand Prices (inflation)

62. Cont… Increase growth For maintenance the balance of prices and growth, RBI do less or more the rate of repo and reverse repo. Repo rate Reverse repo 3.5% 3.0% Interest rate Loans Money supply Demand Growth rate Prices (inflation)

63. Marginal standing facility (MSF) MSF is a window for banks to borrow from the reserve bank of India (RBI) in an emergency situation when inter-bank liquidity dries up completely. In which we take the minimum amount is 1 Cr. or multiple. MSF rate = Repo rate + X% Initially, MSF rate = repo rate + 1%

64. Why MSF Repo rate MSF rate If total NDTL of banking – Rs. 80 lakh Cr. Max. repo lending – Rs. 80,000 Cr. If total NDTL of banking – Rs. 80 lakh Cr. Max. MSF lending – Rs. 80,000 Cr. Eligibility: Scheduled commercial banks and primary dealers. Eligibility: Only Scheduled commercial banks. Collateral: Govt. securities under SLR requirements cannot be considered. Collateral: Govt. securities under SLR requirements can be considered.

65. Topic Qualitative monetary policy

66. Monetary policy tool Qualitative measure (selective control credit method)

67. Qualitative monetary policy Definition : They are used when central bank wants to alter/ change the use, distribution and direction of credit.

68. Monetary policy

69. 1. Margin requirement : Margin requirement influence the flow or direction of credit. The margin refers to the proportion of loan amount which is not financed by the bank. A change in margin implies change in loan size. Example: Margin requirement loan increase discourage decrease encourage

70. Continue... Central bank can increase margin for non- necessary sectors so as to discourage them to take loans and central bank can decrease margin for needy sectors to encourage them to take more loan.

71. 2. Rationing of credit: Credit rationing is controlling the amount of credit available for various sectors such that no sector is neglected. Under this, central bank fixed ceiling on loans for specific categories which commercial bank cannot exceed. profit Priority sectors

72. 3. Moral suasion: Moral suasion is a method that central bank adopts to persuade commercial bank to adhere to the policies and act in a manner as desired by central. Under this, central bank convince or persuade the commercial bank to advance credit in accordance with the directive of central bank in economic interest of the country. For this:

73. 4 . Direct action : The central bank can enforce direction on all banks or a particular bank related to their lending. This method is adopted when commercial bank do not cooperate with central bank in controlling the credit . It is too severe and involve punishment in form: Reject altogether any application for grant of discounting facilities of banking. Penal rate can be charged from bank.