Chapter 6- moneytary policy and its management for BBA

Monetary policy and its management

Chapter 6

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Monetary policy and its management

“There have been three great inventions since the beginning of time: fire, the wheel, and central banking.” Will Rogers

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The concept of money supply Money supply ("monetary aggregates", "money stock"),

a macroeconomic concept, is the quantity of money available within the economy to purchase goods, services, and securities. Thus, the quantity of money available in an economy is money supply.

In other words, money supply means total stock of money held by the public in spendable form.

The term public refers to the individuals and the business firms in the economy, excluding the central government, the central bank, and the commercial banks.

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The concept of money supply

Constitutnets of money supply: Different views. Broadly there are two views:

1. Traditional view: According to this view, money supply is composed of (a) currency money and legal tender i.e. coins and currency notes, (b) bank money i.e. chequable demand deposits with the commercial banks.

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2. Modern view: The phenomenon of money supply refers to the whole spectrum of liquidity in the asset portfolio of the individual. Thus, this approach includes (a) coins (b) currency notes (c) demand deposits with the banks (d) time deposits with the banks (e) financial assets such as deposits with the non-banking financial intermediaries like the post office saving banks, building societies etc.(f) treasury and exchange bills, (g) bonds and equities.

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There are two concepts of money supply: Narrow money supply and broad money supply. In Nepal, we have narrow money (M1) and broad money (M2).

Narrow money supply (M1)=Currency in circulation +Demand deposits

Broad money supply (M2)= M1+time deposits

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In the US, money supply is calculated as below: The most common measures are named M0 (narrowest), M1,

M2, and M3. In the United States they are defined by the Federal Reserve as follows:

M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.

M1: M0 + the amount in demand accounts ("checking" or "current" accounts).

M2: M1 + most savings accounts, money market accounts, small denomination time deposits and certificate of deposit accounts (CDs) of under $100,000.

M3: M2 + all other CDs, deposits of eurodollars and repurchase agreements.

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There are just two official UK measures. M0 is referred to as the "wide monetary base" or "narrow money" and M4 is referred to as "broad money" or simply "the money supply".

M0: Cash outside Bank of England + Banks' operational deposits with Bank of England.

M4: Cash outside banks (ie. in circulation with the public and non-bank firms) + private-sector retail bank and building society deposits + Private-sector wholesale bank and building society deposits and CDs.v

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Factors affecting money supply

There are two approaches generally used to identify the factors affecting money supply in the economy: the accounting approach, and the money multiplier or high powered theory of money.

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The accounting approach, which is also known as the balance sheet approach seeks to review monetary accounts: balance sheet of central bank and commercial banks. This approach takes the consolidated balance sheet items into account to identify the sources of money supply. There are two major sources of money supply: Net Foreign Assets (NFA), and Net Domestic Assets (NDA).

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In accounting approach, identical relationship is established. For example, M2 can be written as:

Sources M2 Uses

NFA+NDA M1+Time deposit

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In the above table ,

NFA=net foreign assets of the monetary sector (foreign assets less foreign liabilities)

NDA=net domestic assets of the money sector

M1=Narrow money

TD= Time deposits (saving plus fixed deposits plus call deposits plus margin deposits)

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Foreign assets include gold, SDR holdings, reserve position in the IMF, foreign exchange holding of central bank and commercial bank.

Foreign liabilities include foreign deposits held by the banking system and foreign loan of the banking system.

NFA increases when foreign assets increase or when foreign liabilities go down.

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NDA increases if claims on government, claims on government enterprises, and claims on private sector increase.

While increase in net non-monetary liabilities lower NDA. Net non-monetary liability refers other liability less other assets. Other liabilities include paid-up capital, general reserve etc of the banking system. And the other assets include fixed assets such as vehicle, furniture, sundry etc.

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The money multiplier or high powered theory of money: The money multiplier theory establishes a link between reserve money (also called high powered money or monetary base) and the money supply. This theory states that money stock is the product of joint interaction of demand for and supply of reserve money. According to this theory, there are two proximate determinants of money supply: money multiplier and reserve money.

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Factors affecting money supply According to the money multiplier theory, money

supply is :M= m RMWhere, M=Money supplym=value of money multiplier, which is m=M/RMRM= Reserve money or monetary base. This is the

liability of the central bank. This is equal to currency in circulation+ Deposits of deposit money banks and others with central bank.

The idea is that there is a positive relation between base money (RM) and money supply (M).

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Monetary policy

Monetary policy is the term used to describe the central banks use of tools to influence the economy by shrinking or expanding the money supply.

The money supply affects the interest rates. The two are related inversely, such that, as money supply increases interest rates will fall. When the interest rate equates the quantity of money demanded with the quantity of money supply, the economy is working at the money market equilibrium.

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Objective of Monetary policy

Objectives of monetary policy:

1. Price stability

2. Full employment

3. Economic growth

4. Favorable balance of payments

However, these objectives are conflicting. For example, price stability and high economic growth are very difficult to attain simultaneously.

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Objective of Monetary policy

Following are the objectives of monetary policy as stipulated in NRB Act 2002:

Ensuring the domestic price stability Maintaining BOP stability Managing adequate level of liquidity to facilitate

economic growth Ensuring financial sector stability Developing a secure, healthy, and efficient

domestic payments19

Instruments of monetary policy

The main three, which are also called quantitative instruments of credit control are:

Bank rate/Discount rate: The discount rate is the interest rate at which the central bank stands ready to lend reserves to depository institutions

Cash Reserve Ratio: The central bank sets required reserve ratios, which are the minimum percentages of deposits that depository institutions must hold as reserves.

Open market operations (purchase, sale, repo, and reverse repo): An open market operation is the purchase or sale of government securities— government bills and bonds—by the central bank in the open market.

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Instruments of monetary policy

The qualitative instruments of credit control exercised by monetary authority may include:

Credit limit or credit ceilings Differential interest rates Directed credit (for example, it is between

0.25 percent and 3.0 percent of bank’s loans in deprived sector in Nepal these days)

Moral suasion (includes persuasion and pressure)

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Monetary policy

Tighter Monetary Policy Looser Monetary Policy

Open market sale of securities Open market purchase of securities

Increase in discount rate Decrease in discount rate

Increase in reserve requirement Decrease in reserve requirement

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Monetary policy

If central adopts contractionary monetary policy, it tightens instruments and mops up liquidity from the economy.

If adopts expansionary monetary policy, looses its instruments and injects liquidity into the economy.

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Monetary policy frameworkFollowing table is an outline of the possible and suggestive list of monetary policy instruments, operating targets (indictors), intermediate targets, and ultimate goals.

Instruments Operating Targets

Intermediate Targets

Goals

CRRDR/BROMOsMoral Suasion

Depository reservesDiscount rate/interest rateMonetary base

Monetary aggregatesDR/BRDomestic credit

Price StabilityBoP SurplusHigh growth and employment

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Nepalese monetary policy framework

Right now, in Nepal following is the MP framework. It is not possible to attain goals directly through instruments. Therefore, operating targets and intermediate targets are set in between to attain goals.

Instruments Operating Target

Intermediate Target

Goals

CRR

BR

OMOs

Moral Suasion

Excess Reserve of Commercial banks

Monetary aggregates (Broad money)

Price StabilityBoP Surplus

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Who conducts monetary policy ? The answer is central bank. A central bank is the public

authority that regulates a nation’s depository institutions and controls the quantity of money.

The central bank mainly performs the following functions: Conduct of monetary policy Banker to the commercial banking system Banker to the government Supervisor of the banking system Manager of the national debt Manager of the foreign exchange reserve Issuer of the national currency

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The monetary transmission mechanism

How does money supply work in an economy? Through money transmission mechanism.

Money transmission mechanism, the route through which changes in the supply of money are translated into changes in output, employment, prices and inflation.

Take a few notes:

1. To start the process, the central bank takes steps to reduce bank reserves by selling government securities

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2. Each dollar reduction in bank reserves produces a multiple contraction in checking deposits, thereby reducing the money supply.

3. The reduction in the money supply will tend to increase interest rates and tighten credit conditions.

4. With higher interest rates and lower wealth, interest sensitive spending-especially investment-will tend to fall.

5. Finally the pressure of tight money, by reducing AD, will reduce income, output, jobs, an inflation.

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The above mentioned steps can be summarized as below:

R down M down i up I, C, X down AD down Real GDP down and inflation down

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Monetary Policy in the AS-AD Model

The following figure illustrates the attempt to avoid inflation.

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Monetary Policy, Real GDP,and the Price Level

A decrease in the money supply in part (a) raises the interest rate.

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The rise in the interest rate decreases investment in part (b).

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The decrease in investment shifts the AD curve leftward with a multiplier effect in part (c).

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Real GDP decreases and the price level falls.

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The following figure illustrates the attempt to avoid recession.

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An increase in the money supply in part (a) lowers the interest rate.

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The fall in the interest rate increases investment in part (b).

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The increase in investment shifts the AD curve rightward with a multiplier effect in part (c).

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Real GDP increases and the price level rises.

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The money demand

Money demand in an economy is: MD= P. L (I, Y) The equation suggests that there are three main

determinants of the nominal demand for money:

1. Interest rates. An increase in the interest rate will lead to a reduction in the demand for money because higher interest rates will lead investors to put less of their portfolio in money (that has a zero interest rate return) and more of their portfolio in interest rate bearing assets (Treasury bills).

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The money demand

2. Real income. An increase in the income of the investor will lead to an increase in the demand for money. In fact, if income is higher consumer will need to hold more cash balances to make transactions (buy goods and services).

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The money demand

3. The price level. An increase in the price level P will lead to a proportional increase in the nominal demand for money: in fact, if prices of all goods double, we need twice as much money to make the same amount of real transactions. Since the nominal money demand is proportional to the price level, we can write the real demand for money as the ratio between MD and the price level P. Then, the real demand for money depends only on the level of transactions Y and the opportunity cost of money (the nominal interest rate):

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The money supply targeting

Under monetary targeting (MT), central bank fixes the money supply, and keeps it constant.

MT is easily observable. People will know if the central bank hides information. And central bank controls inflation through MT.

Two types of shocks: inflationary shock and output shock will shift the money demand curve.

Under monetary targeting, central bank changes interest rate to offset the effect of increased demand for money.

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The money supply targeting

OM

S

R1

R

R2

E1

E

E2

MD1

MD

MD2

Money Supply and Demand

Rate of Interest

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Interest rate targeting (IRT)

Under IRT, central bank alters MS.

O

R

E1E

E2

MD1

MD

MD2

Money Supply and Demand

Rate of Interest

S2 S S1

M2 M M1 45

A few questions for you

Think and build your answer on your own. What is the stance of Nepalese monetary

policy this year: tight or loose? What is targeted in Nepal? What is the inflation rate in Nepal in Mid-

March 2007? Is Nepal’s central bank independent?

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Date post:	16-May-2015
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Chapter 6- moneytary policy and its management for BBA

Education