PART 2: Monetary Policy

Chapters 12:250-252, 256-259 & 17:373-374

State Bank of Vietnam

State Bank of Vietnam

– The State Bank of Vietnam defines its principal roles as:

– Promoting monetary stability and formulating monetary policy.

– Promoting institutions’ stability and supervising financial institutions.

– Providing banking facilities and recommending economics policies to the government.

Contd…

– Providing banking facilities for the financial institutions.

– Managing the country’s international reserves.– Printing and issuing banknotes.– Supervising all commercial banks’ activities in

Vietnam. Lending state money to the commercial banks.

– Issuing government bonds, organising bond auctions.

– Being in charge of other roles in monetary management and foreign exchange rates.

Monetary Policy

• “Central banks in most developed economies usually

describe their aims in terms of the pursuit of non-

inflationary growth.

• Today, there’s a consensus that price stability should

be the overriding objective of monetary policy.

• External Balance Goal: Maintain the exchange rate

within a particular band.

• Internal Balance Goal: Maintain the inflation rate

within a particular band.

External Balance

• When there is an increase in the demand for the Dong;

the market exchange rate strengthens and the

exchange rate moves to the lower end of the

established band, the Authority sells VND to banks. • The money base (supply) will increase, pushing down

Vietnamese dollar interest rates. Lower domestic

interest rates relative to foreign interest rates restrain

capital inflows into the nation (encouraging outflows). • Supply of foreign currency decreases, weakening the

currency to restore stability.

External Balancer

Ms0

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Quantity

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External Balance

• When there is a decrease in the demand for the Dong and the currency weakens; the exchange rate moves to the upper end of the established band, the Authority purchases VND from banks.

• The money base (supply) will decrease, pushing up Vietnamese dollar interest rates. Higher domestic interest rates relative to foreign interest rates induce capital inflows into the nation.

• Supply of foreign currency increases, strengthening the currency and restoring stability.

External Balancer

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Inflation

• Inflation is more about value of money than value of goods. Ice cream is the same but when you pay more money becomes less valuable.

• Inflation in an economy is a wide phenomenon that concerns with the value of currency in the economy.

Internal Balance

• Sale and purchase of government securities changes bank reserves and thus their ability to extend credit, thus changing the money supply and the interest rate.

• The Monetary Authority targets interest rates by affecting system liquidity.

• Monetary policy influences the size of bank reserves. This influences:– The size of the money supply.– The interest rate and the availability of credit.– Investment spending, interest-sensitive consumption

spending thus output, employment and the price level.

Open Market Operations

• Monetary Authority actions designed to change interest rates by changing system liquidity to change the cost of credit and thus economic activity and the price level.

Open Market Operations

• Easy Money: Authority announces its decision to reduce interest rates – it buys government securities to maintain the lower interest rates; expanding the money supply and reducing the cost of credit. (Purchases)

• Tight Money: Authority announces its decision to increase interest rates – it sells government securities to maintain the higher interest rates; reducing the money supply and increasing the cost of credit. (Sale)

Internal Balance – Contractionary Policy

DAUD0

Quantity

Exchange rateSAUD

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A policy aimed at increasing interest rates and to restrict AD

Internal Balance – Expansionary Policy

Quantity

Exchange rate

e0

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Policy aimed at reducing interest rates and raising the level of AD.

Monetary Policy Effectiveness

• Responsiveness of capital flows,

consumption and investment to changes

to changes in interest rates.

• Phase of the business cycle.

• Private decisions of lenders and

borrowers.

• Size of the expenditure multiplier.

Application Question 11

Suppose you are the monetary policy adviser for the

government. The economy is experiencing a large and

prolonged inflationary trend. What change in open

market operations would you recommend?

Revision 9

Questions for Review: Problems and Applications:

Chapter 12: 4-5, 7 Chapter 12: 8, 10

Chapter 17: 1, 4-5

Are the following true or false? Explain.

1. If the monetary authority increases the money supply, subsequent

portfolio adjustment will reduce interest rates, which in turn will

increase investment expenditure.

2. The buying and selling of government securities in the open market

by the monetary authority is a major cause of changes in the money

supply.

3. The monetary authorities can influence the money supply or the rate

of interest but they cannot set the two independently.

Review

• RMIT, 2009,Lecture Slides, BB.

• Image ref: http://dollardaze.org/blog/posts/2007/May/31/1/FRN.jpg

References