Monetary Policy Lec

8/8/2019 Monetary Policy Lec

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Monetary policy is concerned with deciding how

much money the economy should have or

perhaps more correctly deciding whether toincrease or decrease the purchasing power of

money.


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There are several objectives of it Like:

1. To Achieve Full Employment

Developing countries have under-utilized

resources.They also have great room of expansion

and development.

2. To High Efficiency

There are wastage and misallocations in theeconomy.


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3. To have Large Scale Resource Mobilization

Resource mobilization refers to the process

of generation of savings and usage in productive process. Developing countries have low rate of

capital formation and accumulation, so monetary

techniques are used to increase resource

mobilization.

4. To Increase Exports

Developing countries are tries to increase

their exports for foreign exchange reserves. So they

make their policies to increases the exports. In other

words exports friendly policies.


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5. High Investment

Investments are lifeblood for developing

countries. Because they increases the living standards,per capita income and lead to efficient utilization of

countrys productive resources.

6. Price and Exchange Stability

Fluctuation in price level and exchange rate

discourage investment and capital inflows. So

monetary policy is used to produce stability in the

economy.


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7. To Accelerate Economic Growth

Monetary policy is a key to accelerate thepace of economic growth. It can be used to increase

credit and investment that leads to economic growth


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1) To have High Aggregate Demand without Inflation

Aggregate demand, when increases, gives

encourage to supply side of the economy to

produced and supply more. It results in largerallocation of resources, increase in general price

level and employment opportunities.


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2. High research / further Development

Developed countries give much importance toresearch and innovations. So monetary tools are

used to channelize recourses towards these fields.

3. Providing assistance to other Countries

It is well known practice that developed countries

provide loans, aids and monetary grants to under

developed countries.

4. Gaining monetary control over other CountriesToday developed countries have greater hold over

less developed countries. They design their

monetary policy to cover the way of their

dominance on others.


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y Quantitative Tools

These tools are of such nature that they produceeffects on whole of the economy without any

differentiation. They directly affect the total amount ofcredit supply in the economy. These are:

I. Open Market Operations

The Process of buying and selling

government bonds in the financial market is calledOpen market operations. This process can be

divided into to cases:


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The government issues securities in order to raise capitaland finance. These securities are traded in gilt

market which is part of capital market.Buying Securities

State bank can buy securities either from thecommercials bank or from public.

Selling securities

Securities can be sold either to bank or to public.

If central bank purchase securities from banks , it paysthem in money. This increases cash reserves of thecommercial bank and hence their lending powerincreases.


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When it sells securities , it hands over securities tocommercial banks. Commercial banks pay cash to

central bank. This reduces commercial banks cashreserves and their lending power is reduced.

The changes in credit and money supply brings relevantchanges in the market.

Effects on interest rateswhen securities are purchased by the central bank

then commercial banks ends up with excessive cashreserves, then they reduced interest rates to attract

borrowers and investors.


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Undeveloped Markets

For effective open market operations the moneyand capital markets must be fully developed. In the

absence of broad and developed market the state bankwill not be able to sell or buy government securitieswell in time to exert desire influences on the economy.

Excessive Cash Reserves

The basic purpose of OMO is to decrease cashbalances of commercial banks so as to reduce theirlending power.


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Now if commercial banks have such excessive cash

reserves, that purchasing of securities does not any

significant reduction in their cash balances then OMOwill be ineffective.

While selling or purchasing securities, the central

bank is in-fact trying to direct cash reserves of

commercial banks in its desired pattern. If this does

not happen and commercial banks keep on channeling

cash reserves according to their own priorities then

OMO are totally failed.


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y In Pakistan the money and capital markets are not welldeveloped. So open market operation are not widelyused as a main tool of monetary policy.

y

However despite all this, the SBP has open marketoperations committee. The committee is responsiblefor conducting open market operations in accordancewith credit control policies.


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y Bank rate is the rate at which central bank is willing to

rediscount first class bills of exchange of commercial

banks or is willing to advance loans against approved

securities.y Initially, the bank rate of SBP was 3%. In 1959, it was

raised to 4%. In 1965 it was raised to 5%. Then from

time to time it was increased. The last increase was

made in june, 1977 when it was raised to 10%.


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Commercial banks require to hold certain amount

of cash reserves with central bank. Which

expressed in %age of banks time and demand

liabilities ( cash reserve ratio). This method

reinforces the effectiveness of open market

operations and bank rate methods to control credit.


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Time Deposit

It is a money deposit at a banking institution that cannot

be withdrawn for a certain "term" or period of time (unless apenalty is paid). When the term is over it can be withdrawn or

it can be held for another term. Generally speaking, the longer

the term the better the yield on the money. A certificate of

deposit is a time-deposit product.

Demand Deposit

The opposite is a demand deposit also known as sight

deposit or on call which can be withdrawn at any time, without

any notice or penalty; e.g. money deposited in a savings

account in a bank.


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y The changing of the reserve ratio causes effect onsurplus funds which the commercial banks can use tocreate credit.

y

When the cash reserve ratio is raised commercialbanks have to keep more cash reserves with centralbank. Thus their surplus funds are reduced and creditpotential contracts.

y The opposite happens when cash reserve is lowered.Commercial banks will have more surplus funds togrant loans.


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y This instrument is more effective than other twoinstruments. This because it gives more effectivecontrol to central bank on commercial banks producesdirect affect on the credit creation potential.

y This weapon is also used to check inflation ordeflation. During inflation when there is a need tocontract

y They supply of credit, central bank increases the cashreserve ratio and credit supply is reduced. Duringdeflation, the ratio is lowered to give stimulus to thedepressed economy to expand prosper.


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y The cash reserve requirements which are discussed

above, is a part of the overall liquidity ratio.

y It means the %age of total demand and time liabilities

which commercial banks must keep in the form ofcash, gold or approved securities.


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y If the liquidity ratio is raised, banks will be required to

hold more and more of their deposits in the form of

securities or gold. Also, they will not able to encash or

discount any previously held securities. Thus theultimate effect will be that the credit creating potential

will decrease.

y When liquidity ratio decreased, commercial banks

will be able to hold more cash reserves. They will beable to encash their securities. Thus the credit creating

power will increase.


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y In Pakistan the liquidity ratio is 25%. In this liquidityratio, the cash reserve ratio is 5%.


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y These weapons which can be used in such a way that

only certain required sectors of the economy are

affected. such weapons are called selective or

qualitative credit control weapons.y They are used when central bank requires to reduce

credit supply to a particular sector of the economy and

when credit expansion is needed in specific avenues.

Such controls directly affect lenders and borrowers.


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y Credit rationing can be used to control credit supply.

In this method, the central bank specifies a maximum

limit to which it is prepared to accommodate

commercial banks in financial pressure. In thismethod central bank can adopt following ways.

y It can restrict the amount of loan that a commercial

bank can obtain from central bank.

y It may refuse to rediscount bills beyond certain

amount.


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y Credit ceiling is another qualitative credit control weapon.

Under this central bank specifies the maximum supply of credit

to the economy during a particular period. The maximum limit

of supply is called credit ceiling and it becomes obligatory for

all banks to follow this.

y This method is used when credit expansion could result in

serious damage to the economy. So in this case central bank

simply impose ceiling, under any circumstances the credit

supply will not exceed certain limit. If any commercial bankfails to follow this order of central bank, then it can be charged

with high penalty.


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y This method works best when it is used in

combination with other credit control weapons. Also

the success of this method depends upon the volume

of assistance that commercial banks receive from

central bank.


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y A friendly and polite type of credit control is calledmoral persuasion. Here instead of specifying a

particular limit and imposing penalties, central bank

requests the commercial banks to follow the general

monetary policy and credit control guidance.

y This is a system of informal advice by the central

bank. The advantage of this system is that it often

results in favorable and positive feedback from

commercial banks.


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y The important advantage of this policy is that through

this weapon, central bank besides controlling

commercial banks can also considerably control creditexpansion of non banking financial institution.


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y When the commercial banks continue to avoid theinstruction of central bank, the central bank can takedirect action against them. Through direct actions thecentral bank restricts commercial banks fromexpanding credit. Which are:

y Central bank can refuse to rediscount bills ofexchange of the defaulting commercial banks.

y It may not provide direct financial assistance ,advances and loans to such commercial banks whichdo not follow the general monetary policy.


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y There are many side effects of direct action as a credit

control policy. If direct actions are frequentlyundertaken then this may induce a general feeling of

fear among all the commercial banks. Secondly it may

go unnoticed if commercial banks have excessive

reserves at their disposal.


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y Monetary policy holds a very different and prominent positionin the monetary and fiscal set up of the economy. Monetary

policy directly affects the level of economic activity.

y A sound monetary policy greatly helps in achieving long term

economic goals of poverty alleviation and resourcemobilization.

y Besides this monetary policy can also be used for the provision

of micro credit to improve living standard in rural areas. These

affects are sufficient to explain that why monetary policy is

given so much importance in the economic set up.

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Monetary Policy Lec

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