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Monetary policy is how a central bank acts in its economic environment. A central bank is a national (or, in the case of the European Central Bank, a supranational) institution. Mostly the primary goal is to maintain price stability. Another common goal is to support the economy if it does not inhibit the achievement of price stability to a risky extent. This chapter examines what different costs arise due to inflation (increasing prices) and why it makes sense to keep inflation at a moderate level, to maintain price stability respectively

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  1. 1. Monetary PolicyMonetary PolicyMonetary Policy in Pakistan
  2. 2. Group MembersGroup MembersJoher Javed RajwanaJoher Javed Rajwana MBE-12-02MBE-12-02Rana Zaheer AbbasRana Zaheer Abbas MBE-12-12MBE-12-12Muhammad MoazzamMuhammad Moazzam MBE-12-20MBE-12-20Zohaib IrshadZohaib Irshad MBE-12-35MBE-12-35Khurram ehsanKhurram ehsan MBE-12-45MBE-12-45Shahid SaeedShahid Saeed MBE-12-59MBE-12-59
  3. 3. Joher Javed RajwanaJoher Javed RajwanaMBE-MBE-112-042-04Introduction of Monetary PolicyIntroduction of Monetary Policy
  4. 4. What is Monetary Policy?What is Monetary Policy?The term monetary policy refers to actions takenby central banks to affect financial conditions.Monetary Policy operates variables such asmoney supply, interest rates and availabilityof credit.Monetary Policy ultimately operates through itsinfluence on expenditure flows in the economy.In other words affects liquidity and by affectingliquidity, and thus credit, it affects total demand inthe economy.
  5. 5. MONETARY POLICYMONETARY POLICYMonetary Policy is the process by which theCentral BankCentral Bank manages the money supply toachieve specific goals e.g. Controllinginflation ,maintaining an exchange rateachieving full employment & GDP growth .Monetary policy refers to the measureswhich the central bank of the country takesin controlling the money and credit supply inthe country with a view to achieving certainspecific economic objectives.
  6. 6. Definitions of Monetary PolicyDefinitions of Monetary Policy“Monetary policy determines the amount ofmoney that flows through the economy.”(Chad Brooks)“Monetary policy consists of the methodsby which governments regulate theInterestrate nations banking systems and the moneysupply. The framework in which monetarypolicy exists consists of policy institutions,policy mandates and targets, and policyinstruments, such as open marketoperations and banking reserves.” ( Shane
  7. 7. MACRO - ECONOMIC POLICYCONSISTS of MONETARY POLICY andFISCAL POLICY.The objective of MACRO - ECONOMICpolicy is to have sustainable GDP GROWTHwhile containing INFLATION and achievingan acceptable rate of UNEMPLOYMENT.The fact that GDP rises or falls shows thatBUSINESS CYCLES are unavoidable andMACRO-ECONOMIC policy can neverreally conquer them.
  8. 8. GDP GROWTH.GDP GROWTH. Countrys annual output and of goodCountrys annual output and of goodand services. Same as economic growth.and services. Same as economic growth.UNEMPLOYMENT.UNEMPLOYMENT. The number of people of workingThe number of people of workingage without a job as a percentage of the workforce.age without a job as a percentage of the workforce.IINFLATIONNFLATION.. Rising prices across the board. MonetaristsRising prices across the board. Monetarists(Milton Friedman) believed it is a monetary phenomena. To(Milton Friedman) believed it is a monetary phenomena. Tostabilize prices the rate of growth of money supply needs to bestabilize prices the rate of growth of money supply needs to becarefully controlled.carefully controlled.
  9. 9. There is a trade off between INFLATIONand UNEMPLOYMENT.The lower the UNEMPLOYMENTRATE the higher is the INFLATIONRATE. Governments have to choosebetween the two evils.Too much GDP growth will cause anincreased rate of inflation calledoverheating in the economy which canlead to a recession and a hard landing.
  10. 10. State Bank of Pakistan (SBP)State Bank of Pakistan (SBP)The Central Board consists of nine members: the Governor (who isChairman), the Secretary, Finance Division, Government of Pakistan –and seven Directors, including one Directors from each Province, to benominated by the Federal Government ensuring representation toagriculture, banking and industrial sectors. The Directors are appointedfor terms of up to three years.◦ Chairman : Yaseen Anwar ( Governor SBP)◦ Dr. Waqar Masood Khan (Secretary Finance)◦ Zaffar A. Khan◦ Mr Qamar Beg◦ Asad Umar◦ Waqar A. Malik◦ Sahar Z. Babar –Corporate Secretary SBP(Secretary to the Central Board)
  11. 11. Rana Zaheer AbbasRana Zaheer AbbasMBE-12-12MBE-12-12Aims/Objectives of Monetary Policy
  12. 12. Aims/Aims/Objectives of Monetary PolicyObjectives of Monetary PolicyThe goals of monetary policy are to promotemaximum employment, stable prices and moderatelong-term interest rates.The core objectives of Pakistan’s monetary policyare to control inflation, maintaining price stability,strong monetary growth and achieving maximumemployment rate
  13. 13. 1. Exchange Stability:-2. Control of Inflation andDeflation:-3. Economic Development:-4. Increase in the Rate ofemployment:-5. Improvement in Standard ofLiving:-
  14. 14. 7.Eliminating Inflationary and7.Eliminating Inflationary andrecessionary gaprecessionary gap When the economy is operating at a level which is greater than fullemployment it is called inflationary gap  When the actual GDP line is above the potential GDP line theeconomy is said to have a positive output gap as at the peak point.Aggregate Demand exceeds the potential capacity thus shortages occurand prices rise (inflation) also called an inflationary gap. Factors of production such as labor, land and capital are fixed in theshort run, and wages can not change. Therefore the inflationary gapwill remain in the short run.
  15. 15. Recessionary GapRecessionary Gap When the actual GDP line is below the potential GDP linethe economy has a negative output gap as in arecession. At this point there is spare capacity, higher thenaverage unemployment leading to less inflationarypressures in the aggregate economy.  Also calleda recessionary gap. We can relate this concept back tothe Real GDP data
  16. 16. Muhammad MoazzamMuhammad MoazzamMBE-12-20MBE-12-20Tools of Monetary PolicyTools of Monetary Policy
  17. 17. Monetary Policy Tools /Monetary Policy Tools /InstrumentsInstrumentsTo accomplish its monetary policy objective, theCentral Bank can use a mix of direct and indirectpolicy tools to influence the supply and demand ofmoney.Following are the tools of Monetary policy1.Reserve Requirement 2.Open market operations 3.Discount Rate (Bank Rate)
  18. 18. Reserve RequirementReserve Requirement
  19. 19. Reserve RequirementReserve RequirementRequirements regarding the amount offunds that banks must hold in reserveagainst deposits made by their customers.RR is Defined as the % of the bank totaldeposit from households that must be kepton reserve at central bankExample: when RR 20% and deposits areone Billion
  20. 20. The Question Arises here HowThe Question Arises here Howthis Affect the supply of money inthis Affect the supply of money inthe economy?the economy?
  21. 21. Open market operationsOpen market operations  OMOs involve buying (outright or temporary) andselling of Govt securities by the central bank, fromor to the public and banks.The conduct of open market operations refers tothe purchase or sale of government securities bythe Bank to the banking and non-banking public.The SBP uses open market operations as its primarytool to influence the supply of bank reserves. Thistool consists of Federal Reserve purchases and salesof financial instruments, usually securities issued bythe Government ( SBP).
  22. 22. Open market operationsOpen market operationsGovernment SecurityControl Money SupplyInvestmentEmployment OpportunitiesCost of Borrowing IRn Sm1 Sm2Control InflationIRIR2 DmQm
  23. 23. Discount Rate (Bank Rate)Discount Rate (Bank Rate)Discount rate is the rate of interestcharged by the central bank for providingfunds or loans to the banking system.Raising Bank Rate raises cost ofcost ofborrowingborrowing by commercial banks, causingreduction in credit volume to the banks,and decline in money supplyFunds are provided either throughlending interest rateinterest rate or rediscountingor buying commercial bills
  24. 24. Discount Rate policy toolsDiscount Rate policy toolsThese tools are used to establish limits oninterest rates, credit and lending. These includeinterest rate credit control, interest rateinterest rate control and interest rate lendingto banks as lender of last resort, but they arerarely used in the implementation of monetarypolicy by the Bank.Interest rate controls Credit controls Lending to commercial banks 
  25. 25. Interest rate controlsInterest rate controls  The Bank has the power toannounce the minimum and maximum rates of interest andother charges that commercial banks may impose for specifictypes of loans, advances or other credits and pay on deposits..Credit controlsCredit controls   The Bank has the power to control thevolume, terms and conditions of commercial bank credit,including installment credit extended through loans, advancesor investments.Lending to commercial banksLending to commercial banks The Bank may providecredit, backed by collateral, to commercial banks to meetinterest rate short-term liquidity needs as lender of lastresort.
  26. 26. Zohaib IrshadZohaib IrshadMBE-12-35MBE-12-35Impact of Monetary policy inImpact of Monetary policy inEconomyEconomy
  27. 27. Impact of Monetary policy inImpact of Monetary policy inEconomyEconomyChange in money supplyChange in interest rateChange in desired investment
  28. 28. Change in money supplyChange in money supply The money supply  is the total amount of monetaryassets available in an economy at a specific time Change in Money Supply = (1/reserve ratio) *(Initial Change in Excess Reserves)3 Tools to Change Money Supply: Open-market operations (buying and selling treasury bonds,notes, and bills). Discount rate: Interest rate banks are charged when theyborrow from the SBP. Reserve requirement: % of deposits that must be held by abank as vault cash or on account with the federal reserve.
  29. 29. The relationship between MoneyThe relationship between MoneySupply and the rate of interestSupply and the rate of interesthigher demand for money will push upinterest rate making it more attractive forbanks to supply credithigher Interest rate may attract depositsfrom overseesHigher Interest rate may encouragedepositors to control money supply In theeconomy
  30. 30. Change in interest rateChange in interest rate An interest rate is the rate at which interest is paid byborrowers for the use of money that they borrow froma lender Interest-rate targets are a vital tool of monetary policy  andare taken into account when dealing with variableslike investment,  inflation, and unemployment The central banks of country generally reduce interest rateswhen they wish to increase investment and consumption inthe countrys economy The average inflation for 2013 is projected to remainbetween eight and nine per cent, well within the target of9.5%. Country GDP growth was expected to remain 4% during thecurrent financial year.
  31. 31. Reasons for interest rateReasons for interest ratechangeschanges Political short-term gain Deferred consumption Inflationary expectations Liquidity preference Taxes
  32. 32. Change in desired investmentChange in desired investment Monetary policy can be restrictive (tight), accommodative(loose) or neutral (somewhere in between). When the economy is growing too fast and inflation ismoving significantly higher, the central bank may take stepsto cool the economy by raising short-term interest rates,which constitutes restrictive or tight monetary policy. when the economy is slow- growth, the central bank willadopt an accommodative policy by lowering short-terminterest rates to inspire investment and get the economyback on track. The impact of monetary policy on investments is thusdirect as well as indirect. The direct impact is throughthe level and direction of interest rates, while the indirecteffect is through expectations about where inflation isheaded.
  33. 33. Syed Khurram EhsanSyed Khurram EhsanMBE-12-45MBE-12-45Types of monetary policyTypes of monetary policy
  34. 34. Types of monetary policyTypes of monetary policyMonetary policy affects a nation’s monetarysupply and the direction of its economy.Central bankers have different types ofpolicy actions at their disposal, and they canuse these in an expansionary orcontractionary manner, depending oneconomic conditions. Contractionary or restrictivemonetary policy takes place if it reducesthe size of the money supply. It can alsooccur with the raising of interest rates.
  35. 35. Contractionary / TightContractionary / Tightmonetary policymonetary policy“Tight monetary policy, also calledcontractionary monetary policy, tends tocurb inflation by contracting/reducing themoney supply”slow economic growth with the highinterest ratesBorrowing money becomes harder andmore expensive, which reduces spendingand investment by both consumers andbusinesses
  36. 36. Expansionary /Easy monetaryExpansionary /Easy monetarypolicypolicy“Easy monetary policy, also calledexpansionary monetary policy, tends toencourage growth by expanding the moneysupply”The cost of borrowing money goes down inhopes that spending and investment will goup.
  37. 37. Targets for monetary policy:Targets for monetary policy:Employment, economic growth, andinflation can not control directly, it mustchoose settings, or targets, for variables thatit can control in order to best achieve itsgoalsIn practice, there are two types of targets:1. Inflation targets.2. Price level targets.
  38. 38. Inflation targetingInflation targetingThe inflation target is achieved through periodicadjustments to the Central Bank interest ratetarget. The interest rate used is generally theinterbank rate at which banks lend to each otherovernight for cash flow purposes. Depending onthe country this particular interest rate might becalled the cash rate or something similar.The interest rate target is maintained for a specificduration using open market operations. Typicallythe duration that the interest rate target is keptconstant will vary between months and years. Thisinterest rate target is usually reviewed on amonthly or quarterly basis by a policy committee.
  39. 39. Price level targetingPrice level targetingPrice level targeting is similar to inflationtargeting except that CPI growth in one yearover or under the long term price level target isoffset in subsequent years such that a targetedprice-level is reached over time, e.g. five years,giving more certainty about future price increasesto consumers. Under inflation targeting whathappened in the immediate past years is nottaken into account or adjusted for in the currentand future years.
  40. 40. Monetary aggregatesMonetary aggregatesIn the 1980s, several countries used anapproach based on a constant growth in themoney supplyThis approach is also sometimes calledmonetarismMost monetary policy focuses on a pricesignal of one form or another, this approachis focused on monetary quantities.
  41. 41. Fixed exchange rateFixed exchange rate This policy is based on maintaining a fixed exchange ratewith a foreign currency. There are varying degrees of fixedexchange rates, which can be ranked in relation to howrigid the fixed exchange rate is with the attach nation Under a system of fiat fixed rates, the local government ormonetary authority declares a fixed exchange rate but doesnot actively buy or sell currency to maintain the rate Under a system of fixed-convertibility, currency is boughtand sold by the central bank or monetary authority on adaily basis to achieve the target exchange rate Under a system of fixed exchange rates maintained by acurrency board every unit of local currency must bebacked by a unit of foreign currency (correcting for theexchange rate)
  42. 42. Gold standardGold standardThe gold standard is a system in which theprice of the national currency is measured inunits of gold bars and is kept constant bythe daily buying and selling of base currencyto other countries and nationalsThe gold standard might be regarded as aspecial case of the "Fixed Exchange Rate"policy. And the gold price might be regardedas a special type of "Commodity PriceIndex".
  43. 43. Shahid SaeedShahid SaeedMBE-12-59MBE-12-59Advantages and disadvantages ofmonetary policySummarySummary
  44. 44. Advantages of monetary policyAdvantages of monetary policy11. Low Inflation:. Low Inflation: The two goals of monetaryThe two goals of monetarypolicy are to promote maximum sustainable levelspolicy are to promote maximum sustainable levelsof economic output and foster a stable price system.of economic output and foster a stable price system.Stable prices mean keeping inflation low, and theStable prices mean keeping inflation low, and theFederal Reserve Bank of San Francisco concedesFederal Reserve Bank of San Francisco concedesthat low inflation is all that monetary policy canthat low inflation is all that monetary policy canachieve in the long run. Inflation reduces theachieve in the long run. Inflation reduces thepurchasing power of money, harming economicpurchasing power of money, harming economicgrowth. In contrast, stable prices enable householdsgrowth. In contrast, stable prices enable householdsand businesses to make financial decisions withoutand businesses to make financial decisions withoutworrying about sudden, unexpected price increasesworrying about sudden, unexpected price increases
  45. 45. 2.Political Independence:2.Political Independence:When central banks operate free of political pressures,When central banks operate free of political pressures,they are free to make policy decisions based onthey are free to make policy decisions based oneconomic conditions and the best available data oneconomic conditions and the best available data oneconomic performance, rather than short-termeconomic performance, rather than short-termpolitical considerations imposed by elected officials orpolitical considerations imposed by elected officials orpolitical parties.political parties.3.3.Household spending: in normalin normalconditions, interest rates have a direct and powerfulconditions, interest rates have a direct and powerfuleffect on effect on household spendingwhenwhen Interest rate (High) spending (Low)Interest rate (High) spending (Low)Interest rate (Low) spending (High)Interest rate (Low) spending (High)
  46. 46. Disadvantages of monetaryDisadvantages of monetarypolicypolicy1. Raising interest ratesRaising interest rates Raising interest rates cannegatively affect on investment spending and the housing market,and the exchange rate and hence the balance of payments2.2. Dual economyDual economy There is also the problem ofthe dual economy - are high rates set for the booming servicesector, or low rates for the depressed manufacturing and exportsector3.3. Time LagTime Lag monetary policy actions take time to worktheir way through the economy, an estimates that monetarypolicy actions to affect output and employment can take threemonths to two years for their effects to be felt. Actions may
  47. 47. 4. Liquidity TrapsLiquidity Traps Interest rates may fall to very lowlevels during a deep recession, and while the demand forcredit may rise, the supply may become trapped in the system,known as the liquidity trap5.5. Conflicting GoalsConflicting Goals Central banks can usemonetary policy to achieve low inflation in the long run andaffect economic output and employment in the short run.these goals sometimes conflict. Reducing interest rates toexpand the money supply and stem rising unemployment ratesduring a recession
  48. 48. Summary of Monetary PolicySummary of Monetary Policy As is true for monetary policy is intended to achieve pricestability, full employment within the full employment-unemployment rate definition, and economic growth. The Central Banks most important assets are stocksecurities and loans to commercial banks. Central monetary policy are that the Govt can usemonetary policy to stop rapid inflation and to push theeconomy away from depression. Nearly all economists consider that monetary policy is animportant tool for economic stability The limitationslimitations of central bank monetary policy are thatglobal economy considerations make monetary policy moredifficult to administer and the outcome much less certain