Monetary Policy

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Monetary Policy

  1. 1. PART 2: Monetary Policy Chapters 12:250-252, 256-259 & 17:373-374
  2. 2. State Bank of Vietnam
  3. 3. State Bank of Vietnam <ul><ul><li>The State Bank of Vietnam defines its principal roles as : </li></ul></ul><ul><ul><li>Promoting monetary stability and formulating monetary policy. </li></ul></ul><ul><ul><li>Promoting institutions’ stability and supervising financial institutions. </li></ul></ul><ul><ul><li>Providing banking facilities and recommending economics policies to the government. </li></ul></ul>
  4. 4. Contd… <ul><ul><li>Providing banking facilities for the financial institutions. </li></ul></ul><ul><ul><li>Managing the country’s international reserves. </li></ul></ul><ul><ul><li>Printing and issuing banknotes. </li></ul></ul><ul><ul><li>Supervising all commercial banks’ activities in Vietnam. Lending state money to the commercial banks. </li></ul></ul><ul><ul><li>Issuing government bonds, organising bond auctions. </li></ul></ul><ul><ul><li>Being in charge of other roles in monetary management and foreign exchange rates. </li></ul></ul>
  5. 5. Monetary Policy <ul><li>“ Central banks in most developed economies usually describe their aims in terms of the pursuit of non-inflationary growth. </li></ul><ul><li>Today, there’s a consensus that price stability should be the overriding objective of monetary policy. </li></ul><ul><li>External Balance Goal: Maintain the exchange rate within a particular band. </li></ul><ul><li>Internal Balance Goal: Maintain the inflation rate within a particular band. </li></ul>
  6. 6. External Balance <ul><li>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. </li></ul><ul><li>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). </li></ul><ul><li>Supply of foreign currency decreases, weakening the currency to restore stability. </li></ul>
  7. 7. External Balance r M s0 M D M 0 r 0 M p AD 0 Y 0 p 0 RGDP AS D FX0 Quantity Exchange rate e 0 S AUD0
  8. 8. External Balance <ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>Supply of foreign currency increases, strengthening the currency and restoring stability. </li></ul>
  9. 9. External Balance r M 0 M s0 M D r 0 M p Y 0 p 0 RGDP AS AD 0 Quantity Exchange rate S AUD0 e 0 D FX0
  10. 10. Inflation <ul><li>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. </li></ul><ul><li>Inflation in an economy is a wide phenomenon that concerns with the value of currency in the economy. </li></ul>
  11. 11. Internal Balance <ul><li>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. </li></ul><ul><li>The Monetary Authority targets interest rates by affecting system liquidity. </li></ul><ul><li>Monetary policy influences the size of bank reserves. This influences: </li></ul><ul><ul><li>The size of the money supply. </li></ul></ul><ul><ul><li>The interest rate and the availability of credit. </li></ul></ul><ul><ul><li>Investment spending, interest-sensitive consumption spending thus output, employment and the price level. </li></ul></ul>
  12. 12. Open Market Operations <ul><li>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. </li></ul>
  13. 13. Open Market Operations <ul><li>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) </li></ul><ul><li>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) </li></ul>
  14. 14. Internal Balance – Contractionary Policy A policy aimed at increasing interest rates and to restrict AD D AUD0 Quantity Exchange rate S AUD e 0 Q 0 r M 0 M s0 M D r 1 r 0 M p Y 0 p 0 RGDP AS AD 0
  15. 15. Internal Balance – Expansionary Policy Policy aimed at reducing interest rates and raising the level of AD. Quantity Exchange rate e 0 Q 0 D AUD0 r M s0 M D M 0 r 0 M p AD 0 Y 0 p 0 RGDP AS S AUD0
  16. 16. Monetary Policy Effectiveness <ul><li>Responsiveness of capital flows, consumption and investment to changes to changes in interest rates. </li></ul><ul><li>Phase of the business cycle. </li></ul><ul><li>Private decisions of lenders and borrowers. </li></ul><ul><li>Size of the expenditure multiplier. </li></ul>
  17. 17. 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?
  18. 18. Revision 9 <ul><li>Are the following true or false ? Explain. </li></ul><ul><li>If the monetary authority increases the money supply, subsequent portfolio adjustment will reduce interest rates, which in turn will increase investment expenditure. </li></ul><ul><li>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. </li></ul><ul><li>The monetary authorities can influence the money supply or the rate of interest but they cannot set the two independently. </li></ul>Questions for Review: Problems and Applications: Chapter 12: 4-5, 7 Chapter 12: 8, 10 Chapter 17: 1, 4-5
  19. 19. Review
  20. 20. <ul><li>RMIT, 2009,Lecture Slides, BB. </li></ul><ul><li>Image ref: http://dollardaze.org/blog/posts/2007/May/31/1/FRN.jpg </li></ul>References

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