Monetary Policy by Faraz Ali

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Monetary Policy

Presentation by:Faraz Ali

3rd December, 2010


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Outline

I. Conceptualizing monetary policy

II. Monetary policy framework in Pakistan

III. Monetary policy formulation process

IV. How monetary policy works?


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I. Conceptualizing Monetary Policy


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Rationale for Economic Policy

If every relevant good is traded in a market at publicly known prices, that is, if

there is a complete set of markets and information, and if households and

firms act perfectly competitively, then the market outcome gives the best

possible welfare enhancing outcome.

Strictly speaking, this means that there is no role of government/policy, if the

highlighted conditions are met.

But, as we all know, in real world these conditions are not met, which provides

rationale for governments role in the economy and need for economic policy.

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When stabilization policies are needed


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Stabilization policies at work


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Monetary Policy: A component of economic policy

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What is monetary policy?

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Regulation of money supply and interest rate inRegulation of money supply and interest rate in

the economy to achieve economic goalsthe economy to achieve economic goals

Monetary policy involves central banks use of

policy instruments to influence interest rates andmoney supply to keep overall prices and financial

markets stable


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Objectives of Monetary Policy

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Price stability is becoming increasingly popular as principalobjective;

Other objectives include economic growth, full employment,

exchange rate stabilization, etc.;

Price stability refers to a situation where inflation remains in aPrice stability refers to a situation where inflation remains in aspecific range for a certain time period, say five yearsspecific range for a certain time period, say five years


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An example from The History of Inflation inTurkey

Inflation hits everyone

Inflation: 18.9% 22.5% 62.0% 101.4%


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Creates uncertainty about the future output and input pricesand lowers the quality of the signals coming from the pricesystem;

Makes it impossible to plan for relatively longer outlook;

Discourages long term contracts (due to uncertainty) andresources are wasted on frequent negotiations;

Undermines confidence in domestic currency;

How high and volatile inflation affects growth?


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II. Monetary Policy Framework inPakistan


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Contours of monetary policy framework in Pakistan

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Objective(s) of SBPs monetary policy is to achieve

price stabilitywhile keeping an eye on economicgrowth.

Targets of average CPI inflation and real GDP growth

are set by the government and announced prior to thebeginning of a fiscal year.

The targets for CPI inflation and real GDP growthprovide a basis for setting an indicative target for M2

expansion, which serves as an intermediate target. For instance, if given targets for inflation and growth

are 10% and 3%, the M2 target is roughly 13%


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Monetary Policy Instruments in Pakistan

Policy RateDiscount rate or SBP reverse repo ratethe rate at

which commercial banks borrow from the central bank.

Currently, it is 14% percent per annum.

Open Market Operations


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Monetary Policy Instruments (cont)

Cash Reserve Ratio (CRR) It is a ratio by which commercial banks are required to

keep a certain portion of their liabilities with SBP in cash

at zero return.

Statutory Liquidity Ratio (SLR)

It is a ratio by which commercial banks are required to

keep a certain portion of their liabilities in the form ofgovernment securities


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Past Policy Rate Mechanism


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Current Policy Rate Mechanism (InterestCorridor)


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III. Monetary Policy Formulation Process


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Monetary policy formulation process

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Employing the framework highlight above, the draft of the Monetary

Policy Statement (MPS), which summarizes all the relevantinformation, analysis, and projections, is prepared by the MonetaryPolicy Department of SBP.

This draft MPS is circulated among the SBPs senior management,

including Governor, to initiate debate and to get their feedback andsuggestions.

After discussion and finalization of the proposed policy measures,draft MPS is presented in the sub-committee of the SBPs Central

Board of Directors the Monetary Policy Committee (MPC).

After approval from the sub-committee, the same is presented in themeeting of the SBPs Central Board of Directors for its final approval.

After this, the Governor usually holds a press conference and

P li t i h d k i i i t d i


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Policy rate is changed keeping in view trends ininflation and other key macroeconomicvariables

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Generally, interest rates are allowed to go down if:

Inflation is decelerating or is at a level that is much lowerthan the target and growth outlook is significantly belowpotential growth;

Generally, interest rates are allowed to go up if:

Inflation is accelerating (or higher than its target) togetherwith actual growth near the potential.


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IV. How Monetary Policy Works?


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Transmission mechanism of monetary policy

The process through which monetarypolicy decisions affect the level of

economic activity and inflation rate inthe economy.


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From operational target to objectives

Monetary policy affects the goal variables (i.e. inflation and

growth) through adjustment in aggregate demand broughtabout by changes in interest rate and money supply in theeconomy.

The changes in policy rate, affects the interbank and other

retail interest rates in the economy directly as well asthrough changing the expectations.

The resulting changes in retail interest rates affects theconsumption and investment behavior of the economic

agents and thus, the level of aggregate demand in theeconomy.

Finally, the adjustment in aggregate demand affects thegeneral price level and thus inflation in the economy.


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Time lags in monetary transmission

Monetary policy shocks require a considerable time before the

consequences of a policy action can become perceptible on inflation andother key macroeconomic variables.

Empirical evidence indicates that there is a 6-24 months time lag indeveloping economies in the transmission of monetary policy impact oninflation.

In Pakistan, this transmission lag is estimated between 12-18 months.

Bottom line: As monetary policy actions affect goal variables with aconsiderable lag, it is important to predict the future course of the goalvariables and possible impact of policy actions on the real variables.

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Conclusion: what monetary policy can andcannot achieve

Monetary policy plays a central role in reducing inflation

and keeping it at moderate or low levels, broadly termed asprice stability.

Overall monetary policy strategy is a crucial element inensuring financial stability.

An expansionary monetary policy can stimulate economicactivity only in the short run, that is, when actual output ismuch below potential and inflation is low.

Monetary policy cannot increase the countrys capacity toproduce goods and services.

Monetary policy has a lasting effect on inflation but only atransient effect on output.

Bottom Line: Monetary policy is a stabilization/aggregate


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Future Prospects

Inflation Targeting:

(IT) is considered to be the best mechanism for

price stability in high inflation countries. It can be

defined as a monetary policy strategy with an

explicit objective of achieving and maintainingprice stability.

Objectives:

The main objective of inflation targeting is to

achieve low and stable inflation in an economy.

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Monetary Policy by Faraz Ali