Economic Analysis for Business

Final Project on Monetary Policy

Submitted To:

Prof. Shahid Hameed

Submitted By:

Hunain Saddaqat

Tayyab Arshad

Submission Date: 28-2-2015

UCP Business School, Lahore

MONETARY POLICY

TABLE OF CONTENTS

Table of Contents Page No

EXECUTIVE SUMMARY 2

INTRODUCTION TO MONETARY POLICY 3

TYPES OF MONETARY POLICY 4

TOOLS OF MONETARY POLICY 6

CURRENT SCENARIO 9

IMPACT OF MONETARY POLICY ON MACROECONOMIC

INDICATORS

9

OVERVIEW OF PAKISTAN’S MONETARY POLICY 10

COMPARATIVE ANALYSIS OF PAKISTAN’S MONETARY

MANAGEMENT (Time-series data)

12

CONCLUSION 17

RECOMMENDATIONS 18

BIBLIOGRAPHY 19

1

Executive Summary

2

INTRODUCTION TO MONETARY POLICY

Definition

“Monetary policy is the process by which the government, central bank or monetary authority of

a country controls supply of money, Availability of money and Cost of money or rate of interest.

Monetary policy is one of the tool that national government uses to influence its economy, using

its monetary authority to control the supply and availability of money a government attempts to

influence the overall level of economic activity in line with its political objectives. Usually this

goal is “macroeconomic stability”, Low unemployment, low inflation, economic growth and the

balance of external payments. Monetary policy is usually administrated by government

appointed central bank.

Monetary policy is generally referred to as either being an expansionary policy if the State Bank

of Pakistan increases the money supply in the market or a contractionary policy if the State bank

of Pakistan decreases the money supply from the market.Where an expansionary policy increase

the total supply of money in the economy and a contractionary policy decrease the total money

supply. Expansionary policy is traditionally used to combat unemployment in a recession by

lowering the interest rate. While contractionary policy involves rising interest in order to combat

inflation.

Monetary Policy involves changes in the base rate of interest to influence the rate of growth of

aggregate demand, the money supply and ultimately price inflation.

Monetarist economists believe that monetary policy is a more powerful weapon than fiscal

policy in controlling inflation. Monetary policy also involves changes in the value of the

exchange rate since fluctuations in the currency also impact on macroeconomic activity

(incomes, output and prices)

Changes in short term interest rates affect the spending and savings behavior of households and

businesses over time and therefore feed through the circular flow of income and spending. The

transmission mechanism of monetary policy works with variable time lags depending on the

3

interest elasticity of demand for different goods and services – e.g. the demand for interest-

sensitive consumer goods and services bought on credit or the demand for capital investment

from private sector businesses.

Overview

Monetary policy rest on the relationship between the rates of interest in a economy, that is the

price at which money can be borrowed, and the total supply of money.

Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like

economic growth, inflation, exchange rate, with other currencies and unemployment, where

currency is under a monopoly of issuance, or where there is a regulated system of issuing

currency through banks which are tied to a central bank, the monetary authority has the ability to

alter the money supply and thus influence the interest rate.

Monetary policy Types:

Monetary policy is the main tool used to modifying the amount of base money in circulation. The monetary

authority like State Bank of Pakistan does this by buying or selling financial assets. These open market

operations change either the amount of money or its liquidity.

Constant market transactions by the monetary authority (SBP) modify the supply of currency and this impacts

other market variables such as short-term interest rates and the exchange rate.

Following are the distinctions between the various types of monetary policy on basis of target variables that are

used by the monetary authority (SBP) to achieve their goals.

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation Targeting Interest rate on overnight debt A given rate of change in the CPI

Price Level Targeting Interest rate on overnight debt A specific CPI number

Monetary Aggregates The growth in money supply A given rate of change in the CPI

Fixed Exchange Rate The spot price of the currency The spot price of the currency

Gold Standard The spot price of gold Low inflation as measured by the gold price

4

The different types of policy are also called monetary regimes, in parallel to exchange-rate regimes

1. Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price

Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The

interest rate used is generally the overnight rate at which banks lend to each other overnight for cash flow

purposes. Depending on the country this particular interest rate might be called the cash rate or something

similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the

duration that the interest rate target is kept constant will vary between months and years. This interest rate

target is usually reviewed on a monthly or quarterly basis by a policy committee.

2. Price level targeting

Price level targeting is a monetary policy that is similar to inflation targeting except that CPI growth in one

year over or under the long term price level target is offset in subsequent years such that a targeted price-level

is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under

inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the

current and future years.

3. Monetary aggregates

This approach is also sometimes called monetarism. While monetary policy typically focuses on a price

signal of one form or another, this approach is focused on monetary quantities. As these quantities could have

a role on the economy and business cycles depending on the households' risk aversion level, money is

sometimes explicitly added in the central bank's reaction function.

4. Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees

of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor

nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate

but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-

convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market

exchange rate where the currency trades at its market/unofficial rate.

5

Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority

on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within

which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to

maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen

as a special case of the fixed exchange rate with bands where the bands are set to zero.)

5. Gold standard

The gold standard is a system under which the price of the national currency is measured in units of gold bars

and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base

currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special

type of commodity price level targeting.

Tools of Monetary Policy

Following are the some tools of monetary policy, through which State Bank of Pakistan can contract and

expand the supply of money to control inflation and to come out from recession respectively.

1. Open Market Operations

Bonds markets are open to all buyers and seller of corporate and government bonds (securities). The State

bank open –market operations consists of the buying of government bonds from, or the selling of

government bonds to commercial banks and the general public. Open –market operations are the federal

government most important instrument for influencing the money supply.

There are two types of open-market operations.

Buying Securities:

Suppose that the federal government decide to have the Federal Reserve Banks buy government bonds.

They can purchase these bonds either from commercial banks or from the public. In both cases the

reserve of the commercial banks will increase.

Selling Securities:

When the State Bank sell government bonds, commercial banks reserve are reduced.Thus, the Federal

government conducts open market operations by buying and selling government securities–especially

Treasury bills. Since the market for Treasury bills is so active, the State bank of Pakistan can make large

6

purchases and sales quickly and easily, without disrupting the market. Although the FOMC makes

decisions on how open market operations are to be conducted, the trades themselves are executed at the

Open Market Desk of the State bank. Open market purchases and sales have permanent affects on the

monetary base, but sometimes the State bank will want to change the monetary base only temporarily.

At these times, it engages in two other types of transactions:

Repurchase Agreement

The State bank purchases government securities will an agreement that the seller will buy them back

(repurchase them) at a specified price on a specified date, usually within two weeks. A repo is therefore

like a temporary open market purchase, temporarily increasing the monetary base.

Matched Sale-Purchase Transaction

The State bank sells government securities with an agreement that the buyer will sell them back at a

specified price on a specified date, again usually within two weeks. A reverse repo is therefore like a

temporary open market sale, temporarily decreasing the monetary base. Hence, in contracting monetary

policy.

Open market operations have a number of advantages:

1. They are under the direct and complete control of the State bank.

2. They can be large or small.

3. They can be easily reversed.

4. They can be implemented quickly

2. Discount Loans

When a bank receives a discount loan from the State bank, it is said to have received a loan at the

“discount window.” The State bank can affect the volume of discount loans by setting the discount rate: A

higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the

volume of discount loans. A lower discount rate makes discount borrowing more attractive to banks and

will therefore increase the volume of discount loans. Discount lending is most important during financial

panics. When depositors lose confidence in the financial system, they will rush to withdraw their money.

7

This large deposit outflow puts the banking system in great need of reserves. The State bank stands ready

to supply these reserves by making discount loans.

Advantage of discount loans:

They allow the State bank to act as a lender of last resort during a financial panic.

Disadvantages of using discount loans as a tool for monetary policy during normal times.

1. The volume of discount loans can be influenced by the State bank, but not completely controlled:

The State bank cannot be sure how many banks will request discount loans at any given interest

rate.

2. Changes in the discount rate must be proposed by the State bank before being approved by the

Board of Governors. Hence, they are neither quickly made nor easily reversed.

3. Reserve Ratio

By affecting the money multiplier, changes in the required reserve ratio can lead to changes in the money

supply. The State bank can also manipulate the reserve ratio in order t influence the ability of commercial

banks to lend.

Reserve Ratio Importance

Reserve ratios are a key component of monetary policy. The Federal Reserve can lower the reserve ratio, for

example, in order to enact expansionary monetary policy and encourage economic growth. The reduction

makes banks free to lend more of their deposits to other bank customers and earn interest. These customers in

turn deposit the loan proceeds in their own bank accounts, and the process continues indefinitely. This increase

in the supply of available funds lowers the price of those funds (i.e., the lending rate), making debt cheaper and

more enticing to borrowers. If the Federal Reserve increases the reserve ratio which leaves less of a bank's

deposits available for lending.

8

Impact of Monetary policy on Macroeconomic Indicators

9

Overview on Pakistan Monetary Policy

State Bank of Pakistan tightened its monetary policy further in july 2006 by raising policy

discount rate by 50 basis points to 9.5 percent, the cash reserve requirement from 5-7% on

demand liabilities and the statutory liquidity requirement from 15-18% for the scheduled banks.

At the same time, in order to incentives bank to mobilize long term deposits, SBP reduced the

credit reserve requirement (CRR) on their time liabilities from 5-3%. Monetary tightening had

visible results on different fronts, as excess aggregated demand pressures in the economy were

reduced. Aside from curbing important demand, which had grown to unsustainable levels in the

last two years, effective liquidity management has allowed adequate growth in private sector

credit but aligned into real prevailing demand. Most importantly FY07 monetary policy was

successful in sustaining a downtrend in inflationary pressure in the economy, while facilitating

the economy to record strong growth, in line with the annual target. If this moderation in

aggregate demand pressures had not been achieved, the country’s hard-won macroeconomic

stability would have come under strain with consequences in terms of further widening of the

10

current account deficit and higher inflationary pressures. All these, in turn would have adversely

affected the country in attracting the investment in the country.

11

COMPARATIVE ANALYSIS OF PAKISTAN’S MONETARY MANAGEMENT

(Time-series data pertaining to the 1960s and 1970s)

State Bank of Pakistan (SBP) shifted its reliance from an administered monetary policy regime

governed by ad hoc changes in reserve ratio’s, directed credit and regulated interest rate policies

in mid 1990s to a liberal and market oriented monetary policy management (Shamshad, 2007).

Broad money supply growth has to be consistent with the targets of growth in real GDP and

inflation rate. However, if there are excessive demand pressures either because of high fiscal

deficit or because of the excessive foreign inflows money supply grows faster than the growth in

productive sectors and generates demand pressures which manifests itself in rise in inflation rate.

Despite all contests and debates, inflation is primarily a monetary phenomenon. To keep it under

Title: IMPACT OF MONETARY POLICY ON GROSS DOMESTIC PRODUCT (GDP) COPY

RIGHT © 2011 Institute of Interdisciplinary Business Research Pages: 1348-1361 control it is

critical that macroeconomic imbalances are kept within the permissible limits. Fiscal

wastefulness in the past has resulted in Government’s unlimited recourse to low and fixed

interest rate financing (State Bank of Pakistan, 2006). Pakistan’s inflation rate for 2009 financial

year is expected to be 20 percent which is 40 percent higher than the last year’s 12 percent. On

the other hand, GDP growth rate of Pakistan for 2009 and 2010 is projected to be 2.8 percent and

4.0 percent respectively (Asma, 2009). Thus there is a need to change the ways monetary policy

have been used to guide economy for future. The Central Bank designs Contractionary policy in

order to constrain the growth of money (i.e. increasing inflation) and credit in the economy. In

the present international scenario, due to hike in inflation internationally, like most of the

countries have adopted contractionary policy, Pakistan recently has also increased interest rate

by 0.5 percent and set 10 percent short-term interest rates. On the other hand Expansionary

policy is used as a tool by the central bank to broaden the monetary base and credit in the

economy by reduction in interest rates and increase in bond prices (Pakistan Defense Forum,

2008). The State Bank of Pakistan has a main objective of achieving price stability and promotes

growth. In order to contain inflation within the targeted level set by the government, SBP used

money supply as an instrument target. The statistics reveals that Money supply growth exceeded

its target level for four consecutive years 2002-2005. Due to easy monetary policy stance to

support the growth process, however the expansionary monetary policy results in rapid inflation

12

reaching double digit in 2005-2006. Inflation tax for the year 2005-2006 is estimated at Rs.

61928 million or 0.98 percent of GDP.

Exports are important for economic development especially for developing countries. It is an

important source of foreign exchange earnings which can be used to finance imports. Imports

play a significant role in domestic capital formation and are also used as input in the production

of exportable commodities. Thus, trade is a major determinant of economic growth. The Pattern

of trade changes with the development process. Initially, a country usually exports primary

commodities and imports consumer goods. With the passage of time, exports changes to

manufactured goods and imports to machinery. Pakistan, one of the Asian developing countries

observed the same pattern of trade for the period 1960-2010. Pakistan is basically an agrarian

economy. Its exports directly or indirectly depend upon agriculture sector. After independence

(1948-1949), Pakistan major exports were made up of raw jute, raw cotton, raw wool, hides and

tea. By 1951, the contribution of the primary commodities in total export earnings was 93%.

However, at the end of 1950s, the share of primary commodities fell to 75% of export earnings

due to shift of policies towards industrialization (Chaudhary & Ahmed, 2004). The main trading

partners of Pakistan during early years were UK, USA, Germany, Belgium, Italy and Japan

(Zaidi, 2005) In 1970s, the average growth rate of exports was 13.5% and imports were 16.6%.

The average growth rate of trade deficit was 20.5%. During this era, the increase in oil prices and

unfavourable weather condition was the major factors for increasing trade deficit. In 1970-71,

share of primary goods was 33% which increased to 42% in 1979-80. The share of manufactured

commodities was 44% in 1970-1971 which decreased to 43% by 1979-80. Imports of consumer

goods had increased from 37% in 1970-71 to 58% in 1979-80. In 1980s the average growth rate

of exports was 8.5% and imports were 4.5%. The average growth rate of trade deficit was 0.9%.

During this decade the share of primary commodities decreased from 44% in 1980-81 to 20% in

1989-90. The share of manufactured goods increased from 45% to 59% in the same time. The

share of consumer goods in imports had declined from 65% in the beginning of the 1980s to 60%

by the end of 1989. Pakistan’s share in total world exports increased marginally from 0.13% in

1980 to 0.15% in 1997 Pakistan’s share in the total world imports declined from 0.25% in 1980

to 0.22% in 1997. During 1990s the average annual export growth was 5.6% and for imports it

was 3.2%. The average growth of trade deficit was -0.6%. During 1990-91, the share of primary 13

commodities was 19% of total exports which fell to 12% in 1999-2000. Similarly, share of

manufactured goods increased from 57% in 1990-91 to 73% in 1999-2000. Share of industrial

raw materials of consumer goods in imports have shown an increasing trend, rising from 60% in

1990-91 to 68% in 1999-2000. This shows that as development proceeds share of industrial raw

material rises to boost the process of industrialization. (Economic survey of Pakistan, 2010) In

2000s, the average growth in exports was 9.9% and imports were 13.7%. The average growth of

trade deficit was around 60%. Exports amounted to $15.9 billion in 2009- 10, that is greater than

the last years export volume of $14.7 billion, showing a growth rate of 8% compared to the

negative growth rate of 3% during the last year. On the other hand the import growth during

2009-2010 declined by 2.8% as compared to the last year’s growth. Lower international prices,

compressed domestic demand, exchange rate depreciation and improved production of cotton

crops were the major reasons for the overall decline in import bill. Thus, overall picture of

Pakistan’s trade shows that nature of trade has changed from primary commodities to

manufactured products but still most of these manufactured goods are primarily agricultural

commodities particularly cotton. The specific objective of present study is to analyse the pattern

of trade and to forecast its future trend in the case of Pakistan. The time span to be covered in the

study is 1960-2010.

and trade with huge trade surplus and Pakistan is suffering from not only trade deficit but also

from budget deficit. This paper provides an excellent approach towards analyzing trade pattern

of Pakistan. Our study will incorporate statistical estimation to analyze the future prospects of

trade pattern. Yousof (2009) has analyzed the industrial and export structure of Pakistan

economy during the decades of 1990s and 2000s. He has evaluated the changes that have

occurred in the structure and composition of exports over the time during the time period 1990-

2007. He had constructed relative comparative advantage index and factor intensity index to

analyze the competitiveness of Pakistan exports and pattern doing the last two decades. The

results of RCA index had shown that out of 349 products only 51 found out to be competitive. 40

products were from manufacturing sector, 2 from agro based and 9 from crude materials group.

He had also studied the liberalization reforms and found that the reforms had not changed the

composition of exports of Pakistan’s manufacturing sector .This study provides good

understanding of the export competitiveness but the author had included lesser agro based 14

commodity groups. Finally this study does not provide a good picture of competitiveness of

exports by analyzing the RCA index alone. III: Structure of Trade (1965-2010) This section

analyses the trends and patterns of the trade over the time period 1965- 2010.The volume of

trade has increased significantly since independence. Pakistan exports and imports account for

12.8% and 20% of GDP in 2009 respectively (World Bank, 2009). Table-1 and Figure-1 shows

the five years average exports and imports in millions of US dollars at current market prices.

15

16

CONCLUSION

The correct way of thinking about issues in monetary policy is not to work within these fields

only, but to include broader political-economy considerations as well. Abstract monetary policy

good and necessary, but without engaging issues of political economy little can be said about

whether a particular monetary policy is desirable. When considering monetary policy, it is

important to remember that central bankers are self-interested and lack access to perfect

information. Because policymakers cannot know everything about the economy at one time and

their incentives as public actors remain the same as their incentives as private actors, establishing

rules for their decision-making is preferable to prolonging the current discretion-based

policymaking at the Fed.

17

Recommendation

I will recommend that government of Pakistan should plan an important role to attract direct foreign

investment in Pakistan. And reduce the security threats for the business man. If the above mentioned

things will work properly then SBP can effectively and efficiently run their policies in order to meet the

targeted objectives.

Finally, and most importantly, the ability of the central bank to conduct monetary policy efficiently and

effectively, especially with regard to its fundamental objective of ensuring price stability, has been

undermined by fiscal domination.

18

Bibliography

1. Lars E. O. Svensson, http://people.su.se/~leosven/, January 26–27, 2004, (accessed May 28, 2010).

2. Study the book published by M c GRAW. Hill

3. http://irelandp.com/ec261/chapter17a.pdf

4. http://www.tutor2u.net/economics/content/topics/monetarypolicy/policy_introduction.htm

5. http://www.bjournal.co.uk/paper/BJASS_13_2/BJASS_13_02_05.pdf

19