Download Monetary Policy

Government Policies
What is a Policy?
 Governments usually formulates a lot of policies on a
lot of issues.
 But, if we concentrate only on the policies to regulate
and guide the economic activities of the country, we
find only two-
Monetary Policy and
 Fiscal Policy

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What is Monetary Policy
It is the government’s
decision about how much
money to supply to the
economy.
This means controlling the supply of M1 or M2
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History of Monetary Policy
 In old times, monetary policy was mainly focused on
seioniorage with the aim to maintain the value of
money
 Inflation was not a big concern
 Bank of England created in 1694
 During 1870 – 1920 industrialized nations set up
central banks
 Monetary policy came into question during the great
depression
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Monetary Policy
Can be-
Loose or
Tight
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Loose monetary policy
 If the Bangladesh Bank (BB) implements a loose
monetary policy (often called expansionary) ,
the supply of credit increases and its cost falls.
 A loose monetary policy is often implemented as
an attempt to encourage economic growth.
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Tight monetary policy
 If the BB allows a tight monetary policy (often called
contractionary), the supply of credit decreases and
its cost increases.
 Why would any nation want a tight money policy?
 In order to control inflation
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The Two Faces of Monetary Policy
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Goals of Monetary Policy
 Price stability
 GDP growth
 Investment
 Fight recession
 Exchange rate stabilization
 Desired level of unemployment rate
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How these goals are achieved by controlling
money supply?
 Price Stability: for example, price is shooting up and
we want to control it…
We
reduce
money
supply
Now
people
have
less
money
at hand
So,
people
buy less
amount
of
goods
Demand
for
goods
falls
Producers
reduce
price to
maintain
sales
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Example: Money Supply vs. Inflation
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How these goals are achieved by controlling
money supply?
 Investment can be induced by
controlling money supply
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How these goals are achieved by controlling
money supply?
 GDP growth: for example, we want to increase GDP
growth…
We
increase
money
supply
Now
people
have
more
money
at hand
So,
people
buy
more
amount
of
goods
Demand
for
goods
rise
Producers
produce
more
goods to
match
market
demand
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How these goals are achieved by controlling
money supply?
 For example: our export is reducing and we want to
increase it…
We
increase
money
supply
As a
result
banks
have
more
idle
money
So,
banks
reduce
interest
rate
Cost of
investment
falls and
goods
become
cheaper
Export
rises
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Channels through which monetary policy
works

Interest Rate channel
 Exchange rate channel
 Credit channel
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How is the money supply controlled
 The Central Bank generally uses three tools



Open market operation (OMO)
Discount rate (DR)
Reserve ratio (RR)
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Open Market Operation (OMO)
 Defined as the buying or selling of treasury bills
and bonds by the Bangladesh Bank in the open
market.
 Expansionary – Bangladesh Bank buys bonds
(injects money)
 Contractionary – Bangladesh Bank sells bonds
(pulls out money)
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Characteristics of OMO
 Sometimes done for temporary periods
 Repurchase Agreement -- BB buys bond with
agreement to sell it back.
 Matched-Sale Purchase -- BB sells bond with
agreement to buy it back.
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Characteristics of OMO
 Occurs at the initiative of the BB.
 BB is in complete control.
 They are flexible: BB can do small or large amounts.
 They are reversible: BB can undo policy mistakes.
 Very low-key policy instrument: difficult to tell what
BB has done
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Discount Rate
 Defined as the rate of interest charged to
banks that borrow from the BB.
 Expansionary -- BB lowers discount rate.
 Contractionary -- BB raises discount rate.
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Characteristics of DR
 Done at the discretion of the commercial banks
 Affects interest rate structure of the commercial
and specialized banks
 DR may influence economic activity
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Reserve Ratio (RR)
 Banks are required to maintain a certain percentage
of their deposits in the form of reserves or balances
with the BB. This percentage is called the Reserve
Ratio.
 Expansionary Policy -- BB lowers reserve ratios.
 Contractionary Policy -- BB raises reserve ratios.
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Characteristics of RR
 Too blunt -- needs tiny changes for
reasonable adjustments in money growth.
 Too Disruptive -- affects all banks balance
sheets.
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Strategies of Monetary Policy
Money Growth Targeting
Inflation Targeting
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Money Growth Targeting
 The decade of 1970s was characterized by high inflation and






unemployment
Central banks initially pursued money growth targeting to achieve
steady growth and low inflation
In this strategy central banks announces the rate of growth of money
for the next one year
But in 1980s, in spite of low inflation, output and unemployment were
unstable in USA, UK, Canada and Germany
Because, due to changing financial system, money demand was hard to
predict and, therefore, money growth targeting was ineffective
A tightly regulated financial system is necessary for money growth
targeting to be successful. Tight financial regulation is often not
possible
Specially, in the developing countries, where financial reforms are still
taking place, strict financial regulations are not viable
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Inflation Targeting
 Central banks in many countries adopted inflation targeting during






1990s. New Zealand was the pioneer.
In this strategy central bank announces the rate(s) of inflation that it
wants to achieve over the next year(s)
Through this announcement the central bank signals that hitting that
target in the long-run is its number one priority
Inflation targeting bypasses the problem of money demand instability
Also, it helps to make central bank’s commitments credible to the
people as most of the people understands what goal the central bank is
trying to achieve
However, success of inflation targeting depends on how quickly the
economy responds to the policy changes
If the economy responds to policy changes slowly then inflation
targeting may lose credibility
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The Issue of Credibility
 Monetary policy has important goals for the country
 If these goals are not achieved, then operation of the
monetary policy tools are not effective
 People do not have faith in monetary policy anymore
 Monetary policy lose credibility
 Country’s development objectives fall into chaos
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Example: Dad, Kids and Fantasy Kingdom
Kids’ Strategy
Dad’s Strategy
Fight
Point assignment
Go to Park
Don’t go to
Park
Don’t Fight
Dad: 2
Kids: 3
Outcome A
Dad: 3
Kids: 2
Outcome B
Dad: 0
Kids: 1
Outcome C
Dad: 1
Kids: 0
Outcome D
Fight
Don’t Fight
Go to park
Don’t go to park
Kids
1
0
2
0
Dad
0
1
2
0
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How can the central bank maintain credibility:
 Appointing a “tough central banker”

In 1979, in the face of serious inflation President Jimmy Carter
appointed Paul Volcker, who succeeded to curb inflation… but
failed to check unemployment!!!
 Changing central bankers’ incentives

For example, if the head of the central bank is easy to remove
s/he might want to be serious about her/his commitments
 Increasing central bank’s independence

If the central bank is independent it might be free of political
influence, and hence, might escape political pressure to increase
output and employment (say, before national election)
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Monetary Policy in Bangladesh
 Until 1990:



limited role of BB
Government directly controlled exchange rate and interest rate
Taka was pegged against foreign currencies
 Financial Sector Reform Program started in 1989
 Strategy was to target monetary aggregates
 Free floating exchange rate was introduced in May,
2003
 Bangladesh Bank is regularly issuing Monetary
Policy Statement since January 2006
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Monetary Policy Outcome
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Monetary Policy Outcome
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Monetary Policy Outcome
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Monetary Policy Outcome
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Monetary policy outcome
%
Money Growth and export growth
25.00
35
30
25
20
15
10
5
0
-5
20.00
15.00
10.00
5.00
0.00
Export growth (rhs)
M2 growth
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Monetary Policy Outcome
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Limitations of Monetary Policy
 Does not work when aggregate demand needs to be
stimulated through direct government spending
(Great Depression)
 Works on the economy through indirect channels.
Therefore, often suffers from lag to have impact
 May be dominated by fiscal policy
 Wrong policy may result in severe damage for the
economy
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Monetary Policy vs. Fiscal Policy
 If the goals of the two policies do not match, development
objective will be damaged.
Example:
 Suppose, Bangladesh is suffering from high inflation and
BB wants to reduce it. BB reduces money supply…
 But, national election is close and will be held within a
year.
 So, the ruling party decides to spend more money on
safety-net programs and employment generating activities
 Accordingly, the ruling party sets its fiscal policy so that
expenditure goes up…
 What will happen?
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Other problems related to mismatch of
policies
 If the government borrows too much from the
banking system, then little money is left for the
private sector to borrow.
 As a result, private sector initiatives are hampered
 This is called the “crowding out effect”
 Because of crowding out private investment falls
and GDP falls as well
 In this case, if the monetary policy authority wants
to enhance private sector credit growth, practically
it has little room to do so…
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Other problems related to mismatch of
policies
Government debt:
 If the government borrows a lot, it means that at some
point of time future, the government will have to pay
substantial amount of interest when the loan matures
 If at that time, the government does not have money
enough to pay the interest, it might print money for the
purpose…
 This means that money supply will go up
 But, if the country at that time suffers from high inflation
and BB wants to control it, the contractionary monetary
policy will not help.
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