Republic of the Philippines

Commission on Higher Education

Region V – Bicol
CALABANGA COMMUNITY COLLEGE
Brgy. Belen, Calabanga, Camarines Sur

MC-SSE 8
MACROECONOMICS
GROUP VI :( MONETARY POLICY)

SUBMITTED BY:
MARIA CRISTINA S. IMPORTANTE
ALILI C. MARTINEZ
HAZEL ESCALANTE
MICHELLE RAMOS
CLARISSE GAGASA
JHON JIMMY CHAVEZ
MARRIANE BOLANOS
BsEd - Social Science

SUBMITTED TO:
MR. BENJAMIN B. TIMBOL
Instructor

Monetary Policy 1
 Introduction

Monetary policy rests on the relationship between the rates of interest in

an economy, that is the price at which money can be borrowed, and the total
supply of money. The use of monetary policy is dated to the late nineteenth
century where it was used to maintain the gold standard.

Monetary policy uses a variety of tools to control one or both of these to

influence outcomes like economic growth, inflation, exchange rates 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 tied to a central bank, the monetary authority has the ability to alter the
interest rate and the money supply in order to achieve policy goals.

A policy is referred to as "contractionary" if it reduces the size of the

money supply or raises the interest rate. An "expansionary" policy increases
the size of the money supply, or decreases the interest rate. Further monetary
policies can be described as "accomodative" if the interest set by the central
monetary authority is intended to spur economic growth, "neutral" if it is
intended to neither spur growth or combat inflation, or "tight" if intended to
reduce inflation or "cool" an economy.

There are several monetary policy tools available to achieve these ends.
Increasing interest rates, reducing the monetary base, or increasing reserve
requirements all have the effect of contracting the money supply. If reversed,
these actions expand the money supply. A fourth primary tool of monetary
policy is open market operations. This entails managing the quantity of money
in circulation through the buying and selling of various credit instruments,
foreign currencies, or commodities. All of these purchases or sales result in
more or less base currency entering or leaving market circulation.

Monetary Policy 2
 The short term goal of open market operations is often to achieve a
specific short term interest rate target. In some instances monetary policy
might instead entail the targeting of a specific exchange rate relative to some
foreign currency. In the case of the United States, the Federal Reserve targets
the federal funds rate, which marks the rate at which member banks lend to
one another overnight. The monetary policy of China, however, is to target the
exchange rate between the Chinese renminbi and a basket of foreign
currencies.

Within almost all modern nations, special institutions (such as the Bank
of England, the European Central Bank, or the Federal Reserve System) exist
which have the task of executing the monetary policy independently of the
executive. In general, these institutions are called central banks and often have
other responsibilities, such as supervising the operations of the financial
system.

"The first and most important lesson that history teaches about what
monetary policy can do—and it is a lesson of the most profound importance—is
that monetary policy can prevent money itself from being a major source of
economic disturbance.

Monetary Policy 3
 History

Monetary policy is associated with currency and credit. For many

centuries there were only two forms of monetary policy: Decisions about
coinage and the decision to print paper money. Interest rates were not
generally coordinated with the other responsibility of an authority with
"seniorage," or the power to coin. With the advent of larger trading networks
came the ability to set price levels between gold and silver, and the price of the
local currency to foreign currencies. This official price could be enforced by law,
even if it varied from the market price.

With the creation of the Bank of England in 1694, which acquired the
responsibility to print notes and back them with gold, the idea of monetary
policy as independent of executive action was established.[3] Early goals of
monetary policy were to maintain the value of coinage, print notes, and prevent
coins from leaving circulation. The establishment of central banks by industrial
nations was associated with the desire to maintain the nation's peg to the gold
standard, and to trade in a narrow band with other gold backed currencies. To
accomplish this end, central banks began setting the interest rates that they
charged to both borrowers and banks who required liquidity. The maintenance
of a gold standard required almost monthly adjustments of interest rates.

During the 1870-1920 period, the industrialized nations set up central

banking systems, with one of the last being the Federal Reserve in 1913.[4] By
this point, the concept of the central bank as the "lender of last resort" was
understood. It was also increasingly understood that interest rates had an
effect on the entire economy, that there existed a business cycle, and that
economic theory had begun to understand the relationship of interest rates to
that cycle.

Monetary Policy 4
Contemporary monetary policies take into account a multitude of diverse
factors including short and long term interest rates, the velocity of money
through the economy, exchange rates, bonds and equities (corporate ownership
and debt), international capital flows, and financial derivatives including
options, swaps, and futures contracts.

What is Monetary Policy?

 The part of the economic policy which regulates the level of money in the
economy in order to achieve certain objectives.
 Is concerned with the changes in the supply of money and credit.
 It refers to the policy measures undertaken by the government or the
central bank to influence the availability, cost and use of money and
credit with the help of monetary techniques to achieve specific objectives.
 Consists of the process of drafting, announcing, and implementing the
plan of actions taken by the central bank, currency board, or other
competent monetary authority of a country that controls the quantity of
money in an economy and the channels by which new money is supplied.
 Is an economic policy that manages the size and growth rate of the
money supply in an economy. It is a powerful tool to regulate
macroeconomic variables such as inflation and unemployment.

Monetary Policy 5
Objective:

The primary objectives of monetary policies are the management of inflation or

unemployment, and maintenance of currency exchange rates.

Inflation

 Monetary policies can target inflation levels. A low level of inflation is

considered to be healthy for the economy. If inflation is high, a
contractionary policy can address this issue.

Monetary Policy 6
Unemployment

 Monetary policies can influence the level of unemployment in the

economy. For example, an expansionary monetary policy generally
decreases unemployment because the higher money supply stimulates
business activities that lead to the expansion of the job market.

Currency exchange rates

 Using its fiscal authority, a central bank can regulate the exchange rates
between domestic and foreign currencies. For example, the central bank
may increase the money supply by issuing more currency. In such a
case, the domestic currency becomes cheaper relative to its foreign
counterparts.

Tools of Monetary Policy

Central banks use various tools to implement monetary policies. The widely
utilized policy tools include:

Interest rate adjustment

 A central bank can influence interest rates by changing the discount

rate. The discount rate (base rate) is an interest rate charged by a central
bank to banks for short-term loans. For example, if a central bank
increases the discount rate, the cost of borrowing for the banks
increases. Subsequently, the banks will increase the interest rate they
charge their customers. Thus, the cost of borrowing in the economy will
increase, and the money supply will decrease.

Change reserve requirements

 Central banks usually set up the minimum amount of reserves that must
be held by a commercial bank. By changing the required amount, the
central bank can influence the money supply in the economy. If
monetary authorities increase the required reserve amount, commercial
banks find less money available to lend to their clients and thus, money
supply decreases. Commercial banks can’t use the reserves to make

Monetary Policy 7
 loans or fund investments into new businesses. Since it constitutes a
lost opportunity for the commercial banks, central banks pay them
interest on the reserves. The interest is known as IOR or IORR (interest
on reserves or interest on required reserves).

Open market operations

 The central bank can either purchase or sell securities issued by the
government to affect the money supply. For example, central banks can
purchase government bonds. As a result, banks will obtain more money
to increase the lending and money supply in the economy.

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They
reduce the money supply by restricting the volume of money banks can lend.
The banks charge a higher interest rate, making loans more expensive. Fewer
businesses and individuals borrow, slowing growth.

Central banks use expansionary monetary policy to lower unemployment and

avoid recession. They increase liquidity by giving banks more money to lend.
Banks lower interest rates, making loans cheaper. Businesses borrow more to
buy equipment, hire employees, and expand their operations. Individuals
borrow more to buy more homes, cars, and appliances. That increases demand
and spurs economic growth

Monetary Policy 8
Expansionary Monetary Policy

 Is adopted when the economy is in a recession, and the unemployment is

the problem. The expansion policy is undertaken with an aim to increase
the aggregate demand by cutting the interest rates and increasing the
supply of money in the economy.

Contractionary Monetary Policy

 Is applied when the inflation is a problem and economy needs to be slow

down by curtailing the supply of money. The inflation is characterized by
increased money supply and increased consumer spending.

Instruments of Monetary Policy

The instrument of monetary policy are tools or devise which are used by the
monetary authority in order to attain some predetermined objectives.

The instruments of monetary policy are of two types:

1. Quantitative Instruments

2. Qualitative Instruments

Quantitative Instruments

 Are also known as the General Tools of monetary policy. These tools are
related to the Quantity or Volume of the money. The Quantitative Tools
of credit control are also called as General Tools for credit control.
 They are designed to regulate or control the total volume of bank credit
in the economy. These tools are indirect in nature and are employed for
influencing the quantity of credit in the country.

Policy instruments are meant to regulate the overall level of credit in the
economy through commercial banks. The selective credit controls aim at
controlling specific types of credit. They include changing margin requirements
and regulation of consumer credit.

Monetary Policy 9
Qualitative Instruments

 Also known as the Selective Tools of monetary policy. These tools are not
directed towards the quality of credit or the use of the credit. They are
used for discriminating between different uses of credit.
 It can be discrimination favoring export over import or essential over
non-essential credit supply. This method can have influence over the
lender and borrower of the credit.

These are various selective instruments of the monetary policy. However the
success of these tools is limited by the availability of alternative sources of
credit in economy, working of the Non-Banking Financial Institutions (NBFIs),
profit motive of commercial banks and undemocratic nature off these tools. But
a right mix of both the general and selective tools of monetary policy can give
the desired results.

Importance of Monetary Policy for Economic Stabilization

Monetary policy is another important instrument with which objectives of

macroeconomic policy can be achieved. It is worth noting that it is the Central
Bank of a country which formulates and implements the monetary policy in a
country. In some countries such as India the Central Bank (the Reserve Bank
is the Central Bank of India) works on behalf of the Government and acts
according to its directions and broad guidelines.

However, in some countries such as the USA the Central Bank (i.e., Federal
Reserve Bank System) enjoys an independent status and pursues its
independent policy. Like the fiscal policy the broad objectives of monetary
policy are to establish equilibrium at full-employment level of output, to ensure
price stability and to promote economic growth of the economy

Monetary policy is concerned with changing the supply of money stock and
rate of interest for the purpose of stabilizing the economy at full-employment or
potential output level by influencing the level of aggregate demand.

More specifically, at times of recession monetary policy involves the adoption of

some monetary tools which tend the increase the money supply and lower
interest rates so as to stimulate aggregate demand in the economy, on the
other hand, at times of inflation, monetary policy seeks to contract the

Monetary Policy 10
aggregate spending by tightening the money supply or raising the rate of
interest.

It may however be noted that in a developing country such as India, in addition

to achieving equilibrium at full employment or potential output level, monetary
policy has also to promote and encourage economic growth both in the
industrial and agricultural sectors of the economy.

Targets for Monetary Policy

In order to become a good target for monetary policy a variable should satisfy
the following conditions:

1. Measurability
2. Attainability
3. Relatedness to Goal Variables

Measurability

 The target variable should be easily measurable with little or no time lag.
To meet this condition, accurate and reliable data must be available. The
data should also conform to the theoretical definitions of the target
variables.

Attainability

 The monetary authority should be able to attain its targeted goals,

otherwise, setting the targets will be an exercise in futility. The targets
which are unattainable are not practical. A target will be attainable
when- (a) it is rapidly affected by policy instruments; and (b) there are no
or very little non-policy influences on it.

Relatedness to Goal Variables

 The target variable should be closely related to the higher level goal
variables and this relation should be well understood and reliably
estimable. For example, even if the monetary authority is able to attain
the interest rates target, all is in vain if the interest rates do not affect
the ultimate goals of employment. The price level, the rate of economic
growth, and the balance of payments.

Monetary Policy 11
Difference between monetary and fiscal policy

 Monetary policy involves changing the interest rate and influencing the
money supply.
 Fiscal policy involves the government changing tax rates and levels of
government spending to influence aggregate demand in the economy.
They are both used to pursue policies of higher economic growth or controlling
inflation.

Monetary policy

Monetary policy is usually carried out by the Central Bank/Monetary

authorities and involves:

 Setting base interest rates (e.g. Bank of England in UK and Federal

Reserve in the US)
 Influencing the supply of money. E.g. Policy of quantitative
easing to increase the supply of money.

How monetary policy works

 The Central Bank may have an inflation target of 2%. If they feel
inflation is going to go above the inflation target, due to economic
growth being too quick, then they will increase interest rates.
Monetary Policy 12
  Higher interest rates increase borrowing costs and reduce consumer
spending and investment, leading to lower aggregate demand and lower
inflation.
 If the economy went into recession, the Central Bank would cut interest
rates.

Which is more effective monetary or fiscal policy?

In recent decades, monetary policy has become more popular because:

 Monetary policy is set by the Central Bank, and therefore reduces

political influence (e.g. politicians may cut interest rates in the desire to
have a booming economy before a general election)

 Fiscal policy can have more supply side effects on the wider economy.
E.g. to reduce inflation – higher tax and lower spending would not be
popular, and the government may be reluctant to pursue this. Also,
lower spending could lead to reduced public services, and the higher
income tax could create disincentives to work.

 Monetarists argue expansionary fiscal policy (larger budget deficit) is

likely to cause crowding out – higher government spending reduces
private sector expenditure, and higher government borrowing pushes up
interest rates. (However, this analysis is disputed)

 Expansionary fiscal policy (e.g. more government spending) may lead to

special interest groups pushing for spending which isn’t really helpful
and then proves difficult to reduce when the recession is over.

Monetary Policy 13
  Monetary policy is quicker to implement. Interest rates can be set every
month. A decision to increase government spending may take time to
decide where to spend the money.

However, the recent recession shows that monetary policy too can have many
limitations.

 Targeting inflation is too narrow. During the period 2000-2007, inflation

was low but central banks ignored an unsustainable boom in the
housing market and bank lending.

 Liquidity trap. In a recession, cutting interest rates may prove

insufficient to boost demand because banks don’t want to lend and
consumers are too nervous to spend. Interest rates were cut from 5% to
0.5% in March 2009, but this didn’t solve recession in the UK.

 Even quantitative easing – creating money may be ineffective if banks

just want to keep the extra money on their balance sheets.

 Government spending directly creates demand in the economy and can

provide a kick-start to get the economy out of recession. Thus in a deep
recession, relying on monetary policy alone, may be insufficient to
restore equilibrium in the economy.

 In a liquidity trap, expansionary fiscal policy will not cause crowding out
because the government is making use of surplus saving to inject
demand into the economy.

 In a deep recession, expansionary fiscal policy may be important for

confidence – if monetary policy has proved to be a failure.

Monetary Policy and Central Banking

A key role of central banks is to conduct monetary policy to achieve price

stability (low and stable inflation) and to help manage economic fluctuations.
The policy frameworks within which central banks operate have been subject to
major changes over recent decades.

Since the late 1980s, inflation targeting has emerged as the leading framework
for monetary policy. Central banks in Canada, the euro area, the United
Kingdom, New Zealand, and elsewhere have introduced an explicit inflation
target. Many low-income countries are also making a transition from targeting

Monetary Policy 14
a monetary aggregate (a measure of the volume of money in circulation) to an
inflation targeting framework.

Central banks conduct monetary policy by adjusting the supply of money,

generally through open market operations. For instance, a central bank may
reduce the amount of money by selling government bonds under a “sale and
repurchase” agreement, thereby taking in money from commercial banks. The
purpose of such open market operations is to steer short-term interest rates,
which in turn influence longer-term rates and overall economic activity. In
many countries, especially low-income countries, the monetary transmission
mechanism is not as effective as it is in advanced economies. Before moving
from monetary to inflation targeting, countries should develop a framework to
enable the central bank to target short-term interest rates (paper).

Following the global financial crisis, central banks in advanced economies

eased monetary policy by reducing interest rates until short-term rates came
close to zero, which limited the option to cut policy rates further (i.e., limited
conventional monetary options). With the danger of deflation rising, central
banks undertook unconventional monetary policies, including buying long-
term bonds (especially in the United States, the United Kingdom, the euro area,
and Japan) with the aim of further lowering long term rates and loosening
monetary conditions.

Principles of Good Monetary Policy

Three key principles of good monetary policy.

1. Monetary Policy should be well understood and systematic.

2. The Central Bank should provide Monetary Policy stimulus when
economic activity is below the level of associated with full resource
utilization and inflation is below its stated goal.
3. The Central Bank should raise the policy interest rate, over time,
by more than one-for-one in response to a persistent increase in
inflation and lower the policy rate more than one-for-one in
response to a persistent decrease in inflation

Monetary Policy 15
Reference:

[Link]
[Link]

[Link]
tary-Policy-and-Central-Banking

[Link]
monetary-policy-rules

[Link]

[Link]
meaning-objectives-scope-role-and-targets-economics/31314

[Link]
tary-policy/

Monetary Policy 16