Professional's Academy of Commerce IEF (CAF-02)

Chapter 12: Monetary policy

12.1. Interest Rate

Interest rate is the amount charged by a lender to a borrower on the principal borrowed. Interest rates are
expressed as a percentage of principal and are typically recorded on per annum basis.

12.1.a. Types of Interest Rates

Nominal Interest Rate: Nominal interest rate is the simplest interest rate. The nominal interest rate (or money
interest rate) is the percentage increase in money you pay the lender for the use of the money you borrowed.
The nominal interest rate doesn’t take inflation into account. In other words, it is unadjusted for inflation.
 For instance if the nominal interest rate on a loan is 10%, the borrower will pay Rs. 10 on every 100
rupees lent to him.
Real Interest Rate: The real interest rate is the one that is inflation adjusted. The real interest rate measures the
percentage increase in purchasing power the lender receives when the borrower repays the loan with interest.
 For instance; if a bond compounds annually and has a nominal interest rate of 10% and the inflation rate
is 6% then the real interest rate is only 4%.

12.1.b. Determinates of Interest Rate

a. Supply and Demand: The interest rate depends upon the supply and demand of the credit. An increase
in demand would lead to an increase in the rate of interest whereas a decrease in demand would lead to a
decrease in the rate of interest. On the contrary an increase in the supply of credit would decrease the
rate of interest and a decrease in supply of credit would cause an increase in the rate of interest.
b. Inflation Rate: With the rise in actual or expected inflation rate, a rise in the interest rate too takes
place.
c. Government: The government has a say in the determination of the interest rates by way of devising the
monetary policy.
d. Type of Loan: The interest rate on different type of loans too depends on multiple factors; credit risk,
time, tax considerations etc. Risk refers to the likelihood of loan being repaid. The higher the risk the
more the return. Time: Time is also an important factor. Long term loans are riskier because of the time
interval involved and the inflation, making them more costly in terms of interest rates.

12.2. Central Bank

A national bank that provides financial and banking services for its country's government and commercial
banking system, as well as implementing the government's monetary policy and issuing currency. It is also
concerned with meeting a number of objectives such as: currency stability, low inflation and full employment.

12.2.b. Functions of the Central Bank

1. Issue of Currency: The central bank is given the sole monopoly of issuing currency in order to secure
control over volume of currency and credit. These notes circulate throughout the country as legal tender money.

Prepared and Compiled By: M. Bilal Kamran Page 1

Professional's Academy of Commerce IEF (CAF-02)

It has to keep a reserve in the form of gold and foreign securities as per statutory rules against the notes issued
by it.
2. Banker to Government: Central bank functions as a banker to the government—both central and state
governments. It carries out all banking business of the government. Government keeps their cash balances in the
current account with the central bank. Similarly, central bank accepts receipts and makes payment on behalf of
the governments. Also, central bank carries out exchange, remittance and other banking operations on behalf of
the government. Central bank gives loans and advances to governments for temporary periods, as and when
necessary and it also manages the public debt of the country
3. Banker’s Bank and Supervisor: There are usually hundreds of banks in a country. There should be some
agency to regulate and supervise their proper functioning. This duty is discharged by the central bank.
Central bank acts as banker’s bank in three capacities: (i) It is the custodian of their cash reserves. Banks of the
country are required to keep a certain percentage of their deposits with the central bank; and in this way the
central bank is the ultimate holder of the cash reserves of commercial banks, (ii) Central bank is lender of last
resort. Whenever banks are short of funds, they can take loans from the central bank and get their trade bills
discounted. The central bank is a source of great strength to the banking system, (iii) It acts as a bank of central
clearance, settlements and transfers. Its moral persuasion is usually very effective so far as commercial banks
are concerned.
4. Controller of Credit and Money Supply: Central bank controls credit and money supply through its
monetary policy which consists of two parts—currency and credit. Central bank has monopoly of issuing notes
(except one-rupee notes, one-rupee coins and the small coins issued by the government) and thereby can control
the volume of currency. The main objective of credit control function of central bank is price stability along
with full employment (level of output).
5. Exchange rate controls: The central bank has control over a country’s foreign currency, and gold reserves.
These are used in times to manipulate the exchange rates with other countries, and also other policy objectives,
such as the balance of payments.
6. Lender of Last Resort: When commercial banks have exhausted all resources to supplement their funds at
times of liquidity crisis, they approach central bank as a last resort. As lender of last resort, central bank
guarantees solvency and provides financial accommodation to commercial banks (i) by rediscounting their
eligible securities and bills of exchange and (ii) by providing loans against their securities. This saves banks
from possible failure and banking system from a possible breakdown. On the other hand, central bank, by
providing temporary financial accommodation, saves the financial structure of the country from collapse.
7. Custodian of Foreign Exchange or Balances: It has been mentioned above that a central bank is the
custodian of foreign exchange reserves and nation’s gold. It keeps a close watch on external value of its
currency and undertakes exchange management control. All the foreign currency received by the citizens has to
be deposited with the central bank; and if citizens want to make payment in foreign currency, they have to apply
to the central bank. Central bank also keeps gold and bullion reserves.
8. Clearing House Function: Banks receive cheques drawn on the other banks from their customers which
they have to realise from drawee banks. Similarly, cheques on a particular bank are drawn and passed into the
hands of other banks which have to realise them from the drawee banks. Independent and separate realisation to
each cheque would take a lot of time and, therefore, central bank provides clearing facilities, i.e., facilities for
banks to come together every day and set off their chequing claims.

Prepared and Compiled By: M. Bilal Kamran Page 2

Professional's Academy of Commerce IEF (CAF-02)

12.3. Monetary Policy

Monetary policy using a variety of techniques to influence the use of money and credit within an economy in
order to meet certain objectives. Monetary policy is based around controlling the growth and size of the money
supply, in turn affecting the interest rate that is set in the economy. The primary objective that the central bank
tries to meet is to keep inflation low and steady, and it does this through controlling the level of spending in an
economy.

12.3.a. Tools of Monetary Policy

a. Reserve Requirement: Reserve requirements are the portions of deposits that banks must hold in cash, either
in their vaults or on deposit at a Reserve Bank. A decrease in reserve requirements is expansionary because it
increases the funds available in the banking system to lend to consumers and businesses. An increase in reserve
requirements is contractionary because it reduces the funds available in the banking system to lend to
consumers and businesses.
b. Open Market Operations: Open market operations are when central banks buy or sell securities. These are
bought from or sold to the country's private banks. When the central bank buys securities, it adds cash to the
banks' reserves. That gives them more money to lend. When the central bank sells the securities, it places them
on the banks' balance sheets and reduces its cash holdings. The bank now has less to lend. A central bank buys
securities when it wants expansionary monetary policy. It sells them when it executes contractionary monetary
policy.
c. Discount-rate Policy: The discount rate is the interest rate Reserve Banks charge commercial banks for
short-term loans. Federal Reserve lending at the discount rate complements open market operations in achieving
the target federal funds rate and serves as a backup source of liquidity for commercial banks. Lowering the
discount rate is expansionary because the discount rate influences other interest rates. Lower rates encourage
lending and spending by consumers and businesses. Likewise, raising the discount rate is contractionary
because the discount rate influences other interest rates. Higher rates discourage lending and spending by
consumers and businesses.
d. Moral Persuasion: The central bank can also discourage behaviour from banks by simply conducting
personal discussions with them, and persuading them not to go through with actions that may jeopardise the
wider objectives that the central bank has. This is not a particularly easy instrument to measure, but is
nevertheless an important part of the central bank’s arsenal.
e. Exchange Rates: The Balance of Payments can be in a deficit or surplus which will affect the monetary base,
and therefore the money supply. The central bank can buy or sell foreign reserves (often in large quantities) in
order to ensure that the exchange rate doesn’t adversely affect the outcome of the real economy.

12.3.b. Types of Monetary Policy

1. Contractionary Policies: A contractionary monetary policy is a type of monetary policy that is intended to
reduce the rate of monetary expansion to fight inflation. A rise in inflation is considered the primary indicator of
an overheated economy, which can be the result of extended periods of economic growth. The policy reduces
the money supply in the economy to prevent excessive speculation and unsustainable capital investment.
 Interest rates are the primary monetary policy tool of a central bank. Commercial banks can usually take
short-term loans from the central bank to meet short-term liquidity shortages. In return for the loans, the
central bank charges the short-term interest rate. In order to reduce the money supply, the central bank
can opt to increase the cost of short-term debt by increasing the short-term interest rate. The increase in

Prepared and Compiled By: M. Bilal Kamran Page 3

Professional's Academy of Commerce IEF (CAF-02)

interest rates will also affect consumers and businesses in the economy as commercial banks will raise
the interest rates they charge their clients.
 Commercial banks are obliged to hold the minimum amount of reserves with the central bank and a
bank’s vault. A rise in the required reserve amount would decrease the money supply in the economy.
 The central bank is involved in open market operations by selling and purchasing government-issued
securities. The central bank can reduce the money circulated in the economy by selling large portions of
the government securities (e.g., government bonds) to investors.
Example: The central bank is concerned that the economy might be overheating, and therefore decides to reign
in the level of aggregate demand in the economy. It does so through increasing the base rate (interest rate) that it
sets throughout the economy. By increasing the rate of interest that banks can borrow from the central bank,
commercial banks must reduce the level of reserves that they hold. In order to cover the higher cost of
borrowing, they will either reduce the total amount of loans that they issue, or increase the cost of borrowing to
those individuals with existing loans (and who haven’t pre-determined the fixed level of interest that they will
pay).
These both have the effect of reducing the level of disposable income that individuals have, hence reducing
consumption. It also reduces the level of investment that occurs in the economy, as a higher interest rate
disincentives firms to invest in long term projects. This results in a decrease in aggregate demand which, as the
diagram shows, reduces the level of output from Y1 to Y2, and the price level from PL1 to PL2.

2. Expansionary Policy: An expansionary monetary policy is a type of macroeconomic monetary policy that
aims to increase the rate of monetary expansion to stimulate the growth of the domestic economy. The
economic growth must be supported by additional money supply. The money injection boosts consumer
spending, as well as increase capital investments by businesses.

Prepared and Compiled By: M. Bilal Kamran Page 4

Professional's Academy of Commerce IEF (CAF-02)

 The adjustments to short-term interest rates are the main monetary policy tool for a central bank.
Commercial banks can usually take out short-term loans from the central bank to meet their liquidity
shortages. In return for the loans, the central bank charges a short-term interest rate. By decreasing the
short-term interest rates, the central bank reduces the cost of borrowing to commercial banks.
Subsequently, the banks lower the interest rates they charge their consumers for loans. Therefore,
whenever the central bank lowers interest rates, the money supply in the economy increases.
 Commercial banks are obliged to hold a minimum amount of reserves with a central bank. In order to
increase the money supply, the central bank may reduce reserve requirements. In such a case,
commercial banks would see extra funds to be lent out to their clients.
 The central bank may also use open market operations with government-issued securities to affect the
money supply in the economy. It may decide to buy large amounts of the government-issued securities
(e.g., government bonds) from institutional investors to inject additional cash into the domestic
economy.
Example: The central bank is concerned that the level of output in the economy is too low, and therefore
decides to try and increase the level of aggregate demand in the economy. It does so through buying
government bonds in a round of open market operations. By purchasing government bonds from commercial
banks, the central bank transfers money to the banks, increasing the cash reserves that they hold. The
commercial banks, with their bolstered reserves, will look to then loan out these additional reserves, to the level
of the reserve rate.
Doing so increases the reserve level for second-generation banks, which do the same. Consequently the initial
increase in cash reserves to the first bank translates to a multiplied effect across the wider economy. This
increases the level of money supply in the economy, and brings down the market rate of interest. Consequently
firms and consumers then increase their investment and consumption respectively, and the level of aggregate
demand increases. This is shown in the diagram by an increase in output from Y1 to Y2, and the price level
from PL1 to PL2.

Prepared and Compiled By: M. Bilal Kamran Page 5

Professional's Academy of Commerce IEF (CAF-02)

12.3.c. Objectives of Monetary Policy

a. Price Stability: Keeping inflation low and steady for a more stable economic performance.
b. Economic Growth: With appropriate economic policy, the government wishes to develop the overall
per capita income within the country.
c. Exchange Rate Stability: Achieve stable exchange rates between countries in part through adjusting for
the balance of payments.
d. Full Employment: Here, it is necessary to increase production and demand for goods, allowing
resources to be fully utilised and the economy to reach full employment.
e. Credit Control: Making banks exercise control over their issuance of credit, but also ensuring that the
most vulnerable in society are receiving their fair share.

Conflicts between Objectives

Price Stability Vs Full Employment: By undertaking monetary policy to increase full employment, a central
bank could undertake policies to increase aggregate demand. Doing so could drive up inflation, putting more
pressure on the price stability target.
Economic Growth Vs Exchange Rate Stability: In order to boost economic growth, a central bank may
decide to manipulate exchange rates to increase the likelihood of exports. Doing so would jeopardise stability in
exchange rates.
Economic Growth Vs Credit Control: A way to grow the economy might be through the expansion of credit,
as it would spur investment and spending. However, this comes with heightened economic risk of credit
defaulting.

12.3.d. Limitations of Monetary Policy

a. Existence of Non-Monetary Sector: This is especially so in developing countries. If a large portion of
society are not using money for exchange (for example bartering in rural areas), then they are not using
commercial banks, which limits the effect of policies reaching these people.
b. Existence of Non-Banking Financial Institutions: These are organisations that offer credit to
consumers, however do not come under the supervision of the central bank.
c. High Liquidity in Financial Markets: When a central bank looks to tighten the money supply, its
effects will be hindered if agents in the economy have access to highly liquid assets. Hence if the central
bank tries to tighten money supply, agents can counter this by creating their own liquidity.
d. Time Lags: The effects of a monetary policy will often take time to occur. Therefore a central bank
must have to predict what will happen in the future, and implement policies accordingly. Sometimes
however there will be too much uncertainty for these policies to be correct.
e. Lack of Co-Ordination between Monetary and Fiscal Policies: In simple terms, monetary policies
are implemented by the central bank, and fiscal policies are implemented by the government. If the two
organisations do not co-ordinate their objectives, then the effect will be corruptive.

Example: The central bank is concerned that the level of inflation is getting too high, and so decides to tighten
the money supply. However, the government believes that unemployment is too high, and so decides to invest
in an infrastructure project (an increase in government spending) to boost output in the economy. As we can
see, the government pushed AD out from AD1 to AD2, only for the Central Bank to cause it to shift back from
AD2 to AD1. The efforts of both have been wasted, due to a lack of co-ordination.

Prepared and Compiled By: M. Bilal Kamran Page 6

Professional's Academy of Commerce IEF (CAF-02)

Example: Had better co-ordination been managed, then the government could have issued a policy to shift out
SRAS (for example forcing wages to stay low, keeping down the cost of inputs) and the central bank could have
lowered interest rates, thereby increasing aggregate demand in the economy.

Prepared and Compiled By: M. Bilal Kamran Page 7

Professional's Academy of Commerce IEF (CAF-02)

12.4. Bank
A financial institute licensed by the government to receive deposits, which then invests these funds in a number
of securities.

12.4.a. Types of Bank

There are two main types of bank: commercial banks and investment banks.
1. Commercial Bank: These banks receive money from the public through deposits, and other means, and in
return finance the business sector and individuals. A bank targeted at the mass-market in which individual
customers can purchase bank services: mortgages, checking accounts, personal loans, and other bank services.
a. Retail Bank: Often used synonymously with commercial bank, this is used to distinguish from
investment banks, and deals with the deposits and loans from large businesses and corporations. A retail
bank is often a branch of a commercial bank. A bank targeted at the mass-market in which individual
customers can purchase: mortgages, checking accounts, personal loans, and other bank services.
b. Specialized Bank: These are banks which service a specific sector in the economy. They will often
have specialized needs that might not be adequately met by other forms of banks. The clearest example
of this is agricultural banks. For example, the Agricultural Development Bank of Pakistan (ADBP)
provides long, medium and short term loans to agriculturalists, and aids them with purchases of land and
other business inputs.
c. Cooperative bank/ building society/ credit union: These are usually a not-for-profit organisation
where members pool their resources and receive favourable credit terms. Membership is restricted to
some shared alliance (employees of the same company, residents in a certain neighbourhood etc.). There
are a number of different variations on this business model, and depending on the region, will be called
any of the above.
2. Investment Bank: An investment bank works by assisting a range of institutions with raising capital by
underwriting their securities and other assets. They also advise on many issues a business might face. A
financial intermediary that undertakes a number of financial services for clients. The investment bank can also
aid companies with acquiring funds, and facilitate a number of transactions through utilising the financial
markets.

Prepared and Compiled By: M. Bilal Kamran Page 8