Monetary Policy
1. MEANING of MONETARY POLICY:
The Monetary Policy which is made by Central bank or Federal Bank in order to control the supply of money is sometime also known as the ³Credit Policy´. Following decisions are made in Monetary Policy: How much would be the supply of money in the economy? How much would be the ratio of interest? How much would be the viability of money? Gaurav Akrani (2010) Monetary Policy- its meaning, definitions, objectives, Articles (http://kalyan-city.blogspot.com/2010/09/instruments-of-monetary-
policy.html ), Accessed 8 November, 2011 Different economists have defined the term ³Monetary Policy´ in their own ways. Some of them are as follow: ³A policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy is a monetary policy.´ (Prof. Harry Johnson) St. Martin's, [1968-1969], Surveys of economic theory. London: Macmillan, New York: 3 v. Número de Chamada: ma4cs AMERICAN ECONOMIC ASSOCIATION. ³A policy which influences the public stock of money substitute of public demand for such assets of both that is policy which influences public liquidity position is known as a monetary policy´. (A.G.Hart) Max F. Millikan, Income stabilization for a developing democracy: a study of the politics and economics of high employment without inflation Volume 5 of Studies in national policy, Yale University From the above definitions, it can be said that a monetary policy is made to control the demand and supply of money in the economy in order to achieve certain broad objectives.
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2. TYPES OF MONETARY POLICY 2.1. Expansionary Monetary Policy:
Expansionary monetary policy is a type of monetary policy which is used by the Federal bank to stimulate the National economy; in other ways we can say that to boost or expand the economic activities. By this policy, Federal bank lower the Federal Funds rate in order to increase the money supply. In this way mortgage rate decline, consumers borrow and spend more, and businesses grow, thereby hiring more workers who will consume even more. Decreasing Interest Rates
Kimberly Amadeo, Expansionary Monetary Policy
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Monetary Policy
2.2. Contractionary Monetary Policy:
Contractionary monetary policy is a monetary policy which is used to put the brakes on the economy to stop inflation. This fed usually use this policy to raise the fed funds rate. This increases the rate that banks charge each other to borrow funds to meet the Federal Reserve requirement. Raising the fed funds rate decreases the money supply because banks would rather lend a little less, and not have to pay a higher fed funds interest rate. By contracting the money supply, a higher fed funds rate means banks will increase variable rate mortgages, consumers will borrow and spend less, and businesses will stop raising prices and giving raises. This usually heads off inflation.
Increasing Interest Rates Interest Rates
Kimberly Amadeo, Contractionary Monetary Policy
3. OBJECTIVES OF MONETARY POLICY:
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Monetary Policy The mentioned below are the general objectives which every Central Bank of a nation tries to attain by employing certain tools (Instruments) of a monetary policy. y y y y y y y Full employment Neutrality of Money Exchange Rate Stability Equal Income Distribution Rapid Economic growth Price stability Balance of Payments(BOP) Equilibrium
3.1. Full Employment: The concept of full employment was much discussed after Keynes's publication of the "General Theory" in 1936. It is the nonexistence of involuntary unemployment. In simple words 'Full Employment' is a situation in which everyone who wants job, gets job. However it does not mean that there is no unemployment but on a very low rate. In that senses the full employment is never full. Monetary policy can be used for achieving the target of full employment. Monetary policy helps in creating more jobs in different sector of the economy. 3.2. Neutrality of Money: Money is considered as an inert factor by the Economists such as Wicksted and Robertson . According to them, money should play only a function of medium of exchange and not more than that. Therefore, the monetary policy should control the supply of money. Monetary disequilibrium occurs because of the change in supply of money. Thus monetary policy has to control the supply of money and neutralize the effect of money expansion. However this objective of a monetary policy is always criticized that if money supply is kept constant or unchanged then it would be difficult to attain price stability.
3.3. Exchange Rate Stability:
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Monetary Policy Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate.
3.4. Equal Income Distribution: Many economists used to justify the role of the fiscal policy is maintaining economic equality. However in resent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality. Monetary policy can make special provisions for the neglect supply such as agriculture, small-scale industries, village industries, etc. and provide them with cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in reducing economic inequalities among different sections of society.
3.5. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the Central Bank opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth. Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability.
3.6. Price Stability: All the economies suffer from inflation and deflation. It can also be called as price instability. Both inflation and deflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. When the economy
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Monetary Policy suffers from recession the monetary policy should be an ³easy money policy´ but when there is inflationary situation there should be a ³dear money policy´.
3.7. Balance of Payments (BOP) Equilibrium: Many developing countries suffer from the disequilibrium in the BOP. The Central Bank through its monetary policy tries to maintain equilibrium in the balance of payment. The BOP has two aspects i.e. the BOP Surplus and BOP Deficit. BOP surplus reflects an excess money supply in the domestic economy, while the BOP deficit stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved. Gaurav Akrani( 2010) Monetary Policy- its meaning, definitions, objectives, Articles http://kalyan-city.blogspot.com/2010/09/instruments-of-monetarypolicy.html , Accessed 8 November, 2011
4. TOOLS (INSTRUMENTS) OF MONETARY POLICY:
The tools of monetary policy used by the Central Bank depend on the level of development of the economy, especially its financial sector. They are classified into two types. 1. Quantitative Methods 2. Qualitative Methods
4.1 Quantitative Instruments or General Tools: The 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.
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Monetary Policy 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. The general tool of credit control comprises of following instruments. 4.1 1. Bank Rate Policy (BRP): The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for influencing the volume or the quantity of the credit in a country. The bank rate refers to rate at which the Central Bank rediscounts bills and prepares of commercial banks or provides advance to commercial banks against approved securities. The Bank Rate affects the actual availability and the cost of the credit. Any change in the bank rate necessarily brings out a resultant change in the cost of credit available to commercial banks. If the Central Bank increases the bank rate than it reduce the volume of commercial banks borrowing from the Central Bank. It deters banks from further credit expansion as it becomes a more costly affair. Even with increased bank rate the actual interest rates for a short term lending go up checking the credit expansion. On the other hand, if the Central Bank reduces the bank rate, borrowing for commercial banks will be easy and cheaper. This will boost the credit creation. Thus any change in the bank rate is normally associated with the resulting changes in the lending rate and in the market rate of interest. However, the efficiency of the bank rate as a tool of monetary policy depends on existing banking network, interest elasticity of investment demand, size and strength of the money market, international flow of funds, etc. 4.1.2. Open Market Operation (OMO): The open market operation refers to the purchase and/or sale of short term and long term securities by the Central Bank in the open market. This is very effective and popular instrument of the monetary policy. The OMO is used to wipe out shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc. It is important to understand the working of the OMO. If the Central Bank sells securities in an open market, commercial banks and private individuals buy it. This reduces the existing money supply as money gets transferred from commercial banks to the Central
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Monetary Policy Bank. Contrary to this when the CENTRAL BANK buys the securities from commercial banks in the open market, commercial banks sell it and get back the money they had invested in them. Obviously the stock of money in the economy increases. This way when the CENTRAL BANK enters in the OMO transactions, the actual stock of money gets changed. Normally during the inflation period in order to reduce the purchasing power, the CENTRAL BANK sells securities and during the recession or depression phase she buys securities and makes more money available in the economy through the banking system. Thus under OMO there is continuous buying and selling of securities taking place leading to changes in the availability of credit in an economy. However there are certain limitations that affect OMO; underdeveloped securities market, excess reserves with commercial banks, indebtedness of commercial banks, etc. 4.1.3. Variation in the Reserve Ratios (VRR): The Commercial Banks have to keep a certain proportion of their total assets in the form of Cash Reserves. Some part of these cash reserves are their total assets in the form of cash. Apart of these cash reserves are also to be kept with the CENTRAL BANK for the purpose of maintaining liquidity and controlling credit in an economy. These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR). The CRR refers to some percentage of commercial bank's net demand and time liabilities which commercial banks have to maintain with the Central Bank and SLR refers to some percent of reserves to be maintained in the form of gold or foreign securities. Any change in the VRR (i.e. CRR + SLR) brings out a change in commercial banks reserves positions. Thus by varying VRR commercial banks lending capacity can be affected. Changes in the VRR helps in bringing changes in the cash reserves of commercial banks and thus it can affect the banks credit creation multiplier. CENTRAL BANK increases VRR during the inflation to reduce the purchasing power and credit creation. But during the recession or depression it lowers the VRR making more cash reserves available for credit expansion.
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Monetary Policy 4.2. Qualitative Instruments or Selective Tools: The Qualitative Instruments are 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. The Selective Tools of credit control comprises of following instruments. 4.2.1. Fixing Margin Requirements: The margin refers to the "proportion of the loan amount which is not financed by the bank". Or in other words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose. A change in a margin implies a change in the loan size. This method is used to encourage credit supply for the needy sector and discourage it for other non-necessary sectors. This can be done by increasing margin for the non-necessary sectors and by reducing it for other needy sectors. Example:- If the CENTRAL BANK feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given. 4.2.2. Consumer Credit Regulation Under this method, consumer credit supply is regulated through hire-purchase and installment sale of consumer goods. Under this method the down payment, installment amount, loan duration, etc is fixed in advance. This can help in checking the credit use and then inflation in a country. 4.2.3. Publicity This is yet another method of selective credit control. Through it Central Bank publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly bulletins, the information is made public and banks can use it for attaining goals of monetary policy.
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Monetary Policy 4.2.4. Credit Rationing Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit expoursure to unwanted sectors. 4.2.5. Moral Suasion It implies to pressure exerted by the CENTRAL BANK on the banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the Central Bank through a monetary policy. Under moral suasion Central Banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes. 4.2.6. Control through Directives Under this method the Central Bank issue frequent directives to commercial banks. These directives guide commercial banks in framing their lending policy. Through a directive the Central Bank can influence credit structures, supply of credit to certain limit for a specific purpose. The CENTRAL BANK issues directives to commercial banks for not lending loans to speculative sector such as securities, etc beyond a certain limit. 4.2.7. Direct Action Under this method the CENTRAL BANK can impose an action against a bank. If certain banks are not adhering to the CENTRAL BANK's directives, the CENTRAL BANK may refuse to rediscount their bills and securities. Secondly, CENTRAL BANK may refuse credit supply to those banks whose borrowings are in excess to their capital. Central Bank can penalize a bank by changing some rates. At last it can even put a ban on a particular bank if it dose not follow its directives and work against the objectives of the monetary policy.
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Monetary Policy 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. Gaurav Akrani( 2010) Instruments of Monetary Policy: Qualitative and Quantitative http://kalyan-city.blogspot.com/2010/09/instruments-of-monetarypolicy.html , Accessed 15 November, 2011
5. EFFECTS OF MONETARY POLICY TO AN ECONOMY:
5.1. Consumption, Saving and Investment: Changes in the real interest rates affect the demand for consumption and savings of the people and also change the investment pattern of the businesses. For instance, a reduction in real interest rate lowers the cost of borrowing, encouraging people to borrow in order to consume (durable items like, electronic items, automobiles etc.). Moreover stimulating bank¶s willingness to lend more and investors to invest more, on the other side discourage saving, resulting to increase spending and aggregate demand. Lower real interest rates also make stocks and other such investments more desirable than bonds, resulting stock prices to rise. People are likely to increase their stock of wealth.
5.2. Foreign Exchange, Imports and Exports: Short-run changes lower interest rate result as currency depreciation, which means lower prices of home-produced goods selling abroad, making exports dearer and discourage imports, reducing the gap between imports and exports and having favorable balance of trade. Again this leads to higher aggregate spending on goods and services produced in the country.
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Monetary Policy 5.3. Output and Employment: The increase in aggregate demand for the output boosts up the production cycle; generating employment, as a result increase investment spending on the existing industrial capacity. Which accelerate the consumption further due to more incomes earned, thus attaining the multiplier effect of Keynes. 5.4. Inflation: Monetary policy affects inflation in two ways. First, affecting indirectly, if monetary policy able to achieve multiplier effect, it boosts up economic activity. Initiating labor and capital markets to raise outputs beyond there capacities and creating an upward pressure on wages, thus resulting inflation to rise (that is cost-push inflation). Thus there would be a trade-off between higher inflation and lower unemployment in the short-run which further accelerate inflation. As wages and prices start to rise they are hard to bring down back, stressing the need for early policy measures to be taken. Secondly, monetary policy can directly affect inflation via future expectations. Like if people expect the rise in prices in future, they persuade to increase in wages, which in turn affect the prices, resulting higher inflation. World Defence Network http://www.defence.pk/forums/economydevelopment/13561-monetary-policy.html
6. ROLE OF MONETARY POLICY:
Economists view monetary policy as the first line of defense against economic slowdowns. Compared with fiscal policy, monetary policy has the advantages of the Federal Reserve¶s ability to act faster than the administration or Congress and to better judge the appropriate timing and magnitude of a stimulus. Further, unless well crafted, fiscal stimulus may impose long-run costs on the economy without providing much short-run gain.
The Federal Reserve can adjust monetary policy more quickly than the administration and Congress can adjust fiscal policy. Because most contractions
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Monetary Policy in economic activity last for only a few quarters, the timeliness of the policy response is crucial. Fiscal policy in practice responds to changes in economic conditions with a considerable lag: it takes time first to enact a stimulus bill and then to implement it, and time for the spending increases or tax reductions to reach the pockets of consumers. As a result, the effect of fiscal stimulus on household and business spending may come too late.
Whether and how much stimulus is needed depends on economic conditions today, on projections of likely future conditions, and on assessments of the risks to both economic activity and inflation going forward. Forecasting economic conditions-or even determining the current state of the economy-is inherently very difficult, given limitations in the available data and in economists¶ understanding of the world. But the Federal Reserve¶s large and sophisticated team of analysts is better positioned to accomplish this task than any other agency of the federal government. In addition, the Federal Reserve staff carries out this work independent of political considerations. Economists worry that poorly crafted fiscal stimulus would have little short-run economic benefit and could do long-run harm. For example, permanent tax cuts unaccompanied by permanent spending reductions would increase the long-run budget deficit. And a permanent increase in the deficit-especially now, when the budget is already so far out of long-run balance-would reduce economic growth over time. Moreover, because higher expected government borrowing is likely to push up current long-term interest rates, the short-run simulative effect would be muted as well. In fact, under plausible assumptions about economic behavior, the response of forward-looking financial markets to a sustained reduction in personal income taxes would offset about half of the incipient simulative effect of the tax cut. Tax Policy Briefing Book: A Citizens' Guide for the 2008 Election and Beyond by the staff and affiliates of the Tax Policy Center, Proceedings of New York University ... annual Institute on Federal Taxation, Volume 1; Volume 66
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Monetary Policy
7.MONETARY
POLICY
FRAMEWORK
IN
PAKISTAN:
Considering the economic and financial market structure in Pakistan, SBP has for sometime pursued a monetary targeting regime with broad money supply (M2) as a nominal anchor to achieve the objective of controlling inflation without any prejudice to growth. The process of monetary policy formulation usually begins at the start of the fiscal year when SBP sets a target of M2 growth in line with government's targets of inflation and growth (usually in the month of May) and an estimation of money demand in the economy. The basic idea is to keep the money supply close to its estimated demand level, as both a significant excess and a shortfall their respective targets.may lead to considerable deviations in actual outcomes of inflation and real GDP growth from
Underlying this framework are two strong assumptions: 1. First, there is a strong and reliable relationship between the goal variable (inflation or real GDP) and M2; and 2. Second, the SBP can control growth in M2. While containing the M2 growth close to its target level is the key consideration in the current monetary framework, the composition of the money supply does matter and at times requires policy actions even if these actions lead to a deviation in monetary growth from its target level. Net foreign Assets (NFA) and Net Domestic Assets (NDA) of the banking system are the two major components of money supply.
The NFA is the excess of foreign exchange inflows over outflows to the banking system, or in other terms it is a reflection of underlying trends in the country's external Balance of Payment (BOP) position. It is estimated by the projected values
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Monetary Policy of all major external transactions such trade, workers' remittances; debt servicing, foreign investment, and debt flows etc.
The NDA of the banking system, which primarily consists of credit to the government and the private sector, reflects changes in the fiscal and the real sectors of the economy, if is estimated as a residual of M2 and the NFA. Further break-up of NDA is estimated on the basis of projected credit needs of the government and the private sector. Depletion in NFA is generally considered as an unhealthy development. Sharp NFA depletion reflects worsening BOP position and a pressure on exchange rate. In such a case, a higher NDA growth, though helps in expanding M2 to reach its target level, may further deteriorate external accounts, sharper depreciation of local currency, and higher depletion of country's foreign exchange reserves.
Although since FY07, only the indicative M2 growth target is being announced. SBP also takes into consideration the causative factors for monetary expansion while pursing this target. Considering the changes in monetary aggregates and other economic variables, the changes in monetary policy are signaled through adjustments in the policy discount rate (3-day repo rate).
Further, the changes in the policy rate are complemented by appropriate liquidity management mainly through Open Market Operations (OMOs) and if required changes in the Cash Reserve Requirement (CRR) and Statutory Liquid Reserve requirement (SLR) are also made."
8. EFFECTIVENESS OF MONETARY POLICY IN PAKISTAN:
Significance of various channels that spread the monetary policy shocks in the real economy of Pakistan has been analyzed by different economists. Ahmed et al said that credit channel is the most important mean for transmitting monetary policy actions to the real economy activity. Authors had found the evidence that shows the different effects of monetary policy in different sectors. Monetary policy shocks have
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Monetary Policy negligible impact on agriculture, mining, construction and ownership of dwelling sector. (2005) Historically, evidence revealed that Pakistan has been a high inflation and high interest economy given its inherent structural weaknesses. The role and effectiveness of monetary policy appears more visible in 2000s when financial sectors began expand in terms of market based money and foreign exchange markets. Entering the 21st century, the loose monetary policy stands in the face of low inflation, low growth and low twin deficits, along with structural measures to open up the economy. Monetary policy position was however altered as the inflationary pressures started to build up in 2005. At the end of the fiscal year, the economy which had been showing a sustained growth since FY 01, registered a high level of growth ( 9 percent), average inflation rose sharply ( 9.3 percent) and the external current account balance turned into deficit ( -1.4 percent of GDP). The fiscal module started to show the symbols of stress as the fiscal balance was converted into a deficit. Because of the domestic and global price pressures, SBP tightened its monetary policy after a prolonged gap of a few years. The efforts to reduce inflation however proved less effective due to a rebound in international commodity prices and a rise in domestic food prices later on. Realizing the complications of monetary management and adverse global and domestic economic developments, the SBP did some changes in the implementation of monetary policy.
9. WHAT NEEDS TO BE DONE TO IMPROVE THE EFFECTIVENESS OF MONETARY POLICY?
Apart from taking policy measures to address the emerging challenges, SBP also introduced structural changes in the process of monetary policy formulation and conduct to make the monetary policy formulation and implementation more transparent, efficient, and effective. Specifically, during the last couple of years, SBP focused on ? Institutionalizing the process of policy formulation and conduct. ? Stepping up movement towards a more market based credit allocation mechanism.
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Monetary Policy ? Developing its analytical and operational capacity. ? Improving its capabilities to assess future developments to act proactively, and ? Improving upon the communication of policy stance to the general public. However, the following areas need attention and are keys for effective monetary management. 1. Effectiveness of monetary and fiscal co-ordination would be helpful. Section 9A and 9B of the SBP Act (amended in 1994) articulates the institutional mechanism for economic policy making and co-ordination and defines the ground rules for both the process and the policy making. However, the track record of the Monetary and Fiscal Policies Co-ordination Board (MFPCB), established in February 1994 that requires quarterly meetings of the SBP. 2. For effective analysis of developments and policy making, timely and quality information is extremely important. However, due to weaknesses in the data collection and reporting mechanism of the various agencies of the country, information is not available with desired frequency and timeliness. Also there are concerns over the quality of data. Unlike many developed and developing countries, data on quarterly GDP, employment and wages, etc is not available in case of Pakistan .Moreover, the data on key macroeconomic variables (such as government expenditure and revenue, output of large-scale manufacturing, crop estimates, etc) is usually available with substantial lags. This constrains an in-depth analysis of the current economic situation and evolving trends, and hinders the ability of the SBP to develop a forward-looking policy stance. 3. Unlike many countries, both developed and developing, there is no prescribed limit on government borrowing from SBP defined in the SBP Act or the Fiscal Responsibility and Debt Limitation (FRDL) Act 2005. Besides being highly inflationary, government borrowing from SBP also complicates liquidity management. Therefore, the foremost task to improve the effectiveness of monetary policy is to prohibit the practice of government borrowings from the SBP. In this regard, appropriate provisions are required to cease or limit government recourse to Central Bank financing through amendments in the SBP Act and the FRDL Act 2005.
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Monetary Policy 4. Another issue is to make a clear distinction between exchange rate management and monetary management. Currently, there is a general perception that the State Bank is bound to keep the exchange rate at some predefined level and any movement away from this level is then considered as an inefficiency of the SBP. In conclusion, it is not possible to solve all these problems immediately. It needs a deeper structural reforms and time to cope with these issues. The Effectiveness of Monetary Policy in Pakistan ARTICLE (December 09 2008: The speech of the Governor, State Bank of Pakistan, at the Institute of Business Management on December 6.
http://www.defence.pk/forums/economy-development/17538-effectivenessmonetary-policy-pakistan.html
10. HISTORICAL OVERVIEW OF MONETARY POLICY IN PAKISTAN:
Monetary policy in Pakistan has been used in co-ordination with the fiscal policy to achieve both the objectives of macro-economic stability and higher economic growth. The government supervises monetary situation of economy through the State Bank of Pakistan (SBP). This article attempts to present an overview of the monetary policy in Pakistan overtime. During the decade of fifties, monetary policy was used to correct external balances in the economy. The government followed the tight monetary policy during the early fifties to prevent inflationary tendencies in the economy. But there was an increase in the money supply because of the deficit financing. The phenomenon of monetary expansion continued during the sixties (Although growth rate of money supply slowed down in the late fifties). Increase in bank rates, cash reserve requirements, liquidity ratios, abolition of credit quotas and the imposition of credit ceiling etc. were the main measures because of rapid increases in private investment and growth of GDP (6.8% in 1960s). The government tried to restrict money supply in the economy to counteract inflation because of conflict with India in 1965 and crop failure in 1966. However, heavy defence expenditures and cut in aid flows forced the government to resort to deficit financing for correcting the
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Monetary Policy fiscal imbalance. It would be pertinent to mention that inflation rates remained low (3.8%, annual average) during this period. This was due to an improvement in the economy and steps taken by the monetary authorities (e.g. increase in bank rates, cash reserve requirements, liquidity ratios, abolition of credit quotas and imposition of credit ceiling). Table-1 Monetary assets in Pakistan (annual average) 1 Stock money (Rs billion) Growth rate (%) 7.8** 16.3 21.0 13.2 15.95 1950s 1960s 1970s 1980s l990s of 5.16 13.29 41.10* 180.9 785.0
Notes: The average is for the period 1971 to 1979. The average is for the years 1952 to 1959. Source: Gap, Economic Survey. Various Issues. Internal and external shocks (mentioned above) and devaluation of Pakistani currency resulted in slow growth of the output and higher monetary expansion leading to a rise in the general price level during the seventies. Increase in the public and private borrowings did also increase money supply in the economy. The SBP adopted various measures to control the money supply but achieved limited success in this regard. The eighties started with financing of the budget deficit mainly through external borrowings and bank sources. As a result of this strategy, not only external indebtedness increased, it also led to inflation in the economy (about 12.5% during the years 1981 and 1982). Hence, the government resorted to non-bank borrowings as a major source of financing the public deficit during the period 1983-90. The move was justified on account of debt crisis in the eighties and to prevent inflation as well. As a result of this policy-shift, inflation remained under control (6.0% on average) during the period 1983-90. Lack of domestic resource mobilization and the shortage of foreign loans forced the government to make a hesitant move for additional funds
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Monetary Policy from the World Bank as a part of the structural adjustment loan (SAL) linked with stringent conditions. Resentment on part of the government resulted in disruption of these funds, time and again. During the 1990s, the government introduced various financial reforms through the market-based instruments of monetary management. Increase in reserve requirements, privatization of commercial banks, license to establish private commercial banks, greater financial autonomy to the SBP, development of secondary markets in government securities, increase in commercial lending rates, credit control and capital market reforms etc. are the main features of these reforms. Bank borrowings remained an important source of financing the budget deficit as 32% of the total deficit was financed through such sources forming 2.9% of GDP during the period 1990-96. Such a mode of financing the deficit not only affected the pace of monetary expansion (table-1) but also accelerated the rate of inflation (10.6%), higher than annual average (7.3%) of the eighties. The bank borrowings soared up as a result of financial reforms and the government needs for retirement of the non-bank debt. With the introduction of financial reforms, certain non-bank borrowing instruments were suspended, resulting in lesser availability of funds. This trend has reversed during the recent years as domestic non-bank borrowings have largely been used to accommodate the fiscal deficit. The government has also followed a policy of retiring the debt borrowed through the banking system. As far as the stock of money is concerned, it has grown up enormously during the nineties as compared to that in 1980s. It has grown up at varying rates and stands up about four times higher than what it was during the preceding decade. The average growth rate of money supply during the 1990s has been at par with that of in the sixties but relatively higher than that in the fifties and eighties. The government has tried its level best to contain the growth of money supply through various measures during the recent years. Meddling in monetary policy is usually symptomatic of government failure in fiscal arena. Hence, there stands a need for concerted efforts to rectify the fiscal sinfulness in Pakistan. How to reduce the fiscal deficit is another area of debate. However, fundamental solution lies in expanding the tax net and retiring the foreign debt. Mere tinkering with money supply will only preserve misalignments and convulsion in other economic areas.
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Monetary Policy By Dr. M. Hanif Akhtar, Aug 28 - Sep 03, 2000 Department of Commerce, B. Z. University, Multan
11. CURRENT MONETARY POLICY PAKISTAN: STATE BANK OF PAKISTAN
MONETARY POLICY DECISION 30 November 2011
The SBP reduced its policy rate by 200 bps, to 12 percent, in FY12 so far. The objective of adopting this stance is to support revival of private investment in the economy despite a constraining domestic and global economic environment. The primary factors in support of this stance were the expectation of average CPI inflation remaining within the announced target in FY12 and a small projected external current account deficit. In pursuing this stance SBP did acknowledge the risks to macroeconomic stability emanating from fiscal weaknesses and falling foreign financial inflows. These include resurgence of medium term inflationary pressures and challenges SBP is facing in managing market liquidity and preserving foreign exchange reserves. A reassessment of latest developments and projections indicate that macroeconomic risks have somewhat increased during the last two months. For instance, although the year-on-year CPI inflation stands at 11 percent in October 2011, the month-on-month inflation trends, averaging at around 1.3 percent per month during the first four months of FY12, show existence of inflationary pressures. The sifting of commodity level CPI data reveal that the number of CPI items exhibiting year-on-year inflation of more than 10 percent is consistently increasing and almost all of these items belong to the non-food category. The government has also increased its wheat support price by Rs100 to Rs1050 per 40kg for the next wheat procurement season. Thus, while the average inflation may settle around the targeted 12 percent for FY12, it is uncertain that inflation will come
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Monetary Policy down to a single digit level in FY13. The main determinants of this inflation behavior are government borrowing from the banking system and inertial effects of high inflation on its expected path. The severe energy shortages are also holding back the effective utilization of productive capacity and adding to the high inflation-weak growth problem. On the external front, the earlier comfortable external current account position for FY12, which helped SBP in lowering its policy rate, has become less benign. The actual external current account deficit of $1.6 billion for the first four months of FY12 is now higher than the earlier projected deficit for the year. The main reason for this larger than expected deterioration is the rising trade deficit. In particular, the windfall gains to export receipts due to abnormally high cotton prices in FY11 have dissipated faster than anticipated. This is indicated by slightly less than $2 billion per month export receipts in September and October 2011. At the same time, international oil prices of around $110 per barrel and strong growth in non-oil imports have kept the total import growth at an elevated level of close to $3.4 billion per month. Adding to the challenges faced by the external sector is the precarious global economic outlook. A relatively larger external current account deficit in FY12 would require higher financial inflows to maintain foreign exchange reserves. However, during JulyOctober, FY12, the total net direct and portfolio inflows were only $207 million while there was a net outflow of $113 million in official loans. As a consequence, SBP¶s liquid foreign exchange reserves have declined to $13.3 billion at end-October 2011 compared to $14.8 billion at end-June 2011. Given the scheduled increase in repayments of outstanding loans in H2-FY12, realization of substantial foreign flows, especially the proceeds of assumed privatization receipts, euro bond, Coalition Support Fund, and 3G license fees, becomes important for strengthening the external position. A reflection of widening external current account deficit and declining financial inflows can be seen in the reduction of Rs115 billion in the Net Foreign Assets (NFA) of SBP¶s balance sheet during 1 July ± 18 November, 2011. This implies that to meet the economy¶s prevailing demand for money, SBP has to provide substantial liquidity in the system, at least to the extent of compensating for the declining NFA of SBP. As of 28 November 2011, the outstanding amount of liquidity injected by SBP through its Open Market Operations (OMOs) is Rs340 billion. This is significantly higher than normal SBP operations and appears to have developed characteristics of a permanent nature at this point in time. A dominant
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Monetary Policy source of demand for money and thus liquidity injections by SBP is government borrowings for budgetary support from the banking system. Excluding the issuance of government securities of Rs391 billion to settle the circular debt and commodity loans, the government has borrowed Rs255 billion from scheduled banks and Rs62 billion from SBP during 1 July ± 18 November, 2011 to finance its current year¶s budget deficit. The growth in private sector credit has remained muted so far but may pick up in coming months as the desired effects of a cumulative decrease of 200 bps in the policy rate and reduction in financial constraints of the energy sector gather momentum. In this context where government is the main user of the system¶s liquidity and banks remain hesitant to extend credit to the private sector, SBP faces a dilemma. Efforts to scale down liquidity injections could have implications for settlement of payments in the interbank market, which is an important consideration given SBP¶s mandate of maintaining financial stability. Even if these considerations are addressed, the government may end up settling its obligations by borrowing from SBP. This does not bode well for government¶s own commitment of keeping such borrowings at zero on quarterly basis. The marginally increasing trend of these injections, on the other hand, also carries inflationary risk, which is not consistent with the objective of achieving and maintaining price stability. There are three solutions to this predicament of reconciling price and financial stability considerations and supporting private investment in the economy. First, the government needs to ensure that all or major parts of budgeted foreign inflows materialize as soon as possible. This will alleviate pressure on the balance of payments and help inject fresh rupee liquidity in the system. Second, sooner than later the government will have to initiate comprehensive tax reforms that broadens the tax base of the economy. This is of paramount importance to reduce the government¶s borrowing requirements from the scheduled banks that are currently not consistent with the objective of promoting private sector and economic growth. Third, efforts need to be stepped up to improve financial deepening and increase competition in the banking system. The last of these solutions is something that SBP has been actively working on. For instance, to promote competition in the banking system and to offer alternative sources of savings to the population, SBP has been encouraging depositors to invest in government securities through Investor¶s Portfolio Securities (IPS) accounts. The option of maintaining saving deposits or investments in IPS accounts could provide
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Monetary Policy stiff competition to banks forcing them to offer better returns on deposits. This in turn would incentivize savings and help lower the currency in circulation. Moreover, it will improve the transmission of monetary policy changes to market interest rates. Over time this strategy would also diversify the government¶s funding source, deepen the secondary market of government securities, and facilitate the issuance of corporate debt. Finally, it must be understood that there are uncertainties involved in realizing the full benefits of these measures. These uncertainties can potentially have adverse effects on SBP¶s recent efforts to support private sector credit and investment in the economy. Therefore, after giving due consideration to the need to revive growth and emerging risks to macroeconomic stability, the Central Board of Directors of SBP has decided to keep the policy rate unchanged at 12 percent.
State Bank of Pakistan http:// sbp.org.pk
12. CONCLUSION:
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Monetary Policy
REFERENCE:
Dr. M. Hanif Akhtar, Aug 28 - Sep 03, 2000 Department of Commerce, B. Z. University, Multan Gaurav Akrani( 2010) Monetary Policy- its meaning, definitions, objectives, Articles http://kalyan-city.blogspot.com/2010/09/instruments-of-monetary-policy.html Accessed 8 November, 2011 Gaurav Akrani( 2010) Instruments of Monetary Policy: Qualitative and Quantitative http://kalyan-city.blogspot.com/2010/09/instruments-of-monetary-policy.html Accessed 15 November, 2011 Kimberly Amadeo, Expansionary Monetary Policy Kimberly Amadeo, Contractionary Monetary Policy Max F. Millikan, Income stabilization for a developing democracy: a study of the politics and economics of high employment without inflation Volume 5 of Studies in national policy, Yale University St. Martin's, [1968-1969], Surveys of economic theory. London: Macmillan, New York: 3 v. Número de Chamada: ma4cs AMERICAN ECONOMIC ASSOCIATION. , ,
State Bank of Pakistan http:// sbp.org.pk
Tax Policy Briefing Book: A Citizens' Guide for the 2008 Election and Beyond by the staff and affiliates of the Tax Policy Center, Proceedings of New York
University ... annual Institute on Federal Taxation, Volume 1; Volume 66 The Effectiveness of Monetary Policy in Pakistan ARTICLE (December 09 2008: The speech of the Governor, State Bank of Pakistan, at the Institute of Business Management on December 6. http://www.defence.pk/forums/economy-
development/17538-effectiveness-monetary-policy-pakistan.html World Defence Network http://www.defence.pk/forums/economydevelopment/13561-monetary-policy.html
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doc_840379054.docx
1. MEANING of MONETARY POLICY:
The Monetary Policy which is made by Central bank or Federal Bank in order to control the supply of money is sometime also known as the ³Credit Policy´. Following decisions are made in Monetary Policy: How much would be the supply of money in the economy? How much would be the ratio of interest? How much would be the viability of money? Gaurav Akrani (2010) Monetary Policy- its meaning, definitions, objectives, Articles (http://kalyan-city.blogspot.com/2010/09/instruments-of-monetary-
policy.html ), Accessed 8 November, 2011 Different economists have defined the term ³Monetary Policy´ in their own ways. Some of them are as follow: ³A policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy is a monetary policy.´ (Prof. Harry Johnson) St. Martin's, [1968-1969], Surveys of economic theory. London: Macmillan, New York: 3 v. Número de Chamada: ma4cs AMERICAN ECONOMIC ASSOCIATION. ³A policy which influences the public stock of money substitute of public demand for such assets of both that is policy which influences public liquidity position is known as a monetary policy´. (A.G.Hart) Max F. Millikan, Income stabilization for a developing democracy: a study of the politics and economics of high employment without inflation Volume 5 of Studies in national policy, Yale University From the above definitions, it can be said that a monetary policy is made to control the demand and supply of money in the economy in order to achieve certain broad objectives.
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2. TYPES OF MONETARY POLICY 2.1. Expansionary Monetary Policy:
Expansionary monetary policy is a type of monetary policy which is used by the Federal bank to stimulate the National economy; in other ways we can say that to boost or expand the economic activities. By this policy, Federal bank lower the Federal Funds rate in order to increase the money supply. In this way mortgage rate decline, consumers borrow and spend more, and businesses grow, thereby hiring more workers who will consume even more. Decreasing Interest Rates
Kimberly Amadeo, Expansionary Monetary Policy
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2.2. Contractionary Monetary Policy:
Contractionary monetary policy is a monetary policy which is used to put the brakes on the economy to stop inflation. This fed usually use this policy to raise the fed funds rate. This increases the rate that banks charge each other to borrow funds to meet the Federal Reserve requirement. Raising the fed funds rate decreases the money supply because banks would rather lend a little less, and not have to pay a higher fed funds interest rate. By contracting the money supply, a higher fed funds rate means banks will increase variable rate mortgages, consumers will borrow and spend less, and businesses will stop raising prices and giving raises. This usually heads off inflation.
Increasing Interest Rates Interest Rates
Kimberly Amadeo, Contractionary Monetary Policy
3. OBJECTIVES OF MONETARY POLICY:
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Monetary Policy The mentioned below are the general objectives which every Central Bank of a nation tries to attain by employing certain tools (Instruments) of a monetary policy. y y y y y y y Full employment Neutrality of Money Exchange Rate Stability Equal Income Distribution Rapid Economic growth Price stability Balance of Payments(BOP) Equilibrium
3.1. Full Employment: The concept of full employment was much discussed after Keynes's publication of the "General Theory" in 1936. It is the nonexistence of involuntary unemployment. In simple words 'Full Employment' is a situation in which everyone who wants job, gets job. However it does not mean that there is no unemployment but on a very low rate. In that senses the full employment is never full. Monetary policy can be used for achieving the target of full employment. Monetary policy helps in creating more jobs in different sector of the economy. 3.2. Neutrality of Money: Money is considered as an inert factor by the Economists such as Wicksted and Robertson . According to them, money should play only a function of medium of exchange and not more than that. Therefore, the monetary policy should control the supply of money. Monetary disequilibrium occurs because of the change in supply of money. Thus monetary policy has to control the supply of money and neutralize the effect of money expansion. However this objective of a monetary policy is always criticized that if money supply is kept constant or unchanged then it would be difficult to attain price stability.
3.3. Exchange Rate Stability:
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Monetary Policy Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate.
3.4. Equal Income Distribution: Many economists used to justify the role of the fiscal policy is maintaining economic equality. However in resent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality. Monetary policy can make special provisions for the neglect supply such as agriculture, small-scale industries, village industries, etc. and provide them with cheaper credit for longer term. This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can help in reducing economic inequalities among different sections of society.
3.5. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the Central Bank opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged. This increased investment can speed up economic growth. Faster economic growth is possible if the monetary policy succeeds in maintaining income and price stability.
3.6. Price Stability: All the economies suffer from inflation and deflation. It can also be called as price instability. Both inflation and deflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. It helps in reducing the income and wealth inequalities. When the economy
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Monetary Policy suffers from recession the monetary policy should be an ³easy money policy´ but when there is inflationary situation there should be a ³dear money policy´.
3.7. Balance of Payments (BOP) Equilibrium: Many developing countries suffer from the disequilibrium in the BOP. The Central Bank through its monetary policy tries to maintain equilibrium in the balance of payment. The BOP has two aspects i.e. the BOP Surplus and BOP Deficit. BOP surplus reflects an excess money supply in the domestic economy, while the BOP deficit stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP equilibrium can be achieved. Gaurav Akrani( 2010) Monetary Policy- its meaning, definitions, objectives, Articles http://kalyan-city.blogspot.com/2010/09/instruments-of-monetarypolicy.html , Accessed 8 November, 2011
4. TOOLS (INSTRUMENTS) OF MONETARY POLICY:
The tools of monetary policy used by the Central Bank depend on the level of development of the economy, especially its financial sector. They are classified into two types. 1. Quantitative Methods 2. Qualitative Methods
4.1 Quantitative Instruments or General Tools: The 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.
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Monetary Policy 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. The general tool of credit control comprises of following instruments. 4.1 1. Bank Rate Policy (BRP): The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for influencing the volume or the quantity of the credit in a country. The bank rate refers to rate at which the Central Bank rediscounts bills and prepares of commercial banks or provides advance to commercial banks against approved securities. The Bank Rate affects the actual availability and the cost of the credit. Any change in the bank rate necessarily brings out a resultant change in the cost of credit available to commercial banks. If the Central Bank increases the bank rate than it reduce the volume of commercial banks borrowing from the Central Bank. It deters banks from further credit expansion as it becomes a more costly affair. Even with increased bank rate the actual interest rates for a short term lending go up checking the credit expansion. On the other hand, if the Central Bank reduces the bank rate, borrowing for commercial banks will be easy and cheaper. This will boost the credit creation. Thus any change in the bank rate is normally associated with the resulting changes in the lending rate and in the market rate of interest. However, the efficiency of the bank rate as a tool of monetary policy depends on existing banking network, interest elasticity of investment demand, size and strength of the money market, international flow of funds, etc. 4.1.2. Open Market Operation (OMO): The open market operation refers to the purchase and/or sale of short term and long term securities by the Central Bank in the open market. This is very effective and popular instrument of the monetary policy. The OMO is used to wipe out shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc. It is important to understand the working of the OMO. If the Central Bank sells securities in an open market, commercial banks and private individuals buy it. This reduces the existing money supply as money gets transferred from commercial banks to the Central
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Monetary Policy Bank. Contrary to this when the CENTRAL BANK buys the securities from commercial banks in the open market, commercial banks sell it and get back the money they had invested in them. Obviously the stock of money in the economy increases. This way when the CENTRAL BANK enters in the OMO transactions, the actual stock of money gets changed. Normally during the inflation period in order to reduce the purchasing power, the CENTRAL BANK sells securities and during the recession or depression phase she buys securities and makes more money available in the economy through the banking system. Thus under OMO there is continuous buying and selling of securities taking place leading to changes in the availability of credit in an economy. However there are certain limitations that affect OMO; underdeveloped securities market, excess reserves with commercial banks, indebtedness of commercial banks, etc. 4.1.3. Variation in the Reserve Ratios (VRR): The Commercial Banks have to keep a certain proportion of their total assets in the form of Cash Reserves. Some part of these cash reserves are their total assets in the form of cash. Apart of these cash reserves are also to be kept with the CENTRAL BANK for the purpose of maintaining liquidity and controlling credit in an economy. These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR). The CRR refers to some percentage of commercial bank's net demand and time liabilities which commercial banks have to maintain with the Central Bank and SLR refers to some percent of reserves to be maintained in the form of gold or foreign securities. Any change in the VRR (i.e. CRR + SLR) brings out a change in commercial banks reserves positions. Thus by varying VRR commercial banks lending capacity can be affected. Changes in the VRR helps in bringing changes in the cash reserves of commercial banks and thus it can affect the banks credit creation multiplier. CENTRAL BANK increases VRR during the inflation to reduce the purchasing power and credit creation. But during the recession or depression it lowers the VRR making more cash reserves available for credit expansion.
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Monetary Policy 4.2. Qualitative Instruments or Selective Tools: The Qualitative Instruments are 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. The Selective Tools of credit control comprises of following instruments. 4.2.1. Fixing Margin Requirements: The margin refers to the "proportion of the loan amount which is not financed by the bank". Or in other words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose. A change in a margin implies a change in the loan size. This method is used to encourage credit supply for the needy sector and discourage it for other non-necessary sectors. This can be done by increasing margin for the non-necessary sectors and by reducing it for other needy sectors. Example:- If the CENTRAL BANK feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given. 4.2.2. Consumer Credit Regulation Under this method, consumer credit supply is regulated through hire-purchase and installment sale of consumer goods. Under this method the down payment, installment amount, loan duration, etc is fixed in advance. This can help in checking the credit use and then inflation in a country. 4.2.3. Publicity This is yet another method of selective credit control. Through it Central Bank publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly bulletins, the information is made public and banks can use it for attaining goals of monetary policy.
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Monetary Policy 4.2.4. Credit Rationing Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. For certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit. This can help in lowering banks credit expoursure to unwanted sectors. 4.2.5. Moral Suasion It implies to pressure exerted by the CENTRAL BANK on the banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the Central Bank through a monetary policy. Under moral suasion Central Banks can issue directives, guidelines and suggestions for commercial banks regarding reducing credit supply for speculative purposes. 4.2.6. Control through Directives Under this method the Central Bank issue frequent directives to commercial banks. These directives guide commercial banks in framing their lending policy. Through a directive the Central Bank can influence credit structures, supply of credit to certain limit for a specific purpose. The CENTRAL BANK issues directives to commercial banks for not lending loans to speculative sector such as securities, etc beyond a certain limit. 4.2.7. Direct Action Under this method the CENTRAL BANK can impose an action against a bank. If certain banks are not adhering to the CENTRAL BANK's directives, the CENTRAL BANK may refuse to rediscount their bills and securities. Secondly, CENTRAL BANK may refuse credit supply to those banks whose borrowings are in excess to their capital. Central Bank can penalize a bank by changing some rates. At last it can even put a ban on a particular bank if it dose not follow its directives and work against the objectives of the monetary policy.
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Monetary Policy 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. Gaurav Akrani( 2010) Instruments of Monetary Policy: Qualitative and Quantitative http://kalyan-city.blogspot.com/2010/09/instruments-of-monetarypolicy.html , Accessed 15 November, 2011
5. EFFECTS OF MONETARY POLICY TO AN ECONOMY:
5.1. Consumption, Saving and Investment: Changes in the real interest rates affect the demand for consumption and savings of the people and also change the investment pattern of the businesses. For instance, a reduction in real interest rate lowers the cost of borrowing, encouraging people to borrow in order to consume (durable items like, electronic items, automobiles etc.). Moreover stimulating bank¶s willingness to lend more and investors to invest more, on the other side discourage saving, resulting to increase spending and aggregate demand. Lower real interest rates also make stocks and other such investments more desirable than bonds, resulting stock prices to rise. People are likely to increase their stock of wealth.
5.2. Foreign Exchange, Imports and Exports: Short-run changes lower interest rate result as currency depreciation, which means lower prices of home-produced goods selling abroad, making exports dearer and discourage imports, reducing the gap between imports and exports and having favorable balance of trade. Again this leads to higher aggregate spending on goods and services produced in the country.
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Monetary Policy 5.3. Output and Employment: The increase in aggregate demand for the output boosts up the production cycle; generating employment, as a result increase investment spending on the existing industrial capacity. Which accelerate the consumption further due to more incomes earned, thus attaining the multiplier effect of Keynes. 5.4. Inflation: Monetary policy affects inflation in two ways. First, affecting indirectly, if monetary policy able to achieve multiplier effect, it boosts up economic activity. Initiating labor and capital markets to raise outputs beyond there capacities and creating an upward pressure on wages, thus resulting inflation to rise (that is cost-push inflation). Thus there would be a trade-off between higher inflation and lower unemployment in the short-run which further accelerate inflation. As wages and prices start to rise they are hard to bring down back, stressing the need for early policy measures to be taken. Secondly, monetary policy can directly affect inflation via future expectations. Like if people expect the rise in prices in future, they persuade to increase in wages, which in turn affect the prices, resulting higher inflation. World Defence Network http://www.defence.pk/forums/economydevelopment/13561-monetary-policy.html
6. ROLE OF MONETARY POLICY:
Economists view monetary policy as the first line of defense against economic slowdowns. Compared with fiscal policy, monetary policy has the advantages of the Federal Reserve¶s ability to act faster than the administration or Congress and to better judge the appropriate timing and magnitude of a stimulus. Further, unless well crafted, fiscal stimulus may impose long-run costs on the economy without providing much short-run gain.
The Federal Reserve can adjust monetary policy more quickly than the administration and Congress can adjust fiscal policy. Because most contractions
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Monetary Policy in economic activity last for only a few quarters, the timeliness of the policy response is crucial. Fiscal policy in practice responds to changes in economic conditions with a considerable lag: it takes time first to enact a stimulus bill and then to implement it, and time for the spending increases or tax reductions to reach the pockets of consumers. As a result, the effect of fiscal stimulus on household and business spending may come too late.
Whether and how much stimulus is needed depends on economic conditions today, on projections of likely future conditions, and on assessments of the risks to both economic activity and inflation going forward. Forecasting economic conditions-or even determining the current state of the economy-is inherently very difficult, given limitations in the available data and in economists¶ understanding of the world. But the Federal Reserve¶s large and sophisticated team of analysts is better positioned to accomplish this task than any other agency of the federal government. In addition, the Federal Reserve staff carries out this work independent of political considerations. Economists worry that poorly crafted fiscal stimulus would have little short-run economic benefit and could do long-run harm. For example, permanent tax cuts unaccompanied by permanent spending reductions would increase the long-run budget deficit. And a permanent increase in the deficit-especially now, when the budget is already so far out of long-run balance-would reduce economic growth over time. Moreover, because higher expected government borrowing is likely to push up current long-term interest rates, the short-run simulative effect would be muted as well. In fact, under plausible assumptions about economic behavior, the response of forward-looking financial markets to a sustained reduction in personal income taxes would offset about half of the incipient simulative effect of the tax cut. Tax Policy Briefing Book: A Citizens' Guide for the 2008 Election and Beyond by the staff and affiliates of the Tax Policy Center, Proceedings of New York University ... annual Institute on Federal Taxation, Volume 1; Volume 66
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7.MONETARY
POLICY
FRAMEWORK
IN
PAKISTAN:
Considering the economic and financial market structure in Pakistan, SBP has for sometime pursued a monetary targeting regime with broad money supply (M2) as a nominal anchor to achieve the objective of controlling inflation without any prejudice to growth. The process of monetary policy formulation usually begins at the start of the fiscal year when SBP sets a target of M2 growth in line with government's targets of inflation and growth (usually in the month of May) and an estimation of money demand in the economy. The basic idea is to keep the money supply close to its estimated demand level, as both a significant excess and a shortfall their respective targets.may lead to considerable deviations in actual outcomes of inflation and real GDP growth from
Underlying this framework are two strong assumptions: 1. First, there is a strong and reliable relationship between the goal variable (inflation or real GDP) and M2; and 2. Second, the SBP can control growth in M2. While containing the M2 growth close to its target level is the key consideration in the current monetary framework, the composition of the money supply does matter and at times requires policy actions even if these actions lead to a deviation in monetary growth from its target level. Net foreign Assets (NFA) and Net Domestic Assets (NDA) of the banking system are the two major components of money supply.
The NFA is the excess of foreign exchange inflows over outflows to the banking system, or in other terms it is a reflection of underlying trends in the country's external Balance of Payment (BOP) position. It is estimated by the projected values
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Monetary Policy of all major external transactions such trade, workers' remittances; debt servicing, foreign investment, and debt flows etc.
The NDA of the banking system, which primarily consists of credit to the government and the private sector, reflects changes in the fiscal and the real sectors of the economy, if is estimated as a residual of M2 and the NFA. Further break-up of NDA is estimated on the basis of projected credit needs of the government and the private sector. Depletion in NFA is generally considered as an unhealthy development. Sharp NFA depletion reflects worsening BOP position and a pressure on exchange rate. In such a case, a higher NDA growth, though helps in expanding M2 to reach its target level, may further deteriorate external accounts, sharper depreciation of local currency, and higher depletion of country's foreign exchange reserves.
Although since FY07, only the indicative M2 growth target is being announced. SBP also takes into consideration the causative factors for monetary expansion while pursing this target. Considering the changes in monetary aggregates and other economic variables, the changes in monetary policy are signaled through adjustments in the policy discount rate (3-day repo rate).
Further, the changes in the policy rate are complemented by appropriate liquidity management mainly through Open Market Operations (OMOs) and if required changes in the Cash Reserve Requirement (CRR) and Statutory Liquid Reserve requirement (SLR) are also made."
8. EFFECTIVENESS OF MONETARY POLICY IN PAKISTAN:
Significance of various channels that spread the monetary policy shocks in the real economy of Pakistan has been analyzed by different economists. Ahmed et al said that credit channel is the most important mean for transmitting monetary policy actions to the real economy activity. Authors had found the evidence that shows the different effects of monetary policy in different sectors. Monetary policy shocks have
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Monetary Policy negligible impact on agriculture, mining, construction and ownership of dwelling sector. (2005) Historically, evidence revealed that Pakistan has been a high inflation and high interest economy given its inherent structural weaknesses. The role and effectiveness of monetary policy appears more visible in 2000s when financial sectors began expand in terms of market based money and foreign exchange markets. Entering the 21st century, the loose monetary policy stands in the face of low inflation, low growth and low twin deficits, along with structural measures to open up the economy. Monetary policy position was however altered as the inflationary pressures started to build up in 2005. At the end of the fiscal year, the economy which had been showing a sustained growth since FY 01, registered a high level of growth ( 9 percent), average inflation rose sharply ( 9.3 percent) and the external current account balance turned into deficit ( -1.4 percent of GDP). The fiscal module started to show the symbols of stress as the fiscal balance was converted into a deficit. Because of the domestic and global price pressures, SBP tightened its monetary policy after a prolonged gap of a few years. The efforts to reduce inflation however proved less effective due to a rebound in international commodity prices and a rise in domestic food prices later on. Realizing the complications of monetary management and adverse global and domestic economic developments, the SBP did some changes in the implementation of monetary policy.
9. WHAT NEEDS TO BE DONE TO IMPROVE THE EFFECTIVENESS OF MONETARY POLICY?
Apart from taking policy measures to address the emerging challenges, SBP also introduced structural changes in the process of monetary policy formulation and conduct to make the monetary policy formulation and implementation more transparent, efficient, and effective. Specifically, during the last couple of years, SBP focused on ? Institutionalizing the process of policy formulation and conduct. ? Stepping up movement towards a more market based credit allocation mechanism.
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Monetary Policy ? Developing its analytical and operational capacity. ? Improving its capabilities to assess future developments to act proactively, and ? Improving upon the communication of policy stance to the general public. However, the following areas need attention and are keys for effective monetary management. 1. Effectiveness of monetary and fiscal co-ordination would be helpful. Section 9A and 9B of the SBP Act (amended in 1994) articulates the institutional mechanism for economic policy making and co-ordination and defines the ground rules for both the process and the policy making. However, the track record of the Monetary and Fiscal Policies Co-ordination Board (MFPCB), established in February 1994 that requires quarterly meetings of the SBP. 2. For effective analysis of developments and policy making, timely and quality information is extremely important. However, due to weaknesses in the data collection and reporting mechanism of the various agencies of the country, information is not available with desired frequency and timeliness. Also there are concerns over the quality of data. Unlike many developed and developing countries, data on quarterly GDP, employment and wages, etc is not available in case of Pakistan .Moreover, the data on key macroeconomic variables (such as government expenditure and revenue, output of large-scale manufacturing, crop estimates, etc) is usually available with substantial lags. This constrains an in-depth analysis of the current economic situation and evolving trends, and hinders the ability of the SBP to develop a forward-looking policy stance. 3. Unlike many countries, both developed and developing, there is no prescribed limit on government borrowing from SBP defined in the SBP Act or the Fiscal Responsibility and Debt Limitation (FRDL) Act 2005. Besides being highly inflationary, government borrowing from SBP also complicates liquidity management. Therefore, the foremost task to improve the effectiveness of monetary policy is to prohibit the practice of government borrowings from the SBP. In this regard, appropriate provisions are required to cease or limit government recourse to Central Bank financing through amendments in the SBP Act and the FRDL Act 2005.
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Monetary Policy 4. Another issue is to make a clear distinction between exchange rate management and monetary management. Currently, there is a general perception that the State Bank is bound to keep the exchange rate at some predefined level and any movement away from this level is then considered as an inefficiency of the SBP. In conclusion, it is not possible to solve all these problems immediately. It needs a deeper structural reforms and time to cope with these issues. The Effectiveness of Monetary Policy in Pakistan ARTICLE (December 09 2008: The speech of the Governor, State Bank of Pakistan, at the Institute of Business Management on December 6.
http://www.defence.pk/forums/economy-development/17538-effectivenessmonetary-policy-pakistan.html
10. HISTORICAL OVERVIEW OF MONETARY POLICY IN PAKISTAN:
Monetary policy in Pakistan has been used in co-ordination with the fiscal policy to achieve both the objectives of macro-economic stability and higher economic growth. The government supervises monetary situation of economy through the State Bank of Pakistan (SBP). This article attempts to present an overview of the monetary policy in Pakistan overtime. During the decade of fifties, monetary policy was used to correct external balances in the economy. The government followed the tight monetary policy during the early fifties to prevent inflationary tendencies in the economy. But there was an increase in the money supply because of the deficit financing. The phenomenon of monetary expansion continued during the sixties (Although growth rate of money supply slowed down in the late fifties). Increase in bank rates, cash reserve requirements, liquidity ratios, abolition of credit quotas and the imposition of credit ceiling etc. were the main measures because of rapid increases in private investment and growth of GDP (6.8% in 1960s). The government tried to restrict money supply in the economy to counteract inflation because of conflict with India in 1965 and crop failure in 1966. However, heavy defence expenditures and cut in aid flows forced the government to resort to deficit financing for correcting the
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Monetary Policy fiscal imbalance. It would be pertinent to mention that inflation rates remained low (3.8%, annual average) during this period. This was due to an improvement in the economy and steps taken by the monetary authorities (e.g. increase in bank rates, cash reserve requirements, liquidity ratios, abolition of credit quotas and imposition of credit ceiling). Table-1 Monetary assets in Pakistan (annual average) 1 Stock money (Rs billion) Growth rate (%) 7.8** 16.3 21.0 13.2 15.95 1950s 1960s 1970s 1980s l990s of 5.16 13.29 41.10* 180.9 785.0
Notes: The average is for the period 1971 to 1979. The average is for the years 1952 to 1959. Source: Gap, Economic Survey. Various Issues. Internal and external shocks (mentioned above) and devaluation of Pakistani currency resulted in slow growth of the output and higher monetary expansion leading to a rise in the general price level during the seventies. Increase in the public and private borrowings did also increase money supply in the economy. The SBP adopted various measures to control the money supply but achieved limited success in this regard. The eighties started with financing of the budget deficit mainly through external borrowings and bank sources. As a result of this strategy, not only external indebtedness increased, it also led to inflation in the economy (about 12.5% during the years 1981 and 1982). Hence, the government resorted to non-bank borrowings as a major source of financing the public deficit during the period 1983-90. The move was justified on account of debt crisis in the eighties and to prevent inflation as well. As a result of this policy-shift, inflation remained under control (6.0% on average) during the period 1983-90. Lack of domestic resource mobilization and the shortage of foreign loans forced the government to make a hesitant move for additional funds
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Monetary Policy from the World Bank as a part of the structural adjustment loan (SAL) linked with stringent conditions. Resentment on part of the government resulted in disruption of these funds, time and again. During the 1990s, the government introduced various financial reforms through the market-based instruments of monetary management. Increase in reserve requirements, privatization of commercial banks, license to establish private commercial banks, greater financial autonomy to the SBP, development of secondary markets in government securities, increase in commercial lending rates, credit control and capital market reforms etc. are the main features of these reforms. Bank borrowings remained an important source of financing the budget deficit as 32% of the total deficit was financed through such sources forming 2.9% of GDP during the period 1990-96. Such a mode of financing the deficit not only affected the pace of monetary expansion (table-1) but also accelerated the rate of inflation (10.6%), higher than annual average (7.3%) of the eighties. The bank borrowings soared up as a result of financial reforms and the government needs for retirement of the non-bank debt. With the introduction of financial reforms, certain non-bank borrowing instruments were suspended, resulting in lesser availability of funds. This trend has reversed during the recent years as domestic non-bank borrowings have largely been used to accommodate the fiscal deficit. The government has also followed a policy of retiring the debt borrowed through the banking system. As far as the stock of money is concerned, it has grown up enormously during the nineties as compared to that in 1980s. It has grown up at varying rates and stands up about four times higher than what it was during the preceding decade. The average growth rate of money supply during the 1990s has been at par with that of in the sixties but relatively higher than that in the fifties and eighties. The government has tried its level best to contain the growth of money supply through various measures during the recent years. Meddling in monetary policy is usually symptomatic of government failure in fiscal arena. Hence, there stands a need for concerted efforts to rectify the fiscal sinfulness in Pakistan. How to reduce the fiscal deficit is another area of debate. However, fundamental solution lies in expanding the tax net and retiring the foreign debt. Mere tinkering with money supply will only preserve misalignments and convulsion in other economic areas.
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Monetary Policy By Dr. M. Hanif Akhtar, Aug 28 - Sep 03, 2000 Department of Commerce, B. Z. University, Multan
11. CURRENT MONETARY POLICY PAKISTAN: STATE BANK OF PAKISTAN
MONETARY POLICY DECISION 30 November 2011
The SBP reduced its policy rate by 200 bps, to 12 percent, in FY12 so far. The objective of adopting this stance is to support revival of private investment in the economy despite a constraining domestic and global economic environment. The primary factors in support of this stance were the expectation of average CPI inflation remaining within the announced target in FY12 and a small projected external current account deficit. In pursuing this stance SBP did acknowledge the risks to macroeconomic stability emanating from fiscal weaknesses and falling foreign financial inflows. These include resurgence of medium term inflationary pressures and challenges SBP is facing in managing market liquidity and preserving foreign exchange reserves. A reassessment of latest developments and projections indicate that macroeconomic risks have somewhat increased during the last two months. For instance, although the year-on-year CPI inflation stands at 11 percent in October 2011, the month-on-month inflation trends, averaging at around 1.3 percent per month during the first four months of FY12, show existence of inflationary pressures. The sifting of commodity level CPI data reveal that the number of CPI items exhibiting year-on-year inflation of more than 10 percent is consistently increasing and almost all of these items belong to the non-food category. The government has also increased its wheat support price by Rs100 to Rs1050 per 40kg for the next wheat procurement season. Thus, while the average inflation may settle around the targeted 12 percent for FY12, it is uncertain that inflation will come
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Monetary Policy down to a single digit level in FY13. The main determinants of this inflation behavior are government borrowing from the banking system and inertial effects of high inflation on its expected path. The severe energy shortages are also holding back the effective utilization of productive capacity and adding to the high inflation-weak growth problem. On the external front, the earlier comfortable external current account position for FY12, which helped SBP in lowering its policy rate, has become less benign. The actual external current account deficit of $1.6 billion for the first four months of FY12 is now higher than the earlier projected deficit for the year. The main reason for this larger than expected deterioration is the rising trade deficit. In particular, the windfall gains to export receipts due to abnormally high cotton prices in FY11 have dissipated faster than anticipated. This is indicated by slightly less than $2 billion per month export receipts in September and October 2011. At the same time, international oil prices of around $110 per barrel and strong growth in non-oil imports have kept the total import growth at an elevated level of close to $3.4 billion per month. Adding to the challenges faced by the external sector is the precarious global economic outlook. A relatively larger external current account deficit in FY12 would require higher financial inflows to maintain foreign exchange reserves. However, during JulyOctober, FY12, the total net direct and portfolio inflows were only $207 million while there was a net outflow of $113 million in official loans. As a consequence, SBP¶s liquid foreign exchange reserves have declined to $13.3 billion at end-October 2011 compared to $14.8 billion at end-June 2011. Given the scheduled increase in repayments of outstanding loans in H2-FY12, realization of substantial foreign flows, especially the proceeds of assumed privatization receipts, euro bond, Coalition Support Fund, and 3G license fees, becomes important for strengthening the external position. A reflection of widening external current account deficit and declining financial inflows can be seen in the reduction of Rs115 billion in the Net Foreign Assets (NFA) of SBP¶s balance sheet during 1 July ± 18 November, 2011. This implies that to meet the economy¶s prevailing demand for money, SBP has to provide substantial liquidity in the system, at least to the extent of compensating for the declining NFA of SBP. As of 28 November 2011, the outstanding amount of liquidity injected by SBP through its Open Market Operations (OMOs) is Rs340 billion. This is significantly higher than normal SBP operations and appears to have developed characteristics of a permanent nature at this point in time. A dominant
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Monetary Policy source of demand for money and thus liquidity injections by SBP is government borrowings for budgetary support from the banking system. Excluding the issuance of government securities of Rs391 billion to settle the circular debt and commodity loans, the government has borrowed Rs255 billion from scheduled banks and Rs62 billion from SBP during 1 July ± 18 November, 2011 to finance its current year¶s budget deficit. The growth in private sector credit has remained muted so far but may pick up in coming months as the desired effects of a cumulative decrease of 200 bps in the policy rate and reduction in financial constraints of the energy sector gather momentum. In this context where government is the main user of the system¶s liquidity and banks remain hesitant to extend credit to the private sector, SBP faces a dilemma. Efforts to scale down liquidity injections could have implications for settlement of payments in the interbank market, which is an important consideration given SBP¶s mandate of maintaining financial stability. Even if these considerations are addressed, the government may end up settling its obligations by borrowing from SBP. This does not bode well for government¶s own commitment of keeping such borrowings at zero on quarterly basis. The marginally increasing trend of these injections, on the other hand, also carries inflationary risk, which is not consistent with the objective of achieving and maintaining price stability. There are three solutions to this predicament of reconciling price and financial stability considerations and supporting private investment in the economy. First, the government needs to ensure that all or major parts of budgeted foreign inflows materialize as soon as possible. This will alleviate pressure on the balance of payments and help inject fresh rupee liquidity in the system. Second, sooner than later the government will have to initiate comprehensive tax reforms that broadens the tax base of the economy. This is of paramount importance to reduce the government¶s borrowing requirements from the scheduled banks that are currently not consistent with the objective of promoting private sector and economic growth. Third, efforts need to be stepped up to improve financial deepening and increase competition in the banking system. The last of these solutions is something that SBP has been actively working on. For instance, to promote competition in the banking system and to offer alternative sources of savings to the population, SBP has been encouraging depositors to invest in government securities through Investor¶s Portfolio Securities (IPS) accounts. The option of maintaining saving deposits or investments in IPS accounts could provide
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Monetary Policy stiff competition to banks forcing them to offer better returns on deposits. This in turn would incentivize savings and help lower the currency in circulation. Moreover, it will improve the transmission of monetary policy changes to market interest rates. Over time this strategy would also diversify the government¶s funding source, deepen the secondary market of government securities, and facilitate the issuance of corporate debt. Finally, it must be understood that there are uncertainties involved in realizing the full benefits of these measures. These uncertainties can potentially have adverse effects on SBP¶s recent efforts to support private sector credit and investment in the economy. Therefore, after giving due consideration to the need to revive growth and emerging risks to macroeconomic stability, the Central Board of Directors of SBP has decided to keep the policy rate unchanged at 12 percent.
State Bank of Pakistan http:// sbp.org.pk
12. CONCLUSION:
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Monetary Policy
REFERENCE:
Dr. M. Hanif Akhtar, Aug 28 - Sep 03, 2000 Department of Commerce, B. Z. University, Multan Gaurav Akrani( 2010) Monetary Policy- its meaning, definitions, objectives, Articles http://kalyan-city.blogspot.com/2010/09/instruments-of-monetary-policy.html Accessed 8 November, 2011 Gaurav Akrani( 2010) Instruments of Monetary Policy: Qualitative and Quantitative http://kalyan-city.blogspot.com/2010/09/instruments-of-monetary-policy.html Accessed 15 November, 2011 Kimberly Amadeo, Expansionary Monetary Policy Kimberly Amadeo, Contractionary Monetary Policy Max F. Millikan, Income stabilization for a developing democracy: a study of the politics and economics of high employment without inflation Volume 5 of Studies in national policy, Yale University St. Martin's, [1968-1969], Surveys of economic theory. London: Macmillan, New York: 3 v. Número de Chamada: ma4cs AMERICAN ECONOMIC ASSOCIATION. , ,
State Bank of Pakistan http:// sbp.org.pk
Tax Policy Briefing Book: A Citizens' Guide for the 2008 Election and Beyond by the staff and affiliates of the Tax Policy Center, Proceedings of New York
University ... annual Institute on Federal Taxation, Volume 1; Volume 66 The Effectiveness of Monetary Policy in Pakistan ARTICLE (December 09 2008: The speech of the Governor, State Bank of Pakistan, at the Institute of Business Management on December 6. http://www.defence.pk/forums/economy-
development/17538-effectiveness-monetary-policy-pakistan.html World Defence Network http://www.defence.pk/forums/economydevelopment/13561-monetary-policy.html
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