Central Bank’s Monetary Policy

Program Magister Akuntansi Universitas Trisakti

Scope of discussion

How the monetary sector affects the economy?Macroeconomic policyDemand and supply of moneyTransmission of monetary policyMonetary policy in the long-run Policy conflictsFramework of monetary policy

EXTERNAL SECTOR

Current AccountExportImport

TransferIncome

Capital & Financial Transaction

Direct Investment Financial flows

– Government– Private

Official foreign reserves

REAL SECTOR

Consumption Investment Export Import

GOVERNMENT SECTOR

Fiscal (APBN)Revenues, incl. grantExpenditures Primary balances Financing – Domestic – External Luar Negeri

MONETARY SECTOR

Monetary Authority Foreign assets net Domestic assets net Net Claim on Government

Commercial Banks Foreign assets net Domestic assets net

Base money

Money supply

How the monetary sector affects the economy? (Interrelationship among macroeconomic accounts)

Aggregate demand:Y = C + I + G + (X-M)

Macroeconomic policy

KEBIJAKAN EKONOMI MAKRO:

KEBIJAKAN MONETER

KEBIJAKAN FISKAL

KEBIJAKAN PERDAGANGAN

KEBIJAKAN TENAGA KERJA

KEBIJAKAN LAINNYA

TUJUAN AKHIR:SOCIAL

WELFARE

KEBIJAKAN EKONOMI MAKRO:

KEBIJAKAN MONETER

KEBIJAKAN FISKAL

KEBIJAKAN PERDAGANGAN

KEBIJAKAN TENAGA KERJA

KEBIJAKAN LAINNYA

TUJUAN AKHIR:SOCIAL

WELFARE

Monetary policy is an integral part of macroeconomic policy The ultimate target of macroeconomic policy is economic/social

welfare

Supply and Demand for Money

Supply of money : Ms = mm * Mo determined by the central bank. (Baca AP Lampiran 2.2)

Demand for money : Md = f (GDP, CPI) determined by people or money holder

Definition of money: Mo = C + Rb where Mo = monetary base (high-powered money) ; C = Currency (bank notes);

Rb = Bank reserves (banks’ account at the central bank + cash in vault)

M1 = C + DD where DD = Demand deposits (checking accounts, giro accounts)

M2 = C + DD + TD where TD = Saving and Time deposits

M3 = M2 +

Supply of money: Money multiplier (Baca AP Box 4.2)

Total reserves (Rb) = Required reserves + Excess reserves

Total reserves = Deposits at the Central Bank + Vault cash at commercial banks

Money multiplier (mm) = 1/ (RR +ER) where RR is required reserves ratio (reserve requirements) and ER is the proportion of excess reserves in total reserves

Ms = mm x Mo --- mm = Ms/Mo mm¹ = M1/Mo (narrow money multiplier) mm² = M2/Mo (broad money multiplier)

In practice, the mm can be calculated directly from central bank statistics published by the central bank where Mo, M1 and M2 are regularly (monthly) published. For example, at year-end 2004 the monetary base at BI’s publication is Rp 200 trio and M2 Rp800 trio, then the money multiplier is 800/200 = 4.0.

Reserve requirement

In the most countries, all depository financial institutions are required to conform to the deposit reserve requirements (giro wajib minimum) set by the central bank.

Changes in reserve requirements are a very potent, though little-used tool.

Indeed, reserve requirements have recently been reduced in the U.S., and eliminated in Canada, New Zealand, and the U.K.

An increase in deposit reserve requirements decreases the deposit and money multipliers, slowing the

growth of money, deposits and loans reduces the amount of excess legal reserves - institutions

deficient in required legal reserves will have to sell securities, cut back on loans, or borrow reserves

increases interest rates, particularly in the money market, as depository institutions scramble to cover any reserve deficiencies

Effects of Changes in Reserve Requirements on Deposits, Loans, and Investments

Supply and Demand for Money - Equilibrium Supply of money is determined by the central bank monetary policy, and therefore the supply

curve is vertical. Demand for money is inversely related to the money rate of interest, because higher interest rates

make it more costly to hold money instead of interest-earning assets like bonds. Equilibrium: The money interest will gravitate the rate where the quantity of money people want to

hold (demand) is just equal to the stock of money the central bank has supplied (supply).

Quantityof Money

Interest rate Ms

Md

Qs

i*

At i*, people are willing to hold the money supply set by the central bank

Excesssupply

Excessdemand

i2

i3

Transmission of monetary policy The path that monetary policy takes through the macroeconomic system is called the Transmission

of Monetary Policy. The impact of a shift in monetary policy is generally transmitted through intrest rates, exchange

rates, and assets prices. An expansionary monetary policy will increase supply of loanable funds and put downward

pressure on real interes rates. As real interest rates falls, aggregate demand increases (to AD2), leading to a short run increase in output (Y1 to Y2…..and prices (from P1 to P2)… inflation

Goods/services(real GDP)

Price level

AS1

AD1

Y1 Y2

P1AD2

P2

Quantity of Loanable funds

RealInterest rate

Q

r2 D

S1 S2

Direct monetary transmission 11

Money

MonetaryPolicy:

Base moneyInterest rate

Final Objective:

PricesOutput

Interest rate channel

Real interest

Cost of capital

Substitution effect

Income effect

Asset price channel

Exchange rateNet exports-cap.flows

Tobin’s q

Wealth effect

Credit channels

Bank lending Loan Supply-Demand

Ext. Financing, LeverageFirms balance sheet

Imported prices

Equity-Property prices

Expectation channel

Expectation Real interest rate

Moral hazard,Adverse selection

Uncertainty

Money Supply-Demand

The Mechanism of monetary transmission

Monetary policy in the long-run If the impact of an increase in AD accompanying expansionary policy is felt when the economy

operating below capacity, the policy will help direct the economy back to a long-run full employment output equilibrium (Yf).

In contrast, if the demand-stimulus effects are imposed on an economy already at full employment (Yf), they will lead to excess demand, higher prices,and temporarily higher output (Y2).

In the long-run, the strong demand will push up resources prices, shifting back short-run AS. The price level rises to P3 (from P2) and output back to Yf once again.

Goods/services(real GDP)

Price level

SRAS1

AD1

Yf Y2

P1

AD2P2

Goods/services (real GDP)

PriceLevel

Y1

P2

AD1

SRAS1

LRAS

AD2P1

Yf

e1

e2

SRAS2

LRAS

P3

e1

e2

e3

Monetary policy in the long-run

The quantity theory of moneyM * V = P * Y where M = money; V = velocity of money;

P = price; Y = income If V and Y are constant, than an increase in M would lead to a

proportional increase in P.

Implication: In the long run, the primary impact of monetary policy will be on prices

rather than on real outputWhen expansionary monetary policy leads to rising prices, monetary

authorities eventually anticipate the higher inflation and build it into their choices

As it happens, nominal interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and output will return to their long-run normal levels.

Policy conflicts

Theoretically, in the short-term there is trade-off between achieving targets of containing inflation and promoting outputPhillips Curve: = (y – y*) Long-run full employment vs below capacity

However, there is growing research evidence that maximum employment, sustainable economic growth, and price stability can be compatible with one another in the longer run.

Expantionary monetary policy leads to promote economic activities, but would in turn push inflation upward A need to strike a balance between monetary and fiscal policy and other macroeconomic policies policy coordination.

Framework of monetary policy

UltimateTarget

IntermediateTarget

OperationalTargetInstruments

•Price stability•Economic growth•Employment

Monetary aggregates• M1, M2, M3• Interest rates

•Base money (Mo)•Bank reserves•Interest rates

•Open market operation•Reserve requirement•Discount facility

Not every nation makes it clear to its central bank what its priorities should be among different possible goals (targets).•The goals may also conflict with one another.

•For example, controlling inflation may require the central bank to slow down the domestic economy through restrictions on credit growth and higher market interest rates.

•However, this policy threatens to generate more unemployment and subdue economic growth.

The Goal of Controlling Inflation (& Deflation)

Inflation creates undesirable distortions in the allocation of scarce resources.

In the 1990s, several central banks (such as New Zealand, Canada, and U.K.) began setting target inflation rates or rate ranges.

In 2000s, several Asian central banks (Thailand, Indonesia,etc.) also set inflation targeting.

The U.S. has not set an explicit target, though it seeks to drive inflation so low that it does not affect business and consumer decisions.