Monetary Policy-May 18, 2010

8/8/2019 Monetary Policy-May 18, 2010

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Monetary Policy

Fida HussainMonetary Policy Department

State Bank of Pakistan

May 18, 2010


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Outline

I. Contextualizing monetary policy

II. Monetary policy framework in Pakistan

III. Monetary policy formulation process

IV. How monetary policy works?


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I. Conceptualizing Monetary Policy


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Rationale for Economic Policy

z If every relevant good is traded in a market at publicly known prices, that is, if

there is a complete set of markets and information, and if households and firms

act perfectly competitively, then the market outcome gives the best possible

welfare enhancing outcome.

z Strictly speaking, this means that there is no role of government/policy, if the

highlighted conditions are met.

z But, as we all know, in real world these conditions are not met, which provides

rationale for governments role in the economy and need for economic policy.

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When stabilization policies are needed


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Stabilization policies at work


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Monetary Policy: A component of economic policy

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What is monetary policy?

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Regulation of money supply and interest rate in the economyRegulation of money supply and interest rate in the economy

to achieve economic goalsto achieve economic goals

Monetary policy involves central banks use of policy

instruments to influence interest rates and money supply to

keep overall prices and financial markets stable


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Objectives of Monetary Policy

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z Price stability is becoming increasingly popular as principal objective;

z Other objectives include economic growth, full employment, exchange rate

stabilization, etc.;

z However, these other objectives are being achieved through maintaining price

stability in the long run;

Price stability refers to a situation where inflation remains in a specific range forPrice stability refers to a situation where inflation remains in a specific range for

a certain time period, say five yearsa certain time period, say five years


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Why focus on price stability?

Consensus in economic literature (e.g. Barro, 1995; Fisher, 1994; Mishkin,1999):

Monetary policy can stimulate growth in short-run only but has lasting

impact on inflation;

In long-run, there is no conflict between low inflation and fuller

utilization of resourcei.e. no inflation-unemployment trade-off;

High and volatile inflation is detrimental to the economic growth;

Low and stable inflation is necessary condition for sustained growth;

Price stability is means as well as end

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An example from The History of Inflation in Turkey

Inflation hits everyone

Inflation: 18.9% 22.5% 62.0% 101.4%


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z creates uncertainty about the future output and input prices and lowers thequality of the signals coming from the price system;

z makes it impossible to plan for relatively longer outlook;

z creates incentives for households and firms to shorten their decision horizons

and to spend resources to manage inflation risk;

z diverts resources away from efficient production;

z discourages long term contracts (due to uncertainty) and resources arewasted on frequent negotiations;

z undermines confidence in domestic currency;

z impacts more severely low income strata than the people in high incomebrackets.

How high and volatile inflation affects growth?


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Case of Pakistan

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2

4

6

8

10

12

14

FY51

FY54

FY57

FY60

FY63

FY66

FY69

FY72

FY75

FY78

FY81

FY84

FY87

FY90

FY93

FY96

FY99

FY02

FY05

percent

GDP Inflat ion

Long Term Trends in Inflation and GDP Growth

Low growth

Hi h inflation


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II. Monetary Policy Framework in Pakistan


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Contours of monetary policy framework in Pakistan

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Objective(s) of SBPs monetary policy is to achieveprice stabilitywhile keeping an eyeon economic growth.

Targets of average CPI inflation and real GDP growth are set by the government andannounced prior to the beginning of a fiscal year.

The targets for CPI inflation and real GDP growth provide a basis for setting an indicativetarget for M2 expansion, which serves as an intermediate target.

For instance, if given targets for inflation and growth are 10% and 3%, the M2 targetis roughly 13%

Indicators are available information on the components of M2 and their projections areused in understanding and analyzing interactions of the monetary sector with the real,fiscal and external sectors of the economy.

Monetary policy instruments are used to influence interbank and other market interestrates, starting with the overnight money market repo rate, SBPs operational target.

Change in the monetary policy stance is signaled through adjustments in the policy rate.


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Monetary Policy Instruments in Pakistan

Policy Rate

Discount rate or SBP reverse repo ratethe rate at which commercial

banks borrow from the central bank. Currently, it is 12.5 percent per

annum w.e.f 17th August 2009.

SBP repo rate, on new SBP deposit facility, which is 300 bps

below SBP reverse repo rate.

Open Market Operations

It is a flexible market-based instrument for short term liquidity

management intended to support SBPs policy rate and stance. To drain liquidity SBP sells T-bills to commercial banks generally with a

re-purchase agreement (repo).

To inject liquidity, SBP purchases T-bills from commercial banks

generally with a re-sale agreement (reverse repo).

Outright sale and purchase of T-bills


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Monetary Policy Instruments (cont)

Cash Reserve Ratio (CRR)

It is a ratio by which commercial banks are required to keep a certain

portion of their liabilities with SBP in cash at zero return.

Currently it is 5% for demand liabilities (including less than 1 year

time deposits) and 0% for time liabilities of above 1-year tenor.

Statutory Liquidity Ratio (SLR)

It is a ratio by which commercial banks are required to keep a certain

portion of their liabilities in the form of government securities

Currently, it is at 19% for demand liabilities (including less than 1 year

time deposits) and 0% for time liabilities of above 1-year tenor.Forex Swaps

These are transactions of SBP in the foreign exchange market

Swaps are similar to repo operations described above.

Purchase of dollars results in injection of Pak rupees, while selling of

dollars drains Rupee liquidity.


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III. Monetary Policy Formulation Process


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Monetary policy formulation process

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Employing the framework highlight above, the draft of the Monetary PolicyStatement (MPS), which summarizes all the relevant information, analysis, andprojections, is prepared by the Monetary Policy Department of SBP.

Earlier, the MPS was issued on a quarterly basis. Starting current fiscal year (FY10),two comprehensive (in January and July) and four brief statements (in March, May,September and November) will be issued.

This draft MPS is circulated among the SBPs senior management, including Governor,to initiate debate and to get their feedback and suggestions.

The senior management discusses the policy proposal(s) based on the analysis in thedraft MPS to build consensus on the appropriate monetary policy stance.

After discussion and finalization of the proposed policy measures, draft MPS is

presented in the sub-committee of the SBPs Central Board of Directors theMonetary Policy Committee (MPC)

After approval from the sub-committee, the same is presented in the meeting of theSBPs Central Board of Directors for its final approval.

After this, the Governor usually holds a press conference and announces the policy tothe general public. SBP staff and Governor then give interviews on the media to

explain the policy stance further.


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Policy rate is changed keeping in view trends in inflation

and other key macroeconomic variables

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Generally, interest rates are allowed to go down if:

Inflation is decelerating or is at a level that is much lower than the target

and growth outlook is significantly below potential growth;

Generally, interest rates are allowed to go up if:

Inflation is accelerating (or higher than its target) together with actual

growth near the potential.


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IV. How Monetary Policy Works?


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Transmission mechanism of monetary policy

The process through which monetary policydecisions affect the level of economic activity and

inflation rate in the economy.

Understanding the transmission mechanism of

monetary policy is crucial for appropriate design

and efficient conduct of monetary policy.


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From operational target to objectives

z Monetary policy affects the goal variables (i.e. inflation and growth)through adjustment in aggregate demand brought about by changes in

interest rate and money supply in the economy.

z The changes in policy rate, affects the interbank and other retail interest

rates in the economy directly as well as through changing the

expectations.

z The resulting changes in retail interest rates affects the consumption and

investment behavior of the economic agents and thus, the level of

aggregate demand in the economy.

z Finally, the adjustment in aggregate demand affects the general price

level and thus inflation in the economy.

Bottom Line: Both the current as well as the expected monetary policy

stance are important in influencing the economic behavior and controlling

inflation.


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Market

interest rate

Structure

Monetary

and Credit

Aggregates

Asset Prices

Exchange

RateMonetary

PolicyObjectives

Domestic

Goods Prices

Imported

Goods Prices

Aggregate

Output

Aggregate

Prices

Monetary

Policy Actions- Current

- Expected

Aggregate

Demand

Transmission Mechanism-a graphical depiction


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Time lags in monetary transmission

z Monetary policy shocks require a considerable time before the consequencesof a policy action can become perceptible on inflation and other key

macroeconomic variables.

z Empirical evidence indicates that there is a 6-24 months time lag in

developing economies in the transmission of monetary policy impact on

inflation.

z In Pakistan, this transmission lag is estimated between 12-18 months.

Bottom line: As monetary policy actions affect goal variables with a considerable

lag, it is important to predict the future course of the goal variables and possibleimpact of policy actions on the real variables.

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Conclusion: what monetary policy can and cannot achieve

z Monetary policy plays a central role in reducing inflation and keeping it atmoderate or low levels, broadly termed as price stability.

z Overall monetary policy strategy is a crucial element in ensuring financialstability.

z An expansionary monetary policy can stimulate economic activity only inthe short run, that is, when actual output is much below potential andinflation is low.

z Monetary policy cannot increase the countrys capacity to produce goods

and services.

z Monetary policy has a lasting effect on inflation but only a transient effecton output.

Bottom Line: Monetary policy is a stabilization/aggregate demand

management policy and can not impact long-term growth potential.


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THANK YOU

Documents

Monetary Policy-May 18, 2010