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Monetary Policy
Money matters, so monetary policy is important
Monetary policy is closely related to fiscal policy and to exchange rate policy
Monetary institutions also matter
Thorvaldur Gylfason
Outline
Presentation in four parts
1. Monetary institutions
2. The main instruments of monetary policy
3. The role of money and credit in financial programming
4. Exchange rate regimes
Monetary institutions
Central banks Commercial banks Other financial institutions
Central banks’ clients Government Commercial banks
Commercial banks’ clients Households and firms
1
Central banks:Independent or not? Most central banks, but not all,
are owned and operated by the government
Central bank officials are public officials
Inflation in 1970s and 1980s raised concerns: where central banks being too willing to print money for short-sighted political purposes?
Central banks:Independent or not?
Governments may be tempted to instruct central banks to print money rather than raise tax revenue Major source of inflation, esp. in some
developing countries Several central banks have been made
independent of politicians in order to immunize monetary policy from political pressures (US Fed, ECB, BoE, etc.)
Central banks:Independent or not?
Division of labor Government sets inflation target
Political task Central bank uses its instruments to
achieve that target Technical task “Instrument independence”
Central banks do not make political judgments, not their business
Central banks:Independent or not?
Independence does not mean lack of accountability Courts and judges are supposed to be
independent, yet accountable Central banks: Same story Free press: Same story
Accountability can be upheld through legally stipulated checks and balances
Commercial banks:Private or public?
Some countries have mainly private banks, others have a mixture of private and public banks, a few have only public ones
Private banks are usually better run Commercial vs. political motives Hence, privatization in banking sector Not obvious why governments should own and
operate commercial banks
Commercial banks:Foreign or domestic?
Most countries have home-grown banks Domestic banks know best the needs of their
domestic customers Yet, foreign banks are becoming more
common – e.g., in Eastern EuropeTo increase competition so as to be able to offer
more loans at lower interestTo harness foreign expertise
Foreign central bank governors: may not be such a bad idea!! (Israel, New Zealand)
Other financial institutions:Large or small?
Other financial institutions – financial intermediaries – play an important role
They create additional outlets for national saving, by households and firmsThey buy and sell bonds, facilitating non-
inflationary financing of fiscal operationsThey buy and sell stocks, facilitating the buildup
of a strong private sector Africa needs both
Instruments of monetary policy Methods used by central
banks to change the amount of money in circulation
1. Open-market operations2. Reserve requirements3. Discount rates4. Printing money5. Direct instruments6. Persuasion
2
1. Open-market operations
Central banks conduct open-market operations when they buy government bonds from or sell government bonds to the publicWhen they buy government bonds,
the money supply increasesWhen they sell government bonds, the
money supply decreases Foreign exchange market intervention
also affects the money supply
2. Changing the Reserve Requirement
The reserve requirement is the amount (in %) of a bank’s total reserves that may not be loaned out to its customers Increasing the reserve requirement
decreases the money supply Decreasing the reserve requirement
increases the money supply
3. Changing the Discount Rate
The discount rate is the interest rate the Central Bank charges commercial banks and the government for loans Increasing the discount rate
decreases the money supply Decreasing the discount rate
increases the money supply
4. Printing money
The Central Bank can create money by extending loans to the government How? By buying bonds from the
government that issues them Inflationary finance
Open-market operations are less inflationary than printing money Hence the need for efficient financial
markets that facilitate trade in bonds
5. Direct instruments
Ceilings on interest rates Create excess demand for credit Prone to abuse Inefficient and unfair
Quotas on credit Essentially the same effects as ceilings
on interest rates
Problems in Controlling the Money Supply Central Bank control of the money
supply is not precise Central banks do not control the amount
of money that households and firms choose to hold as deposits in banks
Central Banks do not control the amount of money that commercial bankers choose to lend
Money is endogenous: M = D + RFiscal policy
Exchange rate policy
Rules versus discretionBenefits Costs
Rules
Discretion
Rules versus discretionBenefits Costs
Rules
Discretion Flexibility to react to changing circumstances
Rules versus discretionBenefits Costs
Rules
Discretion Flexibility to react to changing circumstances
Incompetence, abuse of power
Rules versus discretionBenefits Costs
Rules
Discretion Flexibility to react to changing circumstances
Incompetence, abuse of powerPolitical business cycle
Rules versus discretionBenefits Costs
Rules
Discretion Flexibility to react to changing circumstances
Incompetence, abuse of powerPolitical business cycleTime inconsistency
Rules versus discretionBenefits Costs
Rules
Discretion Flexibility to react to changing circumstances
Incompetence, abuse of powerPolitical business cycleTime inconsistencyLack of credibility
Rules versus discretionBenefits Costs
Rules Tying one’s hands as a disciplinary device
Discretion Flexibility to react to changing circumstances
Incompetence, abuse of powerPolitical business cycleTime inconsistencyLack of credibility
Rules versus discretionBenefits Costs
Rules Tying one’s hands as a disciplinary device
Inflexibility that comes from locking the steering wheel
Discretion Flexibility to react to changing circumstances
Incompetence, abuse of powerPolitical business cycleTime inconsistencyLack of credibility
Money and credit in financial programming
History and targets Record history, establish targets
Forecasting Make forecasts for balance of
payments, output and inflation, money
Policy decisions Set domestic credit at a level that is
consistent with forecasts as well as foreign reserve target
3
1)Make forecasts, set reserve target R*– E.g., reserves at 3 months of imports
2) Compute permissible imports from BOP– More imports will jeopardize reserve
target3) Infer permissible increase in nominal
income from import equation4) Infer monetary expansion consistent with
increase in nominal income5) Derive domestic credit as a residual: D = M
– R*
Financial programming step by step Do this in the right order
1)Make forecasts, set reserve target R*– E.g., reserves at 3 months of imports
2) Compute permissible imports from BOP– More imports will jeopardize reserve
target3) Infer permissible increase in nominal
income from import equation4) Infer monetary expansion consistent with
increase in nominal income5) Derive domestic credit as a residual: D = M
– R*
Financial programming step by step Let’s do the arithmetic
Known at beginning of program period:Known at beginning of program period: M-1 = 70, D-1 = 60, R-1 = 10
Recall: M = D + R
X-1 = 30, Z-1 = 50, F-1 = 15Recall: R = X – Z + FSo,R-1 = 30 – 50 + 15 = -5, so R-2 = 15Current account = -20, overall balance = -5
R-1/Z-1 = 10/50 = 0.2Equivalent to 2.4 (= 0.2•12) months of
importsWeak reserve position (less than 3 months)
History Hypothetical Hypothetical
exampleexample
X grows by 33%, so X = 40F grows by 40%, so F = 25R* is set at 15, up from 10 (R* = 5)
Z = X + F + R-1 – R*
= 40 + 25 + 10 – 15 = 60
Level of imports is consistent with R* becauseR*/Z = 15/60 = 0.25Equivalent to 3 (= 0.25•12) months of
imports
Forecast for balance of payments
BOP forecasts
(in nominal
terms)
Increase in Z from 50 to 60, i.e., by 20%, is consistent with R* equivalent to 3 months of imports
Now, recall that Z depends on PY where the increase in nominal income PY
consists of a price increase and an increase in output
Hence, if income elasticity of import demand is 1, PY can increase by 20% E.g., 5% real growth and 15% inflationDepends on slope of aggregate supply
schedule
Forecast for real sector
If PY can increase by 20%, then, if income elasticity of money demand is 2/3, M can increase by 14%
Recall quantity theory of moneyMV = PYConstant velocity means that %M = %PY = %P + %Y (approx.)
Hence, M can expand from 70 to 80
Forecast for money
˜
Recall M = D + M = D +
RR
Having set reserve target at R* = 15 and forecast M at 80, we can now compute level of credit that is consistent with our reserve target, based on M = D + R
So, D = 80 – 15 = 65, up from 60D/D-1 = 5/60 = 8%Quite restrictive, given that PY rises by
20%Implies substantial reduction in domestic
credit in real terms
Determination of credit
Financial programming step by step: Recap
Sequence of stepsSequence of steps
R*R* ZZ YY MM DD
Z = X + F + R-1 – R*
Z = mPY
MV = PY
D = M – R*
Forecasts of X and F play a key role:
Lower forecasts mean lower D for
given R*
Exchange rate regimesThe real exchange rate always
floatsThrough nominal exchange rate
adjustment or price changeEven so, it makes a difference
how countries set their nominal exchange rates because floating takes time
There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates
4
Exchange rate regimesThere is a range of options
Monetary union or dollarizationMeans giving up your national
currency or sharing it with others (e.g., EMU, CFA, EAC)
Currency boardLegal commitment to exchange
domestic for foreign currency at a fixed rate
Fixed exchange rate (peg)Crawling pegManaged floatingPure floating
Benefits and costsBenefits Costs
Fixed exchange rates
Floating exchange rates
Benefits and costsBenefits Costs
Fixed exchange rates
Stability of trade and investment
Low inflation
Floating exchange rates
Benefits and costsBenefits Costs
Fixed exchange rates
Stability of trade and investment
Low inflation
Inefficiency
BOP deficits
Sacrifice of monetary independence
Floating exchange rates
Benefits and costsBenefits Costs
Fixed exchange rates
Stability of trade and investment
Low inflation
Inefficiency
BOP deficits
Sacrifice of monetary independence
Floating exchange rates
Efficiency
BOP equilibrium
Benefits and costsBenefits Costs
Fixed exchange rates
Stability of trade and investment
Low inflation
Inefficiency
BOP deficits
Sacrifice of monetary independence
Floating exchange rates
Efficiency
BOP equilibrium
Instability of trade and investment
Inflation
Exchange rate regimesIn view of benefits and costs, no
single exchange rate regime is right for all countries at all times
The regime of choice depends on time and circumstanceIf inefficiency and slow growth are
the main problem, floating rates can help
If high inflation is the main problem, fixed exchange rates can help
What countries actually do (2001)No national currency 39Currency board 8Adjustable pegs 50Crawling pegs 9Managed floating
33Pure floating 47 186
25%
25%
50%
There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today
Conclusion
The EndMoney and credit play a
key role in financial programming
Not to be taken literally as a one-size-fits-all approachCountries differ, so need to
tailor financial programs to the needs of individual countries
Even so, certain fundamental principles and relationships apply everywhere
These slides will be posted on my website: www.hi.is/~gylfason