ID:2015-3-95-070

MBA

510

SEC-2

ROLES

BROADER

070 | NAME: S.M Shaharia Mojumder

OFMONEYRAY POLICYBROADER ASPECTS OF ECONOMIES

12/4/2015

NAME: S.M Shaharia Mojumder

POLICY IN

ECONOMIES

1.0. Introduction

Monetary policy is the policies that are taken by central bank of a country to control money

supply to make a balance in between inflation and unemployment as well as to maintain a stable

exchange rate with other currencies through increasing or decreasing supply of money in an

economy.

Government uses the fiscal policy and monetary policy side by side to make the overall economy

strive toward sustainable growth. Monetary policy taken by central bank or federal bank might

be accommodative; set an interest rate by central bank to accelerate economic growth; or neutral;

maintain an interest rate which is not for either to reduce inflation and unemployment; or rigid ;

when actions has been taken to reduce hyper inflation.

To maintain an economy with sable inflation, consistent growth, tolerable unemployment and

sustainable exchange rate; importance of monetary policy is like a control panel to the

government and central bank. There are many factors in economy that drive the economy into

the direction of their force and if these factors are not controlled in right time then the economy

will be in the imbalanced condition; for example: if we let inflation to rise then there will a

reduction in living standard in general.

In a developing country like Bangladesh ; momentary policies is not exercise in right time and in

a right manner because of high ineptness of govt. , increased political interference in the rear

side of central bank action plans to materialize non-monetary goals , and adoption of

dollarization ( converting domestic currencies into dollar to settle foreign trade). In the rest of the

discussion we will up leave the importance of monetary policies to the economic development

perspective.

1.1 Monetary policy and Fiscal Policy; Comparative Discussion

Monetary policy and fiscal policy are both important to steer economy to the right direction.

Monetary and fiscal policy are used by central bank and government respectively to control

different macroeconomic factors like inflation , unemployment, consumption level , investment

and exchanges rate etc.

Figure 1:

In the figure above we see that monetary policy has a greater manipulation capacity to directly or

indirectly influence economic factors with the use of some tool that are all about increasing or

decreasing money supply. On the other hand fiscal policy aff

with a change in taxation and government spending.

2.1 Importance of Monetary Policy:

Bangladesh bank exercise monetary policy to satisfy some of

to run an economy smoothly. So the importance of monetary policy is implicitly hidden in the

materialization of these broader macroeconomic objectives. These objectives are

Monetary

policy

Expansionary

Contractionary

Fiscal policy

Agreegated consumption expenditure

Agreegated Investments

government expenditure

Net export

Figure 1: Tools and effects of monetary policy

In the figure above we see that monetary policy has a greater manipulation capacity to directly or

indirectly influence economic factors with the use of some tool that are all about increasing or

decreasing money supply. On the other hand fiscal policy affects aggregated expenditure directly

with a change in taxation and government spending.

2.1 Importance of Monetary Policy:

Bangladesh bank exercise monetary policy to satisfy some of objectives that are strongly desired

to run an economy smoothly. So the importance of monetary policy is implicitly hidden in the

materialization of these broader macroeconomic objectives. These objectives are

Expansionary

Contractionary

Increase money

supply by buying

Treasury note,

reserve

requirements and

Reduce money

supply through

interest rate, selling

treasury bonds

Tool s

Tools

Fiscal policy

Agreegated consumption expenditure

Agreegated Investments

government expenditure

Net export

Monetary policy

Net export

Employment

relative cost of consumption vs. saving

Inflation

In the figure above we see that monetary policy has a greater manipulation capacity to directly or

indirectly influence economic factors with the use of some tool that are all about increasing or

ects aggregated expenditure directly

objectives that are strongly desired

to run an economy smoothly. So the importance of monetary policy is implicitly hidden in the

materialization of these broader macroeconomic objectives. These objectives are –

Inflation;

unemployment

and consumption

level

Halt hyper

inflation; reduce

investment and

consumer

expenditure

Effects

Effects

Figure 2: impact

area of both

Fiscal and

Monetary policy

1. Maintain moderate inflation( keeping price level stable)

2. Reduce unemployment rate at an acceptable label

3. Increase suitability of economic growth for longer period

4. Ensure exchanges rate stability

Now we discuss the importance of monetary policy in detail with an inclusion central bank

action at different situation.

2.1.1 Maintenance of Moderate Inflation

Sometime inflation is considered as a factor to mobilize economy and sometime is also deemed

to be the fetal factor that reduces the long run economic expansion or growth and quality of real

living. Inflation is not so bad when it is maintained at a tolerable level like 6-7% for a longer

time; because it acts as an incentive to producer, investors, and supplier to produce and supply

more of goods and services. If inflation is not controlled and govt. let it to rise at a sustainable

rate then consequence will be severe and economic growth will abruptly fall.

So to control the general price level; central bank use a prominent tool; known as monetary

policy. the prime objective toward which central bank drive the monetary policy is to ensure

equivalent money supply to national GDP ( which is also known as multiplication of general

price level and total transaction incurred in given year in the economy).

Now we want to look over the impact of expansionary monetary policy and its impact on general

price level and reason behind choosing such type policy-

What will happens: If central bank increase money supply then three effects will

persuade three different area –

1. Money market: increase in money supply shift MS curve to the right ; which

therefore reduce interest rate

2. Interest sensitive expenditures: since interest rate reduced at lower level;

borrowing fund became cheaper thus investment and large consumer

expenditure encouraged.

Related topics to be dealt with

simultaneously while monetary

policy is taken

3. Real GDP and price level: Price level and real GDP rise because AD shifts to

the right to reflect high interest sensitive expenditures and high multiplier

effect

Central bank adopts this expansionary monetary policy to encourage consumption

Aggregated expenditure when the economy is passing through recession period. CB does

this because of some reasons –

1. Every firm and individual in an economy became pessimistic about to expend and

invest because of less expectancy about future and prefer to hold their money in

their wallet or used to lend money for higher interest. As a consequence the

economy faces a sordid production due to people’s reluctance to expend and

consume. In such situation govt. increase money supply ( monetary policy) and

increase Govt. expenditure ( fiscal policy ) to increase inflation ( as an incentive

to invest and production) and decrease interest rate ( discourage saving and

encourage investment and consumption expenditure) .

2. Since economy is at the initial stage of production after recovering a recession;

multiplier effect will be high for monetary policy.

Ms1 Ms2 LRAS

Md

Real money Investment Y1 Y2 Y0

Now we are concerned to see how central bank reduces hyper inflation or sustained rise in

inflation through decreasing broad money supply.

Before proceeding into the depth of discussion we should know about hyper inflation

.Because contractionary monetary policy is all about to reduce hyper inflation. Hyper

Interest

rate Interest

rate

AS AD3

AD2

AD1

Investment

expenditure effect Multiplier effect

General

Price level

inflation occurs when economy is near to its full capacity or above it capacity in SRAS.

Where firm respond to market to market with higher price with little or no increase in

output. Besides these the endeavor of expansionary monetary policy loses their

effectiveness due to zero multiplier effect. So central bank take contractionary monetary

policy to restore real GDP back to the full employment level or natural GDP (Y0)

SRAS

P1

0 Y1 Y0

When central bank takes contractionary monetary policy to control hyper inflation there will be

inverse impact as that happened to expansionary monetary policy.

1. Decreasing broad money (M2) supply thus increase interest rate ( value of money)

2. The rise in interest rate will crowd out investment expenditure

3. As a result AD shift rightward along the SRAS which restore the restore the real GDP to

natural GDP (y0)

Ms1 MS0

P1

AD0 AD1

1 2 Real Money I1 I2 Investment Y0 Y

The contractionary monetary policy is taken when economy is approached to full capacity and

raise in aggregated demand doesn’t increase aggregated output although higher price is offered.

P2 AD3

AD2

AD1

G Ms T shift AD

Further and further to the right

cause consistent rise in P with little

or no increase in Y. (multiplier

effects lose its effectiveness)

Interest

rate Interest

rate

LRAS

P0

2.1.2 Reducing Unemployment at Tolerable Label

Unemployment is a curse to any economy and every economy face dilemma in choosing higher

inflation or higher unemployment in short run. Central bank can reduce unemployment rate in an

indirect way through increasing money supply or giving more loan to excel the AD of an

economy. Although rise in AD increase price level; it reduce unemployment rate above the

natural rate of unemployment. Now there might be a question in our mind; which is about natural

rate of unemployment. The Natural Rate of Unemployment is the rate of Unemployment when

the Labor market is in equilibrium and economy is facing potential GDP. This natural rate of

unemployment exists in an economy because of structural unemployment- -people who doesn’t

get job because of lack of skill and potential to work.

When central bank takes expansionary monetary policy then due to availability of fund; real

interest rate will fall; consequently shift AD from long run equilibrium situation to the right

along the SRAS curve.

LRAS SRAS

P* AD1

To reduce unemployment rate central bank takes expansionary Monetary Policy then the

scenario will be as follow –

SRAS

P

P* AD2

AD1

LR GDP SR GDP

Price

Natural GDP

In long run equilibrium –

Potential or natural GDP can be

maintained for longer period of time

without any inflationary pressure

Unemployment rate exist at long run

equilibrium is called natural rate of

unemployment

If AD shift from the point to left then

actual unemployment rate > natural

unemployment rate

Price AD shift to right along SRAS

Price level rise from P* to P

Unemployment rate reduced in

comparative to natural rate of

unemployment

LRAS

In the graph above when AD shifted from AD1 to AD2 then a new short run equilibrium point

derived where unemployment rate will reduced then natural unemployment rate (long run

equilibrium potential GDP) because in short run input price leg behind then output price. So firm

increase production with move involvement of resources (inputs). This reduction in

unemployment rate is temporary because in long run worker will bargain to raise price (W) at

same rate as raise in output price. Which will compel firm reduce production and derived

demand for inputs (Labor)

LRAS Changes in equilibrium points in sequence

SRAS 1

Although the effort to reduce unemployment is temporary (because input price adjust its price to

the output price in long run; causes rise in production cost thus overall short run aggregated

supply reduced and shift to left to restore the short run GDP to long run GDP / natural GDP)

the central bank contribution is major in maintaining lower unemployment

2.1.3 Foreign Exchanges Rate Control

Central bank sometime control exchange rate to ensure the benefit of different economic agents

like importer, exporter, foreign investors, etc. Exchange rate is the rate at which one currency is

exchanged for another. Although now a day exchange rate is determined in market interaction –

floating exchange rate; some country till now intervene on exchange rate through setting a fixed

exchange rate through purchasing or selling foreign currency with domestic currency .

Sometime floating exchange rate became lower due to market interactions; at that situation black

market activities became active (more smuggling) and exporter became disadvantageous. To

prevent situation central bank set exchange rate at cooperatively high level. As a consequence

there will be higher supply of foreign currency in comparative to demand; causes surplus of

Price

LR GDP SR GDP

AD1

AD2

SRAS

foreign currency. This excess supply of foreign currency will be purchased by Central bank and

raise foreign currency reserve.

When floating exchange rate is too high (that mean more domestic currency (taka) need to be

paid for a single dollar) then to ensure importer’s benefit central bank set a fixed rate lower then

floating rate; which causes higher demand for foreign currency in comparative to foreign

currency supply .In the shortage situation central bank will increase supply of foreign currency

from its foreign currency reserve and make a balanced situation.

Beside these to decrease the exchange rate/price of domestic currency without changing the

monetary base, authorities purchase foreign-currency bonds, the same action as in the last

section. After this action, in order to keep the monetary base, Central bank sales an equal amount

of domestic-currency bonds, so that the total money supply is back to the original level.

3.0 Conclusion

Monetary policy is all about to control interest rate; which has long reaching effect in different

areas in economy. Aggregated demand, investment, inflation are the area where the actions of

monetary policy is too effective and vigorous. Besides these it ensure future certainty for the firm

whose are engaged in external trade through ensuring stable exchange rate; rate which more or

less beneficial for all economic agents. Sometime monetary policy play a beak seat role in case

of reducing unemployment through increasing aggregated demand and ensuring more resource

demand for firms via implication of expansionary tools. Most often it is used to make equalize

“balance of payment” through fulfilling government deficit with the use of foreign currency

reserve; done by central bank. At last it has to be mentioned that due to limitation of time and

resources; we can’t describe all the things about importance or role of monetary policy in detail

.So far we discussed ; there is no doubt about the significance of monetary policy.