TOOLS AND GOALS OF MONETARY POLICYSunday 25 December 2016

Tools of Monetary Policy• Reserve Requirements• Open Market Operations• Discount Rate

Conducting Monetary Policy

Conducting Monetary Policy• Monetary policy is the process by which central

banks adjust interest rates through influencing the supply of money in order to restrict inflation and achieve price stability.

Conducting Monetary Policy• This is what the macroeconomic function of the

central bank is all about; influencing a number of macroeconomic variables, such as money supply and interest rate, to limit inflation within moderate rates.

Conducting Monetary Policy• But why central banks always try to limit inflation to

certain rates?

Conducting Monetary Policy• Inflation is an ongoing increase in the general level of

prices of goods and services. • Inflation rate is measured by a certain annual

percentage. • Inflation reduces the purchasing power of money in

which every pound purchases less goods and services.

• The value of currency keeps declining as a result of inflation and its purchasing power declines accordingly.

Conducting Monetary Policy

Conducting Monetary Policy

Conducting Monetary Policy

Conducting Monetary Policy• We highlight Demand-Pull Inflation. This kind of inflation is

caused by the existence of too much money in the economy (increased money supply). A solution to address inflation is to absorb money from the market by reducing money supply.

Conducting Monetary Policy• Price stability is, therefore, the core of monetary

policy. A central bank targets price stability through contracting and expanding its assets. This would influence both money supply and interest rate, and would therefore influence the level of prices.

• Monetary policy is either expansionary توسعية or contractionary انكماشية. Expansionary monetary policy targets increasing money supply in the economy, while the contractionary one targets decreasing money supply.

Economic Growth• Economic growth is an increase in the capacity of an

economy to produce goods and services, compared from one period of time to another. It can be measured in nominal or real terms, the latter of which is adjusted for inflation.

• Economic growth is also a target of monetary policy. It depends on the capability of commercial bank to create credit. Such credit creation will take the form of loans provided for businesses to operate and increase their production.

• An expansion in money supply increases the ability of commercial banks to create credit, and therefore increases economic growth.

Unemployment• Unemployment is a phenomenon that occurs when a

person who is actively searching for employment is unable to find work. Unemployment is often used as a measure of the health of the economy. The most frequently measure of unemployment is the unemployment rate, which is the number of unemployed people divided by the number of people in the labor force.

• Employment is, therefore, a target of monetary policy. An increase in money supply and credit creation results in increasing employment opportunities because businesses that obtain loans require more employees and workers

Conducting Monetary Policy

• Reserves include a commercial bank’s deposits at the central bank plus vault cash.

• All the commercial banks have deposits at the central bank because it is much easier to settle transactions between commercial banks through the central bank and no cash is required to be transferred between them.

• Vault cash, in contrast, includes currency and coins held at a commercial bank’s vault. Although reserves pay no interest for commercial banks, the operation of commercial banks requires keeping these reserves.

• Regulations that govern the activities of commercial banks require from them to keep a certain fraction for every dollar of a checkable account. This kind of reserves is called required reserves.

Reserve Requirements

commercial banks are required to hold more cash on hand and are less able to increase the amount of loans to give consumers and businesses. This reduces the money supply, economic growth, and increases interest rates.

commercial banks are required to hold less cash on hand and are able to increase the amount of loans to give consumers and businesses. This increases the money supply, economic growth, employment, and reduces interest rates.

Incr

easi

ng R

eser

ve R

equi

rem

ents

Decreasing R

eserve Requirem

ents

Open Market Operations• One of the main tools of monetary policy is what is

called Open Market Operations. • Open Market Operations refer to the operations by

which the central bank buys or sells government securities, including treasury bills and bonds, in the open market. These operations either inject or absorb liquidity into or from the economy, and they therefore influence inflation rate.

Open Market Operations

Open Market Operations• Contractionary Policy:

• Sale of government securities less money supplyand absorption of money from market higher interest less borrowing and less credit creation Lower economic growth and higher unemployment

• Expansionary Policy:• Purchase of government securities more money

supply and injection of money to market lower interest more borrowing and more credit creation higher economic growth and lower unemployment.

Discount Loans

• Central banks are also bankers to commercial banks. This explains why the central bank is the lender of last resort.

• Commercial banks request loans from central banks when they suffer from liquidity shortages.

• Loans granted from central banks to commercial banks are called discount loans.

• They are called discount loans because the interest charged on the whole period of the loan is deducted upfront when the loan is granted. A commercial bank that borrowed the loan will then pay the principal fully on the due date of debt repayment. The interest rate charged on discount loans is called discount rate.

• Central banks may force commercial banks to borrow from them as a part of the monetary policy they conduct and in order to balance their assets and liabilities.

Discount Loan

• For example, a discount loan of $1,000 might yield only $930 for the borrower to use. The other $70 would be interest and/or other charges. When it comes time to repay the discount loan, the borrower must pay the full face amount; in our example, this is $1,000.

Discount Rate• Contractionary Policy:

• Increasing discount Rate less money supplyand absorption of money from market higher interest less borrowing and less credit creation lower economic growth and higher unemployment

• Expansionary Policy:• Decreasing discount rate more money supply and

injection of money to market lower interest more borrowing and more credit creation

higher economic growth and lower unemployment.