Monetary Policy Money matters, so monetary policy is important Monetary policy is closely related to...

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.)


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


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

Discretion Flexibility to react to changing circumstances


Rules


Incompetence, abuse of power


Rules


Incompetence, abuse of powerPolitical business cycle


Rules


Incompetence, abuse of powerPolitical business cycleTime inconsistency


Rules


Incompetence, abuse of powerPolitical business cycleTime inconsistencyLack of credibility


Rules Tying one’s hands as a disciplinary device




Rules Tying one’s hands as a disciplinary device

Inflexibility that comes from locking the steering wheel



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



Stability of trade and investment

Low inflation





Low inflation

Inefficiency

BOP deficits

Sacrifice of monetary independence





Low inflation

Inefficiency

BOP deficits



Efficiency

BOP equilibrium




Low inflation

Inefficiency

BOP deficits



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

Monetary Policy Money matters, so monetary policy is important Monetary policy is closely related to...

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