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Monetary Policy Research Paper

Monetary Policy Research Paper

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Research Paper on Importance of Monetary Policy in a developing country (Pakistan) Submitted by Amber Masud Kayani (0958134) EMBA

Submitted to Sir Syed Qamar Ali Zaidi Submission date : 28th Nov,2010

Shaheed Zulfiqar Ali Bhutto Institute of Science & Technology(SZABIST) 90 Clifton, Karachi

........ 10 14....... Objectives of Monetary Policy «««««. 5 4.. References «««««««««««««««««««««««««««. Summary««««««««««««««««««««««««««««.«« 3 2. 1. . How does Monetary Policy affect Inflation«««««««. Conclusion«««««««««««««««.««... Effectiveness of Monetary Policy in Pakistan«««««««««««««..... Introduction««««««««««««««««««««««««.«.« 5 5....Importance of Monetary Policy in a developing country (Pakistan) Table of Contents Titles Page no. How does Monetary Policy affect the economy of a country....... What needs to be done to improve the effectiveness of Monetary Policy?... 6 7.«««««««««« «««..«««««....... Monetary Policy Framework in Pakistan«««««««««««««.. 8 11... State Bank uses tools of Monetary Policy....10 2 .. What is a Monetary Policy? ««««««««««««««««««. ««««««....«« 6 6. Effectiveness of Monetary Policy in Developing Countries «««««««« 8 10.. 7 8... 9 13.«««««««««««««...««« 4 3.............«« 8 9. 9 12....«««««. Abstract «««««««««««««««««««««.

The results from the correlation analysis indicate that there is a positive association between money growth and inflation. The important finding from the analysis is that the excess money supply growth has been an important contributor to the rise in inflation in Pakistan during the study period.Importance of Monetary Policy in a developing country (Pakistan) Abstract: Price and output stabilities determine the success of monetary policy in either economy. rather they often formulate and launch policies under some discretionary framework. The important policy implication is that inflation in Pakistan can be cured by a sufficiently tight monetary policy. thus supporting the monetarist proposition that inflation in Pakistan is a monetary phenomenon. This paper attempts to investigate the linkage between the excess money supply growth and inflation in Pakistan and to test the validity of the monetarist stance that inflation is a monetary phenomenon. This may be due to the loose monetary policy adopted by the State Bank of Pakistan to show the high priority of the growth objective. The formulation of monetary policy must consider development in the real and financial sector and treat these sectors as constraints on the policy. The fundamental objective of this study is to examine the performance of rule-based monetary policy in developing countries by extracting experience from developed ones. The money supply growth at first-round affects real GDP growth and at the second round it affects inflation in Pakistan. This paper briefly examines the monetary policy strategies of developing countries It is found that the developing countries follow ill-organized monetary system do not follow the rule-based policy. 3 .

Monetary policy is usually administered by a Government appointed "Central Bank" like the State Bank of Pakistan. stable. Using its monetary authority to control the supply and availability of money.low unemployment. a government attempts to influence the overall level of economic activity in line with its political objectives. State bank play a highly important role in the international financial systems today. and a balance of external payments. low inflation. and predictable. The ultimate objective of monetary policy is to promote solid economic performance and higher living standards for Pakistani¶s. managing foreign exchange and reserves. 4 .Importance of Monetary Policy in a developing country (Pakistan) Introduction: Monetary policy is one of the tools that a Government uses to influence its economy. Interest rates set by the State bank affects the borrowing by commercial bank and other market institutions. economic growth. and what that money is worth. and one of its main policy instruments is interest rate. The relationship between the State Bank and the Government is an extremely important and equally sensitive area. One of the functions of a State Bank is to ensure the health of the economy of the country. Conditions in different countries are diverse. Usually this goal is "macroeconomic stability" . They share virtually the totality of policy framework where by Ministry of Finance manages the fiscal policy while the State Bank organizes the monetary and exchange rate. therefore the structure of a State bank can also be quite different. It does so by setting monetary policies. hence affecting the other interest rates in the market. It mainly influences the economy of a country by controlling the money supply. However the function that a State bank is most associated with is setting monetary policies. The best way to achieve that objective is to keep inflation low. With the right monetary policy they are able to bring about economic growth and financial stability in a country. setting interest rate and money supply to mange inflation among others. Pakistan¶s monetary policy is concerned with how much money circulates in the economy.

‡ Maintenance of full employment.Importance of Monetary Policy in a developing country (Pakistan) What is a Monetary Policy? Monetary policy is a short-run tool used by the State bank to persist sustainable economic growth (in the long-run) by controlling the money supply through open market operations. and ‡ The economic prosperity and welfare of the people of the economy. to accelerate strong and sustainable economic growth. Achievement of inflation target directs strong currency valuation in terms of other foreign currencies. achieving full employment or more well-being. the significance of monetary policy is to achieve the inflation target (set by the State bank for required economic growth). Price stability develops investor¶s confidence ± boosting investments. causing acceleration of economic activity and achievement of full employment. first discuss what monetary policy is? And how it is used by the State bank? ³Monetary policy is the process of managing a nation's money supply to achieve specific goals such as constraining inflation. resulting as favorable balance of payments. margin requirements. Price stability. 5 . but in developing countries with floating exchange rates (like Pakistan etc. and as a consequence. Monetary policy can involve setting interest rates. Thus. discount lending and reserve requirements. A wide variety of policy systems are possible to conduct monetary policy operations. is the imperative condition for the constant economic growth. Objectives of Monetary Policy: ‡ Price stability. Before focusing on the significance for and affects of monetary policy on the economy of the country. that is controlled price level.) and monetary policy involves the management of short-term interest rates by central banks to pursue the macroeconomic objectives of the economy. once accomplished leads to full employment and economic prosperity. capitalization standards for banks or even acting as the lender of last resort or through negotiated agreements with other governments´.

Reserve requirements Nominal interest rate ‡ Use Open Market Operations to change the monetary base: The most effective and major tool the State bank uses to affect the monetary supply in the economy is open market operations. the Bank lowers its discount rate to encourage borrowing by the banks and thus helps increasing the money supply. that is the slow down of economic activity. Conversely. 6 .Importance of Monetary Policy in a developing country (Pakistan) Monetary Policy framework in Pakistan State Bank uses tools of Monetary Policy: The State Bank is also in charge of conducting monetary policy which means changing the supply of money in the economy. 2. Banks only maintain a small portion of their assets as cash available for immediate withdrawal. the rest is invested in illiquid assets (like loans and mortgages). the monetary authority can directly change the size of the money supply. resulting a drop of investment spending. ‡ Changing the reserve Requirements: the proportion of the total assets that banks must hold in reserve with State bank. Having less money in these reserve accounts the opportunity cost of lending money decline. The discount rate. the State bank sell the government securities. such as bills of exchange. in order to tighten the monetary base in the economy. In order to attain the objectives discussed above. If the State bank decides to increase monetary base in the economy it buys securities from the open market and pays for these securities by crediting the reserve amounts of banks involved in selling. as a result collect payments from banks by reducing their reserve accounts. the State bank uses tools of the monetary policy which are: 1. This act as a change in the money supply. 3. Also by calling in existing loans or extending new loans. ‡ Changing the Discount Rate: Banks borrow money from the State Bank by cashing or discounting credit instruments. If and when the goal is to increase the money supply. Open market operations. Increasing the proportion of total assets to be held as liquid cash increases the amount of money available to banks as loan able funds. such that interest rates may increase. thus mean the broader monetary base in the economy. By raising the discount rate SBP discourages bank to borrow money. The bank would buy and sell government securities (usually bonds or T-bills) in exchange of hard currency. 4. The monetary policy can be implemented by altering the proportion of these required reserves.

GDP and economic growth. Again this leads to higher aggregate spending on goods and services produced in the country. resulting stock prices to rise. a reduction in real interest rate lowers the cost of borrowing. 7 . encouraging people to borrow in order to consume (durable items like. electronic items.Importance of Monetary Policy in a developing country (Pakistan) ‡ Affecting a change in nominal interest rate: The contraction of the monetary supply can be achieved indirectly by increasing or decreasing the nominal interest rates. Imports and Exports: Short-run changes lower interest rate result as currency depreciation. Saving and Investment: Changes in the real interest rates affect the demand for consumption and savings of the people and also change the investment pattern of the businesses. For instance.). rate of inflation. making exports dearer and discourage imports. Output and Employment: The increase in aggregate demand for the output boosts up the production cycle. By changing the discount rate and by conducting open market operations a change in money supply would affect the nominal interest rates. Which accelerate the consumption further due to more incomes earned. How does Monetary Policy affect the economy of a country? After having discussed the objectives and tools of monetary policy. automobiles etc. as a result increase investment spending on the existing industrial capacity. reducing the gap between imports and exports and having favorable balance of trade. A change in the nominal interest rates influences the overall economic activity. thus attaining the multiplier effect of Keynes. now talk about how policy affects the economy: Consumption. on the other side discourage saving. resulting to increase spending and aggregate demand. Lower real interest rates also make stocks and other such investments more desirable than bonds. A tight money supply tends to increase nominal interest rates while an increase in money supply can help bring down the interest rates. generating employment. Moreover stimulating bank¶s willingness to lend more and investors to invest more. Foreign Exchange. which means lower prices of home-produced goods selling abroad. People are likely to increase their stock of wealth.

This was certainly an encouraging development. Effectiveness of Monetary Policy in Pakistan Significance of various channels that transmit the monetary policy shocks in Pakistan to the real economy has been analysed by few economists. however. monetary policy can directly affect inflation via future expectations. affecting indirectly. However. As wages and prices start to rise they are hard to bring down back. The primary difficulty is that few developing countries have deep markets in government debt. it is hoped. In general. 8 . it boosts up economic activity. stressing the need for early policy measures to be taken.6 percent in FY06. The efforts to rein-in inflation. resulting higher inflation. thus resulting inflation to rise (that is cost-push inflation). if monetary policy able to achieve multiplier effect. Initiating labor and capital markets to raise outputs beyond there capacities and creating an upward pressure on wages. Thus there would be a trade-off between higher inflation and lower unemployment in the short-run which further accelerate inflation. the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government. proved less effective due to a rebound in international commodity prices and a rise in domestic food prices later on. First. Such forms of monetary institutions thus essentially tie the hands of the government from interference and. they persuade to increase in wages. particularly as if was achieved without affecting economic growth as the real GDP growth remained strong at 6. developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Like if people expect the rise in prices in future. With the emerging domestic and global price pressures. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly.Importance of Monetary Policy in a developing country (Pakistan) How does Monetary Policy affect Inflation? Monetary policy affects inflation in two ways. that such policies will import the monetary policy of the anchor nation. For this and other reasons. recent attempts at liberalizing and reforming the financial markets are gradually providing the leeway required to implement monetary policy frameworks by the relevant central banks. Secondly. which in turn affect the prices. so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. SBP tightened its monetary policy after a prolonged gap of a few years. Effectiveness of Monetary Policy in Developing Countries Developing countries may have problems establishing an effective operating monetary policy.

Specifically. SBP also introduced structural changes in the process of monetary policy formulation and conduct to make the monetary policy formulation and implementation more transparent. Like. SBP formulates the country's monetary policy that is consistent with these announced targets. selected thoughts on effectiveness of Pakistan's monetary policy framework y Finally. and ‡ Improving upon the communication of policy stance to the general public. Conclusion: This paper is written with the aim of getting a clear understanding of Monetary Policy Framework and its effectiveness to control inflation in Pakistan. I have come up with the following findings. although adopted tight monetary policy. The basic hurdles are the deep debt burdens on government.Importance of Monetary Policy in a developing country (Pakistan) The objective of monetary policy in Pakistan. The calculation of money supply target needs to be improved to get appropriate target level of M2. information and data problems 9 . SBP focused on ‡ Institutionalizing the process of policy formulation and conduct. It is also concluded that in the recent years SBP failed to control money supply and hence rate of inflation within the set target level. why central banks focus on price stability? y Second. the monetary policy plays effective role to control the money supply in economy in the short-run for a sustainable prosperous long-term growth of developed countries. The results show that mostly developing countries fail to attain the desired goals of monetary policy. ‡ Stepping up movement towards a more market based credit allocation mechanism. y First.5% (in FY 07).an inevitable policy response for regaining macroeconomic stability has aroused anxiety but better public understanding of this question will help them to appreciate central bank's monetary policy stance. during the last couple of years. against the inflation target of 6. how the monetary policy transmission mechanisms work? y Third. and inflation pressures. as laid down in the SBP Act of 1956. In this regard. In pursuit of this mandate. ‡ Developing its analytical and operational capacity. I presented the salient features of current Monetary Policy. is to achieve the targets of inflation and growth set annually by the government. what are the principal features of Pakistan's monetary policy framework? y Fourth. The monetary authority was successful in controlling inflation when it successfully controlled the money supply target. stood at actual inflation rate of 7. Moreover. what measures are needed to improve the effectiveness of the monetary policy framework in Pakistan? These questions have been a subject of much debate lately. What needs to be done to improve the effectiveness of Monetary Policy? Apart from taking policy measures to address the emerging challenges. Pakistan. efficient. ‡ Improving its capabilities to assess future developments to act proactively. and effective. as monetary tightening .7% (FY 2006-07). However.

pk 5. References: 1.google. A. The Pakistan Development Review 35:4.org. ³Inflation and Growth: An Estimate of the Threshold level of Inflation in Pakistan´ by Yasir Mubarik in SBP Working Papers. Vol. No. this art is firmly rooted in the science of monetary policy as embedded in the current knowledge of economic science. www. 747±759. Inflation of a country. and M. ³The Science of Monetary Policy: A New Keynesian Perspective´ by Richard Clarida. 8. 4.yahoo.com 10 . Monetary policy.com 6. H. www. Jordi Gali. How does Monetary Policy affect the economy. Qasim (1996) Inflation in Pakistan Revisited. 37. Nonetheless.Importance of Monetary Policy in a developing country (Pakistan) in developing countries are much more severe than in advanced economies.4 (Dec 1999).2005). an analysis of the role of State Bank in stabilization of prices and controlling inflation and circulation of currency and importance of monetary policy in a developing countries.sbp. 2. The paper specifically discusses objectives. Mark Gertler in Journal of Economic Literature. (June. In addition. NO. This makes the art of implementing monetary policy in a developing country far more challenging than in developed countries. Summary: This paper provides an overview of the historical developments and achievements of State banks. www. tools of monetary policy. 3. A. Khan. how to keep monetary policy stable. as well as State banks' tasks and tools and the structure of SBP are discussed.

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