You are on page 1of 6

Course Name: Central Banking and Monetary Policy

Course No. FIN: 425

Chapter note
Prepared by SM Nahidul Islam
Dept. of Finance & Banking
Islamic University, Kushtia.
Chapter Money Creation & Framework of monetary policy
Questions at a glance:

Define the components of money and its measurement.

Describe the sources of money creation.
Define monetary policy and comprehend its statutory environment.
Discuss the objectives of monetary policy.
Describe the inflation targeting monetary policy framework.
Deliberate on monetary policy accountability and transparency.
Discuss the limitations of monetary policy.
Describe the instruments and operation of monetary policy.
Expound the significance of the independence of central banks.

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
1. Define the components of money and its measurement.
Answer: The stock of money is made up of bank notes and coins and bank deposits in possession of the
Non-bank Private Sector (NBPS). Central banks across the world have various definitions of money, and
they range from M1 to M5. They all include bank notes and coins held by the NBPS; where they differ is
in the cut-off point of the term to maturity of NBPS deposits, and the higher numbers add in other near
money assets. For the sake of simplicity we will use one of the measures: M3. It includes notes and coins
(N&C) in the hands of the NBPS and all NBPS deposits with banks, and we justify this on the basis that
the vast majority of deposits with banks are short-term in nature. So, M3 is made up of
M3 = N&C + BD of the domestic NBPS
Central banks calculate M3, as well as its counterparts, from the consolidated balance sheet of the
banks and the CB. In most countries there are also other monetary institutions (such as rural banks,
building societies, mutual banks, land banks and so on) ; they are also consolidated with the central
banks and the banks balance sheets. From the consolidated balance sheet of the monetary banking sector
(MBS), the money is easily identified.
2. Describe the sources of money creation
Answer: The actual sources of money creation are the transactions that underlie the balance sheet sources
of changes (BSSoC), and they are:
A. Net foreign assets (NFA): Bank and CB dealings in the foreign exchange market. If these
institutions do nothing in the forex market, the market clears at a particular exchange rate. If they
do, they alter the demand / supply equation of the forex market and create / destroy money, and
the market will clear at a different exchange rate.
B. Net loans to government (NLG):
Bank and CB purchases or sales of government securities.
The movement of NBPS deposits at banks to government (which we assume banks at the CB
only), for example when taxes are paid; and the movement of government deposits to the NBPS,
when government spends locally.
C. Loans to the NBPS (LNBPS): The demand for loans by the NBPS which is satisfied by the
3. Define monetary policy and comprehend its statutory environment.
Answer: Monetary policy may be defined as the central banks policy pertaining to the control of the
availability, cost and use of money and credit with the help of monetary measures in order to influence
prices and employment for achieving the objectives of general economic policy. Monetary policy works
through expansion or contraction of investment and consumption expenditure.
In many countries monetary policy is underpinned by law, which is confirmation of the significant
role of monetary policy. Examples: In the US, the responsibility for setting monetary policy is contained
in the Federal Reserve Act of 1913.
Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
In the UK the Bank of England Act of 1998 formally gives the operational responsibility for
setting monetary policy to the Bank of England. The mandate for the European Central Bank to conduct
monetary policy is laid down in Article 105 (1) of the Treaty establishing the European Community.
In South African law, the responsibility for setting monetary policy is contained in the
Constitution of the Republic of South Africa Third Amendment Act 26 of 1996 and the South African
Reserve Bank Act 90 of 1989.
4. What are the objectives of monetary policy?
Answer: The objectives of monetary policy are given below:
a. Price stability: Price stability is low and stable (non-volatile) changes in the general price level.
Inflation distorts economic calculations and expectations while deflation creates depression in the
economy. Thus price stability should be the main aim of monetary policy. Price stability promotes
business confidence, makes economic calculation possible, controls business cycle and introduces
certainty in economic life.
b. Exchange Stability: Maintenance of stable exchange rates is an essential condition for the
creation of international confidence and promotion of smooth international trade on the largest
scale possible. A restrictive monetary policy trends to reduce a countrys balance of payment
defect in various ways.
c. Full Employment: In under developed countries, the full employment objective is more crucial,
because such economies have both unemployment and under employment open and disguised. In
less developed countries, though full employment cannot be achieved within a short period, the
monetary policy should try to achieve at least a near full employment situation.
d. Economic Growth: This comparatively a recent object of monetary policy. If refers to the growth
of real income or output per capita. Monetary policy can contribute to economic growth in the
following ways:

It can maintain a balance between monetary demand and supply of goods.

It can create atmosphere in which a higher rate of saving and investment would be generated.
Monetary policy minimizes fluctuation in business activity and prices.
It creates stability for growth.
It influences the rate of interest, investment and the use of credit in the most productive
channels in the economy.

e. Neutrality of Money: Neutrality of money indicates a situation in which changes in the quantity
of money occurs in such a way as to cause a proportionate change in the equilibrium prices of
commodities, and the equilibrium rate of interest remains unchanged. If money is neutral, an
increase or decrease in the quantity of money will both produce and disturbing effects in the
f. Balance of Payment Equilibrium: Balance of payment equilibrium condition is a position at
which a country repaid its debts and has attained an adequate reserve at zero balance over time.
This main objective on monetary policy has become significant in the pose-period. It is realized
that the existence of balance of payment deficit seriously reduces the ability of an economy to
attain other objectives. So, monetary policy must make into consideration the international
payment problem.
Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
5. What are the main instruments of monetary policy?
Answer: The main instruments of monetary policy are given below:
A. Quantitative instruments:
1. Bank Rate or discount rate Policy: Bank rate is the rate at which the Central Bank is prepared to
rediscount the approved bills or to lend on eligible paper. By changing this rate the Central Bank
control the volume of credit.
2. Open Market Operations: Open market operations refer to the purchase and sale of securities by
the central bank. As an instrument of credit control open market operations are generally used as
collateral to support or reinforce the instruments of the bank rate.
3. Variation of Cash Reserve Ratios: Variable Reserve Ratio refers to the percentage of the
deposits of the commercial banks to be maintained with the central bank, being subject to
variations by the central bank.
B. Qualitative instruments:
1. Fixation of margin requirements: The Central Bank prescribes the margin which banks and
other lenders must maintain for the loans granted by them against commodities, stocks and shares.
To contract credit, the Central Bank raises margins and lowers the margins to expand the credit
2. Rationing of credit: The Central Bank controls the credit created by the banks through the
rationing of credit. Under this method, the Central Bank fixes a maximum limit for loans that a
commercial bank can provide to a particular sector or for all purposes.
3. Regulation of consumer credit: The central bank authorized to regulate the terms and conditions
under which credit repayable in installments may be extended or reduced for purchasing or
carrying consumers durable goods.
4. Control through Directives: The Central Bank issues directives to control the credit created by
commercial banks.
5. Moral Suasion: It implies persuasion and request made by the central bank to commercial banks
to follow the general monetary policy that has been established.
6. Publicity: To control the credit central bank publishes periodicals, journals, bulletins etc to create
awareness of the scheduled bank regarding credit facilities.
7. Direct Action: Direct action refers to all forms of controls and directions, which the central bank
may enforce upon a particular bank or banks, concerning lending and investment.
6. Describe the limitations of monetary policy
Answer: The limitations of monetary policy are given below:
1. Time Lags: If the time lags are long, the policy may become ineffective. The response time lag of
monetary policy are longer than fiscal policy
2. Problem in forecasting: Its important to forecast the effect of monetary actions. However
prediction of the outcome and formulation of the policy is a difficult task
3. Non- Banking Financial Intermediaries: Huge share in financial operation reduces the
effectiveness of monetary policy.
Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
4. Underdevelopment of Money and Capital Market: Markets are fragmented, unorganised and
does work independently.
7. Describe the inflation targeting monetary policy framework
Answer: Under this framework, a numerical target or target range for the inflation rate that is intended to
be achieved over a specified time period is publicly announced by government. Thus, it is a government
target, and it is to be executed by the CB, because the CB has the operational tools to best achieve it.
The advantages of this framework are:
1. It makes the objective of monetary policy crystal clear and thereby improves planning in the
private and public sectors.
2. It makes it clear that government is part of a formalised and co-ordinated effort to contain inflation
in pursuit of the broader economic objective of sustainable high economic growth and
employment creation.
3. It focuses monetary policy and enhances the accountability of government and the central bank to
the public.
4. It provides an anchor for expectations of future inflation which has an influence on price and wage
5. It often contains the caveat of the target being flexible, as manifested in a target range and it is to
be attained over a period.
The inflation-targeting monetary policy framework regards money stock and bank loan extension as
critically important, and they are monitored closely, but together with other economic indicators such
1. The level of international interest rates.
2. The shape and position of the yield curve.
3. Changes in nominal and real salaries and wages.
4. Changes in employment.
5. Nominal unit labour costs.
6. The gap between potential and actual national output.
7. General money market conditions.
8. Changes in asset prices.
9. The overall balance of payments position.
10. The terms of trade.
11. Exchange rate developments.
12. Public sector borrowing requirement.
8. Deliberate on monetary policy accountability and transparency
Answer: The following steps are taken by most central banks to enhance monetary policy accountability
and transparency:
1. The inflation target is announced openly to the public; in this way it indicates visibly that the central
bank is accountable for the target and makes the application of the inflation targeting framework as
transparent as possible.
2. Announcement of the target makes the intent of monetary policy explicit; the corporate sector is
therefore well-informed and better able to plan in terms of production and expansion of production.
3. If the target is not met, the central bank has to explain the situation to the public (in Parliament).
Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
4. The governor of the central bank is obliged to report to the Minister of Finance (Parliament) twice per
annum and report on the stance of monetary policy.
5. The monetary policy stance of the central bank is communicated regularly to the public in various
A monetary policy statement issued after each meeting of the Monetary Policy Committee (MPC).
In some cases central banks invite the public to Monetary Policy Forums held in the major centres
of the country, where presentations are made and discussions are held in which the public
In some cases central banks publish a Monetary Policy Review; it describes in more detail the
decisions taken by the central bank and analyses the factors that could have an influence on future
9. Expound the significance of the independence of central banks
Answer: Central bank independence is a key precondition for the successful implementation of monetary
policy and hence for sustainable non-inflationary economic growth.
Independence is important for the fulfilment of the central banks primary monetary objective, which for
the vast majority of central banks is to maintain price stability. The importance of price stability ensues
from empirical experience with the world economy, which confirms that high and volatile inflation has
negative economic consequences. As a rule, higher inflation implies greater inflation volatility, causing
investors to focus more on short-term financial investments and on hedging against inflation, and
consequently less on longer-term productive investments. When inflation is high in the long term,
inflation and depreciation expectations become fixed in the decision-making of economic agents.
Unforeseen high inflation causes several other economic distortions that reduce the growth potential of
the economy.
The importance of central bank independence comes to the forefront here primarily because
politicians may seek to compel the central bank to adopt measures that although in the short-run may
boost economic growth, in the long run will lead to an undesirable rise in inflation. Economic growth will
meanwhile return to its original level, or even sink to a lower level. A sufficient degree of independence
from political influence allows the central bank to resist such pressures.

Islamic University, Kushtia