Chapter 5

Monetary
Theory &
Policy
Prepared by
Imroz Mahmud
Assistant Professor (DBA, UAP)
Chapter Objectives

• Introduce the theory of monetary policy.

• Describe the different monetary policy tools available.
• Explain the economic circumstances when expansionary or
contractionary policy should be adopted.
• Briefly discuss the goals of monetary policy.

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What’s Monetary Policy

Monetary Policy – the actions a central bank takes to influence a

country’s money supply and the overall economy.
• It consists of the management of money supply and interest rates,
aimed at meeting macroeconomic objectives
• Controlling inflation, consumption, growth, unemployment, and liquidity.

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Types of Monetary Policies
Expansionary Monetary Policy
• Increases money supply and decreases
interest rates.
• Boost consumer demand and business
CAPEX.
• Intended to prevent or moderate
economic downturns and recessions.
• Excessive use triggers inflation.
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Contractionary Monetary Policy
• Decreases money supply and increases
interest rates.
• Reduces consumer demand and
business CAPEX.
• Intended to curb inflation and stabilize
prices.
• Excessive use can slow production and
increase unemployment.
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Conventional Monetary Policy Tools

During normal times, the Central Bank uses four tools of monetary
policy:
Open Market Discount
Operations Lending

Reserve Interest on
Requirements Reserves

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Conventional Monetary Policy Tools – Open
Market Operations (OMO)

OMO refers to a central bank buying or selling Treasury securities in

the open market to regulate the money supply.
• Buying securities increases the money supply and lowers interest
rates – more economic activities.
• Selling reduces the money supply and increases interest rates – less
economic activities.
• Quickest and most effective ways to implement monetary policy.

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 Conventional Monetary Policy Tools –
Discount Lending
Discount lending is a central bank lending facility meant to help commercial
banks manage short-term liquidity needs.
• The interest rate on these loans is called the discount rate or bank rate.
• Lowering bank rate makes loans less expensive and encourages borrowing –
increases the money supply
• Raising bank rate makes loans more expensive and discourages borrowing –
decreases the money supply.
• Borrowing from the central bank is a substitute for borrowing from other
commercial banks, and so it is seen as a lender of last-resort measure.
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 Conventional Monetary Policy Tools –
Reserve Requirements
Reserve requirements are the amount of funds that a bank holds in reserve to ensure that
it is able to meet liabilities in case of sudden withdrawals.
• Cash Reserve Ratio - the portion of customer deposits that commercial banks must keep
as a reserve with the central bank authority.
• Statutory Liquidity Ratio – the portion of customer deposits that commercial banks has
to maintain in the form of a liquid asset (cash, gold, and govt. approved securities).

CRR
Reserve Ratio
SLR
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 Conventional Monetary Policy Tools –
Reserve Requirements

When central bank increases the reserve ratio, it reduces the bank’s
capacity to lend money.
• Hence, reduces the money supply.
In contrast, lowering this reserve ratio releases more capital for the banks
to offer loans.
• Therefore, increases the money supply

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 Conventional Monetary Policy Tools –
Interest on Reserves
Excess reserves are funds that a bank keeps back beyond what is required by
regulation.
• This tool has a very short history because Federal Reserve only started paying
interest on excess reserves since 2008.
• The interest rate on excess reserves is now being used to encourage bank behavior
that supports the target monetary policy.
• Fed can shift up the interest on excess reserve to encourage more capital to be
parked at the central bank – reducing the money supply, and vice versa.

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 Unconventional Monetary Policy Tool –
Negative Interest Rate Policy (NIRP)

• NIRP occurs when a central bank sets its target nominal interest rate at less than zero
percent.
• In other words, commercial banks now had to pay their central bank to keep deposits.
• Central banks in Europe and Japan began experimenting this tool after the global
financial crisis.
• Objective: To strongly encourage borrowing, spending, and investment rather than
hoarding cash – stimulate the economy
• Two doubts:
• Banks might not lend out their deposits at the central bank, but instead move them into cash
• Charging banks interest on their deposits might be very costly to banks

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Monetary Policy Goals

Stability of
Price High Economic Interest Rate Stability in
Financial
Stability Employment Growth Stability Forex
Markets

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Monetary Policy Goals (cont.)

1. Price Stability:
• Central bankers define price stability as low and stable inflation.
• Rising price level (inflation) creates uncertainty in the economy, and
that uncertainty lowers economic growth.
• Inflation also complicates the decision making for consumers,
businesses, and govt. and leads to a less efficient financial system.
• The most extreme example of unstable prices is hyperinflation.

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Hyperinflation

• A situation where the general price level of goods and services rises
rapidly and uncontrollably.
• Typically defined as an inflation rate exceeding 50% per month.
• Occurs when a government or central bank prints too much money
without a corresponding increase in the supply of goods and
services.
• Hyperinflation can have severe economic and social consequences.

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Monetary Policy Goals (cont.)

2. High Employment
• Is a worthy goal for two main reasons:
• Unemployment causes much human misery
• High unemployment leads to loss of resources and output (GDP)
• Not all unemployment is harmful for the economy.
• This goal for high employment is not an unemployment level of
zero.
• At a level where demand for labor equals the supply of labor.
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Monetary Policy Goals (cont.)

3. Economic Growth
• Closely associated with the goal of high employment.
• Monetary policy needs to be planned in a way that encourages businesses to
invest and households to save.

4. Stability of Financial Markets

• Financial crises can interfere with the ability of financial markets to channel
funds.
• Promotion of a more stable financial system in which financial crises are
avoided is thus an important monetary policy goal.
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 Monetary Policy Goals (cont.)

5. Interest Rate Stability

• Fluctuations in interest rates can create uncertainty in the economy and
make it harder to plan for the future.
• The stability of financial markets is also fostered by interest-rate stability.
6. Stability in Forex
• An appreciation of currency value hurts exports, while a depreciation stimulate
inflation.
• Stability in currency value also makes it easier to plan ahead for both exporters
and importers.

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End of Chapter 5

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