23/02/2023 Monetary Policy Lecture 5 Dr. J. Onyango Learning Objectives 4 By the end of the lecture leamers should be able to understand; 1, Meaning of monetary policy 2 Instruments of monetary policy 2 Stances of monetary policy 4 Money market equilibrium 5. Goals of monetary policy Understand monetary policy and inflation nexus Dr. J. Onyango23/02/2023 Meaning of Monetary Policy 1 Monetary Policy refers to the actions taken by the Central Bank to regulate the supply of money in the economy with a view to achieving predetermine macroeconomic goals. a The need to regulate money supply is based on the knowledge that; ‘There is a relatively stable relationship between the quantity of money supply and economic activity 2 If the supply of money is not limited to what is required to support productive activities, it will result in undesirable effects i.e. inflation and higher interest rates. Dr. J. Onyango Stances of Monetary Policy 4 The stance of monetary policy refers to the specific actions of the central bank to control money supply. There are two stances namely. Quantitative easing/expansionary monetary policy: actions by the Central Bank that lead to an increase in the supply of money. 2 Quantitative tightening/contractionary monetary policy: actions by the Central Bank that lead to a decrease in the supply of money. Dr. J. Onyango23/02/2023 Money Supply Money supply comprises of narrow money and broad money. a Narrow money (M1): currency in circulation with non-bank public and demand deposits with the commercial banks. 2 Broad money (M2): includes narrow money plus savings and time deposits, as well as foreign currency denominated deposits in commercial banks. 4 Broad money therefore measures the total volume of money supply in the economy. a Thus, excess money supply (liquidity) may arise when the quantity of broad money is higher than the level required to sustain non-inflationary output growth in the economy. Dr. J. Onyango Determinants of Money Supply 2 There are two theories that seek to explain the supply of money. Money supply is determined exogenously by the central bank (Monetary Policy). 2 Money supply is determined endogenously by changes in the economic activities which affect people's desire to hold currency relative to deposits, the rate of interest, etc. Dr. J. Onyango23/02/2023 Money Market Equilibrium 2 Equilibrium in the money market occurs when money supply equals money demand; M, = Ma a Where M, is taken as an exogenous variable, determined by the Central Bank's monetary policy and M, is Keynesian theory of money demand or the liquidity preference theory that emphasizes transactional, precautionary and speculative motives for holding money. a Therefore at equilibrium we have; Ms = Mp + Msp = f(r) + £7) Dr. J. Onyango Money Market Equilibrium At Equilibrium a Atr,, the money market is at equilibrium since M,=M,q. Thus 7, is the equilibrium interest rate. a Any other rate of interest will cause Ty fee--S Mg = L(Y,r) disequilibrium in the money market. 0 Ms, Ma Dr. J. Onyango23/02/2023 a This increases investment, depending on the : Pee interest elasticity of the investment demand and the investment multiplier. Therefore, Met Me expansionary monetary policy can help reduce As, MS, MS, MS, is the intrest rate athe liu op unemployment and expand output in the a Reducing interest from r, through economy. to r* will lead to expansion of Any further increase in MS beyond MS, will be money supply from MS, through to ineffective in bringing about a fall in interest MS4. tate. This is termed liquidity trap Dr. J. Onyango Liquidity Trap 4 Liquidity trap is when monetary policy becomes ineffective due to very low interest rates combined with consumers who prefer to hoard cash (because they expect an adverse event such as deflation, insufficient aggregate demand etc) rather than invest in higher- yielding bonds or other investments. a This is why at and beyond MS,, the liquidity trap exists and therefore, the entire increase in money beyond this point goes to satisfy the demand for idle speculation balances and not transactional and precautionary balances. Dr. J. Onyango23/02/2023 Goals of Monetary Policy 2 The principal objective of monetary authority is the formulation and implementation of monetary policy aimed at achieving and maintaining price stability - measured by a low and stable inflation, and to sustain the value of the local currency. 4 The specific objectives and focus of monetary policy may change from time to time, depending on the level of economic development and economic fortunes of the country. Price stability 4 Stability of exchange rate 2 Investment and GDP growth and financial markets 3 Interest rate stability Dr. J. Onyango Tools/Instruments of Monetary Policy a The instruments of monetary policy used by the Central Bank depend on the level of development of the economy, especially the financial sector. ‘Open Market Operations 7 Moral suasion 2 Central Bank Rate/Discount Rate 3. Required Reserve Ratio 4 Discount Window Operation s. Foreign Exchange Market Operations «Prudential Guidelines; Monitoring and oversite of commercial bank's activit lies23/02/2023 1. Open Market Operations (OMO) OMO's refer to actions by the CBK involving purchases and sales of eligible Government securities in the open market (primary or secondary) to regulate the money supply and the credit conditions in the economy. It is the most important and flexible tool of monetary policy a Expansionary - Central Bank buys bonds (injects money) a Contractionary - Central Bank sells bonds (mops out excess liquidity) The effectiveness of OMO, therefore depends on the existence of well-developed financial markets that are sensitive to interest rate movements. Dr. J. Onyango a stance being adopted. Dr. J. Onyango 2. Central Bank Rate (CBR) CBR refers to the interest rate charged by the central bank on loans granted to commercial banks. By law, it is reviewed and announced by the Monetary Policy Committee (MPC) at least every two months. (Curent CBR is 8.5%, Feb 2023) It is the base rate (nominal anchor rate) for all monetary policy operations. Meaning, changes in CBR primarily affects interest rate regime in the money market. CBR allows the Central Bank to perform its role as the lender of last resort, thus preventing financial panics that may cause bank failures to spin out of control. Movements in the CBR, both in direction and magnitude, signal the monetary policy23/02/2023 3. Discount Window Operations a The CBK, as lender of last resort, provides secured loans (against government securities or other acceptable securities) referred to as the Discount Window or Standing Facility to commercial banks on an overnight basis at a penal rate (rate above the CBR). [14.25%jan,2023h a The penal rate is meant to restrict banks to seek funding in this market, only resorting to Central Bank funds as a last solution. a Expansionary Policy - Central Bank lowers discount/penal rate. a Contractionary Policy - Central Bank raises discount/penal rate Dr. J. Onyango 4. Required Reserve Q Specified proportion of commercial banks total deposits (domestic and foreign currency) Tequired by law to be held by the Central Bank at no interest. This proportion of deposits is called the Cash Reserve Ratio (CRR). It is reviewed every month by the CBK a When the Central Bank needs to significantly adjust the amount of money in the market, it increases or decreases this ratio. [Current CRR: 4.3%pec2022)- 2 To facilitate commercial banks’ liquidity management, commercial banks are required to maintain their CRR based on a daily average level from the 15th of the previous month to the 14th of the current month and not to fall below a CRR of 3% on any day. De. J Onyango23/02/2023 5. Foreign Exchange Market Operations 2 The CBK can also inject or withdraw liquidity from the banking system by engaging in foreign exchange transactions. a_A sale of foreign exchange to banks withdraws liquidity from the system while the purchase of foreign exchange injects liquidity into the system. a Participation by the CBK in the foreign exchange market is usually motivated by the need to acquire foreign exchange to service official debt, and to build-up the foreign exchange reserves in line with the statutory requirement (i.e. equivalent to 4 months’ imports as recorded and averaged for the last three preceding years). Dr. J. Onyango 6. Prudential Guidelines a The central bank may require commercial banks to exercise particular care in their operations in order to achieve some specific outcomes. 2 Key elements of prudential guidelines remove some discretion from bank management and replace them with rules and regulations i.e. credit line limits, withdrawal and deposit limits etc. Dr. J. Onyango23/02/2023 2 The central bank issues licenses to commercial banks and regulates the operation of the banking system. a Thus, it can on gentleman grounds, engage and persuade banks to follow certain policies such as credit restraint or expansion, increase savings mobilization and promote exports through export financing, which otherwise they may not do, on the basis of their risk/return assessment. 7. Moral Suasion Dr. J. Onyango 1 2 a The scope of monetary policy is severely restricted in controlling inflation. The following are some of its limitations. Limitations of Monetary Policy Increase in the Velocity of Money Discriminatory Threat to Credit Market Alter Expectations of Borrowers and Lenders Time Lags. Dr. J. Onyango 1023/02/2023 Cases of Mismatch in Economic Policies 2 These are instances where the objectives of fiscal andior monetary policy instruments are clashing leading to unintended outcome. If the goals of the two policies do not match, development objective will be jeopardised. Price Stability and Interest Rate Conflict Monetary Policy and Inflation Budget Deficits and Inflation «Government Debt and Inflation 5 Government borrowing and Private Investment Dr. J. Onyango Self - Test ‘Explain the principal instruments of monetary policy. What are their limitations? 2. Critically discuss the effectiveness of monetary policy in controlling inflation. Distinguish between cheap and dear monetary policy. Explain their relative effectiveness. 4 What are some of the limitations of monetary policy Dr. J. Onyango at23/02/2023 Monetary Policy END Dr. J. Onyango 12