Names:

Aimel Hasssan – 20I-0203

Neha Zainab – 20I-1708
Accounting &Finance- 20
FIM PROJECT
Teacher: Dr. Naureen
Submission date: 08/05/23
 The impact of monetary policy on economy

Intro
Monetary policy broadly relates to numerous tools used by nation’s central bank or monetary regulatory
authority to control the supply of money circulation in economy, fostering economic expansion and
implementing strategies for instance interest rate for that purpose. Monetary policy varies from country
to country but they are broadly split into two main categories Expansionary monetary policy and
Contractionary monetary policy. A contractionary policy relates to increase in interest rates which
increases the cost of borrowing and inclines people to save more as return is higher on savings, as cost
of borrowing rises so investment and expansion in economy reduces. This also minimizing the
purchasing power of people causing a downward pressure on inflation as prices of commodities and
services rise too. The vice versa happens in expansionary monetary policy. The two basic models in
practice are Inflation targeting monetary policy which is a central bank method involving setting an
inflation rate as a target and modifying monetary policy to attain that rate and Interest based monetary
policy where interest rate is the key component used to stabilize money supply. In developed countries
usually inflation targeting policy can be witnessed while in developing countries interest based policy is
more in practice, both of them carrying their own pros and cons. Reserve requirements, open market
operations, the discount rate, and interest on reserves are main tools that central banks utilize to carry
out their monetary policies. Open market operations involve the central bank buying and selling
government assets to affect the money supply, reserve requirements set limits on the amount of
deposits that banks may use to fund loans. The interest rate at which banks can borrow money from the
central bank is known as the "discount rate," and changes to this rate may have an impact on the cost of
borrowing for banks and eventually have an impact on the money supply and amount of money in
circulation. Interest on reserves is the interest that the central bank pays to banks that retain reserves
with them. Ultimately, the goal of monetary policy is to promote price stability, economic growth, and
stable long-term interest rates.

We will further discuss monetary policy frameworks of different countries and how they have affected
those economies.

Global perspective
USA

The central bank of USA that is Federal Reserve also known as Fed is responsible for conducting
monetary policy implementation across the country and also administers the monetary policy
framework. The monetary policy framework of US is influenced by numerous macroeconomic factors
that include GDP, inflation etc. The monetary policy framework of US focuses on dual mandate as the
Federal Reserve main goal is to eradicate unemployment, and ensure price stability while guarding
reasonable long term interest rates. The Federal Reserve pursues these goals using a range of policy
instruments while upholding independence and openness in its decision-making while adopting a data-
driven approach. Fed relies on economic data of US in order to devise monetary policy as since the
global crises have hit US Fed has been more conscious in devising monetary policy and is on verge of
being hit by another crisis. There are several policy tools used by Fed to achieve its objectives which are
further split into some traditional monetary tools and non-traditional monetary tools. Traditional
monetary policy tools include Open market operations which stimulates federal funds market balances,
the availability of money and credit in the economy as government securities influence money supply in
economy and helps maintain federal funds rate that is established by Federal Open Market Committee.
One of the main form of open market operations is Quantitative Easing which is purchasing long-term
securities on the open market, which increases the country's money supply and promotes borrowing
and investment which falls under expansionary monetary policy instrument. Another instrument used
by Fed is Reserve requirement where minimum ratio is to be curtailed by all commercial banks in order
to meet urgencies, this helps accomplish and channelize the funds supply and credit in economy. The
mechanism behind it is the amount to be maintained in dollars is set after Boards regulation after
monitoring reserve requirement ratios and simultaneously the liabilities of financial institutions. Lastly
discount rate policy is one of main instrument too as interest rate that is applied on commercial banks
on loans received from federal reserve bank discourages or boosts borrowing affecting money
circulation and monetary policy. A special feature used by Fed to manner its monetary policy includes
interest on reserve balances too which helps them connect to Federal Open Market Committee set
target rate. The Federal Reserve has recently supported the American economy by using its policy
instruments to combat early stage crises. In order to boost lending to families and companies and to
supply liquidity to the financial markets, the Fed reduced interest rates to almost zero and launched
numerous quantitative easing programmes. These measures are recognized with aiding in the
stabilization of the American economy during a time of major economic upheaval. Some non-traditional
monetary policy tools used by Fed in crisis situation specially include Forward guidance which are
community facilitation announcements aiding public to understand what are monetary objectives of Fed
in future so that public can devise strategies according to that and another tool is Large scale asset
purchases specially designed to tackle interest-sensitive spending and this affects the economy the same
way as traditional monetary policy tools do, These include Reverse repurchase agreement which helps
central bank to regulate its fund rate, also asset backed securities loan conveniences lending and stream
lines the funds.
All of these combined help Federal reserve accomplish its goal by stabilizing economic growth through
stable prices, maximum employment and moderate interest rates.

EU

The European Central Bank (ECB), which is in charge of guaranteeing price stability and promoting
economic growth in the nations of the Eurozone, manages the monetary policy of the European Union
(EU). To carry out monetary policy, the ECB employs a range of instruments, such as interest rate
setting, open market operations, and lending liquidity to banks. The ECB utilizes a monetary framework
made up of two essential pillars: a quantitative support and a qualitative support, in order to stabilize its
prices. The qualitative aspect considers a variety of economic and financial indicators, whereas the
quantitative aspect is based on the examination of monetary and credit aggregates. Setting ECB policy
rates, which have an impact on financing conditions and economic developments and help to keep
inflation at the ECB's target level, is the main tool of monetary policy which is navigated through open
market transactions, standing facilities, and minimum reserve requirements. These policy rates include
deposit facility rate, marginal lending facility rate and main refinancing operations rate. Banks can access
overnight cash from national central banks through the marginal lending facility at an interest rate set
by the ECB. Banks are permitted to seek an unlimited amount of money, but they must first provide
enough collateral. Also, With the use of the deposit facility, banks can store money overnight with
national central banks and receive interest at a rate set by the ECB known as the deposit facility rate
(DFR). Through these rates the ECB tries to control inflation rate at 2% in order for inflation to be at
creeping level so that price shocks are avoided and stability amongst all member countries is ensured.
The following collection of tools make up the operating monetary framework of the ECB and euro area
national central banks: open market operations, standing facilities, minimum reserve requirements for
credit institutions, and forward guidance. These measures are all based on the legislative framework for
monetary policy instruments in the Euro system and help them reach inflation target and stabilize prices
in economy.

It has been challenging for the ECB to conduct monetary policy that is suitable for all member countries
since certain nations have suffered with high levels of debt and slow economic development. The ECB
has struggled in recent years to meet its inflation target too since the rate of inflation in the Eurozone
has been consistently over 2% and hit around 6.9%. In order to address this issue, ECB has introduced a
variety of new policy tools, including as lowering interest rates to historical lows, carrying out substantial
asset purchases via quantitative easing programmes, forward guidance announcements regarding future
prospects to general public and giving targeted lending assistance to banks. Also to boost lending to the
real economy when banks might otherwise be more unwilling to do so, the ECB provides longer-term
loans to banks through targeted longer-term refinancing operations (TLTROs) at advantageous interest
rates. The transmission challenge used by EU for monetary policy decision is that a change in the official
interest rates affects markets and banks interest rates which impacts the expectations of public, hence
this triggers the asset prices bringing impact on saving plus investment decisions too. This leads to a shift
in supply of credit and changes aggregate demand and supply within economy affecting bank loans
supply too, all these impact the monetary policy and prices are then developed.

To sum it all EU monetary policy is somewhat effective as it is working to achieve economic and
monetary stability but financial instability and soaring asset value are also results of ECB monetary
policy.

Regional perspective
INDIA

The Reserve Bank of India's (RBI) develops monetary policy that best fits the Indian economy. With the
goal of stabilizing inflation expectations, enhancing overall macroeconomic stability, and improving long-
term development prospects, India has adopted interest rate targeting. The Monetary Policy Committee
has developed a framework describing a few tools to assist in achieving operating objectives, which then
assists in achieving intermediate targets, and ultimately results in goals being accomplished. The primary
duty of the MPC is to establish the repo rate, a yardstick policy rate that takes inflation into account with
respect to a set tolerance band, which is now between (_-+)2 and should then be changed to function in
line with macroeconomic circumstances in India. Repo rates function such that when the RBI wants to
increase the money supply, decreasing the repo rate encourages banks to borrow money at a cheaper
cost, which increases the amount of money in circulation in the economy, and vice versa when the RBI
wants to decrease the amount of money in circulation. Repo rate is the most crucial instrument,
although other instruments also have a big role. After the repo rate is announced, the liquidity facilities
are viewed, including the Reserve Bank of India's (RBI) Liquidity Adjustment Facility (LAF), a mechanism
that enables banks to obtain loans from the RBI through reverse repo agreements or to borrow money
from it through repos. This effectively regulates liquidity requirements and ensures the core stability of
the financial markets. Additionally, it aids in controlling high inflation rates. Reserve Requirement, which
is the proportion of total deposits that a bank must retain in cash to operate risk-free, is another tool it
employs. The Reserve Bank of India sets the amount, which is kept in reserve for financial security. The
RBI does not pay interest on this money, and the bank is not allowed to use it for lending or investment
reasons. The MPC also keeps an eye on open market activity since the central bank may alter the
amount of reserves in the banking system and ultimately the country's money supply by buying or
selling bonds and other financial instruments on the open market, which also impacts the flow of money
in the economy. India's monetary policy includes lending to banks as well. A bank rate and a margin
standing facility are first established. The MSF Rate is the rate at which commercial banks borrow money
from the central bank overnight over its LAF, whereas the Bank Rate is the discount rate at which the
RBI offers long-term loans to commercial banks. Monetary policy committee needs to govern it as a
balance between both rates is very important for smooth running of economy. Last but not least, MPC
keeps a close eye on foreign exchange operations because an increase or decrease in the value of the
rupee would have an impact on the Indian economy's overall goal. As a result, it maintains a managed
floating exchange rate system so that it can intervene and adjust it to meet this goal as it evaluates the
Net forex purchases made by the RBI when determining monetary policy.

Together, these instruments assist in achieving operating short-term interest rate objectives (WACR)
and then intermediate long-term and short-term interest rate targets. In conclusion, the framework
within which India conducts its business aims to encourage pricing stability and economic growth in the
context of financial and foreign exchange market stability. However, there have been some criticisms
that the RBI's monetary policy has at times been overly strict, making it difficult for individuals and
businesses to access credit and preventing economic growth.

BANGLADESH

The monetary policy of Bangladesh is governed by central bank of Bangladesh that is Bangladesh bank.
The main aim of Bangladesh monetary policy is to alleviate their domestic monetary value and also to
keep the external par value competitive of Bengali Taka in order to achieve long term objectives of
nurturing economic growth and development. The monetary policy system of Bangladesh encourages
investment, is boosted internally through demand and adopts inflation controlling money growth
strategy. The policy instruments being used by BB for monetary policy control are Cash Reserve Ratio,
Statutory Liquidity Ratio which fall under category of reserve requirements. BB decides a ratio that is to
be kept in form of cash by the banks and cannot be used for operations or lending hence controlling
supply of currency flow whereas SLR is percentage of deposits that banks have to maintain in form of
cash or securities. These reserve ratios inform commercial banks regarding how much they can lend to
general public which then determines the development of the country. Changes in policy interest rates
which includes repo rates, reverse repo rates and bank rates need to be determined too. The last
instrument being used is it regulates open market operations too which government central bank does
by injecting or withdrawing liquidity from system through its securities to control takas being circulated
in economy. The main targets that BB wants to accomplish from its monetary policy is to achieve
operational targets by determining appropriate reserve rate as an increase in the reserve ratio may be
beneficial for a commercial bank with little cash because banks with large cash holdings will have
enough excess reserves to create credit, raising the reserve ration in this situation won't be successful.
Other target includes intermediate target that is linked to broad money which Bangladesh Central bank
evaluates yearly and tries that it is demand driven hence increases proportion of taka in economy by
limited percentage. The final goals that framework of monetary policy will accomplish include Price
stability, Economic growth and Financial stability.

Over the years Bangladesh monetary policy has moved from conservative approach to an approach
which targets inflation and monetary stability which has played a vital role in development of
Bangladesh economy. There are several perspectives on how Bangladesh's monetary policy has
impacted that nation. Inflation can rise and currencies might depreciate as a result of low interest rates
and loose monetary policy. On the other side, a restrictive monetary policy can lead to less economic
growth and job opportunities hence balancing the objectives have become a difficult hurdle for BB to
accomplish. Due to the Bangladesh Bank's emphasis on achieving price stability while promoting
economic growth, recent years have seen comparatively low rates of inflation and sustained economic
growth. Despite detailed framework the implementation of framework is a challenging activity as a
significant informal component of the economy, high levels of non-performing loans in the banking
sector, and other factors including political unpredictability and outside variables like the state of the
world economy has affected economic implementation of monetary policy.

Pakistan
Current policy
Monetary policy of Pakistan is formulated by State Bank of Pakistan where monetary policy committee
governs the instruments and transmission channels. The main objective of Pakistan’s monetary policy is
to ensure price stability while promoting financial growth. Pakistan currently follows interest rate based
monetary policy where interest rate plays the main part. By changing the policy rate a delayed and
multiplied effect on the economy's demand is observed. First off, adjustments to the policy rate have an
impact on the interest rates set in the interbank market, where financial institutions lend to or borrow
from one another. The central bank's actions in the money and foreign exchange markets as well as its
communication with the public have an impact on market interest rates as well. The cost of borrowing
for individuals and companies, as well as the return on deposits for savers, are all impacted by changes
in market interest rates. SBP is utilizing a number of measures to make sure that the policy signals are
transferred to other important interest rates in the economy, such as bank lending and deposit rates,
and financial markets continue to operate efficiently. Some of the instruments used by State bank of
Pakistan to indirectly influence monetary policy include SBP Policy rate which is set within interest rate
corridor bounded by SBP standing facilities, this policy rate influences KIBOR and retail interest rates
which govern economic growth of economy. Secondly, some standing facilities are deployed too which
include SBP Repo facility and SBP Reverse Repo Facility. SBP Repo facility is a facility provided by state
bank to financial institutions to place excess funds with SBP over night while receiving treasury bills in
place of that. SBP reverse repo rate is when financial institutions can obtain local currency funds for one
day against approved securities with agreement to repurchase the day after. Another tool used is the
open market operations which is the most used instrument used for implementation of monetary policy
in Pakistan. The main purpose that OMO’s have is to manage liquidity amongst interbank markets with
aim to make sure sufficient funds are available for smooth transaction processes. Pakistan uses
temporary open market operation facilities where government transfers its debts to that of scheduled
banks’ balance sheet. Variable rate tenders are used for this purpose. Reserve requirements are also a
key component which influences monetary policy. Cash reserve requirement is set by SBP for
commercial banks which outlines the minimum amount of domestic currency and foreign currency
deposits to be kept in order to meet unforeseen circumstances. Statutory liquidity requirements are set
too which deems commercial banks to maintain minimum requirement of their liquid assets in form of
government approved securities, gold or cash. Lastly state bank also utilizes Forex swaps which helps
ensure liquidity management in economy and has the objective to temporarily increase the rupee
liquidity in market or reduce it. The short term objective that state bank monetary policy framework
aims to achieve through these instruments are short term interest rates stability that are aligned with
policy rate and also Liquidity management is short run objective.

The monetary policy transmission in Pakistan follows 5 main channels. Firstly, interest rate channel
which influences KIBOR and retail interest rate affecting borrowing cost plus savings in order for
contractionary or expansionary monetary policy to be established. Second to that is Balance sheet
channel which refers to how policy rate influences credit portfolio of financial institutions as the rate
affects availability of loanable funds altering credit portfolios and cash flows of other economic agents
too. Exchange rate channel is also used to affect inflation where local economy is linked with
international economy and by the use of interest rate local currency is either made attractive or
depreciated. Then Asset price channel can become in practice too where prices of real and financial
assets are influenced by interest rate and public decides whether to go for returns on savings or return
on assets. Lastly, there is expectation channel where general public and investors expect the changes in
interest rate and inflation and according to that adopt behaviors regarding price setting and wage
setting as such news trigger the economy. As Pakistan follows interest rate based monetary policy so
state bank adopts to these channels which are affected by interest rate helping economy to either
stabilize or to compress.

Currently in recent times Pakistan has undergone large trade deficits, large level of debts and political
unrest which have made implementation of monetary policy challenging and questioned its
effectiveness. In order to devise an efficient monetary framework SBP can use multiple instruments
which aligns them to reach its goals of price stability and economic growth.

Suggested frame work

Currently Pakistan’s economy is governing under the interest based monetary policy. Despite the
success of interest-based policy in the past, it has been witnessed above that an inflation targeting
monetary policy would work well under the economic conditions currently faced by Pakistan.
This can be backed up by noticing the progressions it led in Bangladesh and the USA. Figure 1
shows the suggested framework, if Pakistan changes its policy to inflation targeting.
Given the current inflation rate of 34.5% Pakistan must devise a monetary policy that caters this
level of inflation. As presented in the figure, higher interest rates would result in higher reserves
in the banks. As, there will be less demand for loans and more savings. This will decrease the
money supply from the market. The policy can be further implemented through permanent open
market operations. Quantitative tightening would have to be implemented for the current
situation at hand. This would further aid in the burst of asset price bubble.

Why inflation targeting policy?

It is a modified monetary policy to attain a specific yearly inflation rate. The idea behind it is
maintaining price stability by reducing inflation to promote long term economic growth. These
policies are carried out by setting intermediary aims to like monetary aggregate or exchange rates
due to convenience and experience. The central bank becomes accountable for maintaining a
specific inflation target. The success of setting up inflation targeting monetary policy has
encouraged many countries to adopt this policy. The ability of central banks to respond to shocks
to the domestic economy and concentrate on home issues is provided by inflation targeting.
Investor uncertainty is reduced by stable inflation, enabling invertors to anticipate changes in the
interest rates and grounds inflation expectations. Inflation targeting also promotes more openness
in the monetary policy if the aim is made public. Inflation targeting has evolved into a flexible
framework that has proven durable even in the most recent financial crisis.

Many counties like the USA has accepted an inflation target of 2% in 2012. They have promoted
maximum employment and moderate long-term interest rates, as reported by IMF, in addition to
stable prices.

Furthermore, Bangladesh has implemented a monetary policy to control inflation. The policy was
formulated to contain inflationary pressure caused by the pandemic and expansionary fiscal
policy. The Bangladesh Bank has increased its policy rate by 50 basis points to 5.50 percent from
5.00 percent to deal with the demand. The government can support this inflation control strategy
by keeping fiscal deficits below 5% of GDP. The effectiveness of the policy is yet to be seen, as
the inflation rate is projected to be 5.6 percent in FY2022-23. And it is projected to remain at
target level inflation and reach 5.5% by 2028.
Below is a graphical representation of the effectiveness of the policy, over the years, for
Bangladesh and the USA.

Bangladesh
50

40

30

20

10

0
61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 18 21
19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20
-10

-20

GDP Inflation Interest

USA
16
14
12
10
8
6
4
2
0
-2 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 18 21
19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20
-4

GDP Inflation Interest