Monetary Theory and Policy - BAF 3il QO Outline: * Module One ~ Analysis of Monetary Policy Meaning of monetary policy Y Y Trade-Off in Monetary Goals + Targets of Monetary Policy Strategies and Effectiveness of Monetary Policy Implementation in Nigeria Module Two — Monetary Policy: Instruments and Types instruments of Monetary Policy Expansionary Monetary Policy vs Restrictive Monetary Policy Lag in Monetary Policy Role of Monetary Policy in a Developing Economywe Meaning of Monetary Policy Cont'd ¥ Changing Cred lender will all il restriction/Credit fOW you to spend on * Moreso, the actions of a central bank currency board or other regulatory committees that determine the size and rate of growth of the money supply affects interest rates, ~ in * Monetary policy is maintained through actions such as increasing the interest rte, or changing the amount of money banks need to keep in the vault (bank reserves), + Monetary policy aims at influencing the economic activity in the economy sity through two major variables, i.e., (a) money or credit ‘supply, and (b) the rate of interest.+ Objectives or Goals of Monetary Policy > Full Employment - © Price stability © Economic Growth © Balance of Payments per 8 A 8 Full employment has been ranked among the foremost objectives of macroeconomic goal. It is an important goal not only because unemployment leads to wastage of potential output, but also because of the | loss of social standing and self-respect. Moreover, it breeds poverty. Y According to Keynes, full employment is a situation in which everybody who wants to work gets work. ¥ To achieve full employment, Keynes advocated increase in effet demand to bring about reduction in real wages. 7 ey b v Alternatively, in Keynes General Theory, he perceived full employment as a situation in which aggregate employment is inelastic in response to an increase in the effective demand for its Output - when any father increase m afecive dermand ie not accompanied by any increase mn ouputObjectives or Goals of Monetary Policy Cont’d ¥ In other words, effective demand is the willingness and ability of consumers to purchase goods at different prices. ¥ It shows the amount of goods that consumers are actually buying. v In Keynesian econo! , effective demand is the point of equilibrium where aggregate demand equals aggregate supply. pepopie ammavanegse sels Thus, the Keynesian concept of full employment involves three conditions ‘+ Reduction in the real wage rate Increase in effective demand + Inelastic supply of output at the level of ful employmentObjectives or Goals of Monetary Policy Cont'd Price Stability is one of the goals of macroeconomics policy Is to stabilize the Price level. Both economists and laymen favour this policy because fluctuations in prices bring uncertainty and instability to the economy. Rising and falling prices are both bad because they bring unnecessary loss to some and undue advantage to others. Price stability are associated with business cycles. So a policy of price stability keeps the value of money stable, eliminates cyclical fluctuations, brings economic stability, helps in reducing inequalities of income and wealth, secure social justice and promotes economic welfare. However, there are certain difficulties in pursuing a policy of stable pri problem relates to the type of price level to be stabilized. ¢ level. The first Should the relat ral price level be stabilized, the wholesale wr retail of consumer sets or producer goes how hs foes he yucsom that remain mans Hene: there is no specific criterion with regard to the choice of a price level. Economists suggest stabilize a price level which would include consumers’ goods prices as well as wagesObjectives or Goals of Monetary Policy Cont'd Economic Growth is another important goals of macroeconomics objective. Economic growth is perceived as the process whereby the/,real per capita income of a country increases over along period of time. * Economic growth is measured by the increase in the amount of goods and services in each successive time period. Thus, growth occurs when an economy's productive capacity increases which, in turn, is used to produce more goods and services. However, economic development implies raising the standard of living of the people, and reducing inequalities of income distribution. You should agree with me that economic growth is a desire goal for a country. Generally, economists believe in the possibility of continual growth. This belief is based on the presumption that innovations tend to increase productive technologies of both capital and labour over time. But there is very likelihood that an economy might not grow despite technological innovations. Production might not increase further due to the lack of demand which may retard the growth of the productive capacity of the economy. The economy may not grow further if there is no improvement in the quality of labour in Keeping with the new technologies. AA iObjectives or Goals of Monetary Policy End Balance of Payments (BOP) is a statement of all transactions made between entities in cone country and the rest of the world over a defined period of time BOP is another goal of macroeconomic objectives has been to maintain equilibrium in the balance of payments. ‘The achievement of this goal has been necessitated by the phenomenal growth in the world trade as against the growth of international liquidity (that’s the resources available to national monetary authorities to finance potential balance of payments deficits) It is also recognized that deficit in the balance of payment will retard the attainment of other goals. This is because a deficit in the balance of payments leads to a sizeable outflow of gold. But it is not clear what constitutes a satisfactory balance of payments position. Clearly a country with a netdebt must be at a surplus torepay the debt over a reasonably short period of time. But how is this satisfactory balance to be achieved on the trading aceount or what is the balance of payments target of a country?Trade-Off in Monetary Goals For the purpose of this course, the analysis of trade off in monetary Policy can be discuss with emphasis on Phillips curve and Freidman. jn hes 1976 Nobel lecture, “Inflation and Unemployment,” Milton Friedman (1977) traced out three ‘stages in the evolution of the Phillips curve. The first stage featured the simple curve in fig 1, showing 9 stable, negative relationship between inflation and unemployment. Peuae ¥ This suggests policymakers have a choice ee AE. between prioritizing inflation or a unemployment. ¥ Phillips curve analysis suggested there was trade-off, and policymakers could use demand management (fiscal and monetary policy) to try and influence the rate of ‘economic growth and inflation ¥ For example, if unemployment was high and inflation low, policymakers could stimulate agategate demand. ¥ This would help to reduce unemployment, but cause a higher rate of inflationTrade-Off in Monetary Goals The second stage featured Friedman's “natural rate hypothesis,” which he first described in his 1967 presidential address to the American Economic Association. In this stage, the short-run Phillips curve is adjusted for expectations and the long-run curve is vertical at the natural rate of unemployment (Friedman, 1968). An unexpected increase in inflation initially reduces unemployment. However, once workers and employers fully anticipate higher inflation, they will revise their plans and unemployment will return to its “natural” level consistent with equilibrium real wages and the overall structure of the labor market. fig 2, shows an increase in inflation from 0 percent to neues temporarily reduces unemployment below its long-run Fie. Erbe erin Abgeaten Pauses Conve “natural” level U, to U,, say from 4 percent to 3 percent. ‘The movement from point a to point b on the initial Philips curve (PC,) is posited on the assumption that the initial inflation rate is O percent. However, once the higher inflation rate is Fully recognized by market participants, unemployment will return to U, and PC, will become the relevant Phillips curve — provided ‘expected inflation remains at Y Points @ and c now lie on the long-run Phillips curve (LRPC), ‘where each point represents a state of full adjustment between actual and expected inflation. Thus, the fong-eun Phillips curve is verticalTargets of Monetary Policy There are three target variables for monetary policy. They are the money supply, availability of credit, and interest rates. Money Supply: So far monetary policy.is concerned, the central bank cannot directly control output and prices. So it selects the growth rate of money supply as an intermediate target Friedman suggests that the money supply should be allowed to grow steadily at the rate of 3 to 4 per cent per year for a smooth growth of the economy and to avoid inflationary and recessionary tendencies. Availability of Credit and Interest Rates: Availability of credit and interest rate are the other two target variables of monetary policy. Economists call them as money market conditions’ which refers to short-term interest rates and the banking system's —free reserves (that is ‘excess reserves minus borrowed reserves). The monetary authority can influence the short term interest rates. It can change credit conditions and affect economic activity by rationing of credit or other means. The monetary authority influences economic activity by following an easy or expansionary monetary policy through low and/or falling short term inter - contractionary monetary policy through high and/or rising short- ete clay eaeMonetary Aggregation *Monetary aggregates are 2 formal way of measuring the total sum/stock of money in a country. The monetary aggregates are conventionally denoted 25M, M,,M,, and M, in the and embody different meanings ‘*Apex banks use monetary aggregates to create monetary policies, given their ability to measure a nation’s financial stability and economic health.Mo: The amounts of currency in circulation, ‘cluding paper money and coin currency, it js also called narrow money af monetary M, The sum of all M, plus non-bank travelers’ checks and checkable deposits. My: repurchase agreements, and general- purpose, fund balances of broke money market, saving deposits, plus M,. Mg: Entails large deposits of over $100,000, agreements, balance in money market funds, and Eurodoliar deposits, plus M, It is important to note that since 2006, the Federal Reserve no longer tracks Ms, also known as a legacy aggregate, but it is still calculated by some analysts. Monetary Aggregation End includes money market shares, overnight | Paper money isa country's official, paper currency that is Circulated for the transactions involved in acquiring goods and services. Narrow money isa category of money supply that includes all physical money such as coins and currency, ‘demand deposits, and other liquid assets held by the central bank ‘A traveler's cheque is a medium of exchange utilized as an alternative to hard currency, CCheckable deposits is a technical term for any demand ‘deposit account against which checks or drafts of any kind may be written. Demand deposit account simply ‘mean account from which deposited funds can be withdrawn, Money market instrument shares is a kind of mutual fund that invests in highly liquid, near-term instruments ‘These instruments include cash, cash equivalent securities. A mutual fund is money pooled fommany investors, and invested in securities such ass bonds, and short-term debt by a company Eurodollar : US. dollar denominated deposits at foreign ‘banks or at the overseas branches of American barksTargets of Monetary Policy Cont’d Its Limitations: the use of interest rates and credit availability as target variables are beset with a number of difficu No doubt interest rates and the supply of credit influence spending. but it cannot be predicted with definiteness about the size and timing of the effects of any change in them. Y So far as interest rates are concerned, itis the real interest rate that matters and not the nominal interest rate. Y itis possible to control and observe the movements in the nominal interest rate and not inthe real interest rate because itis difficult to measure the expected rate of price inflation. When the monetary authority raises the nominal interest rate, the real interest rate will also rise other things being equal. But this does not happen always because when money interest rates are raised, the expectations of price inflation are growing. Y Under such circumstances, arise in the nominal interest rate may be associated with fall in the expected real rate. Thus the nominal interest rate isnot good target of monetary policy Y The use of credit availability as a monetary target is not helpful in monetary policy. Suppose there is reduetion in the availability of credit, it may be offset by credit flows through National bank of financial institution (NBFIs). / Morcover, it is dificult to predict the amount of reduction‘increase in the availability of credit.Targets of Monetary Policy end Intermediate Targets: money supply and interest rate are intermediate targets of monetary policy. In fact, they are competing targets. ‘The central bank can either aim at a certain rate of increase in the monetary supply or at a certain level of interest rate. It cannot adopt both the targets at the same time. ‘The money supply target means loss of control over the interest, while th target means loss of control over the money supply.Fist Quiz plementation in Nigeria. Discuss the strategies and effectiveness of monetary policy imee U Thanks for your time Remain blessed