EC 127 Monetary Policy and National Output

EC 127 Introductory Macroeconomics II
Topic 2
Monetary Policy and

National Output
J. Mtui
May 2019
1.General Economic Policy
 A set of policies are principles, rules, and
guidelines formulated or adopted by an
organization to reach its long-term goals
 Economic policy refers to actions that
governments take in the economic field.
 It covers the systems for:
◦ setting interest rates and government budget
◦ the labour market,
◦ national ownership, and
◦ many other areas of government interventions into the
economy.
◦ Etc.
General Economic Policy
 Such policies are often influenced by international
institutions like:
◦ the IMF or World Bank,
◦ WTO,
◦ WHO,
◦ EAC,
◦ SADC, etc.
◦ as well as political beliefs and the consequent policies of
parties.
Types of economic policy
 A few example of types of economic policy include:
◦ Macroeconomic stabilization policy tries to keep the money
supply growing, but not so quick that it results in excessive
inflation.
◦ Trade policy refers to tariffs, trade agreements and the
international institutions that govern them.
◦ Policies designed to create Economic growth
 Policies related to development economics,
◦ Redistribution of income, property, or wealth
◦ Regulation
◦ Anti-trust (competition laws) they ensure that fair competition
exists in an open-market economy
◦ Industrial policy
◦ Technology-based Economic Development Policy
Economic policy…
 Macroeconomic stabilization policy
 Stabilization policy attempts to stimulate an
economy out of recession or constrain the
money supply to prevent excessive inflation.
◦ Two types of policies are used:
 Fiscal policy
 Monetary policy
Economic policy…
◦ Fiscal policy, often tied to Keynesian

economics, uses government spending
and taxes to guide the economy.
 Fiscal stance: The size of the deficit o Tax policy:
 The taxes used to collect government income.
 Government spending on just about any area of
government •
 Incomes policies and price controls that aim at
imposing non-monetary controls on inflation
Economic policy…
 Macroeconomic stabilization policy
◦ Monetary policy controls the value of currency
by lowering the supply of money to control
inflation and raising it to stimulate economic
growth. It is concerned with the amount of
money in circulation and, consequently,
interest rates and inflation.
 Interest rates, monitored by the central bank
 Reserve requirements which affect the money multiplier
Economic policy…
 Tools and goals
◦ Policy is generally directed to achieve particular
objectives, like targets for inflation, unemployment,
or economic growth. Sometimes other objectives,
like military spending or nationalization are
important.
 These are referred to as the policy goals: the
outcomes which the economic policy aims to
achieve.
Economic policy…
 To achieve these goals, governments use policy
tools which are under the control of the
government.
◦ These generally include the interest rate and money
supply, tax and government spending, tariffs, exchange
rates, labour market regulations, and
◦ many other aspects of government.
Economic policy…
 Selecting tools and goals
◦ Government and central banks are limited in the
number of goals they can achieve in the short term.
 For instance, there may be pressure on the government
to reduce inflation, reduce unemployment, and reduce
interest rates while maintaining currency stability.
 If all of these are selected as goals for the short term,
then policy is likely to be incoherent, because a normal
consequence of reducing inflation and maintaining
currency stability is increasing unemployment and
increasing interest rates.
2.Background to monetary policy
in East Africa
 The East African Currency Board (EACB)
◦ Established by the British colonialists in 1919.
 Major objective (initially) was
◦ to supply/issues and control its own currency (the EA
shilling) in the E.A.
◦ Fixed the exchange rate, between the Boards’ currency
and pound (GBP)
◦ To control currency in East African States. It could
increase currency in circulation by exchanging with GBP
i.e. Thus currency issuance undertaken only if fully
backed with pound sterling
 EACB required to hold reserves in sterling, more
than 100% cover.
Background to monetary policy…
 EACB achievements
◦ The EACB had two main achievements:
 Ensured continuous convertibility of the shilling
– CONFIDENCE
 No room for inflationary financing (money
supply was strictly tied to foreign assets)
 Setbacks of the EACB
◦ Failure to expand domestic credit.
◦ Domestic money supply governed by foreign
trade.
◦ Lack of monetary sovereignty for states with
different levels of economic development
◦ High cost of holding high levels of sterling
reserves
 Reorientation of EACB functions
 The changes
◦ Headquarters of the Board were moved from

London to Nairobi.
◦ Limited government borrowing allowed since 1955.
◦ The “lender-of-last-resort function”, introduced
(bankers to banks).
◦ Crop financing facility was introduced in 1961
◦ 1962 the Board started a clearing system for
commercial banks
◦ Representatives from member countries appointed
to the Board.
 Following independence in 1961 Tanzania
commissioned a study on the operations of EACB. It
recommended that:
◦ The EACB be converted to East African Central Bank.
◦ The individual states establish smaller country central
banks,
◦ BUT: The E.A. authorities considered the idea unfeasible.
 1966, the Board was dissolved paved the way to the

respective central Banks and country’s currencies
Monetary Policy making in East Africa
1st Generation Central Banking
 New central banks started operations in a
background of:
◦ a low growth in money supply,
◦ low domestic credit, and
◦ rapid capital flight.
 Policies
◦ Policies directed towards direct controls –
◦ Stringent exchange controls.
◦ Directed credit – especially to agriculture
◦ Preferential interest rates set by CBs.
1st Generation Central Banking…
 Characteristics of the 1st generation CBs
◦ Excessive government borrowing from central
banks.
◦ Accumulation of bad debts by commercial banks.
◦ Very evident in Tanzania and Uganda .
◦ Lack of serious supervision of financial
intermediaries
◦ Financial repression .
 Characteristics of the 1st generation CBs
 Also…
◦ Multiple policy objectives:

◦ development financing,
◦ export promotion,
◦ guarantees to priority sectors, etc.
 Impacts:
◦ High levels of inflation.
◦ Negative real interest rates.
◦ Large parallel markets.
◦ Increase in cash transactions – weaknesses in the
formal financial system.
2nd generation Central Banking (CB)
 Between early 1980 and early 1990s:
 Deliberate efforts to free the economies from:
◦ financial repression,
◦ state controls, and
◦ introduction of market economy/free market.
 Laid the foundation for the introduction of
indirect instruments of monetary
management.
2nd generation CB…
 Early period
 Marked with:
◦ expansionary fiscal policies,

◦ automatic central bank accommodation,
◦ high growth in money supply,
◦ high inflation, and
◦ absence of central bank independence.
 Measures
 Interest rates were raised towards positive
real rates.
 Introduction of ceilings on government
borrowing.
 Frequent devaluations – to restore value of
currency.
 Structural measures to eliminate controls in
the foreign exchange market.

 Adoption of indirect instruments
 After 1994, central banks in E. Africa moved
towards:
 Total abolition of controls.
 Adopting indirect instruments.
 Liberalization of financial sectors, esp. –
Tanzania and Uganda

 Central Bank pushed for:
 Single policy objective – PRICE STABILITY
 Greater independence.
 Monetary targeting is the means towards
stabilization.
 Hence…
 Reserve Money Programming.
 Open Market Operations – the primary instrument.
 Treasury bill auctions – anchor for market rates.
 Competitiveness in the banking stepped up.
Monetary Policy in Tanzania
 Establishment of the Bank of Tanzania (BoT)
 Established 1966 by Act of Parliament.
◦ To perform all traditional functions of central

banking.
◦ It was required to operate under indirect
instruments.
 The Arusha Declaration 1967 – Socialism
◦ The BOT reoriented its functions.
◦ Indirect instruments were suspended.
◦ Direct Instruments introduced.
Monetary Policy in TZ…
 This led to…
◦ The creation of Annual Finance and Credit Plan
(AFCP),
◦ administered interest rates and
◦ Foreign Exchange Plan (FEP).
The 1978 Amendment of the BoT Act
◦ To enable the BoT to address development
problems
 The BoT established special funds
◦ Rural Finance Fund.
◦ Industrial Finance Fund.
◦ Export Credit Guarantee Fund.
◦ Capital and Interest Subsidy Fund.
 Rapid money supply growth
◦ Increased monetization of Government deficit.
◦ Increased financing of agriculture.
◦ Increased financing of state parastatals.
 The new 1995 BoT Act
◦ A move away from multiple policy objectives.
◦ To single policy objective – PRICE STABILITY.
◦ The implementation of monetary policy through
indirect instruments.
◦ Increased autonomy of the central bank.
Implementation of Monetary Policy Under the
New BoT Act
 Objectives of monetary policy in Tanzania
◦ Primary objective – PRICE STABILITY.
◦ Secondary Objectives:
 financial stability,
 adequate reserves to facilitate intervention,
 efficient financial markets,
 realistic interest rates (at least above inflation),
 increase in credit consistent with growth and money
supply targets.
Monetary Policy the New BoT Act…
 Implementation of monetary policy
 Two issues:
1. Set targets
2. Choose instruments
 SETTING THE TARGETS
 There are three levels of targets:
1. Operating Target.
2. Intermediate Target.
3. Final Objective/Target.
Monetary Policy: the New BoT Act…
 Operating Target.
◦ Is a variable easily controlled by the central bank
 BoT uses Reserve Money as operating variable/target.
 Reserve Money is also called: – Base Money or High-
powered Money. – Monetary Base.
 The Intermediate Target

◦ Is a quantifiable target, highly influenced by the
Operating Target and closely linked to the
Ultimate/Final Target.
◦ BoT uses M2 as intermediate target
Monetary Policy -the New BoT Act…
 Instruments of monetary policy
◦ Direct instruments
 Mandatory monetary limits set by the central bank, in
order to attain certain policy objectives
 Applied by BoT in the past
 Such as credit ceilings, fixed interest rates, fixed
exchange rates, etc. •
◦ Indirect instruments
 Central bank operations, which influence money supply
indirectly
 Current policy is indirect instruments
◦ As a country’s markets expand, direct controls
become less effective.
◦ Markets can easily find a way around direct
controls.
 Instruments used in Tanzania include:
◦ Open market operations (OMO).
◦ Reserve requirements.
◦ Discount policy.
◦ Foreign-exchange market operations.
◦ Repurchase agreements.
◦ Moral suasion.
◦ Gentlemen's agreement.
◦ Deposit policy
 These instruments affect the supply of money
through changing either the stock of reserve
money or the money multiplier.
 Open market operations (OMO)
◦ OMO are the principal policy instrument used by
the BOT.
◦ They operate on the cash reserve position of the
banking system,
◦ They influence the supply and demand for reserve
(central bank) money.
◦ Expansionary vs contractionary policy
 Repurchase agreements (REPOs)
◦ Used for fine tuning
◦ REPO is a form of short-term borrowing, e.g. a
dealer sells securities to government/central
bank/investors, usually on an overnight/7or 15day
basis, and buys them back the following day/after 7
or 15 days.
 Reserve requirements
◦ Traditionally used by central banks for monetary
control.
◦ Affect the proportion of assets that banks are
required to hold, hence their ability to expand
liquidity.
◦ Currently the requirement is 8% (from March 2017)
of all deposit liabilities (including foreign currency),
but excluding vault cash.
 Discount policy
◦ Imposes limitations on access of banks and
Government to borrowing from the central bank,
◦ where discount rate is charged
◦ the discount policy is very restrictive.
 Discount rate was reduced from 12% in August 2017 to
9% and further to 7% in August 2018
 Signaling expansionary policy
 Foreign-exchange market operations.
◦ Foreign Exchange Market interventions
◦ Foreign exchange intervention is conducted by the
central banks to influence foreign exchange rates
by buying and selling currencies in the foreign
exchange market.
◦ Foreign exchange intervention is intended to
contain excessive fluctuations in foreign
exchange rates and to stabilize them.
 Moral suasion
◦ Attempts by the central bank to influence the behavior of
market players.
◦ Sometimes applied in Tanzania, to persuade commercial
banks to apply prudence in setting deposit and lending
rates.
 Gentlemen’s agreements
◦ Voluntary agreements between the central bank and
economic agents aimed at improving monetary conditions
in the economy.
◦ Once used between the Bank and the largest commercial
bank on interest rates.
 Need for
◦ Effective implementation of monetary policy
requires a framework to manage the supply of
money.
 In Tanzania
◦ MONETARY TARGETING Framework is used.
◦ Done by controlling reserve (high powered, or base)
money.
◦ Through reserve money programming.
 Control of reserve money by the central bank
◦ The central bank controls money supply by
controlling the monetary base or reserve money,
given that: MS = m.MO
where MS = Money supply
m = Money multiplier
MO = Reserve money
 Basically, this is done by controlling the
Central Bank Balance Sheet
 Procedure
◦ Get the macroeconomic targets of GDP and inflation.
◦ Determine MS growth, which is consistent with
growth and inflation targets.
◦ This is based on the Exchange Equation, MV = PQ
◦ M = M3, V= money velocity, P = CPI inflation , Q =
GDP
 Therefore:
◦ ΔM3 + ΔV = ΔP + ΔGDP
◦ Assuming a constant velocity for money,
◦ ΔM3 = Δ real GDP+ inflation (CPI inflation)
 Suppose you are given
◦ Real GDP growth target = 7%
◦ Inflation rate target = 5%
◦ What will be the growth of M3 or M2???
 Recall MV = PY
 log linearize M+V=P+Y
◦ Then ΔM3 = ΔP + ΔGDP

◦ What is the answer??
 Implementation of the programme Monthly:
◦ Monetary Policy Committee meeting held at end of
each month.
◦ Estimated liquidity position at close of month is
made.
◦ Comparisons with programmed liquidity for the
period instruments to mop up (or inject) liquidity are
suggested/approved.
 Same procedure followed for weekly and adily
programmes.
 Policy implementation and co-ordination:
 Facilitated through:
◦ the Monetary Policy Statement (MPS),

◦ the Monetary Policy Committee (MPC),
◦ The MPC Subcommittee,
◦ Daily Management internal consultations. [Daily
liquidity forecasting]
 The MPS (contents)
◦ Policy document by the central bank, tabled at the
National Assembly.
◦ Reviews performance of the macro-economy.
◦ Performance of monetary policy.
◦ Monetary policy objectives for coming year (in line
with macroeconomic objectives).
◦ Monetary policy instruments to be employed.
 The MPC
◦ Meets monthly to agree on monetary policy targets and
instruments. Members are:
◦ Governor (Chairman),
◦ Permanent Secretaries - Treasury (Z’Bar & Mainland),
◦ 2 Directors of the Board,
◦ Treasury Commissioner for Policy and the Accountant-
General,
◦ BoT Research and Markets staff.
 The MPC Subcommittee

◦ Meets weekly.
◦ Chaired by Governor.
◦ Research and markets staff.
 Monetary policy transmission mechanism
◦ Is the process by which changes in monetary policy affects
aggregate income and then demand
 Channels of monetary policy (assume expansionary
monetary policy i.e. increase in money supply)
◦ Interest channel
 M↑; i↓; I↑; Y↑
 where M, i, I and Y stands for money supply, nominal interest
rate, investment and income/output, respectively
◦ Asset price channel
 M↑, Pe↑, I↑, Y↑
 Pe is the price of financial assets (equity, bonds, T-bills,
etc.)
◦ Wealth channel
 M↑, Pe↑, W ↑, C ↑, Y↑
 W and C are wealth and consumption, respectively
◦ Credit channel
 M↑, i↓; Loans ↑, (G ↑ and I↑) they Y↑
 G is government expenditures
 Practical Limitations of monetary policy
implementation in Less Developed countries
(LDCs)
◦ Low control of government expenditures (especially in
LDCs) which creates huge budget deficits –financed by
printing money
◦ Narrow organized financial markets –common in LDCs
◦ Financial dependence –LDCs often can not stand on their
own due to low tax base, poor tax administration,
corruption all these lead to less revenue collection
◦ Lack of central bank independence in LDCs
Structure of Financial System in
Tanzania
 The financial system in Tanzania (just like other
LDCs) constitutes of two major types of financial
institutions, namely i) banks and ii) non-bank
financial intermediaries
◦ Banks
 A bank is defined as a financial institution authorized to receive
money on current account subject to withdrawal by cheque.
◦ Non-bank financial intermediaries (NBFIs)
 Is defined as any person/institution authorized under the
Banking and Financial Institutions Act (1991) to engage in
banking business not involving the receipt of money on current
account subject to withdrawal by cheque
◦
Structure of Financial System…
 Roles of Financial Sector in any economy
◦ The financial sector consists of commercial
banks, non-bank deposit taking financial
institutions and other financial institutions.
 The following are the roles of financial
sector in any economy:
◦ Financial Intermediation
 Deposits mobilization
 Channeling resources to profitable users through
extension of affordable credits
◦ Opportunities for savings
◦ Facilitate payments
 Clearing and settlement of financial claims
◦ Risk management
 Risk sharing through investments diversification,
insurance and hedging
◦ Exerting corporate control
 Lenders monitor performance of their borrowers to
alleviate risk of mismanagement of resources
Figure 1: Financial Superstructure of Tanzania in early 1970s
BANK OF TANZANIA
Commercial Near banks & other savings Insurance & Statutory Development finance comp.
Banks (NBC, PBX, mobilizers (NBC, PBZ, CRDB, contractual savings (TDFL, TIB, CARATHA, THB,
CRDB THB POSB DJIT) CRDB, DJIT etc.)
(NIC, NPF)
Operations of the Savings mobilization Finance development

payment system (mainly domestic) (plus external savings
mobilization)
Where
NBC –National Bank of Commerce
PBZ –People’s Bank of Zanzibar
CRDB–Cooperative Rural Development Bank
THB –Tanzania Housing Bank
POSB –Postal Office Savings Bank
DJIT –Diamond Jubilee Investment Trust
NIC –National Insurance Corporation
NPF –National provident Fund
TIB –Tanzania Investment Bank
TDFL –Tanganyika Development Finance Co. Ltd
KARADHA –is a subsidiary of NBC
 Since 1960s banking and non-banking sector in
Tanzania was characterized by
◦ Increase of players
◦ Changes in structural composition dictated by shift in policy
regime
 Eg. Between independence in 1961 to 1967 (Arusha declaration)
there were only 7 NBFIs
 Over the period 1967 to 1991 financing the public sector
 Financial repression undermined the performance of banks and
NBFIs to economic growth
 Recommendations of Nyirabu Commission (formed 1988) led to
significant legal, structural and organizational reforms in the
financial sector in Tanzania during 1991 – 2012 period
 d
 Set of reforms
◦ Banking and Financial Institutions act 1991
 Lift entry restrictions to local and foreign participants
◦ The Loans and Advances Realisation Trust Act
(LART) 1991
◦ The Foreign exchange Act of 1992
 To liberalize foreign exchange markets
◦ Parastatal Sector Reform Commission established
in 1993
◦ The CMSA 1994
 Mobilize savings for medium and long term investments
◦ The Bank of Tanzania Act in (1995)
End of the Topic

EC 127 Monetary Policy and National Output

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EC 127 Monetary Policy and National Output

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EC 127 Introductory Macroeconomics II

Monetary Policy and

◦ Fiscal policy, often tied to Keynesian

◦ Headquarters of the Board were moved from

 1966, the Board was dissolved paved the way to the

◦ Multiple policy objectives:

◦ expansionary fiscal policies,

the foreign exchange market.

Tanzania and Uganda

◦ To perform all traditional functions of central

 The Intermediate Target

◦ Then ΔM3 = ΔP + ΔGDP

◦ the Monetary Policy Statement (MPS),

 The MPC Subcommittee

Operations of the Savings mobilization Finance development

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