CHAPTER

MONETARY
POLICY
6:
FINANCIAL MARKETS
OBJECTIVE
S:
• Discuss the concept of monetary policy.
• Converse the objectives and instruments of monetary policy.
• Identify the tools of monetary policy.
• Discuss the effects of expansive and restrictive monetary policy
• Reiterates the approaches of monetary policy.
 CONCEPT OF MONETARY
POLICY
A component and instrument of macroeconomic policy is monetary policy.
It is a collection of measures and policies that use tools of monetary or currency
policy to achieve the necessary goals. Money and the central bank-controlled money
supply will be interpreted. In this work, we define currency policy as interventions on
foreign exchange markets (for the goal of changing foreign exchange prices) while
monetary policy is understood to refer to changes in the
money supply and fundamental interest rates.
The main objective of monetary policy, a tool of the central bank, is to
actively monitor and affect the rate of inflation. The Czech National serves as the
country's central bank. Maintaining price stability is the CNB's primary goal. The
central bank employs a variety of tools to carry out its monetary policy objectives,
which have an impact on both the operation of specific commercial banks and the
state's entire economy.
 OBJECTIVES AND INSTRUMENTS OF MONETARY
POLICY

To establish monetary policy, a number of prerequisites must be met. It is

necessary to first construct a two-tier banking system (the central bank and a
network of commercial banks), develop a money and capital market, and enable
international payments if the central bank conducts operations on foreign exchange
markets. The integration processes have an impact on how important monetary
policy is as well. The gear mechanism, which refers to the tools of monetary
policy's impact on aggregate supply and demand, allows for the modification of
fundamental macroeconomic variables.
As seen in the following graphic, the central bank's monetary policy affects two
fundamental macroeconomic goals: employment and price stability.
The central bank uses various monetary policy tools to influence targets
(employment and price level). These tools are divided into direct (administrative)
and indirect (market).

l. Direct (administrative) instrumentssignify a direct central bank intervention in the

banking system. Usually utilized to a lesser degree than the indirect tools. These tools
include
:
• Liquidity Rules -establish the legally required structure of assets and liabilities for
commercial banks.
•
Credit contingents (limits) -Absolute credit limits set the maximum amount of loans
that commercial banks may make to businesses, whereas relative credit limits set the
maximum amount of loans the central bank may make to commercial banks.
•Mandatory deposits -take the form of keeping state institution accounts
open and only conducting transactions through the Central Bank.

• Recommendations, challenges and agreements -while agreements are

written down and detail the regulations reached between the central bank and
commercial banks, recommendations and challenges are the unwritten
expression of the central bank's requirements.
ll. Indirect (market) instruments are available to all commercial banks and must be utilized in
accordance with market principles. The main indirect instruments include:

• Reserve requirements (RR) –Commercial banks are required to keep a predetermined

amount of their deposits on deposit at the central bank or in cash as part of their
reserve requirements (RR). The ability of commercial banks to lend money is impacted by
reserve requirements. The amount of money in the economy changes depending on the
growth (reduction) in RR.

•Open market operations (OMO) –are transactions between the central bank and
commercial banks that involve the sale and acquisition of treasury assets (such as
government bonds). The money supply is decreased if the central bank sells government
securities to commercial banks. The amount of money in circulation is increased if the
central bank purchases government securities from commercial banks.
• Discount rate –is often the minimum interest rate at which commercial banks can get loans
from the government's central bank. This instrument has an impact on the money supply. The
amount of money in circulation decreases as the discount rate rises, and vice versa. The
commercial banks' reliance on the resources of the central bank has an impact on this tool's
efficacy. Through an automated facility, the CNB compensated commercial banks for their
surplus liquidity at the discount rate (deposit liquidity overnight).

• Lombard rate –is the interest rate charged on loans made by commercial banks in
exchange for pledged securities. The money supply in the economy is reduced by raising the
Lombard rate, and vice versa.

• Re-rebate bills –are promissory notes that commercial banks can sell to the central bank
after they have previously been repurchased by economic operators. In this situation,
commercial banks enhance liquidity, which tends to increase the amount of money in the
economy.
• Currency conversion and swap transactions –involve the central bank and commercial banks
buying or selling foreign currency for local currency. Conversion in this context refers to the
act of purchasing (selling) foreign currency at the going rate without consenting to the
reversal of the transaction. The term of the reverse operation and the future exchange rate
are agreed upon in the case of swaps. Exchange rates are impacted by these operations. A
central bank's sale of foreign currency will result in a reduction in the amount of domestic
currency in circulation, while its purchase of foreign currency will result in an increase.

•Operations at the international foreign exchange market –carried out by the central bank
in order to influence the exchange rate. The foreign trade and currency policy includes
these operations.
 THE EFFECTS OF EXPANSIVE AND RESTRICTIVE MONETARY
POLICY

There are two types of monetary policy -expansive and restrictive.

1.Expansive type –is identified by an increase in the amount of money in the
economy.

2.Restrictive type –is the result of restrictive monetary policy. The effects of
both monetary policies are felt in the overall demand (AD).

In order monetary
for an expansionary to promotepolicy.
the rise of aggregate
Uncertainty demand,the
surrounds theoutcome
central bank
of opts

expansionary monetary policy.

Depending on the state of the economy, it is important to differentiate between different
time periods. Since the aggregate supply curve over the long run is vertical and the increase in
aggregate demand only affects the level of prices, the long-term behavior of money is neutral,
which means that monetary expansion has no effect on the real product. The economy's
ability to produce at its full potential or whether there is an output gap also play a role in this.
The output growth in the second scenario outpaces the rise in price levels.

The unwillingness of commercial banks, which do not increase the volume of loans in
response to interest rate cuts, or negative expectations, when businesses do not expect things to
get better, can also have an impact on the effect of monetary expansion. As a result, falling
interest rates might not affect the increase in consumption and investment activity, which will
then increase aggregate demand and output.
 WHAT DOES A FREQUENTLY USED TERM “QUANTITATIVE EASING“ (QE)
MEAN?

We hear that central banks have employed quantitative easing as the

economy is contracting. In this case, standard monetary policy tools are insufficient
to stimulate the economy (base interest rates, for example, cannot be lowered), so
central banks are looking for alternative ways to stimulate the economy. The main
goal is to enhance the monetary basis (strong money) through multiplication,
which will increase the amount of loans made and the expansion of the money
supply
.
QE in other words means unconventional expansionary monetary policy which may be
implemented in the following ways:

•purchase of financial assets of the central bank from commercial banks or other financial
institutions (extension for trading assets, and entities the central bank trades with);

•lessening in setting the conditions under which the central bank lends funds to commercial
banks, softening the conditions for loans provided to the banking sector;

•purchase of foreign assets; it will increase the money supply and weaken domestic currency;

•subordinating of monetary policy to the government, when the central bank finances fiscal
expansion (purchases of government bonds by the central bank).
 The recent financial crisis in the US has been frequently expressed through
quantitative easing. Economic slump and deflationary trends are reasons given by central
banks for implementing quantitative easing. Only economies with complete control over
their national currency and money supply are eligible to implement quantitative easing.

In specifically, a central bank adopts a restrictive monetary policy to lower inflation

by reducing the money supply and, as a result, lowering aggregate demand. The impact of
monetary restrictions on time and economic circumstances intensifies. In the long run,
monetary limitation lowers the price level but has no effect on real output or employment.
Contrary to the intended outcome of monetary restraint (lowering inflation), there can be
some favorable expectations among economic actors or the
chance to buy more affordable loans elsewhere.
 EFFECTS OF EXPANSIONARY MONETARY
POLICY
1 In the short run: declining interest rates will lead to an increase in the spending of
. economic agents who are interest rate dependent, particularly investment,
consumption, and government spending, leading to an increase in AD, an
increase in product (Y), an increase in employment, and an increase in price
levels; if the economy is in the output gap, product growth will be greater than
price level growth.
2 In the long run: just the price level will expand; actual factors like real output
. or real wages won't be impacted.
 EFFECTS OF RESTRICTIVE MONETARY
POLICY
1 In the short run: falling employment and prices are caused by falling
. employment, rising interest rates, and decreasing consumption, investment, and
government spending; if the economy is in the output gap, the product decline is
bigger than the price level drop.

2 In the long run: the effects only include a drop in the price level; they have no
. impact on real variables, such as real output or real salaries.
 APPROACHES TO MONETARY
POLICY
Attitudes of the implementation of monetary policy of economic trends are not
uniform. There are two approaches to the implementation of monetary policy: the
Keynesian and monetarist
l. The Keynesian approach of monetary policy –serves as the foundation for the Keynesian
approach to monetary policy. The main goal of economic (and monetary) policy is to boost
employment, and the economy should be in the output gap. The Keynesian approach places
a strong emphasis on the interest rate's function as an intermediate monetary policy objective
that influences output and employment. The Keynes transmission mechanism describes the
relationship between interest rates and total demand.
The following steps make up the process:

TheinCB
an increase decisioninvestment,
consumer, or an increase in the moneyexpenditure
or government supply that that
lowers interest rates
is influenced by leads to
interest rates. This increase in aggregate demand leads to output growth and lowers
unemployment.

Thebeen
rates have unpredictable
challengesdemand for money
for Keynesians. Weand increased sensitivity
acknowledged to variations
that the central in interest
bank cannot
manage both the money supply and interest rates at once. According to Keynesians, the
central bank should keep an eye on the target interest rate. It was a tenet of Keynesian
macroeconomics that an expansionary monetary policy, manifested as low interest rates,
would boost output and employment.
ll. Monetarist approach –is founded on the traditional idea of macroeconomic equilibrium. Its
backers predicated a steady demand for money and low interest rate sensitivity. The impact of
liquidity was contested by monetarism (i.e. the growth in money supply will reduce interest
rates).

Therefore, monetarists favor steady, expected monetary growth that is followed by

consistent real output growth. They both agreed that the money supply criterion should be the
central bank's top concern. The primary proponent of monetarism, American economist and
Nobel laureate in economics Milton Friedman, established the maxim that the money supply
should rise in proportion to potential GDP growth (roughly between 3 and 5 percent). To achieve
the objectives, monetary policy must be coordinated with other policies,
particularly fiscal policy, and is not undertaken in a vacuum. To stabilize the economy, a suitable
combination of monetary and fiscal policy, or "policy mix," is required.
 Thank
For Your
You Attention ☺