Conduct of Monetary policy: Goals & Target

Content

 Defining monetary policy

 Goals of Monetary policy
 Tools of monetary policy
 Monetary Targeting
Defining Monetary Policy

 The term ‘monetary policy’ refers to the regulations of money Supply

and interest rates by a central bank, such as central bank of Sudan in
order to control inflation , and stabilize exchange rate in the economy.

 Moreover , monetary policy is the management of money supply and

interest rates by central banks to influence prices and employment.

 Monetary policy works through expansion (increase economic growth)

or contraction(slow economic growth) of investment and consumption
expenditure.
Goals of Monetary Policy
 1.High Employment
 2.Economic Growth
 3.Price Stability
 4.Interest Rate Stability
 5.Financial Market Stability
 6.Foreign Exchange Market Stability

Goals often in conflict

 1. High Employment
 High employment is a worthy goal for two reasons:
1. The alternative situation, high unemployment, causes much human misery,
with people suffering financial distress, loss of personal self-respect, and
increase in crime.
2. When u is high, the economy has not only idle workers but also idle resources,
resulting in a lower GDP.
2. Economic Growth

 The goal of steady economic growth is closely related to the goal of low u,
because businesses are more likely to invest in physical capital to increase
productivity and growth when u is low.
 If u is high and factories are idle, it does not pay for firms to invest in
additional physical capital.
 Hence, policies can be specifically aimed at promoting economic growth by
directly encouraging firms to invest or by encouraging people to save, which
provides more funds for firms to invest.
3. Price Stability
 In recent years, policymakers have become increasingly aware of the social
and economic costs of inflation and more concerned with a stable P as a goal
of economic policy. In fact, P stability is viewed as the most important goal
for monetary policy because:
1. Inflation creates uncertainty that may hamper growth .
2. Inflation makes it hard to plan for the future.
3. Inflation may damage a country’s social fabric (by creating conflicts between
different groups)
4. Extreme inflation, known as hyperinflation, leads to slower growth, as for
example in Argentina, Brazil, and Russia in the recent past.
4. Interest Rate Stability
 Interest-rate stability is desirable because fluctuations in interest rates can
create uncertainty and make it harder (for both firms and households) to plan
for the future.
5. Stability of Financial Markets

 Financial crises can interfere with the ability of financial markets to channel
funds from surplus to shortage units, thereby leading to a sharp contraction in
economic activity.
 The promotion of a more stable financial system in which financial crises are
avoided is thus an important goal for a central bank.
 The stability of financial markets is also promoted by i stability because
fluctuations in i create uncertainty for financial firms, affecting both their
profits as well as their net worth.
6. Stability in Foreign Exchange Markets
 The effect of exports and imports .
 Also, preventing large changes in Ex makes it easier for firms and people
involved in international trade to plan ahead.
 Stabilizing extreme movements in E in Ex markets is thus viewed as a worthy
goal of monetary policy.
 In fact, in countries that are even more dependent on foreign trade, stability
in FX markets takes on even greater importance.
Tools of Monetary Policy

 There are three basic tools of monetary policy including the following:
1. Open market operation
2. Discount loans
3. Changes in Reserve requirements
1. Open market operations

There are types of open market operations:

1. Open market purchase=central bank buys government securities to increase
the monetary base
2. Open market sales=central bank sells government securities to decrease the
monetary base. Thus , the central bank conducts open market operations by
buying and selling government securities especially treasury bills.
 Open market purchase and sales have permanent effects on the monetary base ,
but sometimes the central bank will want to change the monetary base only
temporarily.

 At this time it engage in two other types of transactions:

1. Repurchase Agreement(repo) = the central bank purchases government
securities with an agreement that the seller will buy them back (repurchase them) at
a specified price on a specified date , usually within one weeks.

 A repo is therefore like a temporary open market purchase, temporarily

increasing the monetary base.
2. Matched Sale-Purchase Transaction(reserve repo) = The central bank sells
government securities with an agreement that the buyer will sell them back at a
specified price on a specified date, again usually within two weeks.

A reserve repo is therefore like a temporary open market sale, temporarily

decreasing the monetary base.
Hence , in conducting monetary policy , open market operations have a number of
advantages:

 They are under the direct and complete control of the central bank
 They can be large or small
 They can be easily reversed
 They can be implemented quickly
2. Discount Loans

 When a bank receives a discount loan from the central bank , it is said to have
received a loan at the “discount window”. The central bank can affect the volume
of discount loans by setting the discount rate:

 A higher rate makes discount borrowing less attractive to banks and will
therefore reduce the volume of discount loans. A lower discount rate make
discount borrowing more attractive to banks and will therefore increase the
volume of discount loans.
Discount lending is most important in financial panic;

 When depositors loss confidence in the financial system , they will rush to
withdraw their money

 This large deposit outflow puts the banking system in great need of reserves.

 The central bank stands ready to supply these reserves by making discount loans

 In such situations , the central bank acts as al ender of last resort.

 Advantages of discount loans; they allow the central bank to act as a lender of
last resort during a financial panic.
 Disadvantages of using discount loans as a tool for monetary policy during
normal times;

 The volume of discount loans can be influenced by the central bank , but not
completely controlled:
 The central bank can not be sure how many banks will request discount loans at
any given interest rates.
 Changes in discount rate must be proposed by central bank before being
approved by the Board of Governance.

 Hence, they are neither quickly made nor easily reversed.

 3. Changes in reserve requirement

Changes in the required reserve ratio can lead to changes in money

supply.

Disadvantages to using changes in reserve requirement as a tool

foe monetary policy:
 Large changes in reserve must be approved by Congress ,Hence,
large changes cannot be made quickly and easily
 Also , if a bank holds only a small amount of excess reserve and
the required reserve ratio is increased , the bank will have to
quickly acquire reserves by borrowing ,selling securities, or
reducing its loans.
 Hence, changes in reserve requirements can cause problems for banks by making
liquidity management more difficult.

 Finally , open market operations are by far the most effective tool with which the
central bank can conduct monetary policy on day-to day basis.

 Thus in practice, the central bank relies heavily on open market operations in
conducting monetary policy.
 Monetary targeting

 Since the central bank cannot control employment, economic

growth, and inflation directly, it must choose settings, or targets
for variable that it can control in order to best achieve its goals

 In practice, the central bank has a choice between two types of

targets: 1. money supply targets 2. Interest rate targets.