The Conduct of Monetary Policy:

Monetary Theory
Strategy and
o It is based on the idea that a change in money
supply is the main driver of economic activity.

Quantity Theory of Money Tactics

• It is a theory that variations in price relate o Price Stability in an economy means that the
to variations in the money supply. general price level in an economy does not
COMPONENTS: change much over time…
➢ High employment and output stability
➢ Volume of currency in circulation ➢ Economic growth
➢ Velocity of circulation ➢ Stability of financial markets
➢ Volume of bank deposits ➢ Interest rate stability
➢ Velocity ➢ Stability in foreign exchange market
➢ Volume of trade
Full Employment
Fisher’s Equation of Exchange
• When all available labor resources are
MV + M¹ V¹ = PT being used in the most efficient way
M = money possible.

V = velocity of circulation
P = average of level of prices
T = quantity of goods and services

KEYNESIANS
John Maynard Keynes
• Rejected the direct relationship between M
and P, as he felt it ignored the role of
interest rates.
• His theory emphasized that velocity (V) is
not constant or stable, but can swing widely
based on optimism or fear and uncertainty
about the future, which drives liquidity
preference.
• Keynes believed inflationary policies could
help stimulate aggregate demand and boost
short-term output to help an economy
achieve full employment. Phillips Curve
• An economic concept developed by A.W
Phillips stating that inflation and
unemployment have a stable and inverse
relationship.
Fiscal Stimulus TROUGH

• Reduce the tax or increase their spending ➢ This is when an economic contraction
to add or inject more money into the hits nadir.
circulation.
Financial Stability
BENEFITS OF FULL EMPLOYMENT:
• It is a condition in which an economy's
➢ Reduced poverty if all workers have mechanisms for pricing, allocating, and
access to work at or above the managing financial risks (credit, liquidity,
prevailing rate of compensation counterparty, market, and so forth) are
➢ Improved wages and working conditions functioning well enough to contribute to the
as employment must complete for performance of the economy.
workers
➢ Preventing the unemployed from
becoming demotivated or losing
valuable skills
➢ GDP growth as workers are able to MNC – multinational corporations
afford goods and services
➢ Reduction in government spending on o When central bank lowers interest rates,
employment benefits and welfare monetary policy is easing. When they raise
programs. interest rates, monetary policy is tightening.
➢ Less government borrowing due to FACTORS INFLUENCING FOREIGN EXCHANGE
increased revenue from income taxes
RATE FLUCTUATIONS:
GENERATING ECONOMIC GROWTH:
➢ Interest rates and central bank policies
➢ An increase in the amount of physical ➢ Economic indicators (employment, price,
capital goods in the economy inflation)
➢ Technological improvement ➢ Political stability and geopolitical events
➢ Grow the labor force (government)
➢ Increase in human capital ➢ Market speculation and investor
sentiment
Economic Cycle ➢ Interconnectedness of factors

• The fluctuations of the economy between Inflation Targeting

periods of expansion (growth) and
contraction (recession). • Policy measure of central bank to control
rate of and money supply at the
EXPANSION macroeconomic level.
➢ During this phase, employment, income,
industrial production, and sales all
increase, and there is a rising real GDP.
Inflation
Targeting
PEAK
➢ This is when all economic expansion hits
its ceiling.
o A monetary policy strategy aimed at
CONTRACTION maintaining inflation at a specific target level.
o PURPOSE: to provide a clear framework for
➢ During this phase, the elements of an
expansion all begin to increase. monetary policy (expansionary) and…
KEY FEATURES: KEY COMPONENTS:
➢ EXPLICIT TARGET: central banks set a • Interest Rate Channel
specific inflation rate. ➢ Mechanism: changes in the central
➢ TRANSPARENCY: central banks bank's policy rate influence short-term
communicate their targets and policy interest rate.
decisions. ➢ Effects: lower interest rates reduce
➢ ACCOUNTABILITY: regular reports on borrowing costs, encouraging
inflation outcomes and policy investment and consumption. Higher
adjustments. rates have the opposite effect, slowing
MECHANISMS: down economic activity.
• Credit Channel
➢ INTEREST RATE ADJUSTMENT: central ➢ Affects the availability of credit in the
banks raise or lower interest rates to economy.
influence economic activity.
➢ Key Points: monetary policy impacts
➢ EXPECTATIONS MANAGEMENT: bank lending and the credit worthiness
communicating… of borrowers. Easier credit conditions
BENEFITS: stimulate spending and investment;
tighter conditions restrict them.
➢ STABILITY: reduces uncertainty and • Exchange Rate Channel
anchors. ➢ Changes in interest rates influence
➢ FLEXIBILITY: allows for adjustments currency exchange.
based on economic conditions. ➢ Effects: a weaker currency makes
➢ CREDIBILITY: builds trust in central bank exports cheaper and imports more
policies. expensive, boosting domestic demand. A
CHALLENGES: stronger currency has the opposite
effect, potentially dampening economic
➢ RIGIDITY: overemphasis on inflation can activity.
neglect other economic objectives. • Expectations Channel
➢ MEASUREMENT ISSUES: difficulty in ➢ Role of Expectations: influence how
accurately measuring inflation. businesses and consumers perceive
➢ TIME LAGS: delays between policy future economic situations.
implementation and effect on inflation. ➢ Key Points: forward guidance from
Monetary Policy’s central banks can shape expectations
about future interest rates and

Transmission
economic growth. Positive expectations
can lead to cautious spending.
CHALLENGES:
Mechanism ➢ TIME LAGS: delays between policy
implementation and observable effects
on the economy.
o The process through which monetary policy ➢ UNCERTAINTY: economic conditions,
decisions affect the economy, and ultimately, global influences, and consumer
the price level and output (employment and behavior can complicate the
economic growth). transmission process.
➢ FINANCIAL MARKET DYNAMICS: volatility
in financial markets can disrupt
traditional transmission paths.
TYPES OF ECONOMIC SHOCKS: ➢ POLICY FRAMEWORK ADJUSTMENTS:
need for ongoing evaluation of the
➢ DEMAND SHOCKS: sudden change in effectiveness of existing tools in new
consumer or business demand (ex. economic contexts.
financial crises).

Quantitative
➢ SUPPLY SHOCKS: disruption in
production capabilities (ex. Natural
disasters, pandemics).
➢ FINANCIAL SHOCKS: instability in
financial markets (ex. Stock market Easing (QE)
crashes).
THE FEDERAL RESERVE'S MANDATE: o It is a monetary policy where central banks buy
financial assets to increase the money supply
➢ DUAL MANDATE: promote maximum
and lower interest rates.
employment. Maintain stable prices
➢ CENTRAL BANK ACTION: asset purchases
(control inflation).
(ex. Government bonds, mortgage-
➢ FINANCIAL STABILITY: ensure the
backed securities).
stability of the financial system.
➢ COMMUNICATION: clear guidance on
TOOLS OF MONETARY POLICY: goals and duration of QE.
➢ MONITORING: economic indicators like
➢ OPEN MARKET OPERATIONS: inflation and unemployment.
buying/selling government securities to
influence money supply. POSITIVE EFFECTS: lower borrowing costs,
➢ DISCOUNT RATE: interest rate charged increased investments, and higher asset prices.
to commercial banks for loans from the RISKS: potential for inflation, asset bubbles, and
fed. increased inequality.
➢ RESERVE REQUIREMENTS: the amount of
funds banks must hold to reserve, Central Bank
impacting lending capabilities.
➢ FORWARD GUIDANCE: communicating • GOAL: stabilize the economy and promote
future policy intentions to influence growth.
market expectations. IMPACT OF QE:
CHALLENGES IN RESPONSE: ➢ Increases the money supply by
➢ TIMING AND EFFECTIVENESS: delays in purchasing government securities.
implementing policy changes can affect ➢ Lowers interest rates, making borrowing
their effectiveness. cheaper.
➢ UNCERTAINTY: difficulty in predicting ➢ Aims to boost lending and investment,
economic recovery trajectories. helping to stimulate economic activity.
➢ INFLATION RISKS: potential for rising ➢ Potential risk of inflation if too much
inflation following aggressive monetary money is injected in the economy.
stimulus.
Government
LONG-TERM IMPLICATIONS:
• GOAL: foster economic growth and maintain
➢ ECONOMIC RECOVERY: the fed's actions fiscal stability.
can significantly influence the speed
and sustainability of economic IMPACT OF QE:
recovery.
➢ Lower borrowing costs make it cheaper
➢ MARKET EXPECTATIONS: the fed's for the government to finance public
credibility and communication affect projects and manage debt.
how markets respond to policy changes.
 ➢ Can help improve economic conditions,
lending to higher tax revenues.
➢ May create dependency on low-interest
rates, complicating future fiscal policy.

Consumers
• GOAL: improve financial well-being and
purchasing power.
IMPACT OF QE:
➢ Lower interest rates encourage
borrowing for big-ticket items (ex.
Homes, cars).
➢ Increased disposable income due to
lower loan repayments can lead to
higher consumer spending.
➢ Potentially higher asset prices (ex. Real
estate, stocks), which can enhance
wealth but may also lead to
affordability issues.

Investors
• GOAL: maximize returns on investments.
IMPACT OF QE:
➢ Increased liquidity in the market can
drive up asset prices, leading to capital
gains.
➢ Search for yield becomes more
pronounced, pushing investors toward
riskier assets as bond yields decrease.
➢ Can create asset bubbles if prices are
driven up excessively due to cheap
money.

Businesses
• GOAL: expand operations and profitability.
IMPACT OF QE:
➢ Lower interest rates can facilitate
cheaper financing for expansion and
investment capital.
➢ Increased consumer spending can drive
higher demand for products and
services.
➢ May lead to increased hiring and wage
growth but businesses may be cautious
if they perceive economic uncertainty.