Monetary Policy

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Basic Points About Money
• What is money?
Currency, Demand and time deposits, Financial assets and other liquid assets
• Why do people want money?
1. Medium of Exchange: Money facilitates transactions of goods and services

2. Unit of account: Measure of value in terms of which accounts are kept and
values stated.
3. Standard for differed payment: Money allows future payments and
contractual payments such as salaries, loans, interest payments, etc.
4. Store of Value: it is an asset that can be invested, stored in a bank, left in a
safe at home, and then later used to purchase something in the future.
What is the Monetary Policy?
Monetary policy comprises measures taken by the central bank (state bank of Pakistan)
to regulate monetary flows. The country's central bank or government can take to
influence how much money is in the economy and how much it costs to borrow.
Monetary Policy Committee is responsible and fully empowered to decide the monetary
policy stance. A brief statement (Monetary Policy Decisions), is issued eight times a
year in Pakistan. The statement contains a brief analysis of economic conditions and
rationale behind the monetary policy decision. (previously, the monetary and credit
policy statement, announces in every two months). The latest monetary policy statement
issued on 25th November 2022.
It deals with both the lending and borrowing rates of interest for commercial banks.
Monetary policy is not only a regulatory mechanism, it also performs allocative
functions in the economy.
Objectives of Monetary Policy
Monetary policy involves central banks’ use of instruments to influence
interest rates and/or money supply in the economy with the objective to
keep overall prices and financial markets stable.
• Ultimate Objectives:
1. Stability in inflation, real intertest rate, exchange rate
2. Sustainable economic growth
3. Low unemployment
• Targets:
1. Inflation only;
2. Money supply only;
3. Exchange rate only;
4. all of them; or two of them; or none of them
The Tools or Instruments of Monetary Policy
• SBP Policy Rate - Fixing the interest rate – Credit controls
• Open Market Operations on treasury bills - rediscounting
• Standing Facilities:
a) SBP Reverse Repo Facility (Ceiling of corridor), b) SBP Repo Facility (Floor of corridor)
A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In the
case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them
back the following day at a slightly higher price. (currently +1% or – 1% of the policy rate )
• Reserve Requirements
a) Cash reserve requirement, b) statutory liquidity requirement.
Reserve requirements are the amount of funds that a commercial bank holds in reserve to ensure that it is able
to meet liabilities in case of sudden withdrawals.
• Foreign Exchange (Forex) Swaps
Swap lines are arrangements between two central banks to keep currency available for their member banks in
the reciprocal countries.
Monetary Policy Intermediate Targets
• SBP uses intermediate targets to guide policy as a step between its tools or
instruments (such as open-market purchases or sale) and its goals or ultimate
targets of price stability, financial stability and stable economic growth)
• Intermediate targets are variables the SBP can’t directly control but can
influence predictably, and they are related to the SBPs goals.
• Most frequently used are monetary aggregates such as M1 and M2, and
short-term interest rates, such as the discount rate (The bank rate refers to
the discount/interest rate on loans that the central bank extends to banks and
other financial institutions. On the other hand, the repo rate refers to the rate
the central bank uses for the repurchase of securities.)
Note: The SBP cannot target both the money supply and the interest rate
simultaneously.
Transmission Mechanisms of Monetary
Policy
i,r,er,Pe P
Market
C+I+G
rate MS Domestic
Y Domestic
Official demand inflationary pressure
rate Total demand
Asset
prices Inflation
Net external
π
Expectations demand
and confidence
Import
X,M prices

Exchange
rate

Two Conditions to have real effect of Monetary policy

Central bank controls monetary base M0 = R + Cu
Prices do not adjust instantaneously
M
M  i, r  C , I , X , G  Y  P     i, r 
P
Transmission Mechanisms of Monetary Policy
• Interest rate Channel • Credit Channel
• Lower interest rate • Lower interest
• More borrowing and • More reserves
Spending • More lending
• More aggregate demand • Higher aggregate demand
Open Market Operation Deficit financing
(purchase) Rediscounting of Treasury Bills

• Exchange Rate Channel • Balance Sheet Channel

• Lower interest rate • Lower interest rate
• Depreciation of domestic currency • Increase in prices of stocks,
• More exports and less imports bonds and other assets
• Higher aggregate demand • More wealth
Buy back own currencies selling some foreign assets
to avoid depreciation - sterilisation • More aggregate demand
selling its currency to avoid appreciation Moral hazards - bank panics, systematic risk,
regulation - bank supervision
Keynesian View on Monetary Policy : Main Points
• Monetary affects real economy through the interest rate. (IS-LM model)
• Interest rate is determined by the supply and demand in the money
market. Three kinds of demand
1. Speculative Demand
2. Transaction Demand
3. Precautionary Demand
• Demand for money is not stable because of changing velocity of money.
People do not spend and the velocity is low in depression and high in the
boom.
• Increase in money supply, leads to lower interest rate, reduced cost of
investment, more investment and more Aggregate Demand but Keynes
favors Fiscal Policy.
Monetarist view on Monetary Policy –
Friedman 1968
• Given the natural rates of interest and unemployment, monetary policy
cannot be pegged to lower the interest rate or the unemployment. Is so
it only raises inflationary expectation and increase in price level. There
will be no impact on real magnitudes. (Augmented Philips curve)
• Monetary authority can control nominal quantities such as it liabilities,
M0, M3 or M4. By controlling them it can stabilise the price level.
• Price mechanism in the market system works better when prices are
stable and relative prices can adjust according to the dynamics of the
economic system.
Monetarist view on Monetary Policy
• Supply of money is the determinant of the national income.
• In the long run, the influence of money is primarily on the price level
and other nominal magnitudes. Real output and employment are not
determined by monetary factors.
• In the short run the supply of money does affect the output. Money is
the dominant factor in causing cyclical fluctuations in output and
employment in the short run.
• Private sector is inherently stable and instability is primarily the result
of the government policy. (non- interventionist view)
Pre-Financial crisis 2007 monetary policy paradigm
The central bank consensus comprised three key elements:
1. Central bank independence as a corner stone for an effective monetary policy;
2. Price stability as the primary objective of central banks; and
3. Solidly anchored inflation expectations on the basis of transparent
communication.

The central bank consensus also emphasized three key-elements

4. Monetary policy has a primary role in the management of aggregate demand
in the short-run;
5. Money and credit indicators can be disregarded;
6. Monetary policy should react to asset price busts; not to asset price booms.
Post Financial Crises 2007 and beyond
Unconventional monetary policy Tools introduced
• ZIRP (Zero Interest Rate Policy): ZIRP is a method of stimulating growth while keeping interest
rates close to zero. Under this policy, the governing central bank can no longer reduce interest
rates, rendering conventional monetary policy ineffective.
• QE (Quantitative Easing): central bank purchases government securities or other securities from
the market in order to lower interest rates and increase the money supply
• CE (credit easing): Credit easing is a group of policy tools used by central banks to make credit
and liquidity more readily available in times of financial stress. Credit easing happens when
central banks purchase private assets such as corporate bonds.
• FG (Forward Guidance): central bank gives forward guidance, it means it is providing
information about its future monetary policy intentions, based on its assessment of the outlook
for price stability.
• Yield curve control: Central Bank seeks a decline in real interest rates by controlling short-term
and long-term interest rates,
• Negative Interest Rates: Negative interest rates refer to the case when cash deposits incur a
charge for storage at a bank, rather than receiving interest income
• Liquidity Support of Banks and Non-Banks
 History of Monetary Policy in Pakistan - 1948-59
• In 1947, Pakistan gained independence from the British Raj. After independence, the State Bank
of Pakistan was established in 1948, as the central bank of the country, with its headquarters in
Karachi. Prior to independence, the Reserve Bank of India acted as the central bank.
• Given the conditions prevailing in 1948 the SBP adopted a monetarist approach so far as
achievement of price stability was concerned. One of the objectives of money policy was to
develop the various aspects of the financial sector particularly the banking system.
• Up to 1960 the bulk of monetary expansion was on account of credit to the government sector
(71%), lending to the private sector was a relatively unimportant source of changes in money
supply (24%) compared with deficit financing by the public sector because the size of the private
sector was small and banks were very conservative in lending.
• The responsibilities of the State Bank during the early years of its existence (1948–59) mainly,
included rehabilitation of the banking system and ensuring its growth through helping the setting
up of financial institutions, developing the money market and training bankers.
State Bank of Pakistan Act 1956
• The scope of the Bank's operations was considerably widened in the
State Bank of Pakistan Act 1956, which required the Bank to "regulate
the monetary and credit system of Pakistan and to foster its growth in
the best national interest with a view to securing monetary stability
and fuller utilization of the country's productive resources.
History of Monetary Policy in Pakistan- 1960-72
• The year 1959-60 marked the beginning of a phase of liberalization and
deregulation of the economy and substantial flow of resources from abroad. The
Government’s liberal economic policies met with an enthusiastic response from
the private sector. Both the expansion in investment and production entailing
liberalization enhanced demand for credit in the private sector.
• With high growth rates of investment and production as well as large movements
in the external accounts, policy changes were made by the State Bank to keep
pace with these developments and adequately meet the genuine credit needs of
the economy
• Percentage Share in Total Credit-- private sector 72.6%, government sector 41%
and other items -13.6 %
Choice of Policy Instruments for Monetary
Management 1948 – 72
• During this period interest rate as an instrument of monetary policy was rarely used. The
State Bank was of the view that the effectiveness of interest rate change in the economy
was subject to many constraints. During 1949-50 - 1958-59 bank credit formed a small
percentage of GDP.
• Up to 1972 the main thrust of the State Bank policy was based on the belief that any
increase in the interest rate would adversely affect the investment activity.
• During 1959-72 the State Bank made extensive use of Selective Credit Controls to achieve
the objective of monetary policy.
• Selective Credit Controls pre-dominantly consist of changes in minimum margin
requirements to be retained by banks on advances against various commodities, to various
borrowers, ban on advances against selected commodities, margins against letters of credit
etc.
• Even in 1962-63 when credit to the private sector had expanded considerably the State
Bank introduced the quota system and did not favor an increase in the Bank Rate because
of the Bank’s perceived adverse implications of such a measure for the country’s economy.
History of Monetary Policy in Pakistan 1972-88
Monetary policy during this period was characterized by:
1. Creation of National Credit Consultative Council (NCCC) and Annual Credit Plan, 1972
2. Regimes of credit ceilings with effect from October 1973
3. Directed, concessionary and mandatory credit targets
4. Targets for fixed investment and exports
5. Control on bank deposits and lending rates
In addition, the State Bank prescribed for commercial banks annual mandatory targets for
production loans, tobacco marketing and loans both for production and development for small
farmers. Simultaneously there were protected targets for fixed investments and refinancing of
loans under locally manufactured machinery (LMM) and agro based activities.
Also subsidized/concessionary loans were given under various Special Financing Schemes
introduced by the State Bank during 1972-73.
History of Monetary Policy in Pakistan 1989 and forward
• The system of credit ceilings was replaced with the somewhat flexible system of credit deposit ratio
(CDR) with effect from 1st of August, 1992.
• Various reforms continued during this phase (1992-93 to 1994-95), culminating in the abolition of CDR
itself on 30th September, 1995.
• This marked the beginning of the third phase covering the period up to June 2001. Indicative credit
targets replaced the CDR and the main reliance to conduct monetary policy was placed on Open Market
Operations (OMOs) . Subsequently, when the Pak rupee was put on free float in May 1999 and in the
real sense in July 2000.
• Monetary Policy and Exchange Rate Policy were fully integrated. This marked the beginning of the fourth
and the final stage.
• Under financial sector reforms, the State Bank of Pakistan was granted autonomy in February 1994. On
21st January, 1997, this autonomy was further strengthened by issuing three Amendment Ordinances
(which were approved by the Parliament in May, 1997) namely, State Bank of Pakistan Act, 1956,
Banking Companies Ordinance, 1962 and Banks Nationalisation Act, 1974.
BRIEF ON STATE BANK AMENDMENT
ACT 2021
The amendments have six key purposes:
1. to clearly define the objectives of the SBP to improve its accountability; First, the
amendments identify domestic price stability as the primary objective of the SBP,
followed by financial stability and support of the general economic policies of the
Government
2. to outline the SBP’s functions in line with these objectives; Given the inflationary
nature of government borrowing from the Central Bank, the amendments propose to
exclude provisions related to Government borrowing5 as well as the quasi-fiscal
operations of the State Bank
3. to provide the SBP necessary financial resources to help achieve its objectives; A
central bank’s autonomy can be jeopardized if it cannot continually avail itself of
sufficient financial resources to fulfill its mandate. The amendments allow SBP to be
sufficiently capitalized and prescribe the necessary mechanism to achieve the desired
level of capital over time, through both statutory reserves as well as retained earnings
BRIEF ON STATE BANK AMENDMENT ACT 2021
…. Continued
4. to strengthen the functional and administrative autonomy of the SBP; A key element
of the functional independence of Central Banks is protection of its officials for actions
taken in good faith. In addition, the Monetary and Fiscal Policies Coordination Board is
proposed to be abolished, as its terms of reference overlap with the work that has been
assigned to the Monetary Policy Committee under the existing Act and such a
mechanism for coordination goes beyond provisions in the acts of other central banks.
5. to increase transparency in the operations of the SBP and strengthen its governance;
the amendments prescribe qualification and experience requirements, tenure, conflict
of interest and disqualification criteria for all appointments , including the directors on
the Board of State Bank, members of the Monetary Policy Committee, the Governor
and the Deputy Governors.
6. to enhance the SBP’s accountability by strengthening oversight functions and
increasing reporting requirements. the amendments strengthen provisions related to
accountability of the State Bank to the Parliament, constitution of an Audit Committee,
designation of a Chief Internal Auditor and appointment of External Auditors.
Source: https://www.sbp.org.pk/about/pdf/LF/Brief-1.pdf