Monetary Policy: Central Banks, Tools, & Frameworks PDF

Functions: Central Banks, Tools of Monetary Policy, Inflation Targeting, and Policy Frameworks Presenter: Efren James S. Aquino, MBA OBJECTIVES 1. The functions of central banks, 2. Key tools of monetary policy (Interest rates & Open market operations), 3. The monetary transmission mechanism, 4. Th...

Functions: Central Banks, Tools of Monetary Policy, Inflation Targeting, and Policy Frameworks Presenter: Efren James S. Aquino, MBA OBJECTIVES 1. The functions of central banks, 2. Key tools of monetary policy (Interest rates & Open market operations), 3. The monetary transmission mechanism, 4. The concept of inflation targeting, and 5. Various policy frameworks central banks use. Functions of Central Banks Central banks are responsible for several critical functions that ensure the financial stability and health of an economy. Monetary Policy Implementation Lender of last Resort Issuing Currency Regulating the Banking System Managing Foreign Exchange and Gold Reserves Monetary Policy Implementation: Central banks manage the money supply and control inflation through the use of various tools. By setting interest rates and engaging in open market operations, they influence the amount of money circulating in the economy. Lender of Last Resort: Central banks provide emergency loans to financial institutions in distress, preventing bank runs and ensuring the stability of the financial system. Issuing Currency: Central banks have the exclusive right to issue national currency, ensuring sufficient money supply in the economy. Regulating the Banking System: They regulate commercial banks to ensure sound practices, minimize systemic risk, and protect depositors. Managing Foreign Exchange and Gold Reserves: Central banks hold reserves to stabilize their national currency and manage exchange rates.  Tools of Monetary Policy Interest Rates (Policy Rates) - Discount Rate - Federal Funds Rate Open Market Operations - Buying Bonds - Selling Bonds Interest Rates (Policy Rates): Interest rates are the primary tool used by central banks to influence the economy. When a central bank changes its policy rate, it affects the entire economy, from borrowing costs for businesses to the interest rate on savings accounts. The two main policy rates are: Discount Rate: The rate at which commercial banks borrow from the central bank. Federal Funds Rate (U.S.) / Repo Rate (India): The rate at which commercial banks lend to one another. Open Market Operations (OMOs): OMOs involve the buying or selling of government securities in the open market to regulate the money supply. By purchasing securities, a central bank injects money into the banking system, encouraging lending and spending. Conversely, by selling securities, it absorbs excess money from the system, tightening the money supply. Buying Bonds: Increases the money supply, reduces interest rates, and stimulates economic activity. Selling Bonds: Decreases the money supply, raises interest rates, and curtails inflation. The Monetary Transmission Mechanism Policy Action Market Reaction Transmission to Households and Businesses Impact on Aggregate Demand Final Impact on Inflation and Output The monetary transmission mechanism describes how changes in the central bank’s monetary policy affect the broader economy. Key stages include: Policy Action: A central bank adjusts interest rates or conducts OMOs. Market Reaction: Financial institutions respond by adjusting their lending rates and deposit rates. Transmission to Households and Businesses: Changes in interest rates affect consumer spending, business investments, and credit availability. Impact on Aggregate Demand: Lower interest rates encourage borrowing and spending, boosting aggregate demand; higher interest rates have the opposite effect. Final Impact on Inflation and Output: Over time, these changes influence inflation and economic output, driving the central bank’s desired outcome. Inflation Targeting Advantages of Inflation Targeting: - Provides a clear, predictable path for policy decisions. - Helps anchor inflation expectations. - Strengthens public trust in the central bank's ability to manage the economy. Challenges:  Inflation targeting can be too rigid, especially in situations where inflation and unemployment are moving in opposite directions  It may not be effective if the central bank cannot control other factors like global commodity prices or exchange rates. Policy Frameworks Inflation Targeting Monetary Targeting Exchange Rate Targeting Flexible Inflation Targeting Central banks can adopt different policy frameworks based on their economic goals and the challenges they face. Some popular frameworks include: Inflation Targeting: As mentioned, central banks set a clear inflation target and use interest rates to achieve it. Monetary Targeting: This approach involves controlling the growth rate of the money supply to keep inflation under control. It is used less often today due to challenges in measuring and controlling money supply Exchange Rate Targeting: Some central banks, especially in smaller or developing economies, use exchange rate targeting to stabilize their currency by pegging it to another (usually the U.S. dollar). Flexible Inflation Targeting: A more flexible approach that allows central banks to adjust their policy when needed to respond to fluctuations in other macroeconomic variables, such as output or employment, in addition to inflation