ECO-531 Chapter 6 Monetary Policy PDF

OBJECTIVES OF THE LESSON • Goals of Monetary Policy • Types of Monetary Policy • To overcome inflation and unemployment GOALS OF MONETARY POLICY Loading… CLASS ACTIVITIES - 1 • 1. Divide the class into 6 groups • 2. Pick one goal of Monetary Policy • 3. Discuss on the following is...

OBJECTIVES OF THE LESSON • Goals of Monetary Policy • Types of Monetary Policy • To overcome inflation and unemployment GOALS OF MONETARY POLICY Loading… CLASS ACTIVITIES - 1 • 1. Divide the class into 6 groups • 2. Pick one goal of Monetary Policy • 3. Discuss on the following issues: Loading… - current data/ trend - why it is important to keep (the goal) stable? - what are the effects of having a low/ unstable (the goal)? TO ACHIEVE HIGH EMPLOYMENT • High employment achieve when economy use all its available resources/factor more efficiency to attain maximum output. • Full employment also can refer to 1 condition where there is lower level of unemployment rate. • All country want to achieve high employment because of unemployment problem would create higher losses. • At high employment level, all labors have their own job. • Therefore, the more resources are employed, the greater the level of output and the higher standard of living. TO ACHIEVE PRICE STABILITY • Is a situation of no inflation or deflation in the economy. This means that there is no overall change in the level of prices of g&S and resources. • Price stability is desirable because a rising price level creates uncertainty in the economy and that may hamper economic growth. • Problem 1: Uncertainty about future prices • When the overall level of prices is changing, the information conveyed by the prices of g&S is hard to forecast, which complicates decision making for consumers, businesses and government. • Creditors lose when there is inflation because when they receive the money owed to them, the real value of the money will be less. But debtors gain because the real value of money has increased. Cont’d.. •Problem 2: Money loses its function as a medium of exchange •When inflation, money loses its value and not able to buy the same amount as before the inflation. Thus, standard of living reduces. •If inflation rate becomes extremely rapid, money loses its usefulness as a means of paying for g&S. •Problem 3: Redistribution effects •To those whose nominal incomes do not rise as fast as prices, so their real income fall. TO ACHIEVE ECONOMIC GROWTH • The goal of steady economic growth is closely related to the high-employment goal. • because businesses are more likely to invest in capital equipment to increase productivity and economic growth when unemployment is low. • Conversely, if unemployment is high and factories are idle, it does not pay a firm to invest in additional plants and equipment. • Although the 2 goals are closely related, policies can be specifically aimed at promoting economic growth by directly encouraging firm to invest or by encouraging people to save, which provides more funds for firms to invest. Cont’d.. EG also refer to any increase in the productive capacities, whether as a result of • • • an increase in the labor supply, • an increase in the productivity of labor, • or a net increase in the Q or quality of the country’s capital stock. Therefore, the economy operating at maximum capacity. TO ACHIEVE STABILITY OF FINANCIAL MARKETS Loading… • The stability of financial markets is also fostered by interest-rate stability. • because fluctuations in interest rates create great uncertainty for financial institutions. • An increase in interest rates produces large capital losses on long-term bonds and mortgage. • Which can cause the failure of the financial institutions holding them. TO ACHIEVE INTEREST-RATE STABILITY • Interest rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future. • Fluctuations in interest rates that affect consumers’ willingness to buy houses, for example, make it more difficult for consumers to decide when to purchase a house and for construction firms to plan how many houses to build. TO ACHIEVE FOREIGN EXCHANGE MARKET STABILITY • Stabilizing extreme movements in the value of dollar in foreign exchange markets is thus viewed as a worthy goal of monetary policy. • A rise in the value of the dollar makes • American industries less competitive with those abroad, • and declines in the value of the dollar stimulate inflation in the US. • In addition, preventing large changes in the value of a dollar makes it easier to firms and individuals purchasing or selling goods abroad to plan ahead. • In other countries, which are even more dependent on foreign trade, stability in foreign exchange markets takes on even greater importance. Is a government policy on money supply and credit creation aimed at achieving higher economic growth, stability in prices and full employment. • There are 2 types of monetary policy: 1. 2. • 3. 4. Contractionary MP - implemented during Inflation Expansionary MP - implemented during Recession There are 2 instruments/tools of MP: Quantitative tools Qualitative tools CLASS ACTIVITIES - 2 • 1. Divide the class into 6 groups • 2. Pick one tool of Monetary Policy • 3. Discuss on the following points: - how it can be use to overcome inflation? – which type of policy used? - how it can be use to overcome unemployment? – which type of policy used? provide fun class quiz for the class (Consider using multiple choice, true or false, fill-in-the-blank, or open-ended questions. Provide students with an opportunity to discuss their answers with each other. Offer a reward or incentive for participation in the live quiz.) DISCOUNT RATE/ BANK RATE • Is the interest rate the bank charges on loans of reserves to banks. Changes in the bank rate or discount rate affect the cost at which borrowing can be made available to banks from the BNM. • If the BNM increases its bank rate, the interest rate on borrowing becomes more expensive and this will lead to a decrease in the demand for loans. OPEN MARKET OPERATION (OMO) • The BNM can influence the cash reserves of Commercial Banks (CB) through its OMO. • Its includes the buying and selling of government securities by the BNM to influence the cash reserves in CB. • The BNM can change the direction of its OMO according to the situation i.e. from a policy of increasing the cash reserves of CB to decreasing their reserves and vice versa. LEGAL RESERVE REQUIREMENTS • The legal cash reserve requirement is the minimum amount of cash that the BNM requires all CB to keep in the BNM. • Its will affects the total amount of CB reserves. • At the same time, it also affects the amount of excess cash reserves in CB which reflects their ability to lend. • The BNM has the right to vary the cash and liquidity requirement ratios of CB depending on the situation. FUNDING • Refers to the conversion of short-term loans to long-term loans. The objective of the conversion from short-term (liquid) to long-term (illiquid) is to enable the CB to create multiple credits. INTEREST RATE • BNM will persuade CB to increase/decrease their interest rate on deposit/loan. SELECTIVE CREDIT CONTROL • Its enable the BNM to restrict unhealthy expansion of credit for specific purposes. • During inflation, the banking system can control credit through hire-purchase restrictions by imposing regulations. • The BNM will persuade CB to grant loans for productive purposes only and reduce non-performing loans. MORAL SUASION • Its refer to the pressure by the BNM on CB to discourage them from borrowing heavily from the BNM, so as to reduce their lending to the public. • The objective is to reduce the money supply in an effort to cure inflation. SPECIAL DIRECTIVE > - by force : arahan : strict : takleh pinjam • The government through BNM will inform the step taken by them to reduce inflation and unemployment. BNM instruct CB to reduce the volume of loans given to the public. • The central bank will also influence CB to restrict their lending policy such as the need for collateral security, guarantors and other measures, which will discourage borrowings. • Contractionary/ Restrictive or tight monetary policy to overcome • Tools used will reduce Money Supply in the economy. This is aimed at reducing the pressures of inflation in an economy Expansionary/ Cheap/ easy monetary policy To overcome • Tools used will increase Money Supply and activities in an economy. This will help increase employment and growth. To overcome inflation (quantitative tools) To overcome inflation (qualitative tools) unemployment To overcome (quantitative tools) To Toovercome overcome unemployment Unemployment (quantitative (Quantit ativetools) tools) Loading… Discuss the strengths and weaknesses of each of the following policy tools: a) DISCOUNT RATE Merits Demerits 1. Immediate effect on entire system 1. Limited control by BNM 2. Effective solution for cash flow problems 2. Misinterpretation of announcement (effects) Less Effective3. than OMOencourage banks to take large 3. Aid to problematic FI (lender of last May resort) risks. 4. Can prevent financial panics 4. Large spread between market i and discount i 5. Cost, Availability & Announcement effects 5. Hard to reverse action B) RESERVE REQUIREMENT Merits Demerits 1. Effective solution 1. Too clumsy (uncoordinated) 2. Useful for major changes in policy 2. May be too powerful 3. Powerful to fine tune credit & market conditions 3. May cause immediate liquidity problems for banks with low excess reserves 4. Effect on entire system (all FI equally) 4. Not very effective if conducted alone 5. Elastic action (powerful) on Ms & credit 5. Fluctuations may create uncertainty for banks & make liquidity mgmt more difficult 6. Expensive to administer 7. Rarely used Less Effective than OMO & Discount Rate C) OPEN MARKET OPERATION Merits Demerits 1. Effective solution 1. Slow action for massive effects 2. Effect on entire system 2. Announcement effect may be confused 3. Flexible (may change quickly) & precise (elastic) 4. Suitable to fine-tune market operations 5. Complete control (volume of OMO) by BNM 6. Easily reversed 7. Can be implemented quickly 8. Announcement effect The Most Effective Tool • TQ