Monetary Policy Framework PDF

FRAMEWORK OF MONETARY higher money supply stimulates business activities make loans or fund investment into a new that lead to the expansion of job market businesses. Since its constit...

FRAMEWORK OF MONETARY higher money supply stimulates business activities make loans or fund investment into a new that lead to the expansion of job market businesses. Since its constitute a lost POLICY opportunity for the commercial banks, central Currency exchange rates. Using its fiscal banks pay them interest on the reserves. The authority, a central bank can regulate the Monetary policy exchange rates between domestic and interest in known as IOR or Interest on is a central bank's actions and communications Reserves foreign currencies. that manage the money supply. Example: the central bank may increases the 3. Open market operations. The central bank can Central Banks use monetary policy to prevent monetary supply by issuing more currency. In such either purchase or sell securities issued by the inflation, reduce unemployment and promote a case, the domestic currency becomes cheaper government to affect the money supply. moderate long-term interest rates. relative to its foreign counterparts. Monetary policy increases liquidity to create Example: central banks can purchase government economic growth and reduces liquidity to bonds. As a result, banks will obtain more money to prevent inflation. Tools of Monetary Policy increase the lending and money supply in the Central banks use interest rates, bank reserve Central banks use various tools to implement economy. requirements, and the number of government monetary policies. The widely utilized policy tools bonds that banks must hold. include: The money supply includes forms of credit, Expansionary vs. Contractionary 1. Interest rate adjustment. A central bank can cash, checks, and money market mutual funds. Monetary Policy Credit includes loans, bonds, and mortgages. influence interest rates by changing the discount Depending on its objectives, monetary policies can In a recession, central banks might combat high rate. The discount rate (base rate) is an interest be expansionary or contractionary. unemployment by giving banks more money. rate charged by a central bank to banks for Banks in turn lower interest rates, which allows short-term loans. 1. Expansionary Monetary Policy business to hire more employees. Example: if central bank increases discount rate, the This is a monetary policy that aims to cost of borrowing for the banks increases. increase the money supply in the economy by Subsequently, the banks will increase the interest Objectives of Monetary Policy rate they charge to their customers. Thus, the cost decreasing interest rates, purchasing government securities by central banks, and lowering the The primary objectives of monetary policies are the of borrowing in the economy will increase and reserve requirements for banks. An expansionary management of inflation or unemployment and money supply will decrease. policy lowers unemployment and stimulates maintenance of currency exchange rates. business activities and consumer spending. The Inflation. Monetary policies can target 2. Change reserve requirements. Central banks overall goal of the expansionary monetary policy is inflation levels. A low inflation is considered usually set up the minimum amount of reserves that to fuel economic growth. However, it can also healthy and if inflation is high, a contrary must be held by a commercial bank. By changing possibly lead to higher inflation policy can address this issue the required amount, the central bank can influence Unemployment. Monetary policies can the money supply in the economy.If monetary 2. Contractionary Monetary Policy. influence the level of unemployment in the authorities increase the required reserve amount, economy. commercial banks find less money available to lend The goal of a contractionary monetary their clients, and thus money supply decrease policy is to decrease the money supply in the Example, an expansionary monetary policy economy. It can be achieved by raising interest generally decreases unemployment because the Commercial banks can’t use the reserves to rates, selling government bonds, and increasing the reserve requirements for banks. The contrary policy will be able to settle their monthly payments argue that, during recessions, not all consumers is utilized when the government wants to control regularly - a win-win situation for creditors, would have the confidence to spend and take inflation levels. merchandisers and property investors as well advantage of low interest rates, making it a disadvantage. 4. It can promote low inflation rates. Advantages of Monetary Policy One of the biggest perks of monetary policy is that it 2. It is not that useful during global recessions. 1. It can bring out the possibility of more can help promote stable prices, which are very Proponents of expansionary monetary investments coming in and consumers spending helpful in ensuring inflation rates will stay low policy state that even if banks lower interest rates more. throughout the country and even the world. As for consumers to spend more money during a global In an expansionary monetary policy, where inflation essentially makes an impact on the way we recession, the export sector would suffer. If this is banks are lowering interest rates on loans and spend money and how much money is worth, a low the case, export losses would be more than what mortgages, more business owners would be inflation rate would allow us to make the best commercial organizations could earn from their encouraged to expand their ventures, as they would financial decisions in life without worrying about sales. have more available funds to borrow with affordable prices to drastically rise unexpectedly. interest rates. Plus, prices of commodities would 3. Its ability to cut interest rates is not a also be lowered, so consumers will have more 5. It promotes transparency and predictability. guarantee. reasons to purchase more goods. As a result, A monetary policy would oblige Though a monetary policy is said to allow businesses would gain more profit while consumers policymakers to make announcements that are banks to enjoy lower interest rates from the Central can afford basic commodities, services, and even believable to consumers and business owners in Bank when they borrow money, some of them might property. terms of the type of policy to be expected in the have the funds, which means that there would be future. insufficient funds that people can borrow from them. 2. It allows for the imposition of quantitative easing by the Central Bank. 6.It promotes political freedom. 4. It can take time to be implemented. The Bangko Sentral ng Pilipinas can make With things expected to be done immediately in Since the central bank can operate separately from use of a monetary policy to create or print more these modern times, implementing a monetary can the government, this will allow them to make the money,allowing them to purchase government certainly take time, unlike other types of policies, best decisions based upon how the economy is bonds from banks and resulting to increased such as a fiscal policy, that can help push more performing doing at a certain point in time. Also, the monetary base and cash reserves in banks. This money into the economy faster. According to banks would operate based on hard facts and data, also means lower interest rates and, eventually, experts, changes that are made for a monetary rather than the wants and needs of certain more money for financial institutions to lend its policy might take years before they begin to take individuals. Even the Bangko Sentral ng Pilipinas borrowers. place and make changes felt, especially when it can operate without being exposed to political comes to inflation. influences. 3. It can lead to lower rates of mortgage payments. 5.It could discourage businesses to expand. As monetary policy would lower interest rates, it Disadvantages of Monetary Policy With this policy, interest rates can still would also mean lower payments homeowners increase, making businesses not willing to expand would be required for the mortgage of their houses, 1. It does not guarantee economy recovery. their operations, resulting to less production and leaving homeowners more money to spend on other Economists who criticize the Bangko eventually higher prices. While consumers would important things. It would also mean that consumers Sentral ng Pilipinas on imposing monetary policy not be able to afford goods and services, it would take a long time for businesses to recover and even 4.Liquidity Trap policy, which is enacted by central bankers and cause them to close up shop. Workers would then not elected government officials. lose their jobs. A liquidity trap is when interest rates are Fiscal policy is largely based on the ideas of close to zero and savings rates are high, rendering British economist John Maynard Keynes monetary policy ineffective. In a liquidity trap, Limitations of Monetary Policy consumers choose to avoid purchasing treasury (1883-1946). He argued that economic recessions are due to a deficiency in the Monetary policy has quite a number of shortcomings securities and keep their funds in savings because consumer spending and business investment and, as such, usually does not reach expectations. of the prevailing belief that interest rates will soon components of aggregate demand. rise. A rise in interest rates will cause a decrement Keynes believed that governments could 1. Case of Deflation in bond prices. stabilize the business cycle and regulate Compared to inflation, deflation is usually economic output by adjusting spending and tax 5.Case of the Government Reducing the Money hard to control. During deflationary periods, central policies to make up for the shortfalls of the Supply banks reduce their policy rates to as low as zero. private sector. The economy therefore, cannot be stimulated If a government decreases the money His theories were developed in response to the beyond this point. We've recently seen in which supply, for example, with higher taxes, individuals Great Depression, which defied classical have ever opted for negative rates. would expect low future inflation. This could render economics' assumptions that economic swings an expansionary monetary policy ineffective. were self-correcting. 2. Case of Banks Decreasing the Money They In Keynesian economics, aggregate demand or Lend Bond Market Vigilantes spending is what drives the performance and growth of the economy. Aggregate demand is Sometimes when the money supply banks Vigilantes are individuals who participate in made up of consumer spending, business can have' excess reserves, making the short-term the bond market, which can reduce their demand for investment spending, net government spending, rates decrease. This is mostly a result of the long-term bonds, thus raising their yields. The rise in and net exports. business environment yields can easily make it difficult for any expansionary monetary policy to be effective. 3.Uncertainty About How the Economy Reacts to TYPES OF FISCAL POLICY Expansionary and Contractionary Policy Expansionary Fiscal Policy and Tools Fiscal Policy Expansionary fiscal policy is usually Uncertainty about the effect of a policy puts Fiscal policy refers to the use of government characterized by deficit spending. Deficit the economy and prices on a complicated path. spending and tax policies to influence economic spending occurs when government Some economies might over or underreact to conditions, especially macroeconomic expenditures exceed receipts from taxes and central bank policies. It is imperative to note that conditions. These include aggregate demand for other sources. In practice, deficit spending tends economists often disagree on the policies central goods and services, employment, inflation, and to result from a combination of tax cuts and banks should use. economic growth. higher spending. During a recession, the government may lower Every attempt of central banks to tax rates or increase spending to encourage Contractionary Fiscal Policy and Tools manipulate the supply of money within an economy demand and spur economic activity. Conversely, In the face of mounting inflation and other does not always work. This is due to their lack of to combat inflation, it may raise rates or cut expansionary symptoms, a government can capacity to control the deposits households and spending to cool down the economy. pursue contractionary fiscal policy, perhaps corporations make in commercial banks. Fiscal policy is often contrasted with monetary even to the extent of inducing a brief recession  to restore balance to the economic cycle. consumption of such products by individuals is non increases and as the level of tax revenue The government does this by increasing taxes, rival, in the sense that one person's partaking of decreases. reducing public spending, and cutting public does not reduce the benefits available to others. sector pay or jobs. The benefits of social goods are extemalised. 4) Economic Growth Where expansionary fiscal policy involves Secondly, the exclusion principle is not feasible in spending deficits, contractionary fiscal policy the case of social goods. The application of Moreover, the problem is not only one of is characterized by budget surpluses. This exclusion is frequently impossible or prohibitively maintaining high employment or of curtailing policy is rarely used, however, as it is hugely expensive. So, the social goods are to be provided inflation within a given level of capacity output. The unpopular politically. by the government. effects of fiscal policy upon the rate of growth of potential output must also be allowed for. Fiscal Public policymakers thus face differing incentives policy may affect the rate of saving and the relating to whether to engage in expansionary or 2) Distribution Function willingness to invest and may thereby influence the contractionary fiscal policy. Therefore, the preferred rate of capital formation. tool for reining in unsustainable growth is usually a Adjustment of the distribution of income and wealth contractionary monetary policy.. Monetary policy to assure conformance with what society considers Capital formation in turn affects productivity involves the Bangko Sentral ng Pilipinas raising a 'fair' or state of distribution. The distribution of growth, so that fiscal policy is a significant factor in interest rates and restraining the supply of money income and wealth determined by the market forces economic growth. and credit in order to rein in inflation. and laws of inheritance involve a substantial degree of inequality. Tax transfer policies of the government play an important role in reducing the inequalities in COORDINATING FISCAL AND FISCAL FUNCTIONS income and wealth in the economy. MONETARY POLICIES Although particular tax or expenditure Monetary policy refers to central bank activities that measures affect the economy in many ways and 3) Stabilization Function are directed toward money and credit in an may be designed to serve a variety of purposes, economy. influencing the quantity of money and Fiscal policy is needed for stabilization, since full several more or less distinct policy objectives may credit in an economy employment and price level stability do not come be set forth. They include: automatically in a economy. Without it the economy By contrast, fiscal policy refers to the government's tends to be subject to substantial fluctuations, and it decisions about taxation and spending. 1) Allocation Function suffer from sustained periods of unemployment or Both monetary and fiscal policies are used to inflation. Unemployment and inflation may exist at regulate economic activity over time. They can be The provision for social goods, or the the same time. Such a situation is known as used to accelerate growth when an economy starts process by which total resource use is divided stagflation. to slow or to moderate growth and activity when an between private and social goods and by the mix of The overall level of employment and prices in the economy starts to overheat. In addition, fiscal policy social goods is chosen. This provision may be economy depends upon the level of aggregate can be used to redistribute income and wealth. termed as the allocation function of budget policy. Social goods, as distinct from private goods, cannot demand, relative to the potential or capacity output be provided for through the market system. valued at prevailing prices. Government expenditures add to total demand, while taxes The basic reasons for the market failure in the reduce it. This suggests that budgetary effects on provision of social goods are: firstly, because demand increase as the level of expenditure