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FINANCIAL INSTITUTIONS AND MARKETS Term Project Spring 2014

IMPORTANCE AND ROLE OF MONETARY POLICY OF PAKISTAN

Presented by: Marria Pirwani (5183), Mariam Khan Presented to: Mr. Riaz Ahmed Dated: 29th, March, 2014

Acknowledgement

To Him belongs the dimension of the Heavens and the earth, it is He who gives, Life and death and He has power over all things. (Al-Quran) The report in hand is not a hard copy of activities during the working of this project of Financial institutions and markets rather it is a container of many soft feeling of gratitude, responsibility and affection that were having during this project . For this favor, all acclamation to ALLAH, WHO has empowered and enabled me to accomplish this project successfully and helps in every problem during the project. I would like to express my sincere and humble gratitude to My PARENTS whose blessings, help and guidance has been a real source of all our achievements in our life. I definitely thank our Institute PAF-Karachi Institute of Economics and Technology, our TEACHERS MR RIAZ AHMED, who contribute jointly in this project.

Contents
Acknowledgement ............................................................................................................... 2 Introduction ......................................................................................................................... 4 What is a Monetary Policy? ................................................................................................ 9 Objectives of Monetary Policy: ...................................................................................... 10 Significance of the monetary Policy .............................................................................. 10 Monetary Policy framework in Pakistan .......................................................................... 11 State Bank uses tools of Monetary Policy: ......................................................................... 11 Use Open Market Operations to change the monetary base ..................................... 11 Changing the reserve Requirements: ......................................................................... 12 Affecting a change in nominal interest rate: .............................................................. 12 Effect of monetary policy on the economy of our country: .............................................. 13 Instruments of monetary policy ........................................................................................ 14

Introduction
Monetary policy is one of the tools that a Government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank" like the State Bank of Pakistan. Pakistans monetary policy is concerned with how much money circulates in the economy, and what that money is worth. The ultimate objective of monetary policy is to promote solid economic performance and higher living standards for Pakistanis. The best way to achieve that objective is to keep inflation low, stable, and predictable. State bank play a highly important role in the international financial systems today. With the right monetary policy they are able to bring about economic growth and financial stability in a country. Conditions in different countries are diverse; therefore the structure of a State bank can also be quite different. One of the functions of a State Bank is to ensure the health of the economy of the country. It does so by setting monetary policies, managing foreign exchange and reserves, setting interest rate and money supply to manage inflation among others. However the function that a State bank is most associated with is setting monetary policies. It mainly influences the economy of a country by controlling the money supply, and one of its main policy instruments is interest rate. Interest rates set by the State bank affects the borrowing by commercial bank and other market institutions, hence affecting the other interest rates in the market. The relationship between the State Bank and the Government is an extremely important and equally sensitive area. They share virtually the totality of policy framework where

by Ministry of Finance manages the fiscal policy while the State Bank organizes the monetary and exchange rate.

History
Monetary policy is primarily associated with interest rate and credit. For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seignior age, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price. Paper money called "jiaozi" originated from promissory notes in 7th century China. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The successive Yuan Dynasty was the first government to use paper currency as the predominant circulating medium. In the later course of the dynasty, facing massive shortages of specie to fund war and their rule in China, they began printing paper money without restrictions, resulting in hyperinflation. With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established. The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest

rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. During the 1870-1920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913. By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs. Monetarist macroeconomists have sometimes advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth. However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables. Even Milton Friedman acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003. Therefore, monetary decisions today take into account a wider range of factors, such as:

short term interest rates; long term interest rates; velocity of money through the economy; exchange rates; credit quality; bonds and equities (corporate ownership and debt); government versus private sector spending/savings; international capital flows of money on large scales; financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will

result in drastic harm to the populace should monetary policy fail. Others see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt. In fact, many economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved. Some have claimed that these arguments lost credibility in the global financial crisis of 2008-2009. The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets. A central bank can only operate a truly independent monetary policy when the exchange rate is floating. If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in

foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Accordingly, the management of the exchange rate will influence domestic monetary conditions. To maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate. In the 1980s, many economists began to believe that making a nation's central bank independent of the rest of executive government is the best way to ensure an optimal monetary policy, and those central banks which did not have independence began to gain it. This is to avoid overt manipulation of the tools of monetary policies to effect political goals, such as re-electing the current government. Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence. In the 1990s, central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. In other words, a central bank may have an inflation target of 2% for a given year, and if inflation turns out to be 5%, then the central bank will typically have to submit an explanation. The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI (now 2% of CPI).

The debate rages on about whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the neoclassical model). There is also the Austrian school of economics, which includes Friedrich von Hayek and Ludwig von Mises's arguments, but most economists fall into either the Keynesian or neoclassical camps on this issue. Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policies takes a backseat to the political desires of the government or are used to pursue other nonmonetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation. Recent attempts at liberalizing and reforming financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks.

What is a Monetary Policy?


Monetary policy is a short-run tool used by the State bank to persist sustainable economic growth (in the long-run) by controlling the money supply through open market operations, discount lending and reserve requirements.

Before focusing on the significance for and effects of monetary policy on the economy of the country, first discuss what monetary policy is? And how it is used by the State bank? Monetary policy is the process of managing a nation's money supply to achieve specific goals such as constraining inflation, achieving full employment or more well-being. Monetary policy can involve setting interest rates, margin requirements, capitalization standards for banks or even acting as the lender of last resort or through negotiated agreements with other governments. A wide variety of policy systems are possible to conduct monetary policy operations, but in developing countries with floating exchange rates (like Pakistan etc.) and monetary policy involves the management of short-term interest rates by central banks to pursue the macroeconomic objectives of the economy.

Objectives of Monetary Policy:


Price stability, Maintenance of full employment, and The economic prosperity and welfare of the people of the economy. Price stability, that is controlled price level, is the imperative condition for the constant economic growth, once accomplished leads to full employment and economic prosperity. Price stability develops investors confidence boosting investments, causing acceleration of economic activity and achievement of full employment.

Significance of the monetary Policy


The significance of monetary policy is to achieve the inflation target (set by the State bank for required economic growth), and as a consequence, to accelerate strong and sustainable economic growth. Achievement of inflation target directs strong currency

valuation in terms of other foreign currencies, resulting as favorable balance of payments.

Monetary Policy framework in Pakistan

State Bank uses tools of Monetary Policy:


The State Bank is also in charge of conducting monetary policy which means changing the supply of money in the economy. In order to attain the objectives discussed above, the State bank uses tools of the monetary policy which are: 1. Open market operations. 2. The discount rate. 3. Reserve requirements 4. Nominal interest rate 5. Discount window lending.

Use Open Market Operations to change the monetary base: The most effective and
major tool the State bank uses to affect the monetary supply in the economy is open market operations. The bank would buy and sell government securities (usually bonds or T-bills) in exchange of hard currency. If the State bank decides to increase monetary base in the economy it buys securities from the open market and pays for these securities by crediting the reserve amounts of banks involved in selling. Conversely, in order to tighten the monetary base in the economy, the State bank sell the government securities, as a result collect payments from banks by reducing their

reserve accounts. Having less money in these reserve accounts the opportunity cost of lending money decline, such that interest rates may increase, resulting a drop of investment spending, that is the slowdown of economic activity.

Changing the reserve Requirements: the proportion of the total assets that banks
must hold in reserve with State bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets (like loans and mortgages). The monetary policy can be implemented by altering the proportion of these required reserves. Increasing the proportion of total assets to be held as liquid cash increases the amount of money available to banks as loan able funds, thus mean the broader monetary base in the economy. This act as a change in the money supply.

Affecting a change in nominal interest rate: This contraction of the monetary


supply can be achieved indirectly by increasing or decreasing the nominal interest rates. By changing the discount rate and by conducting open market operations a change in money supply would affect the nominal interest rates. A tight money supply tends to increase nominal interest rates while an increase in money supply can help bring down the interest rates. A change in the nominal interest rates influences the overall economic activity, rate of inflation, GDP and economic growth.

Discount window lending: Discount window lending is where the commercial banks,
and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), there by affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over.

By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates, and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.

Effect of monetary policy on the economy of our country:


After having discussed the objectives and tools, now talk about how policy affects the economy:

Consumption, Saving and Investment:


Changes in the real interest rates affect the demand for consumption and savings of the people and also change the investment pattern of the businesses. For instance, a reduction in real interest rate lowers the cost of borrowing, encouraging people to borrow in order to consume (durable items like, electronic items, automobiles etc.). Moreover stimulating banks willingness to lend more and investors to invest more, on the other side discourage saving, resulting to increase spending and aggregate demand. Lower real interest rates also make stocks and other such investments more desirable than bonds, resulting stock prices to rise. People are likely to increase their stock of wealth.

Foreign Exchange, Imports and Exports:


Short-run changes lower interest rate result as currency depreciation, which means lower prices of home-produced goods selling abroad, making exports dearer and discourage imports, reducing the gap between imports and exports and having favorable balance of trade. Again this leads to higher aggregate spending on goods and services produced in the country.

Output and Employment:


The increase in aggregate demand for the output boosts up the production cycle; generating employment, as a result increase investment spending on the existing industrial capacity. Which accelerate the consumption further due to more incomes earned, thus attaining the multiplier effect of Keynes.

Instruments of monetary policy


The instruments of monetary policy on which the whole process is based are given below: Bank Rate of Interest Cash Reserve Ratio Statutory Liquidity Ratio Open market Operations Margin Requirements Deficit Financing Issue of New Currency Credit Control

Cash Reserve Ratio:


CRR, or cash reserve ratio, refers to a portion of deposits (as cash) which banks have to keep/maintain with the SBP. During Inflation SBI increases the CRR (cash reserve ratio) due to which commercial banks have to keep a greater portion of their deposits with the SBP. This serves two purposes. It ensures that a portion of bank deposits is totally riskfree and secondly it enables that SBP control liquidity in the system, and thereby, inflation.

Bank rate of interest:


It is the interest rate which is fixed by the SBP to control the lending capacity of Commercial banks. During Inflation, SBP increases the bank rate of interest due to which borrowing power of commercial banks reduces which thereby reduces the supply of money or credit in the economy. When Money supply Reduces it reduces the purchasing power and thereby curtailing Consumption and lowering Prices.

Statutory Liquidity Ratio:


Banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements. If SLR increases the lending capacity of commercial banks decreases thereby regulating the supply of money in the economy.

Open market operation:


It refers to the buying and selling of Govt. securities in the open market. During inflation SBP sells securities in the open market which leads to transfer of money to RBI. Thus money supply is controlled in the economy.

Deficit financing:
It means printing of new currency notes by State bank of Pakistan .If more new notes are printed it will increase the supply of money thereby increasing demand and prices. Thus during Inflation, SBP will stop printing new currency notes thereby controlling inflation.

Issue of New currency:

During Inflation the SBP will issue new currency notes replacing many old notes. This will reduce the supply of money in the economy.

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