MINA ALI QURAT-UL-AIN NOSHABA NUMEEARH YOUSAF SIDRA SHAFQAT

Monetary Policy:Manipulation of Interest Rates to achieve Macroeconomic goals

 Monetary policy is a policy of influencing the

economy through changes in the banking systems reserves that influence the money supply and credit availability in the economy
Monetary policy is controlled by the central bank, the Federal

Reserve Bank (the Fed)

Monetary policy works through its influence on credit

conditions and the interest rate in the economy

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The Demand for Money

Money interest rate

Money Demand
Quantity of money

The quantity of money people want to hold (the demand for money) is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earning assets like bonds.

 Expansionary monetary policy is a policy that increases

the money supply and decreases the interest rate and it tends to increase both investment and output
M i I Y

Contractionary monetary policy is a policy that decreases

the money supply and increases the interest rate, and it tends to decrease both investment and output M i I Y
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Price level

Monetary policy affects both real output and the price level
Expansionary monetary policy shifts the AD curve to the right Contractionary monetary policy shifts the AD curve to the left

SAS

P1
P0 AD1 AD0 AD2 Y2 Y0 Y1

P2

Real output

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 The Federal Reserve System was created in 1913 by

Woodrow Wilson.
Regulate the banking industry Lender of Last Resort

Control the money supply

Provide banking services for the federal

government Check Clearing

Note: The Federal Reserve System is a private bank. It is actually owned by the banks within the Federal Reserve System

 The Federal Reserve has five main jobs

Conduct monetary policy which is, by far, the

most important job

Monetary policy is the control of the rate of growth

of the money supply to foster relatively full employment, price stability, and a satisfactory rate of economic growth
Serve as lender of last resort to commercial

banks, savings banks, savings and loan associations, and credit unions

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 The Federal Reserve has five main jobs

Issue currency Provide banking services to the U.S. government Supervise and regulate our financial

institutions

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 The Fed makes current monetary policy known by

making announcements concerning the federal funds rate target. If the Fed talks about changing interest rates, it can do so by actively entering the market for federal government securities.

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 Monetary policy involves changing the amount of

money in circulation in order to affect interest rates.

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 If the Fed implements a loose monetary policy

(often called expansionary) , the supply of credit increases and its cost falls. A loose money policy is often implemented as an attempt to encourage economic growth.

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 If the Fed allows a tight monetary policy, the supply

of credit decreases and its cost increases. Why would any nation want a tight money policy?
In order to control inflation

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 Nominal interest rates - the interest

rate actually observed in financial markets.

directly affect the value (price) of most

securities traded in the market

 It says that a dollar received today is worth more

than a dollar received at some future date Simple interest

interest earned on an investment is not reinvested

Value = Principal + Interest

Compound interest interest earned on an investment is reinvested Value = Principal + Interest + Compounded interest

 PV function converts cash flows received over a

future investment horizon into an equivalent (present) value by discounting future cash flows back to present using current market interest rate
lump sum payment a single cash payment received at the end of some investment horizon annuity a series of equal cash payments received at fixed intervals over the investment horizon

PVs decrease as interest rates increase

PV = FVn(PVIFi/m,nm)
where: PV = present value FV = future value (lump sum) received in n years i = simple annual interest n = number of years in investment horizon m = number of compounding periods in a year PVIF = present value interest factor of a lump sum

PV = PMT(PVIFA i/m,nm)
where: PV = present value PMT = periodic annuity payment received during investment i = simple annual interest n = number of years in investment horizon m = number of compounding periods in a year PVIFA = present value interest factor of an annuity

 Translate cash flows received during an investment

period to a terminal (future) value at the end of an investment horizon FV increases with both the time horizon and the interest rate

FV of lump sum equation

FVn = PV(FVIF i/m, nm)

FV of annuity payment equation

FVn = PMT(FVIFAi/m, mn)

Present Value (PV) Future Value (FV)

Interest Rate

Interest Rate

Rate returned over a 12-month period taking the compounding of interest into account
EAR = (1 + i/m)m - 1

 A theory of interest rate determination that views

equilibrium interest rates in financial markets as a result of the supply and demand for loanable funds

D Interest Rate
IH

i
IL

Quantity of Loanable Funds Supplied and Demanded

 Inflation
continual increase in price of goods/services

Real Interest Rate

nominal interest rate in the absence of inflation

Default Risk
risk that issuer will fail to make promised payment

(continued)

 Liquidity Risk
risk that a security can not be sold at a predictable

price with low transaction cost on short notice

Special Provisions
taxability convertibility

callability

Time to Maturity

 Real Risk-free Rate: Refers to the interest rate on a risk-

free security where there is inflationary concerns. Inflation Premium: The premium added to an interest rate to cover the cost of any inflationary concerns that may affect purchasing power. Default Risk Premium: Refers to the premium added to an interest rate relative to the likelihood that the financial obligation will not be fulfilled. Maturity Risk Premium: An opportunity cost arises over the lifetime of loaned funds, thus a maturity risk premium is added to compensate for opportunity costs.

 TOOLS OF MONETORY POLICY

 Discount rate - the

interest rate charged to banks. The committee meets 10x a year to determine what to do to the interest rate. An increase in the discount rate make borrowing money more costly, the money supply contracts.

 Reserve

Requirement - % of money that banks must keep on hand. This is rarely changed. The current reserve requirement is 10%.

 Open market

operations Buying and selling of government securities. This is used daily to regulate the money supply. This is the most used monetary tool.

 Margin requirements

Credit regulation

the percentage of cash an investor must have to buy stocks

Power to regulate

consumer credit in times of national emergency

Moral suasion

Unofficial pressure

that the Fed can request informally

Targets can be broadly classified into either Price Targets or Quantity Targets

Suppose that the Federal Government could influence the supply of oranges and wanted to regulate the orange market

Price

Supply

Lowering the price to $4 (price target) and Raising the quantity to 1,500 (quantity target) are both describing the same policy (expanding the orange market)

$5/Lb

$4/Lb
Demand

1,000 1,500

Quantity of Oranges

Targets can be broadly classified into either Price Targets or Quantity Targets

However, your response to demand changes will differ across policies

Price

Supply

If demand for oranges increases and the Fed is following a price target, they must respond by increasing supply

$5/Lb

Target Range

Demand

Quantity of Oranges

Targets can be broadly classified into either Price Targets or Quantity Targets
However, your response to demand changes will differ across policies Target Range Price
Supply

If demand for oranges increases and the Fed is following a quantity target, they must respond by decreasing supply 1000Lbs

Demand

Quantity of Oranges

 STRATAGIES OF MONETORY POLICY

1.

Monetary targeting
Central bank announces that it will achieve a target value of annual growth rate of money supply (M1 or M2).

2. 3.

Inflation targeting

Inflation rate as the target. No explicit target but have an implicit nominal anchor

Monetary policy with an implicit nominal anchor

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Flexible, transparent, accountable

Advantages
Almost immediate signals, help fix inflation expectations

and produce less inflation Almost immediate accountability

Disadvantages
Must exist a strong and reliable relationship

between the goal variable and the targeted monetary aggregate

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 Public announcement of medium-term numerical

target for inflation (e.g. 3-5%).

Institutional commitment to price stability as the

primary, long-run goal of monetary policy and a commitment to achieve the inflation goal.
Information-inclusive approach in which many

variables are used in making decisions.

Increased transparency of the strategy.
Increased accountability of the central bank.
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 Policy makers are very concerned about establishing

policy credibility because they believe that it is necessary to prevent inflationary expectations from becoming built into the system
Nominal interest rates are the rates you actually

see and pay

Real interest rates are nominal interest rates

adjusted for expected inflation

Nominal interest rate = Real interest rate +

Expected inflation rate

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 The direct effect of an increase in the money supply

refers to people purchasing more goods and services because they have more money or cash balances than they desire.

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 The indirect effect of an increase in the money

supply occurs when such a monetary policy leads to a decrease in interest rates, which then lead to higher levels in desired borrowing by individuals and businesses.

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 When the Federal Reserve System engages in

contractionary monetary policy. The Fed does so by taking money out of the banking system. The result is that aggregate demand is reduced. Consequently, the equilibrium level of real GDP per year falls.

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 In the short run (several months

to a year), many factors can affect inflation beside monetary policy. In the long run, empirical studies show, there is a relatively stable relationship between excess growth in the money supply and inflation.

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 To fight recession,
the Fed will
Lower the discount rate Buy securities on the open market

Lower reserve requirements This would be done only as a last resort

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 To fight inflation,
the Fed will
Raise the discount rate Sell securities on the open market

Raise reserve requirements This would be done only as a last resort

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Importance in Developing Countries

 Development of Financial Institutions Underdeveloped country: Lack of Financial Institutions People do not use Bank : All income goes to consumption No encouragement in Saving No Saving: No Investment Obstruction in economic growth

Monetization of Rural Sector

Underdeveloped countries: More people live to rural areas Transaction in barter system Monetary policy helps to remove barter system eg: Kale Damai

Development of Organized Money Market Lack of organized money market: Money mrket controlled by big and rich money lenders Exploit general class Central Bank: Unorganized money market into organized. Appropriate interest rate.

Increase in Investment
Low income: High MPC, no saving No Saving : No Investment Monetary Policy: Proper environment for saving, Capital formation Increasing interest rate (encourage saving) Loan at appropriate interest rate (encourage investment)