Monetary policy and interest rate

Monetary policy is the process by which the monetary authority of a currency controls the supply of
money, often targeting an inflation rate or interest rate to ensure price stability and general trust in
the currency.[1][2][3]
Further goals of a monetary policy are usually to contribute to economic growth and stability, to
low unemployment, and to predictable exchange rates with other currencies.
Monetary economics provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being expansionary or contractionary, where an expansionary
policy increases the total supply of money in the economy more rapidly than usual, and
contractionary policy expands the money supply more slowly than usual or even shrinks it.
Expansionary policy is traditionally used to try to combatunemployment in a recession by
lowering interest rates in the hope that easy credit will entice businesses into expanding.
Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and
deterioration of asset values.
Monetary policy differs from fiscal policy, which refers to taxation, government spending,
and associated borrowing.[4]
Contents
[hide]

1 Overview
1.1 Theory

1.1.1 General

1.1.2 International economics

2 History

2.1 Trends in central banking

2.2 Developing countries

3 Types
o

3.1 Inflation targeting

3.2 Price level targeting

3.3 Monetary aggregates

3.4 Fixed exchange rate

3.5 Gold standard

4 Policy tools
o

4.1 Monetary base

4.2 Reserve requirements

4.3 Discount window lending

4.4 Interest rates

4.5 Currency board

4.6 Unconventional monetary policy at the zero bound

5 See also

6 Notes and references

7 External links

Overview[edit]

Inflation and the growth rate of money supply (M2) in the United States, 1875 to 2011.

Monetary policy, to a great extent, is the management of expectations. [5] Monetary policy rests on the
relationship between the rates of interest in an economy, that is, the price at which money can be
borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or
both of these, to influence outcomes like economic growth, inflation, EXCHANGE RATES with
other currencies andunemployment. Where currency is under a monopoly of issuance, or where
there is a regulated system of issuing currency through banks which are tied to a central bank, the
monetary authority has the ability to alter the money supply and thus influence the interest rate (to
achieve policy goals). The beginning of monetary policy as such comes from the late 19th century,
where it was used to maintain the gold standard.
A policy is referred to as contractionary if it reduces the size of the money supply or increases it only
slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply
more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as
follows: accommodative, if the interest rate set by the central monetary authority is intended to
create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or
tight if intended to reduce inflation.
There are several monetary policy tools available to achieve these ends: increasing interest rates by
fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of
contracting the money supply; and, if reversed, expand the money supply. Since the 1970s,
monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s,
the Bretton Woods system still ensured that most nations would form the two policies separately.
Within the vast majority modern nations, special institutions (such as the Federal Reserve System in
the United States, the Bank of England, the European Central Bank, the People's Bank of China,
the Reserve Bank of New Zealand, and the Bank of Japan) exist which have the task of executing
the monetary policy and often independently of the executive. In general, these institutions are
called central banks and often have other responsibilities such as supervising the smooth operation
of the financial system.
The primary tool of monetary policy is open market operations. This entails managing the quantity of
money in circulation through the buying and selling of various financial instruments, such as treasury
bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less
base currency entering or leaving market circulation.
Usually, the short-term goal of open market operations is to achieve a specific short-term interest
rate target. In other instances, monetary policy might instead entail the targeting of a

specific EXCHANGE RATE relative to some foreign currency or else relative to gold. For example,
in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member
banks lend to one another overnight; however, the monetary policy of China is to target theexchange
rate between the Chinese renminbi and a basket of foreign currencies.
The other primary means of conducting monetary policy include: (i) Discount window lending (lender
of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral
suasion (Lobbying certain market players to achieve specified outcomes); (iv) "Open Mouth
Operations" (talking monetary policy with the market).

Theory[edit]
General[edit]
This article reads like an editorial or opinion piece. Please help improve this article by
rewriting it in anencyclopedic style to make it neutral in tone. See WP:No original
research and WP:NOTOPINION for further details.(December 2014)

Monetary policy is the process by which the government, central bank, or monetary authority of a
country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of
interest to attain a set of objectives oriented towards the growth and stability of the economy.[1]
Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy rests on the relationship between the rates of interest in an economy, that is the
price at which money can be borrowed, and the total supply of money. Monetary policy uses a
variety of tools to control one or both of these, to influence outcomes like economic growth,
inflation, EXCHANGE RATES with other currencies and unemployment. Where currency is under a
monopoly of issuance, or where there is a regulated system of issuing currency through banks which
are tied to a central bank, the monetary authority has the ability to alter the money supply and thus
influence the interest rate (to achieve policy goals).
It is important for policymakers to make credible announcements. If private agents
(consumers and firms) believe that policymakers are committed to loweringinflation, they will
anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely
different matter; compare for instancerational expectations with adaptive expectations). If an
employee expects prices to be high in the future, he or she will draw up a wage contract with a high
wage to match these prices.[citation needed] Hence, the expectation of lower wages is reflected in wagesetting behavior between employees and employers (lower wages since prices are expected to be
lower) and since wages are in fact lower there is no demand pull inflation because employees are

receiving a smaller wage and there is no cost push inflation because employers are paying out less
in wages.
To achieve this low level of inflation, policymakers must have credible announcements; that is,
private agents must believe that these announcements will reflect actual future policy. If an
announcement about low-level inflation targets is made but not believed by private agents, wagesetting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high
wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push
inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are
not credible, policy will not have the desired effect.
If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an
expansionist monetary policy (where the marginal benefit of increasing economic output outweighs
the marginal cost of inflation); however, assuming private agents have rational expectations, they
know that policymakers have this incentive. Hence, private agents know that if they anticipate low
inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless
policymakers can make their announcement of low inflation credible), private agents expect high
inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there
is higher inflation (without the benefit of increased output). Hence, unless credible announcements
can be made, expansionary monetary policy will fail.
Announcements can be made credible in various ways. One is to establish an independent central
bank with low inflation targets (but no output targets). Hence, private agents know that inflation will
be low because it is set by an independent body. Central banks can be given incentives to meet
targets (for example, larger budgets, a wage bonus for the head of the bank) to increase their
reputation and signal a strong commitment to a policy goal. Reputation is an important element in
monetary policy implementation. But the idea of reputation should not be confused with commitment.
A central bank might have a favorable reputation due to good performance in conducting monetary
policy, the same central bank might not have chosen any particular form of commitment (such as
targeting a certain range for inflation). Reputation plays a crucial role in determining how much
markets would believe the announcement of a particular commitment to a policy goal but both
concepts should not be assimilated. Also, note that under rational expectations, it is not necessary
for the policymaker to have established its reputation through past policy actions; as an example, the
reputation of the head of the central bank might be derived entirely from his or her ideology,
professional background, public statements, etc.
It has been argued[6] that to prevent some pathologies related to the time inconsistency of monetary
policy implementation (in particular excessive inflation), the head of a central bank should have a

larger distaste for inflation than the rest of the economy on average. Hence the reputation of a
particular central bank is not necessarily tied to past performance, but rather to particular institutional
arrangements that the markets can use to form inflation expectations.
Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of
credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to
be the most beneficial. For example, capability to serve the public interest is one definition of
credibility often associated with central banks. The reliability with which a central bank keeps its
promises is also a common definition. While everyone most likely agrees a central bank should not
lie to the public, wide disagreement exists on how a central bank can best serve the public interest.
Therefore, lack of definition can lead people to believe they are supporting one particular policy of
credibility when they are really supporting another.[7]
International economics[edit]
Optimal monetary policy in international economics is concerned with the question of how monetary
policy should be conducted in interdependent open economies. The classical view holds that
international macroeconomic interdependence is only relevant if it affects domestic output gaps and
inflation, and monetary policy prescriptions can abstract from openness without harm. [8] As stressed
by Corsetti and Pesenti (2005)[9] and Devereux and Engel (2003),[10] this view rests on two implicit
assumptions: a high responsiveness of import prices to the EXCHANGE RATE , i.e. producer
currency pricing (PCP), and frictionless international financial markets supporting the efficiency of
flexible price allocation. The violation or distortion of these assumptions found in empirical research
is the subject of a substantial part of the international optimal monetary policy literature. The policy
trade-offs specific to this international perspective are threefold:[11]
First, research, e.g. by Gopinath and Rigobon (2008),[12] however, suggests only a weak reflection
of EXCHANGE RATE movements in import prices, lending credibility to the opposed theory of local
currency pricing (LCP). The consequence is a departure from the classical view in the form of a
trade-off between output gaps and misalignments in international relative prices, shifting monetary
policy to CPI inflation control and real exchange rate stabilization.
Second, another specificity of international optimal monetary policy is the issue of strategic
interactions and competitive devaluations, which is due to cross-border spillovers in quantities and
prices.[13] Therein, the national authorities of different countries face incentives to manipulate
the terms of trade to increase national welfare in the absence of international policy coordination.
Though research by Corsetti & Penseti (2005))[9] suggests that the gains of international policy
coordination might be small, such gains may become very relevant if balanced against incentives for
international noncooperation.

Third, open economies face policy trade-offs if asset market distortions prevent global efficient
allocation. Even though the real exchange rate absorbs shocks in current and expected
fundamentals, its adjustment does not necessarily result in a desirable allocation and may even
exacerbate the misallocation of consumption and employment at both the domestic and global level.
This is because, relative to the case of complete markets, both the Phillips curve and the loss
function include a welfare-relevant measure of cross-country imbalances. Consequently, this results
in domestic goals, e.g. output gaps or inflation, being traded-off against the stabilization of external
variables such as the terms of trade or the demand gap. Hence, the optimal monetary policy in this
case consists of redressing demand imbalances and/or correcting international relative prices at the
cost of some inflation.[14]
Corsetti, Dedola & Leduc (2011)[15] summarize the status quo of research on international monetary
policy prescriptions: "Optimal monetary policy thus should target a combination of inward-looking
variables such as output gap and inflation, with currency misalignment and cross-country demand
misallocation, by leaning against the wind of misaligned EXCHANGE RATES and international
imbalances." This is main factor in country money status.

History[edit]
Monetary policy is associated with interest rates and availability of credit. Instruments of monetary
policy have included short-term interest rates and bank reserves through the monetary base.[16] For
many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii)
Decisions to print paper moneyto 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 seigniorage, 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 1699, 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.[17] 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 18701920 period, the industrialized nations set up central banking systems, with one of
the last being the Federal Reserve in 1913.[18] 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 economists long contended that the money-supply growth could affect the
macroeconomy. These included Milton Friedman who early in his career advocated that government
budget deficits during recessions be financed in equal amount by money creation to help to
stimulate aggregate demand for output.[19]Later he advocated simply increasing the monetary supply
at a low, constant rate, as the best way of maintaining low inflation and stable output growth.
[20]

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.[21] 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.[22][23][24]
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.

Trends in central banking[edit]

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.[25] 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,[26] which argues that central bank
monetary policy aggravates the business cycle, creating malinvestment and maladjustments in the
economy which then cause down cycle corrections, but most economists fall into either the
Keynesian or neoclassical camps on this issue.

Developing countries[edit]
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
policy 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.

Types[edit]
In practice, to implement any type of monetary policy the main tool used is modifying the amount
of base money in circulation. The monetary authority does this by buying or selling financial assets

(usually government obligations). These open market operations change either the amount of money
or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional
reserve banking amplifies the effects of these actions.
Constant market transactions by the monetary authority modify the supply of currency and this
impacts other market variables such as short-term interest ratesand the EXCHANGE RATE .
The distinction between the various types of monetary policy lies primarily with the set of instruments
and target variables that are used by the monetary authority to achieve their goals.
Monetary Policy:
Inflation Targeting

Price Level Targeting

Monetary Aggregates

Target Market Variable:

Interest rate on overnight
debt
Interest rate on overnight
debt
The growth in money
supply

Fixed EXCHANGE RATE The spot price of the

currency
GOLD Standard

The spot price of GOLD

Mixed Policy

Usually interest rates

Long Term Objective:

A given rate of change in the CPI

A specific CPI number

A given rate of change in the CPI

The spot price of the currency

Low inflation as measured by the GOLD
PRICE
Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange-rate regimes.
A fixed EXCHANGE RATE is also an exchange-rate regime; The Gold standard results in a
relatively fixed regime towards the currency of other countries on the gold standard and a floating
regime towards those that are not. Targeting inflation, the price level or other monetary aggregates
implies floating exchange rate unless the management of the relevant foreign currencies is tracking
exactly the same variables (such as a harmonized consumer price index).
In economics, an expansionary fiscal policy includes higher spending and tax cuts, that encourage
economic growth.[27] In turn, an expansionary monetary policy is one that seeks to increase the size
of the money supply. As usual, inciting of money supply is aimed at lowering the interest rates on
purpose to achieve economic growth by increase of economic activity.[28] Conversely, contractionary

monetary policy seeks to reduce the size of the money supply. In most nations, monetary policy is
controlled by either a central bank or a finance ministry. Neoclassical and Keynesian
economics significantly differ on the effects and effectiveness of monetary policy on influencing
the real economy; there is no clear consensus on how monetary policy affects real economic
variables (aggregate output or income, employment). Both economic schools accept that monetary
policy affects monetary variables (price levels, interest rates).

Inflation targeting[edit]
Main article: Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition such
as Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central Bank interest rate target.
The interest rate used is generally the overnight rate at which banks lend to each other overnight for
cash flow purposes. Depending on the country this particular interest rate might be called the cash
rate or something similar.
The interest rate target is maintained for a specific duration using open market operations. Typically
the duration that the interest rate target is kept constant will vary between months and years. This
interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.
Changes to the interest rate target are made in response to various market indicators in an attempt
to forecast economic trends and in so doing keep the market on track towards achieving the defined
inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts
the interest rate in response to changes in the inflation rate and the output gap. The rule was
proposed by John B. Taylor of Stanford University.[29]
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It has
been used in Australia, Brazil, Canada, Chile, Colombia, theCzech Republic, Hungary, New
Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United
Kingdom.

Price level targeting[edit]

Price level targeting is a monetary policy that is similar to inflation targeting except that CPI growth in
one year over or under the long term price level target is offset in subsequent years such that a
targeted price-level is reached over time, e.g. five years, giving more certainty about future price

increases to consumers. Under inflation targeting what happened in the immediate past years is not
taken into account or adjusted for in the current and future years.
Uncertainty in price levels can create uncertainty around price and wage setting activity for firms and
workers, and undermines any information that can be gained from relative prices, as it is more
difficult for firms to determine if a change in the price of a good or service is because of inflation or
other factors, such as an increase in the efficiency of factors of production, if inflation is high
and volatile. An increase in inflation also leads to a decrease in the demand for money, as it reduces
the incentive to hold money and increases transaction costs and shoe leather costs.

Monetary aggregates[edit]
In the 1980s, several countries used an approach based on a constant growth in the money supply.
This approach was refined to include different classes of money and credit (M0, M1 etc.). In the US
this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed
Chairman.
This approach is also sometimes called monetarism.
While monetary policy typically focuses on a price signal of one form or another, this approach is
focused on monetary quantities. As these quantities could have a role on the economy and business
cycles depending on the households' risk aversion level, money is sometimes explicitly added in the
central bank's reaction function.[30]

Fixed exchange rate[edit]

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying
degrees of fixed EXCHANGE RATES , which can be ranked in relation to how rigid the
fixed EXCHANGE RATE is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a
fixed EXCHANGE RATE but does not actively buy or sell currency to maintain the rate. Instead, the
rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In
this case there is a black market EXCHANGE RATE where the CURRENCY TRADES at its
market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary
authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or
a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to
buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed

exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands
where the bands are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of local currency
must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that
the local monetary base does not inflate without being backed by hard currency and eliminates any
worries about a run on the local currency by those wishing to convert the local currency to the hard
(anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used
freely as the medium of exchange either exclusively or in parallel with local currency. This outcome
can come about because the local population has lost all faith in the local currency, or it may also be
a policy of the government (usually to rein in inflation and import credible monetary policy).
These policies often abdicate monetary policy to the foreign monetary authority or government as
monetary policy in the pegging nation must align with monetary policy in the anchor nation to
maintain the EXCHANGE RATE . The degree to which local monetary policy becomes dependent
on the anchor nation depends on factors such as capital mobility, openness, credit channels and
other economic factors.

Gold standard[edit]
Main article: Gold standard
The gold standard is a system under which the price of the national currency is measured in units
of GOLD bars and is kept constant by the government's promise to buy or sell GOLD at a fixed
price in terms of the base currency. The GOLD standard might be regarded as a special case of
"fixed exchange rate" policy, or as a special type of COMMODITY PRICE level targeting.
Today this type of monetary policy is no longer used by any country, although the GOLD standard
was widely used across the world between the mid-19th century through 1971. [31] Its major
advantages were simplicity and transparency. The gold standard was abandoned during the Great
Depression, as countries sought to reinvigorate their economies by increasing their money supply.
[32]

The Bretton Woods system, which was a modified gold standard, replaced it in the aftermath

of World War II. However, this system too broke down during the Nixon shock of 1971.
The gold standard induces deflation, as the economy usually grows faster than the supply of gold.
When an economy grows faster than its money supply, the same amount of money is used to
execute a larger number of transactions. The only way to make this possible is to lower the nominal

cost of each transaction, which means that prices of goods and services fall, and each unit of money
increases in value. Absent precautionary measures, deflation would tend to increase the ratio of the
real value of nominal debts to physical assets over time. For example, during deflation, nominal debt
and the monthly nominal cost of a fixed-rate home mortgage stays the same, even while the dollar
value of the house falls, and the value of the dollars required to pay the mortgage goes
up. Economistsgenerally consider such deflation to be a major disadvantage of the gold standard.
Unsustainable (i.e. excessive) deflation can cause problems during recessionsand financial
crisis lengthening the amount of time an economy spends in recession. William Jennings Bryan rose
to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign
around the argument that deflation caused by the gold standard made it harder for everyday citizens
to start new businesses, expand their farms, or build new homes.[33]

Policy tools[edit]
Monetary policy uses three main tactical approaches to maintain monetary stability:

Money supply. The first tactic manages the money supply. This mainly involves buying
government bonds (expanding the money supply) or selling them (contracting the money
supply). In the Federal Reserve System, these are known as open market operations, because
the central bank buys and sells government bonds in public markets. Most of the government
bonds bought and sold through open market operations are short-term government
bondsbought and sold from Federal Reserve System member banks and from large financial
institutions.[34][35] When the central bank disburses or collects payment for these bonds, it alters
the amount of money in the economy while simultaneously affecting the price (and thereby
the yield) of short-term government bonds. The change in the amount of money in the economy
in turn affects interbank interest rates.[36][37]

Money demand. The second tactic manages money demand. Demand for money, like
demand for most things, is sensitive to price. For money, the price is the interest rates charged
to borrowers. Setting banking-system lending or interest rates (such as the US overnight bank
lending rate, the federal funds discount Rate, and the London Interbank Offer Rate, or Libor) in
order to manage money demand is a major tool used by central banks. Ordinarily, a central bank
conducts monetary policy by raising or lowering its interest rate target for the interbank interest
rate. If the nominal interest rate is at or very near zero, the central bank cannot lower it further.
Such a situation, called a liquidity trap,[38] can occur, for example, during deflation or when
inflation is very low.[39]

Banking risk. The third tactic involves managing risk within the banking system. Banking
systems use fractional reserve banking[40] to encourage the use of money for investment and

expanding economic activity. Banks must keep banking reserves [41][42] on hand to handle actual
cash needs, but they can lend an amount equal to several times their actual reserves. The
money lent out by banks increases the money supply, and too much money (whether lent or
printed) will lead to inflation. Central banks manage systemic risks by maintaining a balance
between expansionary economic activity through bank lending and control of inflation through
reserve requirements.[43]
These three approaches -- open-market activities, setting banking-system lending or interest rates,
and setting banking-system reserve requirements to manage systemic risk -- are the "normal"
methods used by central banks to ensure an adequate money supply to sustain and expand an
economy and to manage or limit the effects of recessions and inflation. These "standard" supply,
demand, and risk management tools keep market interest rates and inflation at specified target
values by balancing the banking system's supply of money against the demands of the aggregate
market.

Monetary base[edit]
Monetary policy can be implemented by changing the size of the monetary base. Central banks
use open market operations to change the monetary base. The central bank buys or sells reserve
assets (usually financial instruments such as bonds) in exchange for money on deposit at the central
bank. Those deposits are convertible to currency. Together such currency and deposits constitute
the monetary base which is the general liabilities of the central bank in its own monetary unit.
Usually other banks can use base money as a fractional reserve and expand the circulating money
supply by a larger amount.

Reserve requirements[edit]
The monetary authority exerts regulatory control over banks. Monetary policy can be implemented
by changing the proportion of total assets that banks must hold in reserve with the central bank.
Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the
rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets
to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts
as a change in the money supply. Central banks typically do not change the reserve requirements
often as it can create volatile changes in the money supply and may disrupt the banking system.

Discount window lending[edit]

Main article: Discount window

Central banks normally offer a discount window, where commercial banks and other depository
institutions are able to borrow reserves from the Central Bank to meet temporary shortages of
liquidity caused by internal or external disruptions. This creates a stable financial environment where
savings and investment can occur, allowing for the growth of the economy as a whole.
The interest rate charged (called the 'discount rate') is usually set below short term interbank market
rates. Accessing the discount window allows institutions to vary credit conditions (i.e., the amount of
money they have to loan out), thereby affecting the money supply. Through the discount window, the
central bank can affect the economic environment, and thus unemployment and economic growth.

Interest rates[edit]
Main article: Interest rate
The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest
rates. Monetary authorities in different nations have differing levels of control of economy-wide
interest rates. In the United States, the Federal Reserve can set the discount rate, as well as
achieve the desired Federal funds rate by open market operations. This rate has significant effect on
other market interest rates, but there is no perfect relationship. In the United States open market
operations are a relatively small part of the total volume in the bond market. One cannot set
independent targets for both the monetary base and the interest rate because they are both modified
by a single tool open market operations; one must choose which one to control. A meta-analysis
of 70 empirical studies on monetary transmission finds that a one-percentage-point increase in the
interest rate typically leads to a 0.3% decrease in prices with the maximum effect occurring between
6 and 12 months.[44]
In other nations, the monetary authority may be able to mandate specific interest rates on loans,
savings accounts or other financial assets. By raising the interest rate(s) under its control, a
monetary authority can contract the money supply, because higher interest rates encourage savings
and discourage borrowing. Both of these effects reduce the size of the money supply.

Currency board[edit]
Main article: Currency board
A currency board is a monetary arrangement that pegs the monetary base of one country to another,
the anchor nation. As such, it essentially operates as a hard fixed EXCHANGE RATE , whereby
local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate.
Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in

reserves with the currency board. This limits the possibility for the local monetary authority to inflate
or pursue other objectives. The principal rationales behind a currency board are threefold:
1. To import monetary credibility of the anchor nation;
2. To maintain a fixed EXCHANGE RATE with the anchor nation;
3. To establish credibility with the EXCHANGE RATE (the currency board arrangement is the
hardest form of fixed EXCHANGE RATES outside of dollarization).
In theory, it is possible that a country may peg the local currency to more than one foreign currency;
although, in practice this has never happened (and it would be a more complicated to run than a
simple single-currency currency board). A gold standard is a special case of a currency board where
the value of the national currency is linked to the value of GOLD instead of a foreign currency.
The currency board in question will no longer issue fiat money but instead will only issue a set
number of units of local currency for each unit of foreign currency it has in its vault. The surplus on
the balance of payments of that country is reflected by higher deposits local banks hold at the central
bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth
of the domestic money supply can now be coupled to the additional deposits of the banks at the
central bank that equals additional hard foreign exchange reserves in the hands of the central bank.
The virtue of this system is that questions of currency stability no longer apply. The drawbacks are
that the country no longer has the ability to set monetary policy according to other domestic
considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of
trade, irrespective of economic differences between it and its trading partners.
Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board
pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a
mainstay of that country's subsequent economic success (see Economy of Estonia for a detailed
description of the Estonian currency board). Argentina abandoned its currency board in January
2002 after a severe recession. This emphasized the fact that currency boards are not irrevocable,
and hence may be abandoned in the face of speculation by FOREIGN EXCHANGE

traders.

Following the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established
a currency board pegged to the Deutschmark (since 2002 replaced by the Euro).
Currency boards have advantages for small, open economies that would find independent monetary
policy difficult to sustain. They can also form a credible commitment to low inflation.

Unconventional monetary policy at the zero bound [edit]

Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are
concerns about deflation or deflation is occurring, are referred to as unconventional monetary
policy. These include credit easing, quantitative easing, and signaling. In credit easing, a central
bank purchases private sector assets to improve liquidity and improve access to credit. Signaling
can be used to lower market expectations for lower interest rates in the future. For example, during
the credit crisis of 2008, the US Federal Reserve indicated rates would be low for an extended
period, and the Bank of Canada made a conditional commitment to keep rates at the lower bound
of 25 basis points (0.25%) until the end of the second quarter of 2010.

See also[edit]

Interaction between monetary and fiscal policies

Interest on excess reserves

Macroeconomic model

Monetary conditions index

Monetary reform

Negative interest on excess reserves

US specific:

Greenspan put

Notes and references[edit]

1.

Jump up^

An interest rate is the rate at which interest is paid by borrowers (debtors) for the use of money that
they borrow fromlenders (creditors). Specifically, the interest rate is a percentage of principal paid a
certain number of times per period for all periods during the total term of the loan or credit. Interest
rates are normally expressed as a percentage of the principal for a period of one year, sometimes
they are expressed for different periods like for a month or a day. Different interest rates exist
parallely for the same or comparable time periods, depending on the default probability of the

borrower, the residual term, the payback currency, and many more determinants of a loan or credit.
For example, a company borrows capital from a bank to buy new assets for its business, and in
return the lender receives rights on the new assets as collateral and interest at a predetermined
interest rate for deferring the use of funds and instead lending it to the borrower. A commercial bank
can usually borrow at much lower interest rates from the central bank that companies can borrow
from the commercial bank.[1]
Interest-rate targets are a vital tool of monetary policy and are taken into account when dealing with
variables like investment,inflation, and unemployment. The central banks of countries generally tend
to reduce interest rates when they wish to increase investment and consumption in the country's
economy. However, a low interest rate as a macro-economic policy can be risky and may lead to the
creation of an economic bubble, in which large amounts of investments are poured into the realestate market and STOCK MARKET . In developed economies, interest-rate adjustments are thus
made to keep inflation within a target range for the health of economic activities or cap the interest
rate concurrently with economic growthto safeguard economic momentum.[2][3][4][5][6]
Contents
[hide]

1 Interest rate notations

2 Historical interest rates

o

2.1 Interest rates in the United States

3 Reasons for interest rate changes

4 Real vs nominal interest rates

5 Market interest rates

o

5.1 Inflationary expectations

5.2 Risk

5.3 Liquidity preference

5.4 A market interest-rate model

5.5 Spread

6 Interest rates in macroeconomics

o

6.1 Elasticity of substitution

6.2 Output and unemployment

6.3 Open Market Operations in the United States

6.4 Money and inflation

7 Impact on savings and pensions

8 Mathematical note

9 Zero interest rate policy

10 Negative interest rates

o

10.1 Negative interest on central bank reserves

11 See also

12 Notes

13 References

14 External links

Interest rate notations[edit]

What is commonly referred to as the interest rate in the media is generally the rate offered on
overnight deposits by the Central Bank or other authority,annualized.[citation needed]
The total interest on a loan or investment depends on the timescale the interest is calculated on,
because interest paid may be compounded.
In retail finance, the annual percentage rate and effective annual rate concepts have been
introduced to help consumers easily compare different products with different payment structures.
In business and investment finance, the effective interest rate is often derived from the yield, a
composite measure which takes into account all payments of interest and capital from the
investment. The notion of annual effective discount rate, often called simply the discount rate, is also
used in finance, as an alternative measure to the effective annual rate which is more useful or
standard in some contexts. A positive annual effective discount rate is always a lower number than
the interest rate it represents.

Historical interest rates[edit]

Germany experienced deposit interest rates from 14% in 1969 down to almost 2% in 2003

In the past two centuries, interest rates have been variously set either by national governments or
central banks. For example, the Federal Reserve federal funds rate in the United States has varied
between about 0.25% to 19% from 1954 to 2008, while the Bank of England base rate varied
between 0.5% and 15% from 1989 to 2009,[7][8] and Germany experienced rates close to 90% in the
1920s down to about 2% in the 2000s.[9][10] During an attempt to tackle spiraling hyperinflation in
2007, the Central Bank of Zimbabwe increased interest rates for borrowing to 800%. [11]
This section requires expansion.
(October 2008)

The interest rates on prime credits in the late 1970s and early 1980s were far higher than had been
recorded higher than previous US peaks since 1800, than British peaks since 1700, or than Dutch
peaks since 1600; "since modern capital markets came into existence, there have never been such
high long-term rates" as in this period.[12]
Possibly before modern capital markets, there have been some accounts that savings deposits
could achieve an annual return of at least 25% and up to as high as 50%. (William Ellis and Richard
Dawes, "Lessons on the Phenomenon of Industrial Life... ", 1857, p IIIIV)

Interest rates in the United States[edit]

In the United States, authority for interest rate decisions is divided between the Board of Governors
of the Federal Reserve (Board) and the Federal Open Market Committee (FOMC). The Board
decides on changes in discount rates after recommendations submitted by one or more of the
regional Federal Reserve Banks. The FOMC decides on open market operations, including the
desired levels of central bank money or the desired federal funds market rate. Since 1954 the main
policy interest rate for the Federal Reserve has been the federal funds rate, prior to 1954 it was the
nominal discount rate. Currently, interest rates in the United States are at or near historical lows.

Reasons for interest rate changes[edit]

Political short-term gain: Lowering interest rates can give the economy a short-run boost.
Under normal conditions, most economists think a cut in interest rates will only give a short term
gain in economic activity that will soon be offset by inflation. The quick boost can influence
elections. Most economists advocate independent central banks to limit the influence of politics
on interest rates.

Deferred consumption: When money is loaned the lender delays spending the money
on consumption goods. Since according to time preference theory people prefer goods now to
goods later, in a free market there will be a positive interest rate.

Inflationary expectations: Most economies generally exhibit inflation, meaning a given

amount of money buys fewer goods in the future than it will now. The borrower needs to
compensate the lender for this.

Alternative investments: The lender has a choice between using his money in different
investments. If he chooses one, he forgoes the returns from all the others. Different investments
effectively compete for funds.

Risks of investment: There is always a risk that the borrower will go bankrupt, abscond,
die, or otherwise default on the loan. This means that a lender generally charges a risk
premium to ensure that, across his investments, he is compensated for those that fail.

Liquidity preference: People prefer to have their resources available in a form that can
immediately be exchanged, rather than a form that takes time to realize.

Taxes: Because some of the gains from interest may be subject to taxes, the lender may
insist on a higher rate to make up for this loss.

Banks: Banks can tend to change the interest rate to either slow down or speed up economy
growth. This involves either raising interest rates to slow the economy down, or lowering interest
rates to promote economic growth. [13]

Economy: Interest rates can fluctuate according to the status of the economy. It will
generally be found that if the economy is strong then the interest rates will be high, if the
economy is weak the interest rates will be low.

Real vs nominal interest rates[edit]

Further information: Fisher equation
The nominal interest rate is the amount, in percentage terms, of interest payable.

For example, suppose a household deposits $100 with a bank for 1 year and they receive interest of
$10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per
annum.
The real interest rate, which measures the purchasing power of interest receipts, is calculated by
adjusting the nominal rate charged to take inflation into account. (See real vs. nominal in
economics.)
If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the
year buys the same amount as the $100 did a year ago. Thereal interest rate, in this case, is zero.
After the fact, the 'realized' real interest rate, which has actually occurred, is given by the Fisher
equation, and is

where p = the actual inflation rate over the year. The linear approximation

is widely used.
The expected real returns on an investment, before it is made, are:

where:
= real interest rate
= nominal interest rate
= expected or projected inflation over the year

Market interest rates[edit]

There is a market for investments which ultimately includes the money
market, bond market, stock market, and currency market as well as retail
financial institutions like banks.
Exactly how these markets function are sometimes complicated. However,
economists generally agree that the interest rates yielded by any
investment take into account:

The risk-free cost of capital

Inflationary expectations

The level of risk in the investment

The costs of the transaction

This rate incorporates the deferred consumption and alternative

investments elements of interest.

Inflationary expectations[edit]
According to the theory of rational expectations, people form an expectation
of what will happen to inflation in the future. They then ensure that they offer
or ask anominal interest rate that means they have the appropriate real
interest rate on their investment.
This is given by the formula:

where:
= offered nominal interest rate
= desired real interest rate
= inflationary expectations

Risk[edit]
The level of risk in investments is taken into consideration.
This is why very volatile investments like shares and junk
bonds have higher returns than safer ones like government
bonds.
The extra-interest charged on a risky investment is the risk
premium. The required risk premium is dependent on
the risk preferences of the lender.
If an investment is 50% likely to go bankrupt, a riskneutral lender will require their returns to double. So for an
investment normally returning $100 they would require
$200 back. A risk-averse lender would require more than
$200 back and a risk-loving lender less than $200.
Evidence suggests that most lenders are in fact riskaverse.[14]
Generally speaking, a longer-term investment carries
a maturity risk premium, because long-term loans are
exposed to more risk of default during their duration.

Liquidity preference[edit]

Most investors prefer their money to be in cash than in

less fungible investments. Cash is on hand to be spent
immediately if the need arises, but some investments
require time or effort to transfer into spendable form. This is
known as liquidity preference. A 1-year loan, for instance,
is very liquid compared to a 10-year loan. A 10-year
US Treasury bond, however, is liquid because it can easily
be sold on the market.

A market interest-rate model[edit]

A basic interest rate pricing model for an asset

Assuming perfect information, pe is the same for all

participants in the market, and this is identical to:

where
in is the nominal interest rate on a given investment
ir is the risk-free return to capital
i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S. Treasury
Bills).
rp = a risk premium reflecting the length of the investment and the likelihood the borrower
will default
lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money
and thus into goods).

Spread[edit]
The spread of interest rates is
the lending rate minus the
deposit rate.[15] This spread
covers operating costs for
banks providing loans and
deposits. A negative spread is
where a deposit rate is higher
than the lending rate.[16]

Interest rates in
macroeconomics[
edit]

Elasticity of
substitution[edit]
The elasticity of substitution
(full name should be the
marginal rate of substitution of
the relative allocation) affects
the real interest rate. The
larger the magnitude of the
elasticity of substitution, the
more the exchange, and the
lower the real interest rate.

Output and
unemployment[edit]
Higher interest rates increase
the cost of borrowing which
can reduce investment and
output and increase
unemployment. Expanding
businesses, especially
entrepreneurs tend to be net
debtors. However,
the Austrian School of
Economics sees higher rates
as leading to greater
investment in order to earn
the interest to pay its
creditors. Higher rates
encourage more saving and
reduce inflation.

Open Market
Operations in the
United States[edit]

The effective federal funds rate

in the US charted over more
than half a century

The Federal Reserve (often

referred to as 'The Fed')
implements monetary
policy largely by targeting
the federal funds rate. This is
the rate that banks charge
each other for overnight loans
of federal funds, which are the
reserves held by banks at the
Fed. Open market
operations are one tool within
monetary policy implemented
by the Federal Reserve to
steer short-term interest rates
using the power to buy and
sell treasury securities.

Money and
inflation[edit]
Loans, bonds, and shares
have some of the
characteristics of money and
are included in thebroad
money supply.

By setting i*n, the government

institution can affect the
markets to alter the total of
loans, bonds and shares
issued. Generally speaking, a
higher real interest rate
reduces the broad money
supply.
Through the quantity theory of
money, increases in the
money supply lead to inflation.

Impact on
savings and
pensions[edit]
Financial economists such
as World Pensions Council
(WPC) researchers have
argued that durably low
interest rates in most G20
countries will have an adverse
impact on
the funding positions of
pension funds as without
returns that outstrip inflation,
pension investors face the
real value of their savings
declining rather than
ratcheting up over the next
few years [17]
From 1982 until 2012, most
Western economies
experienced a period of low
inflation combined with
relatively high returns on
investments across all asset
classesincluding government

bonds. This brought a certain

sense of complacency
amongst some
pension actuarial consultants
and regulators, making it
seem reasonable to use
optimistic economic
assumptions to calculate
the present value of future
pension liabilities...
This potentially long-lasting
collapse in returns
on government bonds is
taking place against the
backdrop of a protracted fall in
returns for other core-assets
such as blue chip stocks, and,
more importantly, a silent
demographic shock. Factoring
in the corresponding
"longevity risk", pension
premiums could be raised
significantly while disposable
incomes stagnate and
employees work longer years
before retiring.[17]

Mathematical
note[edit]
Because interest and inflation
are generally given as
percentage increases, the
formulae above are (linear)
approximations.
For instance,

is only approximate. In
reality, the relationship is

so

The two
approximations,
eliminating higher
order terms, are:

The formulae
in this article
are exact
if logarithmic
units are
used for
relative
changes, or
equivalently
if logarithms
of indices are
used in place
of rates, and
hold even for
large relative
changes.
Most
elegantly, if
the natural
logarithm is
used, yielding
the neper as
logarithmic

units, scaling
by 100 to
obtain
the centinepe
ryields units
that are
infinitesimally
equal to
percentage
change
(hence
approximatel
y equal for
small values),
and for which
the linear
equations
hold for all
values.

Zero
interest
rate
policy[ed
it]
Main
article: Zero
interest-rate
policy
A so-called
"zero interest
rate policy" is
a very low
near-zero
central bank
target interest
rate. At

this zero
lower
bound the
central bank
faces
difficulties
with
conventional
monetary
policy,
because it is
generally
believed that
market
interest rates
cannot
realistically
be pushed
down into
negative
territory.

Negativ
e
interest
rates[edit
]
Nominal
interest rates
are normally
positive, but
not always.
Given the
alternative of
holding cash,
and thus
earning 0%,

rather than
lending it out,
profit-seeking
lenders will
not lend
below 0%, as
that will
guarantee a
loss, and a
bank offering
a negative
deposit rate
will find few
takers, as
savers will
instead hold
cash.[18]
During
the European
sovereigndebt crisis,
government
bonds of
some
countries
(Switzerland,
Denmark,
Germany,
Finland, the
Netherlands
and Austria)
have been
sold at
negative
yields.
Suggested
explanations
include

desire for
safety and
protection
against the
eurozone
breaking up
(in which
case some
eurozone
countries
might
redenominate
their debt into
a stronger
currency).[19]
More
often, real int
erest rates
can be
negative,
when
nominal
interest rates
are below
inflation.
When this is
done via
government
policy (for
example, via
reserve
requirements
), this is
deemed finan
cial
repression,
and was
practiced by

countries
such as
the United
States and U
nited
Kingdom follo
wing World
War II (from
1945) until
the late
1970s or
early 1980s
(during and
following
the Post
World War II
economic
expansion).[20]
[21]

In the late

1970s, Unite
d States
Treasury
securities wit
h negative
real interest
rates were
deemed certif
icates of
confiscation.
[22]

Negative
interest rates
have been
proposed in
the past,
notably in the
late 19th
century

by Silvio
Gesell.[23] A
negative
interest rate
can be
described (as
by Gesell) as
a "tax on
holding
money"; he
proposed it
as
the Freigeld (f
ree money)
component of
his Freiwirtsc
haft (free
economy)
system. To
prevent
people from
holding cash
(and thus
earning 0%),
Gesell
suggested
issuing
money for a
limited
duration,
after which it
must be
exchanged
for new bills;
attempts to
hold money
thus result in
it expiring

and
becoming
worthless.
Along similar
lines, John
Maynard
Keynes appr
ovingly cited
the idea of a
carrying tax
on money,
[23]

(1936,

TheGeneral
Theory of
Employment,
Interest and
Money) but
dismissed it
due to
administrativ
e difficulties.
[24]

More

recently, a
carry tax on
currency was
proposed by
a Federal
Reserve empl
oyee (Marvin
Goodfriend)
in 1999, to be
implemented
via magnetic
strips on bills,
deducting the
carry tax
upon deposit,
the tax being

based on
how long the
bill had been
held.[24]
It has been
proposed that
a negative
interest rate
can in
principle be
levied on
existing
paper
currency via
a serial
number lotter
y: choosing a
random
number 0 to
9 and
declaring that
bills whose
serial number
end in that
digit are
worthless
would yield a
negative 10%
interest rate,
for instance
(choosing the
last two digits
would allow a
negative 1%
interest rate,
and so forth).
This was
proposed by

an
anonymous
student of N.
Gregory
Mankiw,[23] tho
ugh more as
a thought
experiment
than a
genuine
proposal.[25]
A much
simpler
method to
achieve
negative real
interest rates
and provide a
disincentive
to holding
cash, is for
governments
to encourage
mildly
inflationary
monetary
policy;
indeed, this is
what Keynes
recommende
d back in
1936.

Negative
interest
on
central
bank

reserves[
edit]
Main
article: Negat
ive interest
on excess
reserves
However,
central bank
rates can, in
fact, be
negative.
Countries
such as
Sweden and
Denmark
have set
negative
interest on
reserves
that is to say,
they have
charged
interest on
reserves.[26][27]
[28][29]

In July 2009,
Sweden's
central bank,
the Riksbank,
set its policy
repo rate, the
interest rate
on its one
week deposit
facility, at
0.25%, at the
same time as

setting its
overnight
deposit rate
at -0.25%.
[30]

The

existence of
the negative
overnight
deposit rate
was a
technical
consequence
of the fact
that overnight
deposit rates
are generally
set at 0.5%
below or
0.75% below
the policy
rate.[30][31] This
is not
technically an
example of
"negative
interest on
excess
reserves,"
because
Sweden does
not have a
reserve
requirement,
[32]

but

imposing a
reserve
interest rate
without

reserve
requirements
imposes an
implied
reserve
requirement
of zero. The
Riksbank
studied the
impact of
these
changes and
stated in a
commentary
report[33] that
they led to no
disruptions in
Swedish
financial
markets.

FIFO AND LIFO

FIFO and LIFO methods are accounting techniques used in managing inventory and financial
matters involving the amount of money a company has tied up within inventory of produced goods,
raw materials, parts, components, or feed stocks. These methods are used to manage assumptions
of cost flows related to inventory, stock repurchases (if purchased at different prices), and various
other accounting purposes.
FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first
but do not necessarily mean that the exact oldest physical object has been tracked and sold. In other
words, the cost associated with the inventory that was purchased first is the cost expensed first. With
FIFO, the cost of inventory reported on the balance sheet represents the cost of the inventory most
recently purchased.

Consider this example: WikiWorld Co. had the following inventory at hand, in order of acquisition in
November:

Number of Units

Cost

100 units

$50

125 units

$55

75 units

$59

Suppose WikiWorld Co. sells 210 units during November. The company would expense the cost
associated with the first 100 units at $50 and the remaining 110 units at $55. Under FIFO, the total
cost of sales for October would be $11,050. The ending inventory would be calculated the following
way:

Number of Units

Price per unit

Total

Remaining 15 units

$55

$825 ($55 x 15 units)

75 units

$59

$4425 ($59 x 75 units)

Total

$5250

Therefore, the balance sheet would now show inventory valued at $5250.
LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold
first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their
income taxes in times of inflation, but with International Financial Reporting Standards banning the
use of LIFO, more companies have gone back to FIFO. LIFO is only used in the U.S.[1]

In the example above, the company (using LIFO accounting) would expense the cost associated
with the first 75 units at $59, 125 more units at $55, and the remaining 100 units at $50. Under LIFO,
the total cost of sales for October would be $11,800. The ending inventory would be calculated the
following way:

Number of Units

Remaining 90 units

Price per unit

$50

Total

Total

$4500 ($50 x 90 units)

$4500

So the balance sheet would show $4500 in inventory under LIFO.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is
called the LIFO reserve (which, in the example above, is $750). This reserve is essentially the
amount by which an entity's taxable income has been deferred by using the LIFO method. [2]
In most sets of accounting standards, e.g. IFRS, FIFO (or LIFO) valuation principles are "in-fine"
subordinated to the higher principle of lower of cost or marketvaluation.

Liquidity shortage: SBP injects another Rs526.6b

in third OMO of 2015
By Kazim Alam
Published: January 20, 2015

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Latest injection follows those conducted on Jan 2, Jan 9.

KARACHI:
In the third open market operation (OMO) of 2015, the State Bank of Pakistan
(SBP) injected liquidity of Rs526.6 billion into the banking system on Monday.

The cash injection was aimed at addressing the shortage of liquidity that has
affected the banking system for the last three months.
According to data released by the SBPs Domestic Markets and Monetary
Management Department, the liquidity-injecting OMO had a tenor of four days
with the accepted rate of return clocking up at 9.3% per annum.
The latest injection follows OMOs on January 2 and January 9 that injected
Rs513.1 billion and Rs694.1 billion, respectively, into the banking system.
The SBP conducted as many as six cash injection operations last month that
provided the banking sector with a cumulative liquidity of Rs2.1 trillion.

In contrast, the cumulative liquidity injection in the same month of 2013 was
only Rs241.1 billion. In fact, the SBP had to mop up Rs2.4 trillion from the
interbank market in July-March of the last fiscal year, as the interbank market
had excess liquidity for the most part of 2013-14.
Misconceptions
OMOs help banks address their short-term liquidity shortages by letting them
borrow from the SBP against their holdings in government securities. Following
heavy cash injections on a weekly basis for almost two months, economic
commentators said banks persistent liquidity shortages were self-inflicted
because they kept far less cash than they needed to and invested it in
government papers to earn a return.

It created liquidity shortage in the inter-bank market, they stated, forcing the
SBP to conduct OMOs every week.

Under the banking regulations, the weekly average Cash Reserve Requirement
(CRR) for every bank is 5% of the sum of its demand deposits and time deposits
of up to one year. This is in addition to the Statutory Liquidity Requirement of
another 19%. Banks are penalised instantly for failing to maintain the weekly
average of 5% CRR.
SBP data for the latest period (December 19-January 1) shows that the excess
cash reserve held by banks over and above the required CRR amounted to as
much as Rs119.5 billion. The five biggest commercial banks alone maintained
excess cash reserves of Rs3.9 billion on a daily basis over the same period.
In a press release last week, the SBP said the aim of liquidity injection was not to
benefit banks. Calling this interpretation of successive OMOs partial analysis of
monetary variables, it said the liquidity crunch in the interbank market is
primarily a function of negative government borrowings from the central bank.
As opposed to Market Treasury Bills that result in government borrowings from
scheduled banks, this is the debt that the government had raised through
Market Related Treasury Bills (MRTBs). Thus, its retirement means that the
government is sucking liquidity out of the system at a massive level and putting
it back into the hands of the central bank.
The government retired Rs315.4 billion of its debt from the central bank during
July 1 and December 26. In contrast, government borrowings from the SBP had
totalled Rs780 billion in the comparable period of the preceding fiscal year,
official data shows.
Moreover, government borrowings from scheduled banks are also creating
demand for further liquidity in the system. They amounted to Rs646.8 billion
until December 26 as opposed to the retirement of Rs40.4 billion during the
same period of 2013-14.
Published in The Express Tribune, January 20 th, 2015.
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THE term circular debt in the power sector is widely understood in the country
as representing an issue whose solution has eluded policymakers for the last
three years.This article attempts to explain the genesis of the problem and ways
to resolve it.
Circular debt arises when one party not having adequate cash flows to discharge its
obligations to its suppliers withholds payments. When it does so, the problem affects

other entities in the supply chain, each of which withholds its payments, resulting in
operational difficulties for all service providers in the sector, none of whom are then able
to function at full capacity, causing unnecessary loadshedding.
The circular debt numbers that get reported in the press tend to be the sum of the
receivables of each organisation which ends up exaggerating the amount, simply
because of double counting. After all, one partys payables are the other partys
receivables, and logically these should cancel out when we subtract one from the other.
At worst the net amount should be much smaller.
In our case, however, even this net unadjusted amount on June 30, 2011 was in excess
of Rs200bn, which this year is growing by Rs95 crore a day! Lets refer to this
outstanding amount as the issue of stock. To be able to understand what this stock
represents and its daily build-up lets look at a simplified and abridged version of the
supply chain which results in electricity being provided in our homes. Refineries provide
oil to oil marketing companies. Most of the crude oil is imported and suppliers abroad
have to be paid for them to maintain supplies; in their case there can be no debt beyond
the terms agreed for the supply of oil.
The oil marketing companies sell oil to the IPPs or the Wapda-owned electricity
generation plants (called Gencos) which produce electricity and sell it to the
government-run distribution companies referred to as DISCOs (for example Lesco,
Pesco, etc) which provide power to our homes and factories and bill us for this service.
The tariff (price) at which the Gencos sell to the DISCOs and the tariff at which
electricity is supplied to us consumers is determined by Nepra, after receiving
government approval.
The first problem which results in the receivables not cancelling out payables is when
the tariff is unable to meet the costs of its generation and distribution. For instance, if
the price of oil goes up internationally and tariffs are not revised upwards to account for
this increase, there is an element of subsidy whose cost the government has to pick up.
So one component of what constitutes circular debt is the lower rate at which electricity
is being charged to the consumer than the cost of its generation and distribution. By
failing to foot this subsidy bill the government builds up the circular debt. The bulk of the
issue arising from the failure to revise tariffs upwards on a timely basis has been
resolved; the remaining adjustment required on this account is Rs100bn for this year,
which also includes the cost of poor governance.
Next, three components, and the most critical ones, which raise costs, and feed the
circular debt, are the following:

 The inefficiencies of government-owned generation and distribution companies, cosy

deals struck with providers of rental power plants, overstaffing, free provision of
electricity to Wapda employees (this costs other consumers Rs10 crore a day), poor
maintenance of plant equipment, obsolete technologies (resulting in technical losses),
corruption, all of which simply add to the cost of electricity that consumers are being
constrained to bear with equanimity through tariff increases.
The massive issue of electricity theft the cases of DISCOs in Hyderabad,
Peshawar, Quetta and Fata are now well known; with literally no one paying in Fata.
Poor collection of electricity bills. Rs90bn alone is due from provincial governments.
Powerful private individuals and companies are also defaulters as are those who in
collusion with Wapda employees do not pay without being disconnected Rs120bn is
due from private consumers!
To summarise, the issues are failures to revise electricity tariffs on a timely basis;
prevent electricity theft; and ensure collection of billings speedily and disconnecting
those not paying their bills; disconnections will actually also reduce the extent of
outages/loadshedding. In other words, the principle issue is that of governance.
So what is the solution? The liabilities in the shape of the inherited stock of Rs200bn
can be cleared as a one-time effort even, dare I say it, through printing of money
(the latter admittedly at the expense of a slightly higher rate of inflation) provided, and
this would be the major caveat, we take firm and clear initiatives that will prevent the
build-up of the circular debt again. I highlight this because the prevailing incentive
structures enable those operating the sector to live with the comfortable feeling of
business as usual (with the same level of incompetence and degree of poor
governance), convinced that the government will simply step forward, yet again, a few
months down the road to bail out them out.
From these arguments and facts, it should be fairly obvious that the recent decision of
the government to privatise the management of the Gencos not just betrays a weak
diagnosis of the problem of circular debt but also overlooks the urgency to ensure
continued provision of reliable power so that the economy remains a growing concern
the inefficiencies of Gencos is a relatively minor issue. The principle issue is poor
governance, reflected in the sheer failure to weaken the control of powerful lobbies who
continue to ride this gravy train while the rest of the population wrings its hands
helplessly.
It is difficult to fathom how privatising management of generation companies can solve
the problem if electricity tariffs are not raised in a timely manner and governmentmanaged DISCOs fail to prevent electricity theft or collect their bills regularly and

disconnect those not paying their bills i.e. take actions that will ensure cash flows to pay
Gencos and suppliers of fuel regularly.
Moreover, with existing IPPs already issuing notices to the government that either their
dues be paid or they will wind up their operation, it would not be a good advertisement
for any entrepreneur seriously contemplating such an investment, unless he is foolhardy
or knows something we dont the latter could be a situation in which he will get paid a
minimum capacity payment without having to run the plant in the express knowledge
that fuel, especially gas, would not be supplied.
In other words, we could just end up facilitating a scam, with a government liability being
created in the shape of a capacity payment which never had to be discharged while the
generation company was owned by Wapda.
So the correct solution is to either immediately privatise the management or ownership
of DISCOs (under an appropriate regulatory framework) or hand them over to the
provincial governments. The electricity can be supplied at the provincial borders for the
provincial governments to purchase it from the Gencos and manage the DISCOs,
thereby relieving Islamabads overstretched budget from the burden of this seemingly
never-ending electricity subsidy.
The writer was formerly governor of the State Bank of Pakistan.