CHAPTER 4

MONETARY POLICY AND

FINANCIAL MARKET
Lecturer: PhD. Hoang Huong Giang
 CONTENTS
• Money and money market
• Concept
• Classification
• Functions
• Money supply
• Measures
• Monetary market
• Financial market
• Concept
• Classification
• The collapse of financial market
• Forecast measures, risk analysis and prevention
 MONEY AND MONEY MARKET
• Concept
• Functions
• Classification
• Money supply
• Measures
• Monetary market
 MONEY AND MONEY MARKET
• Concept

• “as anything that is generally accepted in payment for goods or services

or in the repayment of debts” – Mishkin, F.S 1994

• When completing payment, the responsibility of stakeholders will

terminate
 MONEY AND MONEY MARKET
• Functions

• Unit of account

• Medium of exchange

• Store of value
 MONEY AND MONEY MARKET
• Classification

• Commodity money

• Fiat money

• E-money/check

• Cryptocurrency (eg. Bitcoin)?

 MONEY AND MONEY MARKET
• Monetary regimes

• Bimetallic Standard: Both gold and silver used as money in the UK and
the US by 19th century

• Gold Standard: 1870 – 1914

• Fiat money: Paper money or coins issued/printed by governments

MONEY AND MONEY MARKET
Vietnam’s M2 (Billion VND)
 MONEY AND MONEY MARKET
• Measures

• Measures to regulate monetary market:

• Open market operations

• Required reserve

• Discounted interest rate: the central bank’s lending interest rate for
commercial banks

• -> Interest rate

 FACTORS AFFECTING MONEY SUPPLY

Factors Supervisors Changes Effects on MS

Money base Central Bank Increase Increase

Law on Banking and central

Required reserve bank Decrease
Increase

Over reserved ratio Commercial banks Decrease

Increase
Cash/Deposit Non-banking sector
Decrease
Increase 11
 MONEY AND MONEY MARKET
• Monetary market
• factors affecting money demand:

• Transaction motivation

• Preventive motivations

• Venture motivations

• Interest rate

• Income changes
 DETERMINANTS OF MONEY DEMAND
DEMAND FOR TRANSACTION
Nominal Income Nominal Income increase -> MD increase

Interest rate Low interest rate -> MD increase

Price Price increase -> MD increase
Availability of payment methods Lack of payment methods -> MD increase

DEMAND FOR INVESTMENT

Property Property increase -> MD increase
Income of substitute property the decrease of Income of substitute property
->MD increase
expected interest rate Expected interest rate increase -> MD increase

Risk of substitute property Risk of substitute property increase -> MD increase

17

Liquidity of substitute property Liquidity of substitute property decrease -> MD increase

OUTSTANDING THEORIES OF MONEY DEMAND

• Fisher theory: classical theory of money demand

• The Purchasing Power of Money: Its Determination and
Relation to Credit, Interest, and Crises (1911)

• Liquidity Preference theory: Keynes theory

• The General Theory of Employment, Interest and Money
(1936)

• Quantity theory of Money: Friedman theory

• The Quantity Theory of Money: A Restatement (1956)

14
 MONEY AND MONEY MARKET
• Money market:
• MS = MB*m In which: MB: Money base; m: money multiplier

• Fisher equation: MV = PY

%∆M + %∆V = %∆P + %∆Y

MD = MD(P,Y) = MD/Y = (1/V)*Y = k*Y

Fisher equation on the relationship between nominal and real interest rate:

i=r+π

• V and Y are constant in short term, thus, the increase in MS leads to the raise in price.
What should central bank do to stabilize price level?
 MONEY AND MONEY MARKET
Theoretically, money multiplier is determined by the following formula:

mm = 1/rd

Actually, money multiplier is based on MS1:

 NOMINAL INTEREST RATE AND MONEY DEMAND

• (M/P)D = L(Y, i)

interest rate
• Fisher equation: i = r + πe
• Therefore, (M/P)D = L(Y, r + πe) rA A

rB B

17
Liquidity Trap
rC
Zero bound
MA MB MC Spectacular
demand
 MONETARY POLICY
• Monetary policy is the central bank’s action via the management
of MS and interest rate to achieve the targeted macro economic
policies (FED)
 MONETARY POLICY
• Goals of monetary policy:

• Price stability, inflation control: In Vietnam, Ministry of Finance is a participant?

• Reduction of unemployment: In Vietnam, Ministry of Labor, Invalid and Social

Affair is a participant?

• Promotion of economic growth: In Vietnam, Ministry of Planning and Investment is

a participant?

• Stability of financial system and financial institutions

• Others: stability of exchange rate and national financial security

 MONETARY POLICY
• Target selections:
• Central Banks try to achieve multiple targets simultaneously -> too difficult

• Sometimes, CB has to select intermediate targets

• Should CB pursue targeted interest rate? Eg. Vietnam?

• M. Friedman: instead of setting targeted interest rate, CB should control MS:

• The increase of annual MS (percentage) will be equal to the growth of real

GDP in long term
 MONETARY POLICY
• Target selections:
• Should CB pursue both targeted interest rate and MS?

• Are targeted interest rate and MS consistent?

• Case study: How should the CB do if he has to select

only one of the two
 MONETARY POLICY
• Target selections:

• Should CB set up targeted inflation rate?

• The CB has to regulate monetary policy to meet committed

inflation target

• Applications: New Zealand (1989), Canada (1991), England

(1992), Finland (1993), Sweden (1993),Spain (1994), ECB,
Korea, Mexico, Poland etc.
 TAYLOR’S PRINCIPLES (1993)

• Principles of monetary policy: the CB should regulate nominal interest rate to meet the
changes on inflation, GDP or other economics conditions/variables
• If inflation rate increases by 1%, the CB should also increase the nominal interest rate by
1% !" = %" + '∗ + )% %" − %∗ + ) (+ − +* )
"" + " "

In which, it is nominal short-term targeted interest rate, %" is real inflation rate,
%∗ is targeted inflation rate "

, '∗ is interest rate at the equilibrium, yt is logarithm of real GDP and, +#" is
logarithm of potential GDP
 MONETARY POLICY
• Monetary policy and the operation of the economy:
• The influence of monetary policy on AD: (the increase of interest rate)
• C: households tends to increase savings rather than consumption – the increase in
private savings -> is there any changes in Investment?
• I will reduce because I and r have diverse relationship
• G: constant
• Net export: a reduction in imports, but does export increase? (NX = S - I(r))
• The influence of monetary policy on output and price
• Expansionary monetary policy will reduce interest rate and thus, lead to the increase in
real GDP
• Contractionary monetary policy regulates MS leading to the increase in interest rate
to reduce inflation tension
 MONETARY POLICY
• Vietnam’s monetary policy
• Monetary policy is a part of the state economic-financial policies for
stabilization of currency value, inflation control to promote social -
economic development, strengthen the security, and improve living
standard. (Article 2 – Law on State bank, 1997)

• State monetary policy is decisions on money nationwide, which is

promulgated by state agencies, including currency value stability via
inflation indicator, decisions on using tools and measures to implement
targets. (Article 3 – Law on State bank, 2010)
 MONETARY POLICY
• State agencies to supervise monetary policy in Vietnam:
• Assembly: Making decisions on annual inflation via decisions on CPI and
supervision of state monetary policy implementation.
• President: On behalf of Vietnam, Implementing tasks and rights regulated by
constitution and laws to negotiate, sign, participate in international monetary
and banking treaties.
• Government: Submitting the Assembly to decide annual inflation rate.
• Prime minister and banking Minister: Making decisions on using tools and
executive measures to pursue targets of state monetary policy regulated by the
Government.
 VIETNAM’S MONETARY POLICY: PROBLEMS
• Unclear targets with diversified constraints
• Administration-based measures, few market-based measures
• Limited room for policy-based tools
• Distortions due to administrative policy (ceiling interest rate, ceiling
credit etc.)
• Lack of implementation frame for morden monetary policy
• Lack of independence on carrying out policies and dynamism
• ...
STATE BANK POLICY (in the period of Covid-19)
• Debt restructure, fee reduction, unchanged debtor classification
• Extension of credit room for some commercial banks
• Interest rate policy:
• Reducing interest rate for extra deposit (larger than deposit for reserved
requirement): 0% (deposit for reserved requirement: 0,5%)
• Adjusting interest rate 3 times with total reduction by 1.5-2% for regulating interest
rate.
• Reducing by 0,6-1,0%/year for ceiling interest rate for short term credits (below 6
months).
• Reducing by 1,5%/year for short-term ceiling lending interest rate for priority
sectors applied since the 1st June 2018
• Simultaneous reduction of interest rate by 16 commercial banks
• Reserved requirements: Unchanged
 FINANCIAL MARKET
• Concept
• Classification
• The collapse of financial market
• Forecast tools, risk analysis and preventive measures
 FINANCIAL MARKET
• Concept:

• “Financial market includes its banks, nonbank lenders; securities markets;

pension, mutual, and other investment funds; insurers; and market infrastructures
such as central clearing counterparties, payment providers, and central banks, as
well as its regulatory and supervisory authorities. These institutions and markets
provide a framework for carrying out economic transactions and monetary policy
and help channel savings into investment, thereby supporting economic growth.”
– The IMF

• “The settlement mechanism enable financial tools traded and exchanged”

CAPITAL MOBILIZATION AND ALLOCATION

Savers Mobilization Institutions Allocation Borrowers

Households (via Households

pension, Financial (borrowers)
insurance, intermediates Business
investment (borrowering,
funds) corporate
share, leasing)

Businesses Government
Government (bond)
Foreigners Financial Foreigners
market (borrowing,
shares)
 Tổ chức tài chính

Tổ chức Tổ chức
tín dụng tài chính khác

Ngân Tổ chức tín Tổ chức tín dụng

hàng dụng hợp tác phi ngân hàng

NH hợp Quỹ tín HTX

tác tín dụng ND Công Công ty Công ty Công ty Công
C chứng đầu quản lý ty bảo
dụng
ông ty khoán tư CK quỹ hiểm
Ngân hàng Ngân hàng chính ty chính
thương mại phát triển c Quỹ đầu
ho tư
tài
th Bảo lãnh
Tự doanh Quỹ Quỹ Bảo hiểm
NHTM NHTM NHTM
uê tài
chứng
nhà nước cổ phần nước ngoài phát đại thành nhân thọ
khoán hành chúng viên

Đô Nông 100% Liên Chi

Quỹ Quỹ
thị thôn NN doanh nhánh
mở đóng
 Thị trường và công cụ tài chính

Thị trường Thị trường

tiến tệ vốn

Thị trường Thị trường Thị trường Thị trường Thị trường
tín vay liên giấy tờ có giá trái phiếu cổ phiếu
phiếu ngân hàng ngắn hạn khác

Tín Tín Nội Ngoại Chứng chỉ Thương Trái phiếu Trái Cổ phiếu Cổ phiếu
phiếu phiếu tệ tệ tiền gửi phiếu chính phủ phiếu ưu đãi phổ thông
kho NHNN doanh
bạc Hợp đồng nghiệp
mua lại Giấy nợ
CK (Repo) ngắn hạn

Thị trường
hợp đồng phái sinh

Hợp đồng Hợp đồng Hợp đồng

kỳ hạn quyền chọn hoán đổi

Kỳ hạn Tương lai Chọn mua Chọn bán Lãi suất Ngoại tệ Rủi ro tín dụng
 FINANCIAL MARKET
• Classification: Based on International Accounting Standard (IAS) and
ESA 95 (tools introduced in financial market)
• Markets for interest rate instruments;

• Equity markets;

• Markets for investment and money market funds’ shares/units

• Foreign exchange markets; and

• Other financial markets.

 FINANCIAL MARKET
• Classification: Based on term
• Money Market
• Market for short-term capital and financial tools with under 1-year term
• Short-term financial tools are valuable documents
• In Vietnam, short-term financial tools: Treasury Bills, Central Bank Bills,
certificates of deposit, commercial bills, Repo, short-term corporate debts

• Capital Market
• Market for mid-term and long-term capital and financial tools with over 1-year term
• Mid-term and long-term financial tools are common securities: government bills,
corporate bills, common and preferential stock
 FINANCIAL MARKET
• Classification
• Primary & Secondary
• Primary: where financial tools are first issued
• Secondary: where financial tools are exchanged
• Listed & OTC
• Listed: where listed stocks are exchanged
• OTC: where non-listed stock are exchanged
• Official and unofficial market
• Official: which is organized and supervised systematically
• Unofficial: creditors, savings funds, credit collectives etc.
 FINANCIAL MARKET
• The collapse of financial market

• Financial crisis in 1997

• Financial crisis in 2008-2009

 FINANCIAL MARKET
• The collapse of financial market:
• Causes:
• The trend of financial liberalization: ease or abolishment of ceiling
interest rate, reduction in rate of reserve requirement or market entry
barriers or government interference in credit allocation or privatization
of banking and insurance sectors (McKinnon,1973)
• The development of stock market, and encouragement of participation of
international financial intermediates
• -> A fragile financial situation in all countries (Caprio &
Kliengebiel,1995; and Lindgren, Garcia & Saal,1996); Crisis happened
in the countries with high degree of financial liberalization
 FINANCIAL MARKET
• Interest liberalization and Crisis
Countries Interest liberalization Banking Crisis

Chile 1980-95 1981-87

Finland 1986-95 1991-94

Guyana 1991-95 1993-95

Indonesia 1983-95 1992-94

Japan 1985-95 1992-94

Mexico 1989-95 1982, 1994-95

Norway 1985-1995 1987-93

 FINANCIAL MARKET
• Forecast tools, risk analysis and prevention

• Risk management

• Capital adequacy ratio

• Leverage ratio

• Basel III
 FINANCIAL MARKET
• Forecast tools, risk analysis and prevention

• Risk management: Process

• Identifying risk

• Assessing risk

• Controlling risk

• Reviewing control
 FINANCIAL MARKET
• Forecast tools, risk analysis and prevention

• Risk management:

• Risk management structures

• A good risk management structure can forecast the uncertainties and predict
their influence on a business.

• If a business sets up risk management as a disciplined and continuous

process for the purpose of identifying and resolving risks, then the risk
management structures can be used to support other risk mitigation systems.
 FINANCIAL MARKET
• Forecast tools, risk analysis and prevention

• Risk management
• Response to risk
• Avoidance: A business strives to eliminate a particular risk by getting rid
of its cause.
• Mitigation: Decreasing the projected financial value associated with a risk
by lowering the possibility of the occurrence of the risk.
• Acceptance: In some cases, a business may be forced to accept a risk.
 FINANCIAL MARKET
• Forecast tools, risk analysis and prevention
• Capital adequacy Ratio (CAR): is the ratio of a bank’s capital in
relation to its risk weighted assets and current liabilities.
CAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets
• Tier 1 capital is capable of absorbing losses without impacting business
operations)= equity capital + ordinary share capital + intangible assets + audited
revenue reserves
• Tier 2 (revalued reserves, undisclosed reserves, and hybrid securities -> lower
quality, less liquid, and more difficult to measure -> supplementary capital) =
unaudited retained earnings + unaudited reserves + general loss reserves
 FINANCIAL MARKET
• Forecast tools, risk analysis and prevention
• Leverage ratio
Debt-to-Assets Ratio = Total Debt / Total Assets
Debt-to-Equity Ratio = Total Debt / Total Equity
Debt-to-Capital Ratio = Today Debt / (Total Debt + Total Equity)
Debt-to-EBITDA Ratio = Total Debt / Earnings Before Interest Taxes
Depreciation & Amortization (EBITDA)
Asset-to-Equity Ratio = Total Assets / Total Equity
 FINANCIAL MARKET
• Forecast tools, risk analysis and prevention
• UB Basell (2017) Basel III is an internationally agreed set of measures
developed by the Basel Committee on Banking Supervision in response to
the financial crisis of 2007-09. The measures aim to strengthen the
regulation, supervision and risk management of banks.:
• Business indicator: based on financial statement on risk operation
• Business indicator component (BIC) = BI x marginal coefficient
• Internal loss multiplier (ILM): risk-sensitive component capturing a bank’s internal
operational losses and BIC
 FED’S RESPONSE TO COVID-19
• The interest rate is nearly to 0
• Supporting to financial market
• Encouraging commercial banks for
lending
• Supporting business
• Supporting households and consumers
• Supporting states and cities
• Interfering financial market to reduce
the tension of international market
 NEARLY ZERO INTEREST RATE
• Federal interest rate:
• Fed cut federal funds’ target interest rate which is overnight interest rate for commercial banks by 1,5
points percent since 3rd March 2020, led to the reduction of interest rate around 0% to 0,25%.
• Federal funds’ target interest rate is the benchmark for other short term interest rates, which is also
affects long term interest rate, thus, it would lead to a reduction of mortgage cost, cost of car purchase,
cost of housing and others, and of course it also decreases the income of savings

Forward guidance:
Ví dụ: Fed phát tính hiệu lãi suất sẽ tiếp tục duy trì ở mức
thấp “Cho đến khi các điều kiện thị trường lao động đạt
đến mức phù hợp với đánh giá của Ủy ban về việc làm tối
đa và lạm phát đã tăng lên 2% và đang trên đà vượt mức
trung bình 2 phần trăm trong một thời gian.”
https://fred.stlouisfed.org/series/FEDFUNDS
 FINANCIAL MARKET
• Rease:

○ Case study: Enron 2001 and the role of government on

financial supervision
 BUILDING AND IMPLEMENTING MONETARY POLICY

● Building monetary policy:

● Implementing monetary policy
 BUILDING AND IMPLEMENTING MONETARY POLICY

● Building monetary policy:

○ General targets:
■ Economic growth and macro stability
■ Fed: economic growth, price stability, employment, stability of
exchange market and financial market
■ Vietnam: price stability, GDP growth and unemployment reduction
 BUILDING AND IMPLEMENTING MONETARY POLICY
● Building monetary policy: After the collapse of Bretton Woods
system
○ Monetary policy focuses on: quantity control, price control (interest or exchange rate) and
targeted inflation - applied in underdeveloped financial market
○ Monetary policy focuses on: price control and indirect tools: Taylor principle ( growth and
inflation control)
ECB seems rather careful with Taylor principle because its target is inflation control
○ Monetay policy gets target via short-term interest rate control: New Zealand was the founder
of this policy, then over 30 countries pursued this
○ Vietnam: first building monetary policy in 1992
BUILDING AND IMPLEMENTING MONETARY POLICY
○ Implementing monetary policy in Vietnam:
○ In the period of 1992-96: mainly inflation prevention
■ Controlling money supply
■ Abolishing printing money to compensate budget deficit by money base
control
○ 1997-2005: stability of exchange rate, monetary market and banking system
○ 2006-2008: inflation control
○ 2008-2011: both inflation control and economic growth by pump-priming,
○ 2011-now: steady target of inflation control
 FINANCIAL MARKET
• Discussions:

• Vietnam’s monetary policy since its reform

• China’s monetary policy for export promotion

• Thailand’s monetary policy in the period of 1990-now: important changes

• Korea’s monetary policy to foster the development of industrial cluster in the period of 1990-now

• Japan’s monetary policy under Abe sovereignty

• The changes of the US monetary policy under Obama and D.Trump authorities

• The failure of Lizz Truss’ economic policy