MONETARY POLICY

Lecture Outline
5.1 Introduction
5.2 Objectives
5.3 Goals of Monetary Policy
5.4 Monetary Policy Formulation and Implementation
5.5 Monetary Aggregates and Interest Rate Targets
5.6 Selecting Operating and Intermediate Targets
5.7 Monetary Policy Transmission Mechanisms
5.8 Summary
5.9 References
5.1 Introduction
In this lecture we shall study the formulation and
implementation of monetary policy in the economy, as
one of the major functions of the central bank in the
economy.
Monetary policy refers to a set of rules, procedures and
practices employed by the Central Bank to influence
macroeconomic activities.
This is achieved through changing the level of liquidity
and the availability of credit in the economy. Monetary
policy is just one of the major policies the government
can use to stabilize the economy. The other major
policy is fiscal policy.
5.2 Objectives
At the end of this lecture you should be able to:
 State and explain the goals of monetary policy in the
economy
 Identify the objectives, targets and instruments of monetary
policy
 Assess the effectiveness of monetary policy tools
 Distinguish between the money aggregate and the interest
rate operating procedures
 Discuss the transmission of monetary policy in the economy.
5.3 Goals of Monetary Policy
The most common goals of monetary policy are as
follows:
Price stability
High employment or low rate of unemployment.
Economic growth
Financial markets and institutions stability
Interest rate stability
Foreign exchange market stability.
In an effort to achieve the above monetary policy
goals Central Bank faces a number of problems:
a) The Central Bank focus trade-offs in achieving all of its
goals.
b) The Central Bank has no direct control over real
output or the price level.
c) The Central Bank also faces timing difficulties in using
its monetary policy tools: information lag;
implementation lag; and impact lag.

The Central Bank uses targets to solve the above

problems as it strives to achieve its goal.
5.4 Monetary Policy Formulation and
Implementation

The formulation of monetary policy starts with the

definition of goal and objectives of monetary
policy.
This is then followed by the selection of
intermediate and operating targets. Lastly, the
central bank chooses the policy tools.
The central bank uses Open Market Operations (OMO),
the discount rate, and the reserve ratio (RR) to control
money supply in the economy.

The economy can be controlled by varying the reserve

ratio. Specifically, if monetary authorities increase the
reserve ratio then money supply is reduced. If the
reserve ratio is lowered then money supply will increase.
The reason is simple, changes in the reserve ratio
determines the amounts of reserves available to
commercial banks for lending. The higher the amount of
reserves commercial banks have on their books the
higher is their capacity to lend and hence increase
money supply in the economy.
Open market operations entail the purchase and selling of
government securities to commercial banks and the
non-bank public. When the central bank wishes to
increase money supply in the economy, it will buy
government securities from commercial banks and the
public. This has the effect of increasing the reserves of
the commercial banks.
As already explained above there will be an increase in
money supply in the economy as banks transform their
reserves into loans to their customers. If the central
bank wants to reduce money supply in the economy it
will sell government securities to commercial banks and
the public. This has the effect of reducing the reserves of
the commercial banks. Hence, the commercial banks’
capacity to create money will be curtailed.
The discount rate is the rate of interest the central bank
charges on its loans to commercial banks. If
commercial banks reserves are not sufficient to create
enough loans to meet customer demands the typically
borrow from the central bank to meet the deficit.

Therefore the central bank can control money supply in

the economy by controlling how much money it lends
to commercial banks. The Central Bank uses
intermediate and operating targets do achieve its
goals. Specifically, if the central bank desires to reduce
money supply in the economy then it will simply
increase the discount rate. The converse is also true.
 
5.5 Monetary Aggregates and Interest Rate Targets
The Central Bank cannot generally achieve all of its goals
at the same time. Trade offs among goals force the
Central Bank to select one type of target over another
in its policy.

The Central Bank can use either money supply growth

aggregates or interest rate targets, but not both. It has to
chose between the use of Money Supply Targeting Interest
Rate Fluctuations OR Interest Rate Targeting Money
Supply Fluctuations
5.6 Selecting Intermediate Targets
In addition to selecting the intermediate targets, the Central Bank
must evaluate measurability, controllability, relatedness and
predictability of the variable selected do an intermediate targets.

5.6.1Measurability
A good target variable is which is measurable in a short time
frame to overcome information lags. The Central Bank must
be able to measure and assess very quickly whether its
intermediate target is likely to be met. Potential
intermediate targets are interest rates and monetary
aggregates since they are quickly observable and
measurable.
5.6.2 Controllability
A monetary target should be controllable to overcome impact
lags. An effective target must be responsive to the Central
Bank’s attempt to shift course. A target like nominal GDP or
the stock of non-financial credit outstanding is difficult to
control.

5.6.3 Predictability
The Central Bank also needs targets that have a predictable
impact on the policy goals. How do monetary aggregates and
interest rate measure up to this target. The case for interest
rates target rests on the observation that interest rates
influence lending, borrowing, and portfolio decisions. Hence,
the Central Bank could increase economic activity by reducing
real interest rates to stimulate consumer spending and
business spending and vice versa.
There are two problems with interest rates as intermediate targets:
 The Central Banks’ influence on real interest rates is weaker that its
influence over nominal interest rates.
 Central Bank policy to stabilize interest rates may be inconsistent
with the Central Bank goal of maintaining steady economic growth.

The above problems also confound monetary aggregate as

intermediate targets. How then does the central bank choose
intermediate targets? The answer depends on the source of
fluctuations in economic conditions and in the money supply. If the
relationship between consumer and business spending and
investment decisions and interest rates target offer the central bank
a more predictable way to stabilize economic fluctuations. If the
relationship between the demand for money and other assets and
the interest rate are stable, targeting monetary aggregates offer the
central bank a more predictable connection with its goals.
5.6.4 Relatedness
The Central Bank needs to select an intermediate target which
is closely related to its goals. This is necessary to shorten the
transmission channel of monetary policy and thereby assure
the effectiveness of monetary policy.

5.6.5 Political and Administrative Feasibility

This is entirely an exercise in marketing the target in order to
gain political and administrative support. The selected target
must be accepted by politicians and the public before being
employed by the monetary authorities. Administrative
feasibility is concerned with determining the capacity of the
central bank to manage the selected target. It involves
ensuring that the central bank has the right personnel in
terms of education, skills and experience to effectively
manage the selected target.
5.7 Monetary Policy Transmission Mechanisms
As pointed out earlier, a major difference between the
monetarist and Keynesian analysis of how money
affects the economy is that monetarists do not spell
out this transmission proves in details, while
Keynesians do.
Thus we shall first examine just a brief discussion of a
portfolio process that summarizes the monetarist
version of the transition process.
 5.7.1 Portfolio Equilibrium
The simplest explanation of the transmission process starts with each
individual and his or her portfolio. Everyone has a portfolio of assets and
liabilities and tries to keep the (monetary plus imputed) yields of all the
assets equal at the margin. Suppose that the quantity of money
increases, so that at least some portfolios now include more money.
Given, for the usual reasons, declining marginal utility, the imputed
yield on money now falls. Hence, portfolio holders exchange money for
other assets.

The assets one chooses to buy depend upon the cross-elasticities of

demand, which in turn, depends on the similarities between assets. For
example, money and treasury bills, being similar, are close substitutes
(have a high cross-elasticity of demand). Not only are they both
extremely safe assets in nominal terms, but the types of risks to which
they are subject are alike. They are both subject to inflation risk, but not
to default risk. Similarly, there is no significant fall in their values if
interest rates rise.
Hence, those who initially hold excess money balances use them to buy
mainly securities like Treasury bills, and interest rates on such
securities fall. But the sellers of Treasury bills now receive these
excess money balances, and they buy mainly assets that are not too
dissimilar to Treasury bills, for example, commercial paper and three-
year government securities.

The sellers of these items, in turn, then buy others assets, and
eventually the increased demand for assets spreads to all assets in the
economy, until in the new equilibrium the (monetary plus imputed)
yields on all assets are again equal. Among the assets whose prices are
raised in the in this way are common stocks and thus the value of
corporations. As explained by Tobin’s theory of investment,
investment now rises. Moreover, as the yield on various assets such as
money and bonds declines, the imputed yield on consumer durables
starts to exceed these other yields, so that households buy more
durables. Similarly, nondurable consumption may rise as saving
declines.
5.7.2 The Keynesian Interpretation
The Keynesian explanation of the transmission process does not
contradict the portfolio-equilibrium approach, but describes the
process in more detail and in terms of interest rates. Suppose the
money supply increases and the interest rate falls. Except in the
extremely unlikely case that borrowing costs other than the rate
of interest rise correspondingly, the cost of investment has now
fallen. Hence, firms have an incentive to borrow and invest more.
There are also three less obvious channels by which lower interest
rates encourage firms to invest.

One of these channels is an expectations effect. When firms see

that the central bank is becoming more expansionary, they expect
to see their sales rise. Hence, they are willing to invest more.
Similarly, when monetary policy becomes highly restrictive, firms
expect a recession.
A second channel is the result of capital rationing. The capital
market is imperfect. Thus banks do not auction off their loanable
funds, making loans to anyone who is willing to pay a high
enough interest rate. Instead, they ration credit. When they
obtain more reserves they respond not just by lowering interest
rates, but also by relaxing their credit standards, making loans to
some customers they otherwise would have turned down. Other
customers, who previously were given loans smaller than they
had requested now receive larger loans.

The third channel operates through stock prices. One component

of a firm’s cost of capital is the price of its stock. And if firms can
sell new stock at a higher price than before, they are more likely
to sell stock and use the proceeds to undertake physical
investment, so that aggregate expenditure increases. But does a
more expansionary policy actually raise stock prices and if so,
how?
 5.7.3 Monetary Policy and Stock Prices
To see how changes in monetary policy affect stock prices we deal first with a
situation in which there is no fear of inflation. Assume that the central
bank adopts an expansionary policy and the growth rate of money rises. The
way stock prices are affected can be explained in three ways. The first is to
say that public now holds more money in its portfolio, and since its
monetary holdings were previously in equilibrium, it now holds excessive
money and tries to exchange some of it for corporate stock.

The second way of putting this is to look at relative yields and to notice that as
people get more money the implicit yield (adjusted for risk) on stock rises.
As they buy stock they bid stock prices up until at the new price the
unexpected (risk-adjusted) yield on a dollar invested in stock is no greater
than the marginal yield on a dollar held as money. A third way is to say that
the present value of a stock, and hence its price, is equal to an expected
stream of future yield discounted at the interest rate. An increase in the
quantity of money temporarily lowers the interest rate and so increases the
present value of the expected future earnings on the stock and, thus, its
price.
 5.7.4 Consumption
A lower interest rate affects consumption as well as investment. At
least over a period of a year or so, monetary policy might well change
aggregate expenditure more through the consumption channels
than through the investment channels. This is expected because
consumption accounts for about two-thirds of GDP, while net
investment accounts for only about one eighth. The ways in which
interest rates affect consumption are explained as follows.

First, there is an effect (in an uncertain direction) of households

changing the proportion of their incomes that they want to save
because they now earn more on their savings. Second, households,
in their capacity as investors in durables, react to lower interest rates
like firms do. Third, a wealth effect raises consumption, as lower
interest rates raise the value of stocks and bonds. Fourth, there is a
liquidity effect as these increases in wealth raise the liquidity of
household.
5.7.5
At oneInternational Trade
time monetary policy was Effects ofhave
thought to Monetary Policy
nearly all its impact
on aggregate expenditure through its effects on domestic
consumption and investment. If monetary policy can affect net
exports it could have a substantial effect on aggregate expenditure.
Indeed, it can do so. Consider that a country’s total transactions with
the rest of the world must balance out at zero.

If a country imports more goods and services than it exports, it must

transfer securities or money to other countries. This is widely
understood. What is not so widely understood is the mirror image of
this point, that if a country buys more claims (securities and money
holdings) from the rest of the world than it sells to the rest of the
world, then it must necessarily export more than it imports. Since
goods and services plus claims, by definition, comprise all items of
value that can be transferred, the more claims you give to others, the
more goods and services you must get in exchange.
Monetary policy changes net exports in this indirect way by
affecting net foreign claims on national assets. Suppose
that interest rates rise in Kenya. Foreigners will want to
hold more Kenyan securities, while Kenyan residents who
previously would have bought and held foreign securities
now want to hold Kenyan securities instead.

When the net sale of Kenyan securities to foreigners rises, net

imports of foreign goods and services have to rise by an
equal amount. The mechanism that brings this about has
previously been described: foreigners need Kenya shillings
to buy Kenyan securities, so the Kenya shilling appreciates
on the foreign exchange market; as a result. Kenyan goods
become more expensive relative to foreign goods and
exports decline while imports rise.
There is, however, another international finance effect of
monetary policy that tends to weaken it. This is that, as
the interest rate rises in Kenya, that increased purchases
of Kenyan securities by foreigners (and by those Kenyans
who would otherwise have bought foreign securities)
work to moderate the rise in the interest rate.

This, in turn, reduces the impact of the Central Bank’s

restrictive policy on investment and consumption.
However in a system of flexible exchange rates this offset
is limited. Since exchange rates fluctuate, foreigners take
a risk in buying securities denominated in Kenya shillings
rather than in their own currencies, and this limits capital
inflows.
END