ECO 551

Monetary Economics
Chapter 6
Central Bank and the Conduct
of the Monetary Policy
Main Textbook:
Mishkin, Frederic S. (2009). The Economics of Money, Banking & Financial Market,
9th Edition, New York : Pearson Addison Wesley
http://www.cwu.edu/~saunders/ec330/ec330ppt.html
http://databank.worldbank.org/data/home.aspx

LEARNING OBJECTIVES

1. Functions of central bank

2. Types of monetary policy
Expansionary monetary policy
Contractionary monetary policy
3. Transmission mechanism of monetary policy
Monetary policy objectives
Instruments
Advantages and disadvantages

Monetary Policy

Measures implemented by the central

bank to change the money supply, the
level of interest rates, or the availability
of credit in aimed at achieving higher
eocnomic growth, stability in prices, and
full employment.

1. To issue currency (currency issuer) and to

safeguard the external value of the currency
2. Banker to the government
3. Banker to other banks
4. Holder of the countrys stock of gold and
foreign currency reserves
5. Promotes monetary stability of the country.

 To overcome inflation
Contractionary / Restrictive / Tight monetary policy
Tools used will reduce Money Supply in the
economy. This is aimed at reducing the pressures
of inflation in an economy
To

overcome unemployment (during recession)

Expansionary/ Cheap/ Easy monetary policy
Tools used will increase Money Supply and
activities in an economy. This will help increase
employment and growth.

Quantitative

Qualitative

Discount rate/ bank

rate

Selective credit
control

Open market
operations (OMO)

Moral Suasion

Legal reserve
requirements

Special Directive

Funding
Interest rate

1. Open market operations (OMO)

The central bank can influence the cash

reserves of Commercial Banks through its
OMO.
Its includes the buying and selling of
government securities by the central bank to
influence the cash reserves in Commercial
Banks .
The central bank can change the direction of
its OMO according to the situation i.e. from a
policy of increasing the cash reserves of
Commercial Banks to decreasing their
reserves and vice versa.

The legal cash reserve requirement is the

minimum amount of cash that the central bank
requires all Commercial Banks to keep in the
central bank .
It will affect the total amount of Commercial
Banks reserves.
At the same time, it also affects the amount of
excess cash reserves in Commercial Banks
which reflects their ability to lend.
The central bank has the right to vary the cash
and liquidity requirement ratios of Commercial
Banks depending on the situation.
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Refers to the conversion of short-term loans to

long-term loans. The objective of the
conversion from short-term (liquid) to longterm (illiquid) is to enable the Commercial Banks
to create multiple credits.

4. Discount rate/ bank rate

Is the interest rate the bank charges on loans of
reserves to banks. Changes in the bank rate or
discount rate affect the cost at which borrowing
can be made available to banks from the central
bank .
If the central bank increases its bank rate, the
interest rate on borrowing becomes more
expensive and this will lead to a decrease in the
demand for loans.

The central bank will persuade Commercial Banks

to increase/decrease their interest rate on
deposit/loan.
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It enables the central bank to restrict unhealthy

expansion of credit for specific purposes.
During inflation, the banking system can
control
credit
through
hire-purchase
restrictions by imposing regulations.
The central bank will persuade central bank to
grant loans for productive purposes only and
reduce non-performing loans.

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It refers to the pressure by the central bank

on Commercial Banks to discourage them
from borrowing heavily from the central
bank, so as to reduce their lending to the
public.
The objective is to reduce the money supply
in an effort to cure inflation.

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The government through the central bank will

inform the step taken by them to reduce
inflation and unemployment. The central bank
instruct Commercial Banks to reduce the
volume of loans given to the public.
The central bank will also influence
Commercial Banks to restrict their lending
policy such as the need for collateral security,
guarantors and other measures, which will
discourage borrowings.

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1. Open
marke
operations

The central bank buys / sells securities and

treasury bills in the open market to influence the
size of bank deposits

2. Legal
reserve
requireme
nts

Statutory reserve ratio amount of reserves

required on banks to be kept in the central bank.
Liquidity ratio amount of banks liquid assets
required by central bank to be kept in the banks.
Cash ratio amount of cash that are required to
hold
The central bank may increase cash, liquidity, or
statutory reserve ratio requirements to influence
credit creation and money supply. Higher ratios
will mean lesser amount to be loaned out to
public.
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3. Funding

This refers to the conversion of short-term

loans to long-term loans.
Short-term assets like treasury bills are
reduced and more long-term loans and
advances are given. This will lengthern the
payment of the principal sum so that the bank
cannot create multiple credits.

4.
Discount
rate

Rediscount rate of exchange & treasury bills

5. Interest
rate

Banks will be persuaded to increase their

interest rate on deposits to attract more
savings from the public.
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1. Selective credit
control

By allowing loans for productive purposes only, by

increasing minimum margin requirements to open a
letter of credit/ by imposing tighter hire purchase
regulations by fixing minimum down pay payment and
maximum repayment period

2. Moral Suasion

Commercial banks are persuaded to resrict lending

policies.

3. Special directive

Commerical banks are sometimes required by the

central bank to reduce the volume of loans given to
public.
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1. Open market operations - Selling of short term bonds

The central bank may sell the short-term bonds, the central bank
will reduce cash reserves of commercial banks (CBs). Public will
buy these bills. With less cash reserves, banks will be selective in
giving out loans, affect in purchasing activities, will also reduce
general price level.
2. Variations of Legal Reserve Requirements A Increase in
reserve requirements
An increae in reserve requirement ratios will reduce ability of
banks to provide loans to the public, lead to a decrease in the
supply of money and purchasing activities, and thus the inflation
can be controlled.
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3. Funding - Selling long term bonds lengthen the payment of the

principal sum

Successful funding means that people buy illiquid securities which

causes a fall in the general publics expenditure, and money supply. The
inflation rate can be reduced when the public reduced their demand
for money and purchasing activities.
4. Discount rate / Bank rate - A Increase in Discount rate/ Bank rate
A rise in the bank rate raises the price of borrowing funds, thus
borrowing becomes more expensive and demand for loans will be
reduced.
5. Interest rate policy An increase interest rate

The central bank will persuade CB to increase their interest rate on

deposit. Increase the level of saving . This will reduce the total of
demand for money and purchasing activities.

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1. Selective credit control

Hire-purchase: the banking system may fix regulations for
minimum down payment and maximum repaying period.
Capital issue control: the central bank will issue directives to
banks to give loans only to productive purposes, and not to
speculative and unproductive purposes.

2. Moral suasion
The central bank will persuade the commercial bank to restrict
their lending policy.

3. Special directives
The central bank may set up directives and instructions to
banks to reduce the volume of loans given to clients.
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1. Open market operations - buying of short term bonds

The central bank will buy the short-term bonds from public to
increase purchasing power, thus encourage more spending.
Increased in demand will create more job and will reduce the
unemployment rate
2. Variations of Legal Reserve Requiremenst A decrease reserve
requiremens (RR)
The central bank lowers the RR to increase banks ability to create
credit by reducing the percentage of reserves required from
deposits .
Hence encouraging the bank to offer more loans to the public and
businessmen.
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3. Funding- Buying long term bonds shorten the duration of time for loan
repayment allows them to increase the volume of loans
Buying bonds, so people will sell illiquid securities which causes general publics
expenditure to increase.
4. Discount rate / Bank rate A decrease in discount rate/ bank rate
Imposed by the central bank on discount houses, thus borrowing becomes
more cheaper and demand for loans will be increased.
It will affect all other rates in the market to allow more circulation of money in
the economy.
5. Interest rate policy A decrease in interest rate
1. The central bank will persuade commercial banks to lower their interest rate
on deposits.
This will reduce total savings and increase the level of demand for money.
2. When all banks decrease interet rate, the cost of credits to the public will be
reduced.
This will increase the level of demand for money and purchasing activities.
Unemployment will be reduced.
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Qualitative

allowing and supporting the banks and financial institutions to

advance credit to household

as well as firms for productive and non-productive purposes.

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1. Price stability
(the primary goal)
6. Stability in foreign
exchange markets

2. High employment
(output stability)

5. Stability of financial
markets

3. Economic growth

4. Interest rate
stability
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Is a situation of no inflation or deflation in the economy.

Price stability is desirable because a rising price level

(inflation) creates uncertainty in the economy and that
may hamper economic growth.

Inflation is a macro economic situation sustained and

continuous increase in the overall level of all prices.

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Problem 1: Uncertainty about future prices

When the overall level of prices is changing, the

information conveyed by the prices of g&S is hard to
forecast, which complicates decision making for
consumers, businesses and government.

Decisions of producers and consumers are also affected.

This is because producers may not want to supply goods
and services for fear of losses, thus affect consumers
badly.

For
investors
and
business
entrepreneurs,
postponement
projects
will
create
massive
unemployment and slowing the growth of living
standards..
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Problem 2: Money loses its function as a medium of

exchange

When inflation, money loses its value and not able to

buy the same amount as before the inflation. Thus,
standard of living reduces.

If inflation rate becomes extremely rapid, money loses

its usefulness as a means of paying for goods and
services.

Problem 3: Redistribution effects

To those whose nominal incomes do not rise as fast as

prices, so their real income fall.

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High employment can be achieved when economy use all

its available resources more efficiency to attain maximum
output.
Full employment also can refer to 1 condition where
there is lower level of unemployment rate.

The level of employment cannot be zero (natural rate of

employment) because:
- Frictional unemployment involves searches by
workers and firms to find suitable matchups. For
example, a worker who decides to look for a better job
might be unemployed for a while.
- Structural unemployment is a mismatch between
job requirements and the skills of local workers.
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All

countries want to achieve high employment

because of unemployment problem would create
higher losses and social problems such as increased
incidence of crime and mental illness, and reduces the
nations level of output.
At high employment level, all labors have their own
job.
Therefore, the more resources are employed, the
greater the level of output and the higher standard of
living.

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The goal of steady economic growth is closely related to the

high-employment goal because businesses are more likely to
invest in capital equipment to increase productivity and
economic growth when unemployment is low.
Conversely, if unemployment is high and factories are idle, it
does not pay a firm to invest in additional plants and equipment.
Although the 2 goals are closely related, policies can be
specifically aimed at promoting economic growth by directly
encouraging firm to invest or by encouraging people to save,
which provides more funds for firms to invest.
Economic growth also refer to any increase in the productive
capacities, whether as a result of an increase in the labor supply,
an increase in the productivity of labor, or a net increase in the
quantity or quality of the countrys capital stock. The economy
operating at maximum capacity.
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Interest rate stability is desirable because fluctuations in

interest rates can create uncertainty in the economy
and make it harder to plan for the future.
Fluctuations in interest rates that affect consumers
willingness to buy houses, for example, make it more
difficult for consumers to decide when to purchase a
house and for construction firms to plan how many
houses to build.

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The stability of financial markets is also fostered by

interest-rate stability because fluctuations in interest
rates create great uncertainty for financial institutions.
An increase in interest rates produces large capital
losses on long-term bonds and mortgage, losses that
can cause the failure of the financial institutions
holding them.

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Stabilizing extreme movements in the value of dollar in

foreign exchange markets is thus viewed as a worthy
goal of monetary policy.
A rise in the value of the dollar makes American
industries less competitive with those abroad, and
declines in the value of the dollar stimulate inflation in
the US.
In addition, preventing large changes in the value of a
dollar makes it easier to firms and individuals purchasing
or selling goods abroad to plan ahead.
In other countries, which are even more dependent on
foreign trade, stability in foreign exchange markets takes
on even greater importance.
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Merits
1. The central bank has complete control power over
the volume of OMOs.
2. OMOs are flexible and precise.
3. OMOs are easily reserved.
4. OMOs can be implemented quickly.
Demerits
1. the confusion about the central banks intention that
may be created by the OMOs
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Merits
1. The central bank can use it to perform its role as a
lender of last resort.
Demerits
1. Cannot be controlled by the central bank; the
decision maker is the bank
2. May encourage banks to take more risk.

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Merits
1. RR is a powerful tool to affect money supply.
2. Small changes in the RR will result in large changes in
the money supply.
3. RR policy affects all banks equally.
Demerits
1. The raising the RR can cause immediate liquidity
problem in banking institutions.
2. Fluctuating RR would create more uncertainty and lead
the liquidity management to be more difficult.
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