Government Policies Governments usually formulates a lot of policies on a lot of issues. But, if we concentrate only on the policies to regulate and guide the economic activities of the country, we find only two- Monetary Policy and Fiscal Policy 2 What is a Policy?

What is Monetary Policy It is the government’s decision about how much money to supply to the economy. 3 This means controlling the supply of M1 or M2

History of Monetary Policy In old times, monetary policy was mainly focused on seioniorage with the aim to maintain the value of money Inflation was not a big concern Bank of England created in 1694 During 1870 – 1920 industrialized nations set up central banks Monetary policy came into question during the great depression 4

Monetary Policy Can be- Loose or Tight 5

Loose monetary policy If the Bangladesh Bank (BB) implements a loose monetary policy (often called expansionary), the supply of credit increases and its cost falls. A loose monetary policy is often implemented as an attempt to encourage economic growth. 6

Tight monetary policy If the BB allows a tight monetary policy (often called contractionary), the supply of credit decreases and its cost increases. Why would any nation want a tight money policy? In order to control inflation 7

8 The Two Faces of Monetary Policy

Goals of Monetary Policy Price stability GDP growth Investment Fight recession Exchange rate stabilization Desired level of unemployment rate 9

How these goals are achieved by controlling money supply? Price Stability: for example, price is shooting up and we want to control it… 10 We reduce money supply Now people have less money at hand So, people buy less amount of goods Demand for goods falls Producers reduce price to maintain sales

Example: Money Supply vs. Inflation 11

How these goals are achieved by controlling money supply? 12  Investment can be induced by controlling money supply

How these goals are achieved by controlling money supply? GDP growth: for example, we want to increase GDP growth… 13 We increase money supply Now people have more money at hand So, people buy more amount of goods Demand for goods rise Producers produce more goods to match market demand

How these goals are achieved by controlling money supply? For example: our export is reducing and we want to increase it… 14 We increase money supply As a result banks have more idle money So, banks reduce interest rate Cost of investment falls and goods become cheaper Export rises

Channels through which monetary policy works Interest Rate channel Exchange rate channel Credit channel 15

How is the money supply controlled The Central Bank generally uses three tools Open market operation (OMO) Discount rate (DR) Reserve ratio (RR) 16

Open Market Operation (OMO) Defined as the buying or selling of treasury bills and bonds by the Bangladesh Bank in the open market. Expansionary – Bangladesh Bank buys bonds (injects money) Contractionary – Bangladesh Bank sells bonds (pulls out money) 17

Characteristics of OMO Sometimes done for temporary periods Repurchase Agreement -- BB buys bond with agreement to sell it back. Matched-Sale Purchase -- BB sells bond with agreement to buy it back. 18

Characteristics of OMO Occurs at the initiative of the BB. BB is in complete control. They are flexible: BB can do small or large amounts. They are reversible: BB can undo policy mistakes. Very low-key policy instrument: difficult to tell what BB has done 19

Discount Rate Defined as the rate of interest charged to banks that borrow from the BB. Expansionary -- BB lowers discount rate. Contractionary -- BB raises discount rate. 20

Characteristics of DR Done at the discretion of the commercial banks Affects interest rate structure of the commercial and specialized banks DR may influence economic activity 21

Reserve Ratio (RR) Banks are required to maintain a certain percentage of their deposits in the form of reserves or balances with the BB. This percentage is called the Reserve Ratio. Expansionary Policy -- BB lowers reserve ratios. Contractionary Policy -- BB raises reserve ratios. 22

Characteristics of RR Too blunt -- needs tiny changes for reasonable adjustments in money growth. Too Disruptive -- affects all banks balance sheets. 23

Strategies of Monetary Policy Money Growth Targeting Inflation Targeting 24

Money Growth Targeting The decade of 1970s was characterized by high inflation and unemployment Central banks initially pursued money growth targeting to achieve steady growth and low inflation In this strategy central banks announces the rate of growth of money for the next one year But in 1980s, in spite of low inflation, output and unemployment were unstable in USA, UK, Canada and Germany Because, due to changing financial system, money demand was hard to predict and, therefore, money growth targeting was ineffective A tightly regulated financial system is necessary for money growth targeting to be successful. Tight financial regulation is often not possible Specially, in the developing countries, where financial reforms are still taking place, strict financial regulations are not viable 25

Inflation Targeting Central banks in many countries adopted inflation targeting during 1990s. New Zealand was the pioneer. In this strategy central bank announces the rate(s) of inflation that it wants to achieve over the next year(s) Through this announcement the central bank signals that hitting that target in the long-run is its number one priority Inflation targeting bypasses the problem of money demand instability Also, it helps to make central bank’s commitments credible to the people as most of the people understands what goal the central bank is trying to achieve However, success of inflation targeting depends on how quickly the economy responds to the policy changes If the economy responds to policy changes slowly then inflation targeting may lose credibility 26

The Issue of Credibility Monetary policy has important goals for the country If these goals are not achieved, then operation of the monetary policy tools are not effective People do not have faith in monetary policy anymore Monetary policy lose credibility Country’s development objectives fall into chaos 27

Example: Dad, Kids and Fantasy Kingdom Dad: 2 Kids: 3 Outcome A Dad: 3 Kids: 2 Outcome B Dad: 0 Kids: 1 Outcome C Dad: 1 Kids: 0 Outcome D 28 FightDon’t Fight Kids’ Strategy Go to Park Don’t go to Park Dad’s Strategy Point assignmentFight Don’t Fight Go to park Don’t go to park Kids1020 Dad0120

How can the central bank maintain credibility: Appointing a “tough central banker” In 1979, in the face of serious inflation President Jimmy Carter appointed Paul Volcker, who succeeded to curb inflation… but failed to check unemployment!!! Changing central bankers’ incentives For example, if the head of the central bank is easy to remove s/he might want to be serious about her/his commitments Increasing central bank’s independence If the central bank is independent it might be free of political influence, and hence, might escape political pressure to increase output and employment (say, before national election) 29

Monetary Policy in Bangladesh Until 1990: limited role of BB Government directly controlled exchange rate and interest rate Taka was pegged against foreign currencies Financial Sector Reform Program started in 1989 Strategy was to target monetary aggregates Free floating exchange rate was introduced in May, 2003 Bangladesh Bank is regularly issuing Monetary Policy Statement since January

Monetary Policy Stance of (first half): Inflation target 9.0% for GDP growth target was 6.5% for CRR increased from 4% to 4.5% Discount rates enhanced by 25 basis points to slow down private sector credit growth (second half): Inflation target lowered to 8.5% Discount rates decreased to lower level 13% interest cap for lending 31

Monetary Policy Stance of (first half): GDP growth target 6.0% Inflation target 6.5% Loose monetary policy (second half): Double digit export growth Strong agriculture output growth GDP growth rate to be between 5 and 6% Inflation target 6.5% 32

Monetary Policy Outcome 33

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Monetary policy outcome 37

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Limitations of Monetary Policy Does not work when aggregate demand needs to be stimulated through direct government spending (Great Depression) Works on the economy through indirect channels. Therefore, often suffers from lag to have impact May be dominated by fiscal policy Wrong policy may result in severe damage for the economy 39

Monetary Policy vs. Fiscal Policy If the goals of the two policies do not match, development objective will be damaged. Example: Suppose, Bangladesh is suffering from high inflation and BB wants to reduce it. BB reduces money supply… But, national election is close and will be held within a year. So, the ruling party decides to spend more money on safety-net programs and employment generating activities Accordingly, the ruling party sets its fiscal policy so that expenditure goes up… What will happen? 40

Other problems related to mismatch of policies If the government borrows too much from the banking system, then little money is left for the private sector to borrow. As a result, private sector initiatives are hampered This is called the “crowding out effect” Because of crowding out private investment falls and GDP falls as well In this case, if the monetary policy authority wants to enhance private sector credit growth, practically it has little room to do so… 41

Other problems related to mismatch of policies Government debt: If the government borrows a lot, it means that at some point of time future, the government will have to pay substantial amount of interest when the loan matures If at that time, the government does not have money enough to pay the interest, it might print money for the purpose… This means that money supply will go up But, if the country at that time suffers from high inflation and BB wants to control it, the contractionary monetary policy will not help. 42