PAKISTAN ECONOMIC POLICY MONETRY POLICY FAHAD MANSOORI MUSTAFA RAZZAQ -

DEFINITION OF 'MONETARY POLICY' Definition Number 1: “The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves).” Definition Number 2: “Monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.”

Types of Monetary policy 1. Expansionary Monetary Policy  Increases the money supply  It includes purchasing government bonds, and decreasing the reserve requirement and the federal funds interest rate.  The economy expands and output increases. 2. Contractionary Monetary Policy  Decreases the money supply  It includes selling government bonds, increasing the reserve requirement, and increasing the federal funds interest rate.  The economy shrinks and output decreases.

Types of Monetary Policy What to Learn About Expansionary Monetary Policy:  Expansionary monetary policy causes an increase in bond prices and a reduction in interest rates.  Lower interest rates lead to higher levels of capital investment.  The lower interest rates make domestic bonds less attractive, so the demand for domestic bonds falls and the demand for foreign bonds rises.  The demand for domestic currency falls and the demand for foreign currency rises, causing a decrease in the exchange rate. (The value of the domestic currency is now lower relative to foreign currencies)  A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to increase. What to Learn About Contractionary Monetary Policy:  Contractionary monetary policy causes a decrease in bond prices and an increase in interest rates.  Higher interest rates lead to lower levels of capital investment.  The higher interest rates make domestic bonds more attractive, so the demand for domestic bonds rises and the demand for foreign bonds falls.  The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. (The value of the domestic currency is now higher relative to foreign currencies)  A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease.

Tools of Monetary Policy Open Market Operations  Purchase and sale of securities in the open market by a central bank.  The quantity of cash in the money market increases with the purchase of securities whereas there sale has contractionary effect  This instrument is used not so much to control credit. Liquidity Ratio  It’s ratio between a bank’s liquid resources and it’s total liabilities.  Lower the liquidity ratio lower public confidence in banking system which allows banks to invest in government securities to finance credit expansion.  This ratio has a significant effect on the bank’s capacity to expand credit but if it’s used too much than it can disrupt the smooth operation of the money market.

Tools of Monetary Policy Credit Ceiling  Whether for banking system as a whole or for each individual bank can exercise some influence over the total volume of credit though not on its direction or use.  This may tempt the banks to provide more finances to low priority enterprises. Bank Rate  This is the rate at which State Bank buys or discounts bills of exchange and other commercial papers.  All other interest rates like the deposit rate and lender’s rate are tied to it.  It is effective if bank borrow heavily from the central bank and if both bank deposits and credit are interest-elastic.

Tools of Monetary Policy Cash Reserve Requirement  All schedule banks are required to deposit a certain percentage of their total liquid assets with the central bank.  Rise in Cash reserve restricts bank’s lending whereas decrease in it encourages them to advance more credit. Credit Quota  It basically highlight the role of Central bank which can also limit its own lending to banks by fixing a credit quota for each bank. Selective Credit Control  The State Bank of Pakistan can direct banks regarding distribution of credit between different sectors and uses, between short and long-term loans, margin requirements for advances against certain type of assets, and the interest to be charged on different types of advances and from different borrowers.

Monetary Policy Of Pakistan Over The Years.

MONETARY POLICY Given the conditions prevailing in 1948 the SBP adopted a monetarist approach so far as achievement of price stability was concerned. One of the objectives of money policy was to develop the various aspects of the financial sector particularly the banking system. In this context monetary policy gave importance to the asset side of the banking system. Up to 1960 the bulk of monetary expansion was on account of credit to the government sector. In the early years of the country’s economic history the size of the private sector was small and banks were very conservative in lending. Thus, upto lending to the private sector was a relatively unimportant source of changes in money supply compared with deficit financing by the public sector.

Monetary Policy  Government had the effective control in the use of instruments of monetary policy. More specifically, reserve requirements of the commercial banks as well as liquidity requirements, the two important instruments of monetary policy, could be changed only with the government’s approval.  There was no limit on government borrowing from the banking system.  monetary policy, which prior to 1972 was essentially conducted through an indirect method of credit control, was now run by fiat.

Monetary Policy  Political regimes during this period were more pre-occupied with survival than with medium or long-term economic policies.  First was the rising fiscal deficit, the result of a very large increase in government expenditure (including defense), which left a crushing debt burden on the economy

Choice of Policy Instruments  The Bank Rate   Selective Credit Control  Credit Planning and Credit Ceilings: An Appraisal

Monetary Policy  This period is one of transition of monetary policy management from Credit Ceilings (upto end June 1992), Credit Deposit Ratio (August 1992 – September 1995) and indicative targets (October 1995 – Jan. 2001) to reliance of monetary policy on OMOs.  Agreements signed by successive governments with the IMF and the World Bank were breached more often than implemented. Tough decisions to end subsidies, to remove price distortions, mobilize domestic resources, widen the tax base, eliminate discretionary controls.

Monetary Policy, (1999/00 to date)  The Government, in order to keep low interest rate on its debt instruments, borrowed heavily from the State Bank to finance its maturing loans from commercial banks which would not rollover the government debt at low interest rate  rate of monetary expansion picked up from FY02 and since then total monetary expansion has been Rs billion (upto 25th June 2005) and amounted to 90% increase over the stock of money in Credit expansion amounted to Rs billion between 1st July 2004 and 25th June, Private sector credit expanded by Rs billion between 1st July 2003 and 25th June,  When increase in prices turned out to be beyond the State Bank’s expectation, it had no alternative to tightening the monetary policy.  in the case of Pakistan the State Bank deliberately kept the interest rate low to encourage credit expansion presumably to patronize the growth rate, to the complete exclusion of any consideration for price stability, which is the primary function of a Central Bank.

Monetary Policy, (1999/00 to date)  the State Bank allowed the government to borrow an unlimited amount from banks at a low rate of interest  In the process of maintaining a low rate of interest, the SBP allowed increase in liquidity on two counts: gave additional resources to commercial banks and added to reserve money which is the base of monetary expansion.  The low cost funds available to the corporate sector enabled many companies to strengthen their balance sheets, improved profitability and invest retained earnings along with bank borrowing for expansion,

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