Monetary Policy

• What is Monetary Policy?

Monetary policy is the process by which the monetary authority of a country controls (i) the supply
of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of
objectives oriented towards the growth and stability of the economy. Monetary policy rests on the
relationship between the rates of interest in an economy, that is, the price at which money can be
borrowed, and the total supply of money. Monetary policy uses a variety of tools to control money
supply, to influence outcomes like economic growth, inflation, exchange rates with other
currencies and unemployment.

Monetary policy consists of a set of rules that aim at regulating the supply of money in accordance
with predetermined goals. Monetary policy is important because it can influence economic growth,
inflation, & the balance of payments (BOP). The central bank conducts monetary policy by using
instruments that influence the supply of money and interest rates in the economy. The fundamental
objective of pursuing monetary policy by the central bank is to ensure that the expansion in the
money supply is consistent with the objectives of the government policies for economic growth,
inflation, & the BOP. In conducting monetary policy, the central bank tries to ensure that the
supply of money is in line with the amount of money demanded by the economic agents:
households and firms.

Monetary policy is an important device for the central bank of a country to maneuver the economy
in the short run – to stimulate the economy when it is in slump or stagnation and cool it down when
it is overheated. Monetary policy is all about the art and science of influencing the money supply,
credit flow and interest rate in the economy in order to impact the level of price and output. It is
also an art because conducting monetary policy is more than a mechanical drill with some numbers
and algorithms; the experiences, judgment and craftsmanship of the policy makers play a vital role.
There is no unique monetary policy framework which is suitable for all countries as it depends on
objectives, the structure of the financial market and the economy in which it operates. It is also
likely that an economy may experience different monetary policy frameworks over time as the
domestic economy and international financial landscape change.

• How monetary policy works?

Policy Instruments => intermediate targets => macroeconomic goals

Like any other policy, monetary policy has also some specific macroeconomic goals. These goals
may vary with the level of development of economies. The monetary authority or the central bank
can’t achieve the goals directly. It has to rely on a set of policy instruments and intermediate
targets. Policy instruments are the banking variables over which the central bank has full control
such as open market operation, repo and reverse repo, altering Cash Reserve Ratio, etc. Choice of
the policy instruments depends on the state of the financial market and the economy. These policy
variables are set to influence some intermediate targets such as inter-bank interest rate, money
supply (M2), etc. The central bank remains vigilant about that the relationship between policy
instruments and the intermediate target and hope that it will be stable so that central bank can fairly
predict the change in intermediate target by changing he policy instruments. Most of the developed
countries such as USA use inter-bank interest rate (i.e. federal fund rate) as the intermediate target
while most of the developing countries use monetary base as the intermediate target. Targeting
inter-bank interest rate requires a well- functioning and competitive banking sector, which the
developing countries tend to lack. We discuss these issues of instruments, targets and broad
macroeconomic goals in reverse order primarily in the context of Bangladesh. Previously,
Bangladesh Bank announced Monetary Policy Statement (MPS) in every six months. But, now
MPS is announced annually.

• What are the Goals of Monetary Policy?

There are two major goals of monetary policy

1. Stabilization of price and output
2. Stabilization in the financial sector

The main objective of monetary policy is to contain inflation and stimulate output and employment
growth. Achieving the goal of containing inflation has been found easier than impacting the output
and employment in a developing country. Sometimes it is said about monetary policy that ‘you
could pull on it to stop inflation but you could not push on it to halt recession’. We can compare it
with kite flying – we have more control over a kite when we pull the strings but less control when
we loose the strings. It is important to keep in mind that supply-side shocks such as natural disaster,
political instability, international price level, etc. contribute to the increase in price level more than
the demand shocks (i.e., drop of public confidence) in developing countries. Monetary policy can
only impact the demand side where demand comes from the consumers and investors. That is,
monetary policy cannot play any role in combating inflation if the changes in price is due to supply
shocks.

Impacting output and employment through the monetary policy requires that the channels that link
between policy instruments and policy goals work perfectly and predictively. These channels are
formally known as transmission mechanism. Unlike developed countries, transmission mechanism
is very weak in the developing countries. Therefore, setting the monetary policy goals of impacting
real economy can be very ambitious for developing countries.
Central bank as the regulatory body is also responsible to stabilize the financial market. The
regulatory role in ensuring discipline in the market, especially in the banking sector is seen as one
of the major tasks of the central bank in developing countries. Apart from regulatory, monitoring
and supervisory role of the central bank, monetary policy, by using tools of monetary policy, can
also have strong impact on the financial market to ensure stability and discipline.

• What are the Types of Monetary Policy?

o Expansionary Monetary Policy

o Contractionary Monetary Policy

EXPANSIONARY POLICY

An Expansionary Policy increases the total supply of money in the economy more rapidly than
usual. An expansionary policy increases the size of the money supply more rapidly, or decreases
the interest rate. Expansionary policy is traditionally used to try to combat unemployment in a
recession by lowering interest rates in the hope that easy credit will entice businesses into
expanding.

In the above figure, it can be seen that

• First the MS increases (1) which CAUSES

• the interest rate to decrease (2) which CAUSES
• the amount of investment to increase (3), this CAUSES
• AD to increase (4) which CAUSES two things:
• real GDP increases (5) causing UE to go down, and
• the price level rises (5) cause a little inflation

CONTRACTIONARY POLICY

A Contractionary Policy expands the money supply more slowly than usual or even shrinks it. A
policy is referred to as contractionary if it reduces the size of the money supply or increases it
only slowly, or if it raises the interest rate. Contractionary policy is intended to slow inflation in
hopes of avoiding the resulting distortions and deterioration of asset values.
In the above figure, it can be seen that

• First the MS decreases (1) which CAUSES

• the interest rate to increase (2) which CAUSES
• the amount of investment to decrease (3), this CAUSES
• AD to decrease (4) which CAUSES two things:
• the price level decreases (5) reducing inflation
• real GDP increases (5) causing UE to go up a little

• What are the different Monetary Policy Tools?

1. Open Market Operations: Open market operations involve the purchase and sale of
government securities by the Central Bank. An open market operation is also known as OMO.
At its regular meetings, the Central Bank authority decides to buy or sell government bonds.
A central bank uses them as the primary means of implementing monetary policy.

Treasury Bills and Bonds are issued by the government as an important tool of raising public
finance. Treasury bills and bonds are short-term and long-term obligations issued by
Bangladesh Bank on behalf of the Government of Bangladesh. Government has introduced 28-
days, 91-days, 182-days, 364-days, 2-years and 5-years treasury bills and 2-yr, 5-yr, 10-yr, 15-
yr & 20-yr Treasury Bonds.

The central bank reintroduced 30-day and 91-day Bangladesh Bank Bills in October 2006 as
the monetary policy instruments following decision that the government treasury bills and the
bond auctions are exclusively used for the government debt management. Auction of weekly
Bangladesh Bank bills is being used to control the level of reserve money. Bangladesh Bank
bills are allowed as approved securities for the statutory liquidity requirement of the banks and
these bills yields higher than the Treasury bill rate, might have induced the banks to reduce
their holdings of treasury bills.

Bangladesh bank introduces repo in 2002 and reverse repo in 2003. With the introduction of
repo and reverse repo systems as tools of monetary policy in 2003, a new scope has been
created for the Treasury and BB bills in the money market as because Banks and financial
institutions had no short-term liquidity management tools. So these organizations are allowed
to use these bills as securities for enjoying repo facility from Bangladesh Bank.
 Under a Repurchase Agreement (often called a Repo), Bangladesh Bank purchases securities
with an agreement that the seller will repurchase them in a short period of time. When the BB
purchases securities, it extends credit to the commercial bank and rate of interest that banks
pay when they borrow money from central bank against securities is called Repo Rate. A
reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate
increases borrowing from the central bank becomes more expensive.

On the other hand, open market sales shrink the monetary base, lowering the money supply.
In a Reverse Repo transaction, Bangladesh Bank sells securities and the buyer agrees to sell
them back to the BB in near future. The reverse repo rate is the rate at which the banks can
park surplus funds with reserve bank by buying securities.

Open market operations are the most important method which central bank uses to influence
the money supply for several reasons.
• It is a device that can be implemented quickly and cheaply.
• It can be done quietly, without a lot of political debate or a public announcement.
• It is a rather powerful tool, as any given purchase or sale of bonds has an ultimate impact
several times the amount of the initial transaction.
• Central Bank can use this tool to change the money supply by a small or large amount on
any given day.

To reduce the money supply in the Central Bank Sells Securities in the
economy open market

To increase the money supply in the Central Bank purchase Securities in

economy the open market

2. Bank Rate: The rate at which central bank lends money to the commercial banks and discount
bills of exchange is called central bank. Banks having trouble meeting their reserve
requirement can borrow funds directly from the Central bank at its discount window. Bank rate
also referred to as the discount rate. Central bank can control the money supply by altering the
discount rate. If central bank raises the discount rate, it discourages banks from borrowing
reserves from the central bank. This reduces the quantity of reserves in the banking system,
which leads to a reduction in the money supply. Again, if the central bank is promoting an
expansion of money and credit, it will lower the discount rate, making it cheaper for banks to
borrow reserves. Thus, a lower discount rate will encourage banks to borrow from the central
bank, increasing the quantity of reserves and the money supply.
 To reduce the money supply in the economy Central Bank raises the bank rate

Central Bank reduces the bank

To increase the money supply in the economy
rate

3. Variation in Reserve Requirement: Commercial banks have to keep legally a certain portion
of their deposits as reserve with central bank. This is called reserve ratio. If the central bank
increases this reserve ratio, amount of fund available to the hand of commercial bank for
granting loan will and thus credit creation will be contracted in the economy. In an opposite
way central bank can increase the amount of credit by decreasing the reserve ratio.

• Cash Reserve Ratio: Cash Reserve Ratio refers to that part of the Depositor's Balance
that the commercial banks should necessarily hold in their hands in form of cash. Banks
deposit this amount with Bangladesh Bank instead of keeping this money with them.
The level of Cash Reserve Ratio is fixed by the Bangladesh Bank (BB). BB can control
the money supply of the country by changing the level of Cash Reserve Ratio. The
commercial banks can decide on the total volume of credit to be provided to the
customers, only after maintaining the required level of Cash Reserve Ratio. In
abbreviated form, this Cash Reserve Ratio is referred as CRR. According to the existing
rules, banks are allowed to maintain the CRR at 6 per cent on the daily basis, but the bi-
weekly average has to be 6.50 per cent.

• Statutory Liquidity Ratio (SLR): Statutory Liquidity Ratio or SLR refers to the
amount that all banks require maintaining in cash or in the form of Gold or approved
securities. Here approved securities mean, bond and shares of different companies. This
Statutory Liquidity Ratio is determined as percentage of total demand and percentage
of time liabilities. Time Liabilities refer to the liabilities, which the commercial banks
are liable to pay to the customers on their anytime demand. The liabilities that the banks
are liable to pay within one month's time, due to completion of maturity period, are also
considered as time liabilities. According to the existing rules, banks are allowed to
maintain the SLR at 18.50 per cent on the daily basis, but the bi-weekly average has to
be 19.00 per cent. The Shariah-based Islamic banks maintain 11.50 per cent SLR
including the CRR.

To reduce the money supply in the

Central Bank raises reserve requirement
economy

To increase the money supply in the Central Bank reduces reserve

economy requirement
4. Other Policies:
• Rationing of credit: Rationing of credit means fixing the amount of credit among
different sectors of the economy. By this method central bank can decrease the amount
of credit in one sector and can increase it in other sector. For example, if central bank
thinks that there is excessive investment in garments industry and jute industry suffers
form required investment, then it can order the commercial banks not to disburse credit
beyond required amount in garments industry and divert the excess amount to jute
industry.
• Moral Suasion: Moral Suasion is just as a request by the BB to the commercial banks
to take so and so action and measures in so and so trend of the economy. Moral suasion
as a monetary policy instrument, allowing the central bank to control by persuasion and
directive.