Monetary Policy

Macro Economic Policy Final Goals

Monetary Policy

Fiscal Policy

Trade Policy SOCIAL

WELFARE
Labor Policy

Other Policy
Central Bank Strategy:
Use of Targets

Figure 8.6 Central Bank Strategy

 Instruments of Monetary Policy

1. Direct Instruments (until 1970’s)

1. Interest rate ceiling,
2. Credit control,
3. Directed/selected credit
4. “Sanering”
2. Indirect Instruments
1. Open Market Operation
2. Discount Window Policy
3. Reserve Requirement
4. Moral Suasion
 1.Open Market Operation

 Definition:
“the buying and selling of government securities
in the open market (by central bank) in order to
change the quantity of money”
 Instruments of OMO:
USA : T-Bills, central bank bills, prime
commercial paper
INA : SBI, SUN, FASBI (rupiah intervention),
SWBI (Sertifikat Wadiah BI), Forex intervention
 When the Central Bank purchase or sells securities on the
open market, the economy is affected in three direct ways:

1. Depository institution reserves change (See:ch.14 Miller):

Purchase of bond ↑ reserve ↑ MS↑
2. The price (and, therefore, the yield) of securities changes
(see:ch.7)
Purchase of bond ↑ bond d price ↑  yield↓
Purchase of bond ↓ bond price ↓ yield ↑
3. Economy wide expectations change ”announcement
effect”:
There are no a complete agreement among economist
when OMO occur
Ex:OMO buy expansionary policy, will lead 2
interpretations:
1.Ms ↑  r↓  (C,I) ↑ or
2.Ms ↑  expected rate of inflation ↑  r ↑  (I, C) ↓
 Types of reserves & Monetary Base:

1. Monetary Base/High powered

money/(MB)= TR + C
2. Excess Reserve (ER)=TR-RR
3. TR = BR (Borrowed Reserve) +
NBR (Non-borrowed reserve)
4. Non-borrowed Base = MB – BR
5. Free Reserve (FR)= BR - ER
 The effects of OMO on reserves and
the quantity of money

 Open market purchase  quantity of

money to rise by the increase in non
borrowed reserves times the money
multiplier
 Open market sale  quantity of money
to fall by the decrease non borrowed
reserves times the money multiplier
∆M = m x ∆NBR
The effects of open-market operation on total
bank credit:

 Open market purchase  total credit

to rise by the increase in non
borrowed reserves times the money
multiplier
 Open market sale  total credit to fall
by the decrease non borrowed
reserves times the money multiplier
∆L= mL x ∆NBR
 Types of Open Market Operation:

 Outright purchase or sales  no

strings attached to the transactions
 Repurchase agreements (RPs) 
dealer agrees to repurchases the securities
at a specified date and price, &
Reverse repurchase agreement
(reverse RPs)  Fed agrees to buy back
the securities at a specified date and price
 OPT di Indonesia (lelang SBI):

i↑

Jual Surat M0 ↓
Berharga
M1&M2 ↓
Harga
OPT (Inflasi)

i↓

Beli Surat M0 ↑
Berharga
M1&M2 ↑
 Mengapa OPT banyak diterapkan di
banyak negara (Indonesia)?
(Gray, et all, 1995)

1. Lebih berorientasi pasar

2. Keterlibatan peserta OPT tidak mengikat
3. Arah kebijakan mudah ditangkap oleh
pasar
4. Tidak membebankan pajak pada bank
5. Bank sentral dapat mengontrol frekuensi
OPT dan jumlah/kuantitas lelang yang
diinginkan
 Mekanisme Lelang SBI:

Dewan
Gubernur
Bank

Dir. Pengelolaan
Deputi Gub. Moneter
Bidang Target indikatif &
Pengelolaan
Moneter Hasil lelang

Biding lelang

Rapat Penetapan target Pialang

Usulan dan Hasil Lelang
Target (OMC)
Lelang
 2. Discount Window Policy

Discount window policy refers to the:

1. Term and conditions under which the Fed
lend to depository institutions
2. Amount of reserves the Fed is willing to
lend at any given discount rate to
depository institutions
“The Fed would have to increase or decrease its
lending regardless of what happened to
interest rate if it wanted to affect the money
supply in a particular way”
 The effect of changes in discount window borrowing
on bank reserve and quantity of money

∆M= m x ∆BR
 A reduction in the discount rate would
cause an increase in borrowed reserve,
which would cause a multiple positive effect
on the quantity of money
 An increase in the discount rate would
cause an decrease in borrowed reserve,
which would cause a multiple negative
effect on the quantity of money
Discount window policy and total bank credit

∆L= mL x ∆BR
 A reduction in the discount rate would
cause an increase in borrowed reserve,
which would cause a multiple positive effect
on the total credit
 An increase in the discount rate would
cause an decrease in borrowed reserve,
which would cause a multiple negative
effect on the total credit
 Discount rate policy reconsidered

1. The announcement effect

2. A sluggish discount rate policy
unpopular policy(?)
3. Changes in the discount rate
4. Other cost of using the discount
windows
 Announcement effect:

 Discount policy can be used to signal the Fed’s

intention about future monetary policy 
misinterpretation problem  communicate directly
with the public by announcing about the policy

 If central bank increase in the discount rate

could be interpreted as either:
1. The intent of the central bank to tighten monetary
policy, or
2. An admission by the central bank that it is unable
to contain inflation and that is keeping the discount
rate in line with increase in other short-term rates
Advantages and disadvantages

The important advantage:

 TheFed can use it to the performs its role of the
lender of last resort
The disadvantages:
 The confusion about the federal reserve’s
intention
 Large fluctuation will occur in the spread
between market interest rate and the discount
rate
 3. Reserve Requirement

Effect reserve requirement changes

on the quantity of money:
∆M= ∆m x MB m = 1/RR

 Decrease in reserve requirement,

increases the quantity of money
 Increase in reserve requirement,
decreases in the quantity of money
Effect reserve requirement changes on the quantity of total
bank credit

∆L= ∆mL x MB

 Decrease in reserve requirement,

increases the total bank credit
 Increase in reserve requirement,
decreases in the total bank credit
 Advantage and disadvantage

Advantage:
 Affect all the bank equally and have powerful
effect on the money supply
Disadvantage;
 Is not practical strategy  costly
 Raising the requirement can cause
immediate liquidity problem
 The policy tool do not have much to
recommend it, and it is rarely used
Other Miscellaneous Means of Conducting
Monetary Policy

4. Moral Suasion:
5. Selective Control:
 Margin Requirement
 Credit Controls