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Table of Contents

Sno# Topics Page
1 Monetary policy 1
2 History and Origin of Monetary policy 1
3 Objectives of Monetary policy 2
4 Types of Monetary Policy 2-6
5 Tools of Monetary policy 6-7
6 Current monetary policy in Pakistan 8
7 Conclusion 8


Introduction to Monetary Policy
Perhaps, often debates starts from topics that what is the most promising and life inventions
which did best to humanity? We have a list of them of which monetary policy is also at the top.
Monetary policy, is an overall process of what, when, where, which, and how much of money
should be increased or decreased in the economy? It is a very tough time for the governments of
time to make monetary policy especially for developing countries and cash based economies,
where cash is believed to be the most promising way of payment.
Note with standing, that monetary policy is not only the tool to control, increase and decrease,
money supply in the economy; and neither is it shield from both supply and demand side.
Monetary policy defines only control of money through increase and decrease of supply of
money in the economy.
Before going in to detail let me define the views of different economists about monetary policy.
Monetary policy is the macroeconomic policy laid down by the central bank. It involves
management of money supply and interest rate and is the supply side economic policy used by
the government of a country to achieve macroeconomic objectives like inflation, consumption,
growth and liquidity
Monetary Policy is the management of money supply and interest rates by central bank to
influence price and employment

History and Origin of Monetary policy
Barter system was the only way to exchange commodities in pre historic era, history is evidence
that barter system was efficient in very small society that could be called small economy, but due
to the expansion of societies, industrialization and foreign trading, money came into being.
Money was the only substitute for barter system due to some of the main shortcomings it had.
That is why money is believed to be the most extraordinary inventions of humans. Similarly,
when money (Paper, Coins) injected into the economy, all the structure and perspective of
exchanges was changed and people really found themselves to be more convenient. Now when
money came into being so what is the guarantee that it would not be substituted with another big
invention? So economists including Keynes tried to make some philosophical and fundamental
standards like backup of gold and silver for money and guidance policy to regulate the supply of
money in the economy.
Hence, economists came to the conclusions of some policies that were divided into two parts;
Direct control of Money (supply side)/ Monetary policy
Indirect control of Money (demand and Supply side)/ Fiscal Policy
But, why should we use monetary policy? What would be the impact of it? What factors could be
directly affected if we ignore monetary policy? The answers for all such questions is what
objectives monetary policy takes under his umbrella; that are

Objectives of Monetary policy
Full employment
Stable exchange rate
Healthy Balance of Payments
Economic growth
Reasonable Price Stability
Greater equality in distribution of
Income & wealth
Financial stability

Types of Monetary policy
In practice, to implement any type of monetary policy the main tool used is modifying the amount of base
money in circulation. The monetary authority does this by buying or selling financial assets (usually
government obligations). These open market operations change either the amount of money or its
liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve
banking amplifies the effects of these actions.
Constant market transactions by the monetary authority modify the supply of currency and this impacts
other market variables such as short term interest rates and the exchange rate.
The distinction between the various types of monetary policy lies primarily with the set of instruments
and target variables that are used by the monetary authority to achieve their goals.
Monetary Policy: Target Market Variable: Long Term Objective:
Inflation Targeting Interest rate on overnight debt A given rate of change in the CPI
Price Level Targeting Interest rate on overnight debt A specific CPI number
Monetary Aggregates The growth in money supply A given rate of change in the CPI
Fixed Exchange Rate The spot price of the currency The spot price of the currency
Gold Standard The spot price of gold Low inflation as measured by the gold price
Mixed Policy Usually interest rates Usually unemployment + CPI change
The different types of policy are also called monetary regimes, in parallel to exchange-rate regimes. A
fixed exchange rate is also an exchange-rate regime; The Gold standard results in a relatively fixed
regime towards the currency of other countries on the gold standard and a floating regime towards those
that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange
rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such
as a harmonized consumer price index).
In economics, an expansionary fiscal policy includes higher spending and tax cuts that encourage
economic growth.
In turn, an expansionary monetary policy is one that seeks to increase the size of
the money supply. As usual, inciting of money supply is aimed at lowering the interest rates on purpose to
achieve economic growth by increase of economic activity.
Conversely, contractionary monetary
policy seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by
either a central bank or a finance ministry. Neoclassical and Keynesian economics significantly differ on
the effects and effectiveness of monetary policy on influencing the real economy; there is no clear
consensus on how monetary policy affects real economic variables (aggregate output or income,

employment). Both economic schools accept that monetary policy affects monetary variables (price
levels, interest rates).
1) Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer
Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The
interest rate used is generally the overnight rate at which banks lend to each other overnight for cash flow
purposes. Depending on the country this particular interest rate might be called the cash rate or something
The interest rate target is maintained for a specific duration using open market operations. Typically the
duration that the interest rate target is kept constant will vary between months and years. This interest rate
target is usually reviewed on a monthly or quarterly basis by a policy committee.
Changes to the interest rate target are made in response to various market indicators in an attempt to
forecast economic trends and in so doing keep the market on track towards achieving the defined inflation
target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest
rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B.
Taylor of Stanford University.
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It has been
used in Australia, Brazil, Canada, Chile, Colombia, the Republic of Hungary, New
Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United
2) Price level targeting
Price level targeting is a monetary policy that is similar to inflation targeting except that CPI growth in
one year over or under the long term price level target is offset in subsequent years such that a targeted
price-level is reached over time, e.g. five years, giving more certainty about future price increases to
consumers. Under inflation targeting what happened in the immediate past years is not taken into account
or adjusted for in the current and future years.
Uncertainty in price levels can create uncertainty around price and wage setting activity for firms and
workers, and undermines any information that can be gained from relative prices, as it is more difficult
for firms to determine if a change in the price of a good or service is because of inflation or other factors,
such as an increase in the efficiency off actors of production, if inflation is high and volatile. An increase
in inflation also leads to a decrease in the demand for money, as it reduces the incentive to hold money
and increases transaction costs and shoe leather costs.
3) Monetary age
In the 1980s, several countries used an approach based on a constant growth in the money supply. This
approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this
approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.
This approach is also sometimes called monetarism.
While monetary policy typically focuses on a price signal of one form or another, this approach is focused
on monetary quantities. As these quantities could have a role on the economy and business cycles
depending on the households' risk aversion level, money is sometimes explicitly added in the central
bank's reaction function.
4) Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying
degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is
with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange
rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-
convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black
market exchange rate where the currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary
authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a
fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or
sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with
a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to
Under a system of fixed exchange rates maintained by a currency board every unit of local currency must
be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local
monetary base does not inflate without being backed by hard currency and eliminates any worries about a
run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely
as the medium of exchange either exclusively or in parallel with local currency. This outcome can come
about because the local population has lost all faith in the local currency, or it may also be a policy of the
government (usually to rein in inflation and import credible monetary policy).
These policies often abdicate monetary policy to the foreign monetary authority or government as
monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain
the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation
depends on factors such as capital mobility, openness, credit channels and other economic factors.
5) Gold standard
The gold standard is a system under which the price of the national currency is measured in units of gold
bars and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the
base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or
as a special type of commodity price level targeting.
Today this type of monetary policy is no longer used by any country, although the gold standard was
widely used across the world between the mid-19th centuries through 1971. Its major advantages were
simplicity and transparency. The gold standard was abandoned during the Great Depression, as countries
sought to reinvigorate their economies by increasing their money supply
The Bretton Woods system,
which was a modified gold standard, replaced it in the aftermath of World War II. However, this system
too broke down during the Nixon shock of 1971.
The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When
an economy grows faster than its money supply, the same amount of money is used to execute a larger
number of transactions. The only way to make this possible is to lower the nominal cost of each
transaction, which means that prices of goods and services fall, and each unit of money increases in value.
Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal
debts to physical assets over time. For example, during deflation, nominal debt and the monthly nominal
cost of a fixed-rate home mortgage stays the same, even while the dollar value of the house falls, and the
value of the dollars required to pay the mortgage goes up. Economists generally consider such deflation to
be a major disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause problems
during recessions and financial crisis lengthening the amount of time an economy spends in

recession. William Jennings Bryan rose to national prominence when he built his historic (though
unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard
made it harder for everyday citizens to start new businesses, expand their farms, or build new homes.
Tools/Instruments of monetary policy
We have been talking about monetary policy from a long time but how these all happens; here
are the instruments, arms and tools by which we are going to deal with such challenges
Discount rate policy
Reserve ratio requirement
Open market operation
Each of them has its own area of influence and impact on certain macro-economic variables that
collectively contributes to attain the desired objectives;

1) Discount Rate policy
The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they
receive from their regional Federal Reserve Bank's lending facility--the discount window. The Federal Reserve Banks
offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit,
each with its own interest rate. All discount window loans are fully secured.
Under the primary credit program, loans are extended for a very short term (usually overnight) to depository
institutions in generally sound financial condition. Depository institutions that are not eligible for primary credit may
apply for secondary credit to meet short-term liquidity needs or to resolve severe financial difficulties. Seasonal credit
is extended to relatively small depository institutions that have recurring intra-year fluctuations in funding needs, such
as banks in agricultural or seasonal resort communities.
The discount rate charged for primary credit (the primary credit rate) is set above the usual level of short-term market
interest rates. (Because primary credit is the Federal Reserve's main discount window program, the Federal Reserve at
times uses the term "discount rate" to mean the primary credit rate.) The discount rate on secondary credit is above the
rate on primary credit. The discount rate for seasonal credit is an average of selected market rates. Discount rates are
established by each Reserve Bank's board of directors, subject to the review and determination of the Board of
Governors of the Federal Reserve System. The discount rates for the three lending programs are the same across all
Reserve Banks except on days around a change in the rate.

2) Reserve ratio requirement
Reserve requirements are the amount of funds that a depository institution must hold in reserve against
specified deposit liabilities. Within limits specified by law, the Board of Governors has sole authority over
changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or
deposits with Federal Reserve Banks.
The dollar amount of a depository institution's reserve requirement is determined by applying the reserve
ratios specified in the Federal Reserve Board's Regulation D to an institution's reservable
liabilities. Reservable liabilities consist of net transaction accounts, nonpersonal time deposits, and
Eurocurrency liabilities. Since December 27, 1990, nonpersonal time deposits and Eurocurrency liabilities
have had a reserve ratio of zero.
3) Open market operation
Open market operations (OMOs)--the purchase and sale of securities in the open market by a central bank--
are a key tool used by the Federal Reserve in the implementation of monetary policy. The short-term

objective for open market operations is specified by the Federal Open Market Committee (FOMC).
Historically, the Federal Reserve has used OMOs to adjust the supply of reserve balances so as to keep the
federal funds rate--the interest rate at which depository institutions lend reserve balances to other
depository institutions overnight--around the target established by the FOMC.
The Federal Reserve's approach to the implementation of monetary policy has evolved considerably since
the financial crisis, and particularly so since late 2008 when the FOMC established a near-zero target range
for the federal funds rate. Since the end of 2008, the Federal Reserve has greatly expanded its holding of
longer-term securities through open market purchases with the goal of putting downward pressure on
longer-term interest rates and thus supporting economic activity and job creation by making financial
conditions more accommodative.
Current Monetary Policy in Pakistan
Almost all major economic indicators have moved in the desired direction over the past few months.
Inflation has come down and growth in Large Scale Manufacturing (LSM) has been strong. Similarly, the
fiscal deficit has been contained during the first half of the fiscal year while the private sector credit has
increased. Moreover, reflecting positive sentiments prevailing in the market, the fiscal authority has been
able to borrow long term and rupee has appreciated against the US dollar. Above all, the foreign exchange
reserves of SBP, a key source of concern for some time, have increased noticeably.
All-in-all confidence in the economy to rebound seems to have increased. This is visible in a marked
improvement in various IBA-SBP survey-based indices capturing consumers confidence and perceptions
of prevailing and expected economic conditions. Despite these positive developments in headline
variables, however, the economy still faces many challenges and a pro-active policy effort is required to
continue to maintain the momentum.
Increase in SBPs foreign exchange reserves from $3.2 billion at end-January 2014 to $4.6 billion by 7th
March 2014 is only a beginning. A substantial and consistent accumulation of reserves is required to
reach and maintain an adequate level. Similarly, the net capital and financial flows, $428 million during
July January, FY14, are still considerably lower than the external current account deficit of $2055
million during the same period. A timely materialization of anticipated foreign inflows during Q4-FY14
is likely to improve the overall external position in the coming months. This expected outcome, however,
is contingent upon a host of policy actions including an appropriate monetary policy stance.
Concerted structural reforms are required to address the deeper weaknesses in the balance of payments
position. Reliance on one-off inflows and foreign loans may provide short-term stability, but share of
private financial flows need to increase consistently to achieve long term stability. Similarly, there is a
need to reduce trade deficit by improving efficiency and competitiveness of exports and to lower share of
imported oil in meeting domestic energy needs. Nevertheless, increase in SBPs foreign exchange
reserves has improved market sentiments, dispirited speculators and resulted in an appreciation of rupee
viz-a-viz US dollar by 6.0 percent since the last monetary policy announcement on 17th January 2014.
Also playing a role in positively influencing market sentiments is the larger than anticipated decline in
CPI inflation. On the back of a month-on-month deceleration in inflation in two of the last three months,
the year-on-year inflation has come down to 7.9 percent in February 2014. This is broadly in line with
SBPs earlier assessment that pickup in economic activity is more likely to be a reflection of increased
utilization of idle productive capacity rather than a marginal increase in aggregate demand. In other
words, growth of 6.8 percent in the LSM sector is an indicator of improved aggregate supply, which
bodes well for containing inflation. These trends, including exchange rate appreciation, have improved
the inflation outlook with a higher likelihood of average inflation remaining within single digits for FY14.


We have personally been the evidence that it is an influential and impactful tool to curb supply of money
so that we derive our main objectives to help out government and people to utilize money rightly at the
right time.