1. Monetary Policy Money matters, so monetary policy is important Monetary policy is closely related to fiscal policy and to exchange rate policy Monetary institutions also matter Thorvaldur Gylfason

2. Outline Presentation in four parts 1.Monetary institutions 2.The main instruments of monetary policy 3.The role of money and credit in financial programming 4.Exchange rate regimes

3. Monetary institutions Central banks Commercial banks Other financial institutions  Central banks’ clients Government Commercial banks  Commercial banks’ clients Households and firms 1

4. Central banks: Independent or not? Most central banks, but not all, are owned and operated by the government Central bank officials are public officials Inflation in 1970s and 1980s raised concerns: where central banks being too willing to print money for short-sighted political purposes?

5. Central banks: Independent or not? Governments may be tempted to instruct central banks to print money rather than raise tax revenue  Major source of inflation, esp. in some developing countries Several central banks have been made independent of politicians in order to immunize monetary policy from political pressures (US Fed, ECB, BoE, etc.)

6. Central banks: Independent or not? Division of labor  Government sets inflation target Political task  Central bank uses its instruments to achieve that target Technical task “Instrument independence” Central banks do not make political judgments, not their business

7. Central banks: Independent or not? Independence does not mean lack of accountability  Courts and judges are supposed to be independent, yet accountable  Central banks: Same story  Free press: Same story Accountability can be upheld through legally stipulated checks and balances

8. Commercial banks: Private or public? Some countries have mainly private banks, others have a mixture of private and public banks, a few have only public ones Private banks are usually better run  Commercial vs. political motives  Hence, privatization in banking sector  Not obvious why governments should own and operate commercial banks

9. Commercial banks: Foreign or domestic? Most countries have home-grown banks  Domestic banks know best the needs of their domestic customers Yet, foreign banks are becoming more common – e.g., in Eastern Europe  To increase competition so as to be able to offer more loans at lower interest  To harness foreign expertise Foreign central bank governors: may not be such a bad idea!! (Israel, New Zealand)

10. Other financial institutions: Large or small? Other financial institutions – financial intermediaries – play an important role They create additional outlets for national saving, by households and firms  They buy and sell bonds, facilitating non- inflationary financing of fiscal operations  They buy and sell stocks, facilitating the buildup of a strong private sector Africa needs both

11. Instruments of monetary policy  Methods used by central banks to change the amount of money in circulation 1.Open-market operations 2.Reserve requirements 3.Discount rates 4.Printing money 5.Direct instruments 6.Persuasion 2

12. 1. Open-market operations Central banks conduct open-market operations when they buy government bonds from or sell government bonds to the public  When they buy government bonds, the money supply increases  When they sell government bonds, the money supply decreases Foreign exchange market intervention also affects the money supply

13. 2. Changing the Reserve Requirement The reserve requirement is the amount (in %) of a bank’s total reserves that may not be loaned out to its customers  Increasing the reserve requirement decreases the money supply  Decreasing the reserve requirement increases the money supply

14. 3. Changing the Discount Rate The discount rate is the interest rate the Central Bank charges commercial banks and the government for loans  Increasing the discount rate decreases the money supply  Decreasing the discount rate increases the money supply

15. 4. Printing money The Central Bank can create money by extending loans to the government  How? By buying bonds from the government that issues them  Inflationary finance Open-market operations are less inflationary than printing money  Hence the need for efficient financial markets that facilitate trade in bonds

16. 5. Direct instruments Ceilings on interest rates  Create excess demand for credit  Prone to abuse  Inefficient and unfair Quotas on credit  Essentially the same effects as ceilings on interest rates

17. Problems in Controlling the Money Supply Central Bank control of the money supply is not precise  Central banks do not control the amount of money that households and firms choose to hold as deposits in banks  Central Banks do not control the amount of money that commercial bankers choose to lend  Money is endogenous: M = D + R Fiscal policy Exchange rate policy

18. Rules versus discretion BenefitsCosts Rules Discretion

19. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances

20. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances Incompetence, abuse of power

21. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle

22. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle Time inconsistency

23. Rules versus discretion BenefitsCosts Rules Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle Time inconsistency Lack of credibility

24. Rules versus discretion BenefitsCosts Rules Tying one’s hands as a disciplinary device Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle Time inconsistency Lack of credibility

25. Rules versus discretion BenefitsCosts Rules Tying one’s hands as a disciplinary device Inflexibility that comes from locking the steering wheel Discretion Flexibility to react to changing circumstances Incompetence, abuse of power Political business cycle Time inconsistency Lack of credibility

26. Money and credit in financial programming History and targets  Record history, establish targets Forecasting  Make forecasts for balance of payments, output and inflation, money Policy decisions  Set domestic credit at a level that is consistent with forecasts as well as foreign reserve target 3

27. 1)Make forecasts, set reserve target R* –E.g., reserves at 3 months of imports 2)Compute permissible imports from BOP –More imports will jeopardize reserve target 3)Infer permissible increase in nominal income from import equation 4)Infer monetary expansion consistent with increase in nominal income 5)Derive domestic credit as a residual: D = M – R* Financial programming step by step Do this in the right order

28. 1)Make forecasts, set reserve target R* –E.g., reserves at 3 months of imports 2)Compute permissible imports from BOP –More imports will jeopardize reserve target 3)Infer permissible increase in nominal income from import equation 4)Infer monetary expansion consistent with increase in nominal income 5)Derive domestic credit as a residual: D = M – R* Financial programming step by step Let’s do the arithmetic

29. Known at beginning of program period:  M -1 = 70, D -1 = 60, R -1 = 10 Recall: M = D + R  X -1 = 30, Z -1 = 50, F -1 = 15 Recall:  R = X – Z + F So,  R -1 = 30 – 50 + 15 = -5, so R -2 = 15 Current account = -20, overall balance = -5  R -1 /Z -1 = 10/50 = 0.2 Equivalent to 2.4 (= 0.212) months of imports Weak reserve position (less than 3 months) History Hypothetical example

30. X grows by 33%, so X = 40 F grows by 40%, so F = 25 R* is set at 15, up from 10 (  R* = 5) Z = X + F + R -1 – R* = 40 + 25 + 10 – 15 = 60 Level of imports is consistent with R* because R * /Z = 15/60 = 0.25 Equivalent to 3 (= 0.2512) months of imports Forecast for balance of payments BOP forecasts (in nominal terms)

31. Increase in Z from 50 to 60, i.e., by 20%, is consistent with R * equivalent to 3 months of imports Now, recall that Z depends on PY where the increase in nominal income PY consists of a price increase and an increase in output Hence, if income elasticity of import demand is 1, PY can increase by 20% E.g., 5% real growth and 15% inflation Depends on slope of aggregate supply schedule Forecast for real sector

32. If PY can increase by 20%, then, if income elasticity of money demand is 2/3, M can increase by 14% Recall quantity theory of money MV = PY Constant velocity means that %  M = %  PY = %  P + %  Y (approx.) Hence, M can expand from 70 to 80 Forecast for money ˜ M = D + R Recall M = D + R

33. Having set reserve target at R* = 15 and forecast M at 80, we can now compute level of credit that is consistent with our reserve target, based on M = D + R So, D = 80 – 15 = 65, up from 60  D/D -1 = 5/60 = 8% Quite restrictive, given that PY rises by 20% Implies substantial reduction in domestic credit in real terms Determination of credit

34. Financial programming step by step: Recap Sequence of steps R* Z Y M D Z = X + F + R -1 – R * Z = mPY MV = PY D = M – R * Forecasts of X and F play a key role: Lower forecasts mean lower D for given R *

35. Exchange rate regimes  The real exchange rate always floats Through nominal exchange rate adjustment or price change  Even so, it makes a difference how countries set their nominal exchange rates because floating takes time  There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates 4

36. Exchange rate regimes There is a range of options  Monetary union or dollarization Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC)  Currency board Legal commitment to exchange domestic for foreign currency at a fixed rate  Fixed exchange rate (peg)  Crawling peg  Managed floating  Pure floating

37. Benefits and costs BenefitsCosts Fixed exchange rates Floating exchange rates

38. Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Floating exchange rates

39. Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates

40. Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium

41. Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium Instability of trade and investment Inflation

42. Exchange rate regimes  In view of benefits and costs, no single exchange rate regime is right for all countries at all times  The regime of choice depends on time and circumstance If inefficiency and slow growth are the main problem, floating rates can help If high inflation is the main problem, fixed exchange rates can help

43. What countries actually do (2001) No national currency39 Currency board 8 Adjustable pegs50 Crawling pegs 9 Managed floating33 Pure floating47 186 25% 50% There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today

44. Conclusion The End  Money and credit play a key role in financial programming  Not to be taken literally as a one-size-fits-all approach Countries differ, so need to tailor financial programs to the needs of individual countries Even so, certain fundamental principles and relationships apply everywhere These slides will be posted on my website: www.hi.is/~gylfason