28. Monetary policy: subjects, aims, types, instruments and effectiveness.

Monetary policy

M.p.=deliberate attempts of the central bank to control Ms,r and amounts of banks’ credits(which are all subjects of m.p.).The main aim -to stabilize economy.

1. Tight (is aimed against demand-pull inflation) includes reduction of Ms, increase in r, reduction of credit (credit rationing)

1. 

2. ↑r→↓AD→↓inflation

2. Easy (is aimed to decrease unemployment and to stimulate economic growth, aimed against recession) includes increase in Ms, decrease in r, liberalization of credit.

↓r→↑I,C→↑AD→recovery from recession

Instruments of m.p.:

1. Open market operations are operations with government securities which are purchased and sold by CB in the open market.

2. Changing liquidity ratio or required reserve ratio. If gov. wants to reduce Ms=>CB increases RRR=>banks’ excess reserves decrease=> Ms decreases.

3. Changing discount rate or lending rate. The CB in most countries is prepared to provide extra money to banks. If the CB provides more money=> banks can use it as the basis for credit creation. Wishing to boorow from CB depends on a)rate of interest charged by CB; b)its willingness to lend (or repurchase securities).

4. Selective control to availability of credit. “suggestions and request”.

5. Changing exchange rate

Important remarks about effectiveness of m.p. tools:

1. Open-market operations are the most effective tools because: a) changes in RRR influences the banks’ profits; b) changes in discount rate are relatively ineffective because d.r. is just an information about what gov. does, it doesn’t have real influence.

2. Selling or purchasing securities to or from bank sector not public sector is more effective due to credit creation effect.

Problems and effectiveness of the m.p.

1. Problems in the short-run

• problems with the Ms control -mainly,problems with monetary base: (a) banks holding cash in excess can respond to restriction by reducing their cash r, rather then reducing credit; b) Goodhart’s law; c) banks can attract cash away from the uncontrolled institutions; d) banks can encourage the public to withdraw less cash.

• disintermediation= diversion of business away from those banks which are controlled strongly

• problems with selling government securities

2)Problems in the long-run

• budget deficit (if gov reduces Ms by selling more securities=>budget deficit grows because gov.(CB) should pay interest on securities=>incr in public debt)

• financial crowding out (when gov. borrowing diverts money away from the private sector; because if you buy gov. securities – you don’t buy anything from private companies)

• the target dilemma = impossibility to stabilize Ms and r at the same time

• unpredictability of the m.p. results because:

1. it is possible predict reaction of business and society on change in banks’ credit ability

2. b) m.p. may influence the velocity of money circulation: increase in Ms may decrease velocity, and vice versa Ms∙V=P∙Y

3. the link between r and investment may be weak (money transmission mechanism doesn’t work)

Adverse side effects of the credit restriction:

• decrease in banks’ competitiveness

• discouragement of small business

decrease in consumer demand, Y, AD (→risk of recession)