Central Bank’s Monetary Policy

1. Program Magister Akuntansi UniversitasTrisakti Central Bank’s Monetary Policy

2. Scope of discussion • How the monetary sector affects the economy? • Macroeconomic policy • Demand and supply of money • Transmission of monetary policy • Monetary policy in the long-run • Policy conflicts • Framework of monetary policy

3. REAL SECTOR GOVERNMENT SECTOR MONETARY SECTOR Consumption Investment Export Import • Fiscal (APBN) • Revenues, incl. grant • Expenditures • Primary balances • Financing • Domestic • External Luar Negeri Monetary Authority Foreign assets net Domestic assets net Net Claim on Government Commercial Banks Foreign assets net Domestic assets net EXTERNAL SECTOR • Current Account • Export • Import • Transfer • Income • Capital & Financial Transaction • Direct Investment • Financial flows • Government • Private • Official foreign reserves How the monetary sector affects the economy? (Interrelationship among macroeconomic accounts) Base money Aggregate demand: Y = C + I + G + (X-M) Money supply

4. Macroeconomic policy • Monetary policy is an integral part of macroeconomic policy • The ultimate target of macroeconomic policy is economic/social welfare

5. Supply and Demand for Money • Supply of money : Ms = mm * Mo • determined by the central bank. (Baca AP Lampiran 2.2) • Demand for money : Md = f (GDP, CPI) • determined by people or money holder • Definition of money: • Mo = C + Rb where Mo = monetary base (high-powered money) ; C = Currency (bank notes); • Rb = Bank reserves (banks’ account at the central bank + cash in vault) • M1 = C + DD where DD = Demand deposits (checking accounts, giro accounts) • M2 = C + DD + TD where TD = Saving and Time deposits • M3 = M2 +

6. Supply of money: Money multiplier (Baca AP Box 4.2) • Total reserves (Rb) = Required reserves + Excess reserves • Total reserves = Deposits at the Central Bank + Vault cash at commercial banks • Money multiplier (mm) = 1/ (RR +ER) where RR is required reserves ratio (reserve requirements) and ER is the proportion of excess reserves in total reserves • Ms = mm x Mo --- mm = Ms/Mo • mm¹ = M1/Mo (narrow money multiplier) • mm² = M2/Mo (broad money multiplier) • In practice, the mm can be calculated directly from central bank statistics published by the central bank where Mo, M1 and M2 are regularly (monthly) published. For example, at year-end 2004 the monetary base at BI’s publication is Rp 200 trio and M2 Rp800 trio, then the money multiplier is 800/200 = 4.0.

7. Reserve requirement • In the most countries, all depository financial institutions are required to conform to the deposit reserve requirements (giro wajib minimum) set by the central bank. • Changes in reserve requirements are a very potent, though little-used tool. • Indeed, reserve requirements have recently been reduced in the U.S., and eliminated in Canada, New Zealand, and the U.K. • An increase in deposit reserve requirements • decreases the deposit and money multipliers, slowing the growth of money, deposits and loans • reduces the amount of excess legal reserves - institutions deficient in required legal reserves will have to sell securities, cut back on loans, or borrow reserves • increases interest rates, particularly in the money market, as depository institutions scramble to cover any reserve deficiencies

8. Effects of Changes in Reserve Requirements on Deposits, Loans, and Investments

9. Supply and Demand for Money - Equilibrium • Supply of money is determined by the central bank monetary policy, and therefore the supply curve is vertical. • Demand for money is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earning assets like bonds. • Equilibrium: The money interest will gravitate the rate where the quantity of money people want to hold (demand) is just equal to the stock of money the central bank has supplied (supply). Interest rate Ms At i*, people are willing to hold the money supply set by the central bank Excess supply i2 i* Md i3 Excess demand Quantity of Money Qs

10. Transmission of monetary policy • The path that monetary policy takes through the macroeconomic system is called the Transmission of Monetary Policy. • The impact of a shift in monetary policy is generally transmitted through intrest rates, exchange rates, and assets prices. • An expansionary monetary policy will increase supply of loanable funds and put downward pressure on real interes rates. As real interest rates falls, aggregate demand increases (to AD2), leading to a short run increase in output (Y1 to Y2…..and prices (from P1 to P2)… inflation Real Interest rate Price level S1 S2 AS1 P2 AD2 P1 r2 AD1 D Quantity of Loanable funds Goods/services (real GDP) Y1 Y2 Q

11. The Mechanism of monetary transmission Direct monetary transmission 11 Money Supply-Demand Money Credit channels Bank lending Loan Supply-Demand Firms balance sheet Ext. Financing, Leverage Interest rate channel Cost of capital Final Objective: Prices Output Monetary Policy: Base money Interest rate Real interest Substitution effect Income effect Asset price channel Net exports-cap.flows Exchange rate Imported prices Tobin’s q Equity-Property prices Wealth effect Expectation channel Real interest rate Expectation Moral hazard, Adverse selection Uncertainty

12. Monetary policy in the long-run • If the impact of an increase in AD accompanying expansionary policy is felt when the economy operating below capacity, the policy will help direct the economy back to a long-run full employment output equilibrium (Yf). • In contrast, if the demand-stimulus effects are imposed on an economy already at full employment (Yf), they will lead to excess demand, higher prices,and temporarily higher output (Y2). • In the long-run, the strong demand will push up resources prices, shifting back short-run AS. • The price level rises to P3 (from P2) and output back to Yf once again. LRAS LRAS Price level Price Level SRAS2 SRAS1 SRAS1 P3 e3 P2 P2 e2 e2 AD2 AD2 P1 P1 e1 e1 AD1 AD1 Goods/services (real GDP) Goods/services (real GDP) Yf Y2 Y1 Yf

13. Monetary policy in the long-run • The quantity theory of money • M * V = P * Y where M = money; V = velocity of money; P = price; Y = income • If V and Y are constant, than an increase in M would lead to a proportional increase in P. • Implication: • In the long run, the primary impact of monetary policy will be on prices rather than on real output • When expansionary monetary policy leads to rising prices, monetary authorities eventually anticipate the higher inflation and build it into their choices • As it happens, nominal interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and output will return to their long-run normal levels.

14. Policy conflicts • Theoretically, in the short-term there is trade-off between achieving targets of containing inflation and promoting output • Phillips Curve:  =  (y – y*) • Long-run full employment vs below capacity • However, there is growing research evidence that maximum employment, sustainable economic growth, and price stability can be compatible with one another in the longer run. • Expantionary monetary policy leads to promote economic activities, but would in turn push inflation upward  A need to strike a balance between monetary and fiscal policy and other macroeconomic policies  policy coordination.

15. Framework of monetary policy Operational Target Instruments Intermediate Target Ultimate Target • Open market operation • Reserve requirement • Discount facility • Base money (Mo) • Bank reserves • Interest rates • Monetary aggregates • M1, M2, M3 • Interest rates • Price stability • Economic growth • Employment • Not every nation makes it clear to its central bank what its priorities should be among different possible goals (targets). • The goals may also conflict with one another. • For example, controlling inflation may require the central bank to slow down the domestic economy through restrictions on credit growth and higher market interest rates. • However, this policy threatens to generate more unemployment and subdue economic growth.

16. The Goal of Controlling Inflation (& Deflation) • Inflation creates undesirable distortions in the allocation of scarce resources. • In the 1990s, several central banks (such as New Zealand, Canada, and U.K.) began setting target inflation rates or rate ranges. • In 2000s, several Asian central banks (Thailand, Indonesia,etc.) also set inflation targeting. • The U.S. has not set an explicit target, though it seeks to drive inflation so low that it does not affect business and consumer decisions.