Contents

DEFINITION OF MONETARY POLICY......................................................................2

TYPES OF MONETARY POLICY..............................................................................2
OBJECTIVES OF MONETARY POLICY......................................................................3
TOOLS OF MONETARY POLICY.............................................................................6
LIMITATIONS OF MONETARY POLICY IN UNDERDEVELOPED COUNTRIES.................7
DETERMINANTS OF MONETARY POLICY..............................................................10
DETERMINE

SUCCESS OF

MONETARY POLICY.................................................................................10

MONETARY POLICY IN PAKISTAN........................................................................12

HOW DOES MONETARY POLICY WORK?.......................................................................................12
MONETARY POLICY FRAMEWORK................................................................................................13
MONETARY POLICY DECISION-MAKING IN PAKISTAN.......................................................................19
MONETARY POLICY IMPLEMENTATION IN PAKISTAN..........................................................................20
MONETARY POLICY COMMUNICATION IN PAKISTAN.........................................................................23
MONETARY POLICY STATEMENT.........................................................................24
CONCLUSION....................................................................................................25

Definition of Monetary Policy

Monetary policy is the process by which the Central bank manages the money supply to achieve
specific goals e.g. controlling inflation, maintaining an exchange rate achieving full employment
& GDP growth. Monetary policy consists of the actions of a central bank, currency board or
other regulatory committee that determine the size and rate of growth of the money supply,
which in turn affects interest rates. Monetary policy is maintained through actions such as
modifying the interest rate, buying or selling government bonds, and changing the amount of
money banks are required to keep in the vault (bank reserves).

Types of Monetary Policy

1. Contractionary Monetary Policy
2. Expansionary Monetary Policy
Contractionary Monetary Policy
Contractionary monetary policy is a form of economic policy used to fight inflation which
involves decreasing the money supply in order to increase the cost of borrowing which in turn
decreases GDP and dampens inflation.
When the economy is under inflationary pressures, the central bank (in US, the Federal Reserve)
decreases the money supply by either increase in the discount rate or sale of government bonds
or increase in the required reserve ratio or by carrying out all the changes simultaneously.
Contractionary monetary policy has some side effects too. It results in an increase in the
unemployment rate and a decrease in the growth rate of the GDP.
Expansionary Monetary Policy
Expansionary monetary policy is when a central bank uses its tools to stimulate the economy.
That increases the money supply, lowers interest rates, and increases aggregate demand. That
boosts growth as measured by Gross Domestic Product (GDP). It usually diminishes the value
of the currency, thereby decreasing the exchange rate. It is the opposite of contractionary
monetary policy.
Expansionary monetary policy is used to ward off the contractionary phase of the business cycle.

Objectives of Monetary Policy

The objectives of monetary policy differ from country to country according to their economic
conditions. There are different main objectives of monetary policy which every Central Bank of
a country tries to attain by employing certain tools of monetary policy.

Rapid Economic Growth

Price stability
Exchange rate Stability
Balance of payment (BOP) equilibrium
Full employment
Neutrality of Money
Equal Income distribution

Rapid Economic Growth

It is one of the most important objectives of monetary policy. Economic growth is defined as
the process whereby the real per capita income of a country increases over a long period of
time. The monetary policy can play a significant role in accelerating economic development by
influencing the supply and uses of credit, controlling inflation, and maintaining balance of
payment. The monetary policy can influence economic growth by controlling real interest rate
and its impact on investment. If the state bank opts for easy or cheap credit policy by reducing
interest rates, the investment level in the economy can be encouraged. This increased investment
can speed up economic growth. Faster economic growth is possible if the monetary policy
succeeds in maintain income and price stability. Therefore, monetary policy promotes sustained
and continuous economic growth by maintaining equilibrium between the total demand for
money and total production capacity and further creating favorable conditions for saving and
investment. Thus it is the responsibility of monetary authority to circulate the proper quantity and
quality of money.
Price Stability
One of the policy objectives of monetary policy is to stabilize the price level. Both economists
and laymen favor this policy because fluctuations in prices bring uncertainty and instability to
the economy. All the economies suffer from inflation and deflation. It can also be called as price
instability. Both inflation and deflation are harmful to the economy. Monetary policy tries to
keep the value of money stable. It helps in reducing the income and wealth inequalities. Price

stability does not mean price rigidity. A mild increase in the price level is necessary for
economy. Thus price stability means reasonable rate of inflation. A high degree of inflation has
adverse effects on the economy.

Inflation raises the cost of living of the people and hurts the poor most.

Inflation has adverse effects on balance of payments.

Due to inflation value of money rapidly falling

Monetary policy in a developing country should be directed towards maintaining equilibrium

between demand of money and Supply of money so that price level may be maintained. If the
price level is reasonable and there is an adjustment between the price and cost, rate of output can
increase. Monetary policy is used to coordinate the cost and price. So price stability is achieved
through the monetary policy.
Exchange Rate Stability
Exchange rate is the price of a home currency expressed in terms of any foreign currency. If the
exchange rate is very volatile leading to frequent ups and downs in exchange rate, the
international economy might lose confidence in our economy. The monetary policy aims at
maintaining the relative stability in the exchange rates. Fluctuations in the exchange rates bring
changes in the internal rate. If the rate of exchange is stable it shows that economic condition of
the country is stable and if there is instability in the exchange rates it would results in
unfavorable balance of payments. Therefore, stable exchange rate plays an important role in
international trade. So, monetary policy tries to eliminate those adverse forces which tend to
bring instability in exchange rates.
Balance of Payment (BOP) Equilibrium
Equilibrium in the balance of payments is another objective of monetary policy. The monetary
policy in a developing economy should also solve the problem of adverse balance of payments.
Such a problem generally arises in the initial stages of economic development when the import
of machinery, raw material, etc., increase considerably, but the export may not increase to the
same extent. The monetary authority should adopt direct foreign exchange controls and other
measures to correct the adverse balance of payments. Balance of payments has two aspects.

BOP surplus (exports > imports)

BOP deficit (imports > exports)
BOP Equilibrium (Imports = exports)

Equilibrium in balance of payments is the objective of monetary policy because increasing of

deficit in balance of payments reduces the ability of economy to achieve other objectives. As a
result, as a result, many less developed countries have to curtail their imports which adversely
affect development activities. Therefore, monetary authority makes efforts that equilibrium
should be maintained in the balance of payments.
Full Employment
Full employment is another objective of monetary policy. Full employment stands for situation in
which everybody who wants job gets job. It does not means there is zero unemployment.
Monetary policy can be used for achieving full employment. If the monetary policy is
expansionary then credit supply can be encouraged. It could help in creating more jobs in
different sectors of the economy. It is an important goal not only because unemployment leads to
wastage of potential output, but also because of the loss of social standing and self-respect.
Keynes equation of income, Y= C + I throws light as to how full employment can be ensured
with monetary policy. He argues that to increase income, output and employment, it is necessary
to increase consumption and expenditure and investment expenditure simultaneously. This
indirectly solved the problem of unemployment in the economy. When the economy is facing the
problem of unemployment, private investment can be stimulated by adopting cheap money
policy by the monetary authority.
Neutrality of Money
Neutrality of money is another objective of monetary policy. Neutrality of money means that
quantity of money should be perfectly stable. Money is used as a medium of exchange. Monetary
policy should control and regulate the supply of money and neutralizes the effect of money
expansion. In the initial stages of economic development, it is conductive to expand credit
facilities but once a level of growth is achieved, the central bank must impose credit restrictions
so that money may flow into productive activities and in the desired direction.

Equal Income Distribution

Monetary policy plays an important role in maintaining economic equality. Monetary policy can
make special provisions for neglect supply such as small scale industries, agriculture, village
industries etc. and provide them cheaper credit for long term. This can prove fruitful for these
sectors to grow up. Monetary policy can help in reducing economic inequalities among different
sections of society. Monetary policy should also ensure that distribution of credit should be
equitable and purposeful. The credit priority should be given to backward areas.

Tools of Monetary Policy

The fed use three basic tools to accomplish its monetary policy goals and to influence demand
and supply of money. Three basic tools are as follows:
1. Reserve requirements
Reserve requirements are Federal Reserve rules that require banks and other financial
institutions to keep a strict percentage of their deposits on reserve at a Federal Reserve
Bank. The Federal Reserve determines the appropriate percentage. Reserve requirements
are a key component of monetary policy. The Federal Reserve can lower the reserve
requirement, for example, in order to enact expansionary monetary policy and encourage
economic growth. The reduction makes banks free to lend more of their deposits to other
bank customers and earn interest. These customers in turn deposit the loan proceeds in
their own bank accounts, and the process continues indefinitely. This increase in the
supply of available funds lowers the price of those funds (i.e., the lending rate),
making debt cheaper and more enticing to borrowers.
If the Federal Reserve increases the reserve requirement (which leaves less of a bank's
deposits available for lending), the reverse happens and the Federal Reserve can slow
down the economy.
2. Interest rate
A rate which is charged or paid for the use of money. An interest rate is the cost of
borrowing money, or conversely, the income earned from lending money.
Interest rate is often expressed as an annual percentage of the principal. It is calculated by
dividing the amount of interest by the amount of principal. Interest rates often change as
a result of inflation and Federal Reserve Board policies. For example, if a lender (such as

a bank) charges a customer $90 in a year on a loan of $1000, then the interest rate would
be 90/1000 *100% = 9%. From a consumer's perspective, the interest rate is expressed
as annual percentage yield (APY) when the interested is earned, for example, from
a savings account.
When the interest is paid, for example, for a credit card, a mortgage, or a loan, the interest
rate is expressed as annual percentage rate (APR).
In a free market economy, the laws of supply and demand generally set interest rates. The
demand for borrowing is inversely related to interest rates, meaning that high interest
rates discourage companies and individuals from borrowing and low interest rates
encourage borrowing.
3. Open Market operations
Open market operation is a monetary policy tool used by central banks to increase or
decrease money supply by buying and selling government bonds in the open market.
When a central bank (in US the Federal Reserve) is interested in providing stimulus to
the economy by increasing the money supply, it purchases government bonds from
commercial banks and the public. In consideration for the bonds, the central bank pays
the bondholders who keep the money in banks thereby increasing the commercial banks'
excess reserves. Higher excess reserves means commercial banks can lend more money
leading to increase in money supply and decrease in interest rates.
When the central bank is interested in controlling inflation, it sells government bonds to
commercial banks and the public. Banks and the public pay the central bank in return of
the bonds and this reduces excess reserves which in turn reduces the banks' ability to lend
money, thereby decreasing money supply and increasing interest rates.

Determinants of Monetary Policy

Monetary policy plays an important role in achieving sustained economic growth. Researchers
have tried to examine various issues related to monetary policy in developed countries. Several
studied have been carried out to identify the major determinant of stock of money. However, a
little research has been conducted to analyze the level of stock of money by using the money
multiplier approach. In Pakistan, monetary policy is designed to control total monetary assets
keeping in view the projected growth rate of GDP, monetization of the economy and likely
surplus or deficit in the countrys external account. The objective of this paper is to ascertain the

monetary policy in controlling the total monetary assets by analyzing the behavior of the money
multiplier. The findings of this study show that the monetary base remained an important
determinant of the monetary stock (M2) and the monetary policy remained an effective
instrument in controlling and regulating monetary assets in Pakistan

Determine success of Monetary Policy

1. Accuracy of Inflation Forecasts
Monetary policy is pre emptive which means they try to reduce inflationary pressures
before they occur. If inflation is higher than predicted, then interest rates will be too low
to control inflation. Inflation predictions could be wrong if there is an unexpected rise in
cost push inflation, for example an increase in the price of oil. In the past 15 years the
MPC have benefited from generally low global inflation, however some economists feel
that this golden era of price stability may not continue indefinitely. E.g. economic
shocks associated with rising commodity prices.
2. Time Lags
It is estimated interest rate changes can take up to 18 months to have their full effects. For
example if interest rates rise then people who are currently spending on investment will
not stop straight away. They will continue with their project. However higher interest
rates may deter future projects from starting. By the time interest rates have had their
desired effect it may be too late to reduce inflation. (This is why the MPC is always
trying to predict future inflation trends)
3. Interest Elasticity of Demand
This measures how responsive demand is to a change in interest rates. For example if
consumer confidence is very high then higher interest rates may not deter consumer
spending. This is because people expect to make more money in the future so are willing
to borrow at higher levels of interest.
4. Effects of Interest Rates not Equally Shared
The effect of rising interest rates effects some much more than others. For example in the
UK many have high levels of debt through mortgages. Thus first time buyers with large
mortgages will be effected by interest rate changes much more than older people who

have paid off most of their mortgages. To reduce inflation may cause financial hardship
for a small % of the population who have very high levels of mortgage debt.
5. Other Variables
Interest rates effect other variables in the economy. Higher interest rates increase the
value of the (through hot money flows). This causes problems for exporters and may
worsen current account. Higher interest rates also have a disproportionate effect on the
volatile UK housing market.
6. Inflation Expectations
The success of monetary policy depends upon credibility of the monetary authorities. If
people have low inflation expectations then it is much easier to keep inflation low. Since
independence the MPC have benefited from a reduction in inflation expectations. This is
partly due to the credence people give to an independent body rather than politicians with
a poor track record of keeping inflation low.
7. Levels of Government Debt
High levels of government debt generally put upward pressure on interest rates. This is
because to attract enough people to buy government bonds interest rates on these
securities need to rise. This puts upward pressure on interest rates throughout the
economy.

Monetary Policy in Pakistan

Monetary policy involves central banks use of instruments to influence interest rates and/or
money supply in the economy with the objective to keep overall prices and financial markets
stable. Monetary policy is essentially a stabilization or demand management policy that cannot
impact long-term growth potential of an economy. Preamble to SBP Act, 1956 envisages
monetary policy to secure monetary stability and attain fuller utilization of economys productive
resources. In SBPs view, the best way to achieve these objectives on a sustainable basis is to
keep inflation low and stable.
Low and stable inflation provides favorable conditions for sustainable growth and employment
generation over time. It reduces uncertainties about future prices of goods and services and helps
households and businesses to make economically important decisions such as consumption,

savings and investments with more confidence. This, in turn, facilitates higher growth and
creates employment opportunities over the medium term leading to overall economic well-being
in the country.
In practice, SBPs monetary policy strives to strike a balance among multiple and often
competing considerations. These include: controlling inflation, ensuring payment system and
financial stability, preserving foreign exchange reserves, and supporting private investment.

How does Monetary Policy Work?

SBP signals its monetary policy stance through adjustments in the policy rate; that is, the SBP
Target Rate for the overnight money market repo rate. Changes in the policy rate impact demand
in the economy through several channels and with a lag. In the first place, changes in policy rate
influence the interest rates determined in the interbank market at which financial institutions lend
or borrow from each other. The market interest rates are also influenced by central bank
interventions in money and foreign exchange markets as well as by its communication.
The changes in market interest rates influence the borrowing cost for consumers and businesses
as well as the return on deposits for the savers. Generally, lower interest rates encourage people
to save less and consume/invest more, and vice versa. Changes in the policy rate also influence
the value of financial and real assets, impacting peoples wealth and thus their spending. The
adjustment in demand finally affects the general price level and thus inflation in the economy.

Monetary Policy Framework

Monetary Policy Objectives
The preamble of the SBP Act, 1956 envisages these objectives as whereas it is necessary to
provide for the constitution of a State Bank to regulate the monetary and credit system of
Pakistan and to foster its growth in the best national interest with a view to securing monetary
stability and fuller utilization of the countrys productive resources.
SBP focuses on achieving monetary stability by controlling inflation close to its annual and
medium-term targets set by the government. At the same time, SBP also aims to ensure financial
stability, particularly the smooth functioning of the financial market and the payments system.
Consensus in literature as well as country experiences suggests that price and financial stability
facilitate the achievement of sustained economic growth in the long-run.