Government Policies

Governments usually formulates a lot of policies on a lot of issues.

But, if we concentrate only on the policies to regulate and guide the economic activities of the country, we find only two-

Monetary Policy and Fiscal Policy

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What is a Policy?

What is Monetary PolicyIt is the government’s

decision about how much money to supply

to the economy.

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This means controlling the supply of M1 or M2

History of Monetary PolicyIn old times, monetary policy was mainly

focused on seioniorage with the aim to maintain the value of money

Inflation was not a big concernBank of England created in 1694During 1870 – 1920 industrialized nations set

up central banksMonetary policy came into question during

the great depression

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Monetary PolicyCan be-

Loose orTight

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Loose monetary policyIf the Bangladesh Bank (BB) implements a

loose monetary policy (often called expansionary) , the supply of credit increases and its cost falls.

A loose monetary policy is often implemented as an attempt to encourage economic growth.

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Tight monetary policyIf the BB allows a tight monetary policy

(often called contractionary), the supply of credit decreases and its cost increases.

Why would any nation want a tight money policy? In order to control inflation

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The Two Faces of Monetary The Two Faces of Monetary PolicyPolicy

Goals of Monetary PolicyPrice stabilityGDP growthInvestment Fight recessionExchange rate stabilizationDesired level of unemployment rate

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How these goals are achieved by controlling money supply?Price Stability: for example, price is shooting

up and we want to control it…

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We reduce money supply

Now people have less money at hand

So, people buy less amount of goods

Demand for goods falls

Producers reduce price to maintain sales

Example: Money Supply vs. Inflation

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How these goals are achieved by controlling money supply?

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Investment can be induced by controlling money supply

How these goals are achieved by controlling money supply?GDP growth: for example, we want to

increase GDP growth…

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We increase money supply

Now people have more money at hand

So, people buy more amount of goods

Demand for goods rise

Producers produce more goods to match market demand

How these goals are achieved by controlling money supply?For example: our export is reducing and we

want to increase it…

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We increase money supply

As a result banks have more idle money

So, banks reduce interest rate

Cost of investment falls and goods become cheaper

Export rises

Channels through which monetary policy works

Interest Rate channel Exchange rate channel Credit channel

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How is the money supply controlled

The Central Bank generally uses three tools

Open market operation (OMO) Discount rate (DR) Reserve ratio (RR)

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Open Market Operation (OMO)Defined as the buying or selling of treasury bills

and bonds by the Bangladesh Bank in the open market.

Expansionary – Bangladesh Bank buys bonds (injects money)

Contractionary – Bangladesh Bank sells bonds (pulls out money)

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Characteristics of OMOSometimes done for temporary periods

Repurchase Agreement -- BB buys bond with agreement to sell it back.

Matched-Sale Purchase -- BB sells bond with

agreement to buy it back.

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Characteristics of OMOOccurs at the initiative of the BB.BB is in complete control.They are flexible: BB can do small or large

amounts.They are reversible: BB can undo policy

mistakes. Very low-key policy instrument: difficult to

tell what BB has done

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Discount RateDefined as the rate of interest

charged to banks that borrow from the BB.Expansionary -- BB lowers discount rate.Contractionary -- BB raises discount rate.

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Characteristics of DRDone at the discretion of the

commercial banksAffects interest rate structure of the

commercial and specialized banksDR may influence economic activity

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Reserve Ratio (RR)Banks are required to maintain a certain percentage

of their deposits in the form of reserves or balances with the BB. This percentage is called the Reserve Ratio.

Expansionary Policy -- BB lowers reserve ratios.Contractionary Policy -- BB raises reserve ratios.

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Characteristics of RRToo blunt -- needs tiny changes for

reasonable adjustments in money growth.Too Disruptive -- affects all banks balance

sheets.

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Strategies of Monetary PolicyMoney Growth TargetingInflation Targeting

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Money Growth TargetingThe decade of 1970s was characterized by high inflation and

unemploymentCentral banks initially pursued money growth targeting to

achieve steady growth and low inflation In this strategy central banks announces the rate of growth of

money for the next one yearBut in 1980s, in spite of low inflation, output and unemployment

were unstable in USA, UK, Canada and GermanyBecause, due to changing financial system, money demand was

hard to predict and, therefore, money growth targeting was ineffective

A tightly regulated financial system is necessary for money growth targeting to be successful. Tight financial regulation is often not possible

Specially, in the developing countries, where financial reforms are still taking place, strict financial regulations are not viable

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Inflation TargetingCentral banks in many countries adopted inflation

targeting during 1990s. New Zealand was the pioneer. In this strategy central bank announces the rate(s) of

inflation that it wants to achieve over the next year(s)Through this announcement the central bank signals that

hitting that target in the long-run is its number one priority Inflation targeting bypasses the problem of money demand

instabilityAlso, it helps to make central bank’s commitments credible

to the people as most of the people understands what goal the central bank is trying to achieve

However, success of inflation targeting depends on how quickly the economy responds to the policy changes

If the economy responds to policy changes slowly then inflation targeting may lose credibility

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The Issue of CredibilityMonetary policy has important goals for the

countryIf these goals are not achieved, then operation of

the monetary policy tools are not effectivePeople do not have faith in monetary policy

anymoreMonetary policy lose credibilityCountry’s development objectives fall into chaos

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Example: Dad, Kids and Fantasy Kingdom

Dad: 2Dad: 2

Kids: 3Kids: 3

Outcome AOutcome A

Dad: 3Dad: 3

Kids: 2Kids: 2

Outcome BOutcome B

Dad: 0Dad: 0

Kids: 1Kids: 1

Outcome COutcome C

Dad: 1Dad: 1

Kids: 0Kids: 0

Outcome DOutcome D

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Fight Don’t Fight

Kids’ Strategy

Go to Park

Don’t go to Park

Dad’s

Str

ate

gy

Point assignment

FightFight Don’t FightDon’t Fight Go to Go to parkpark

Don’t go to Don’t go to parkpark

KidsKids 11 00 22 00

DadDad 00 11 22 00

How can the central bank maintain credibility:

Appointing a “tough central banker” In 1979, in the face of serious inflation President

Jimmy Carter appointed Paul Volcker, who succeeded to curb inflation… but failed to check unemployment!!!

Changing central bankers’ incentives For example, if the head of the central bank is easy to

remove s/he might want to be serious about her/his commitments

Increasing central bank’s independence If the central bank is independent it might be free of

political influence, and hence, might escape political pressure to increase output and employment (say, before national election)

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Monetary Policy in BangladeshUntil 1990:

limited role of BB Government directly controlled exchange rate and interest

rate Taka was pegged against foreign currencies

Financial Sector Reform Program started in 1989

Strategy was to target monetary aggregatesFree floating exchange rate was introduced in

May, 2003Bangladesh Bank is regularly issuing

Monetary Policy Statement since January 2006

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Monetary Policy Outcome

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Monetary Policy Outcome

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Monetary Policy Outcome

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Monetary Policy Outcome

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Monetary policy outcome

0.00

5.00

10.00

15.00

20.00

25.00

-505

101520253035

%

Money Growth and export growth

Export growth (rhs) M2 growth

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Monetary Policy Outcome

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Limitations of Monetary PolicyDoes not work when aggregate demand

needs to be stimulated through direct government spending (Great Depression)

Works on the economy through indirect channels. Therefore, often suffers from lag to have impact

May be dominated by fiscal policyWrong policy may result in severe damage

for the economy

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Monetary Policy vs. Fiscal Policy If the goals of the two policies do not match,

development objective will be damaged.

Example:Suppose, Bangladesh is suffering from high

inflation and BB wants to reduce it. BB reduces money supply…

But, national election is close and will be held within a year.

So, the ruling party decides to spend more money on safety-net programs and employment generating activities

Accordingly, the ruling party sets its fiscal policy so that expenditure goes up…

What will happen?40

Other problems related to mismatch of policiesIf the government borrows too much from

the banking system, then little money is left for the private sector to borrow.

As a result, private sector initiatives are hampered

This is called the “crowding out effect”Because of crowding out private

investment falls and GDP falls as wellIn this case, if the monetary policy

authority wants to enhance private sector credit growth, practically it has little room to do so…

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Other problems related to mismatch of policiesGovernment debt:If the government borrows a lot, it means that at

some point of time future, the government will have to pay substantial amount of interest when the loan matures

If at that time, the government does not have money enough to pay the interest, it might print money for the purpose…

This means that money supply will go upBut, if the country at that time suffers from high

inflation and BB wants to control it, the contractionary monetary policy will not help.

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