Definition• Monetary policy is

concerned with deciding how much money the economy should have or perhaps more correctly deciding whether to increases or decrease the purchasing power of money.”

• ” According to Macconal: “Changing the money supply to assist the economy to achieve a full employment”.

• Monetary policy is the process of managing a nation's money supply to achieve specific goals such as constraining inflation, achieving full employment or more well-being. Monetary policy can involve setting interest rates, margin requirements, capitalization standards for banks or even acting as the lender of last resort or through negotiated agreements with other governments.�

• A wide variety of policy systems are possible to conduct monetary policy operations, but in the current international scenario, we have two broad groups of countries.

• The first one is the group of those countries (like Hong Kong, Zambia, and China, etc.), whose monetary policies are focused primarily on the exchange rate.

• The second is the group of countries with floating exchange rates (like the United States of America, Japan, Pakistan and Australia, etc.) and monetary policy involves the management of short-term interest rates by central banks to pursue the macroeconomic objectives of the economy.

What are the objectives of monetary policy?

• The objectives of monetary policy are to promote maximum employment, stable prices and moderate long-term interest rates. By implementing effective monetary policy, the Fed can maintain stable prices, thereby supporting conditions for long-term economic growth and maximum employment.

How it is used by the central bank?

• Contractionary policy• The Central Bank designs Contractionary policy or Tight

monetary policy in order to constrain the growth of money, tends to curb inflation by contracting/reducing the money supply (i.e. increasing inflation) and credit in the economy.

• Expansionary policy• Expansionary policy or Easy monetary policy is used as a tool

by the central bank to broaden the monetary base and credit in the economy by reduction in interest rates and increase in bond prices to tends to encourage growth by expanding the money supply.

Tools of Monetary Policy• In order to attain the

objectives discussed above, the central bank uses three tools: open market operations, the discount rate and reserve requirements.. All three affect the amount of funds in the banking system.

The discount rateThe discount rate is the interest rate Reserve Banks charge commercial banks for short-term loans. Federal Reserve lending at the discount rate complements open market operations in achieving the target federal funds rate and serves as a backup source of liquidity for commercial banks. Lowering the discount rate is expansionary because the discount rate influences other interest rates. Lower rates encourage lending and spending by consumers and businesses.

Reserve requirementsReserve requirements are the portions of deposits that banks must hold in cash, either in their vaults or on deposit at a Reserve Bank. A decrease in reserve requirements is expansionary because it increases the funds available Reserve requirements

Open Market OperationsOpen market operations involve the buying and selling of government securities. The term “open market” means that the Fed doesn’t decide on its own which securities dealers it will do business with on a particular day. Rather, the choice emerges from an “open market” in which the various securities dealers that the Fed does business with – the primary dealers – compete on the basis of price. Open market operations are flexible, and thus, the most frequently used tool of monetary policy.

How does Monetary Policy affect the economy of a country?

• Changes in the real interest rates affect the demand for consumption and savings of the people and also change the investment pattern of the businesses.

• For instance, a reduction in real interest rate lowers the cost of borrowing, encouraging people to borrow in order to consume (durable items like, electronic items, automobiles etc.

• Lower real interest rates also make stocks and other such investments more desirable than bonds, resulting stock prices to rise. People are likely to increase their stock of wealth.

• Foreign Exchange, Imports and Exports Short-run changes lower interest rate result as currency depreciation, which means lower prices of home-produced goods selling abroad, making exports dearer and discourage imports, reducing the gap between imports and exports and having favorable balance of trade. Again this leads to higher aggregate spending on goods and services produced in the country.• Output and Employment The increase in aggregate demand for the output boosts up the production cycle; generating employment, as a result increase investment spending on the existing industrial capacity. Which accelerate the consumption further due to more incomes earned, thus attaining the multiplier effect of Keynes.

How does Monetary Policy affect Inflation?

• Monetary policy affects inflation in two ways. First, affecting indirectly, if monetary policy able to achieve multiplier effect, it boosts up economic activity. Initiating labor and capital markets to raise outputs beyond there capacities and creating an upward pressure on wages, thus resulting inflation to rise (that is cost-push inflation). Thus there would be a trade-off between higher inflation and lower unemployment in the short-run which further accelerate inflation. As wages and prices start to rise they are hard to bring down back, stressing the need for early policy measures to be taken.

• Secondly, monetary policy can directly affect inflation via future expectations. Like if people expect the rise in prices in future, they persuade to increase in wages, which in turn affect the prices, resulting higher inflation

Monetary policy in Pakistan Various Monetary policy of SBP in different years In 2000-01 With the free fall of the Rupee in mid-September 2000, SBP had to tighten its monetary policy to defend the exchange rate In 2001-02 The tight monetary discipline visible in FY01 was perceptibly eased in FY02. In2002-03 a substantial increase in the annual external account surplus and the easier monetary stance of the SBP left the money market wash with liquidity during FY03. In 2004-05 During FY04 the thrust of monetary management was towards aligning the market expectations with monetary policy stance. Initially during FY04 when interest rates were under downward pressure.

• In 2005-06 April 2005 in response to the headline when inflation reaching at 11.3%, SBP remains in monetary tightening phase In 2006-07During July-April 14, net credit to private sector grew by Rs266.4 billion (or 12.6 %) against Rs 339.7 billion (or 19.8 %) in the corresponding period of FY05 Despite liquidity in the system In 2007-08 SBP will be closely monitoring the economic developments and outlook for FY07 and will take appropriate actions as and when required in pursuit of maintaining the objective of price stability without prejudice to economic growth. Various Monetary policy of SBP in different years.

• In 2008-09The tight monetary policy was continued by SBP under the macroeconomic stabilization Programme and discount rate was raised by 200 bps on 13 November 2008 resulting in cumulative increase of 300 bps. In 2009-10 The overall level of risk and uncertainty in the economy has increased and the pressure on the fiscal position, has escalated and growth in the real economy is limited. Striking a balance between monetary and financial stability SBP has decided to support the recovering real economic activity Therefore, effective 25th November, 2009, the SBP policy rate will be lowered by 50 bps to 12.5 percent Various Monetary policy of SBP in different years.

• In 2013-14 the monetary policy statement of February 2013, the SBP highlighted two main challenges for monetary policy to manage the balance of payment position and to contain the possible increase in inflation. A cumulative decline of 450 basis points in the policy rate of SBP since the beginning of FY12 has played a role in this uptick. Moreover, an analysis of the balance sheets of the main sectors supports this assessment. In conclusion, given the risks to the balance of payments position, the Central Board of Directors of SBP has decided to keep the policy rate unchanged at 9.5 percent. Various Monetary policy of SBP in different years

• In 2014 (March) Almost all major economic indicators have moved in the desired direction over the past few months. Inflation has come down and growth in Large Scale Manufacturing (LSM) has been strong. Similarly, the fiscal deficit has been contained during the first half of the of concern for some time, have increased noticeably. In conclusion, given the risks to the balance of payments position, the SBP’s Board of Directors has decided to keep the policy rate unchanged at 10.0 percent. Fiscal year while the private sector credit has increased. Moreover, reflecting positive sentiments prevailing in the market, the fiscal authority has been able to borrow long term and rupee has appreciated against the US dollar. Above all, the foreign exchange reserves of SBP, a key source Various Monetary policy of SBP in different years

• SBP has encountered difficulties to targeting the inflation, economic growth, employment and interest rate objectives. But still there are certain difficulties which are a huge hindrance in the way of Economic Policy. So SBP can control all hurdles with some suitable policies.

• (A) Improve its capacity to forecast liquidity conditions and actively preempt inflationary pressures.

• (b) Develop a greater understanding of the channels of transmission of monetary policy.

• (c) Have an increasingly transparent policy framework.

Conclusion

• The results show that mostly developing countries fail to attain the desired goals of monetary policy. The basic hurdles are the deep debt burdens on government, and inflation pressures. Like, Pakistan, although adopted tight monetary policy, stood at actual inflation rate of 7.7% (FY 2006-07), against the inflation target of 6.5% (in FY 07). However, the monetary policy plays effective role to control the money supply in economy in the short-run for a sustainable prosperous long-term growth of developed countries.