Chapter Five

Central Banking and

Monetary Policy

1
 5.1 Introduction
 Among the most important players in financial markets
throughout the world are central banks, the government
authorities in charge of monetary policy/Government officials who
control monetary policy
 Central banks ’actions affect interest rates, the amount of credit,
and the money supply,
 All of which have direct impacts not only on financial markets,
but also on aggregate output and inflation.

2
Cont’d

 To understand the role that central banks play in financial

markets and the overall economy,

 We need to understand how these organizations work.

 Who controls central banks and determines their actions?

 What motivates their behavior?

 Who holds the reins of power?

 i. Activities and responsibilities of Central Banks
 National Bank of Ethiopia, which regulates the money supply and credit,
issues currency, and manages the rate of exchange.
 monopoly on the issue of banknotes
 the Government's banker •
 the bankers' bank ("Lender of Last Resort") •
 manages the country's foreign exchange and gold reserves
and the Government's stock register; •
 regulation and supervision of the banking industry: •
 setting the official interest rate - used to manage both inflation
and the country's
Functions of a Central Bank

Issue New Currency

 Monopoly of note-issue vested in the CB ensures uniformity
which helps in facilitating exchange & trade
 It brings stability in the monetary system & creates confidence
in the public.
 The CB can restrict/expand the supply of cash according to
requirements of the economy.
 Thus, it provides elasticity to the monetary system.
ii. Policy instruments of the Central Bank
 Monetary policy instruments may be divided
in to two main types.
1direct instrument: involves the directives by central
banks to control,
Interest rates on deposit and borrowed funds
Credit amount
2. Indirect instruments:-In the monetary area, financial
liberalization involves a movement away from direct
monetary controls towards indirect ones.
Is the feature of financial liberalization.
Is the ways of controlling monetary liabilities
Classification of indirect instruments
1. Open Market Operations (OMO)
 Involves in buying and selling the securities
 To enable open market operations, a central bank must hold
foreign exchange reserves (usually in the form of government
bonds) and official gold reserves
2. Reserve Requirements
 Its change affects money supply by causing the money supply
multiplier to change. Rise in reserve requirement reduces
money supply and vice versa
3. Discount Policy
 A rise in discount loans adds to the monetary base and
expands the money supply; fall in it also results in contraction
of money supply And vice versa
How Independent Is the Central Bank?

 Why is central bank independence an important issue?

 How free is the Fed from presidential and congressional
pressures?
 Do economic, bureaucratic, or political considerations guide
it?
 Is the Fed/ NBE of truly independence from external
pressure
 price stability is generally considered a good thing, and
that an independent central bank can help to achieve
 Economies work better if investment and wage decisions
are not confused and thwarted by high inflation…
The Case for Independence: Threats which bear upon the
issue of central bank independence:

 the tendency for policy makers and politicians to push the economy to
run faster and further than its capacity limits allow
 the temptation that governments have to incur budget deficits and fund
these by borrowings from the central bank.
 Politicians are shortsighted because they are driven by the need to
win their next election.
 With this as the primary goal, they are unlikely to focus on long-run
objectives, such as promoting a stable price level.
Cont’d

 Cynics blame this inflation bias on the political process, claiming that
politicians have short time horizons, stretching only as far as the next
election
 Instead, they will seek short-run solutions to problems -high
unemployment and high interest rates,
 Even if the short-run solutions have undesirable long-run
consequences.
 The political process leads to political business cycle, in which just
before an election, expansionary policies are pursued to lower
unemployment and interest rates
Cont’d

 After the election, the bad effects of these policies—high inflation

and high interest rates— come home to roost,
 Requiring contractionary policies that politicians hope the public
will forget before the next election.
 Governments which survive by printing money when they could not
survive by other means. It cause of high inflation and hyperinflation in
a number of countries over the years.
 Eg, former Soviet Union and eastern European countries, and
Indonesia 1960,
 The examples are numerous, and the lesson is clear:
 unless a central bank is protected from the need to fund budget
deficits, price stability rests more in the hands of the budgetary
authorities, than the central bank.
 In short, sound money cannot be maintained without a sound
fiscal system.
 so much for the problem, what can be done?
 To be able to do their job of keeping inflation under control,
central banks have to be able to say ‘no’ to governments when
that objective is threatened.
 This is why the notion of central bank independence is so
important.
Cont’d

 The Fed can be used to facilitate Treasury financing of large

budget deficits by its purchases of Treasury bonds.

 Treasury pressure on the Fed to “help out” might lead to a more

inflationary bias in the economy.

 Lack of expertise at making hard decisions on issues of great

economic importance, such as reducing the budget deficit or

reforming the banking system.

 What is central bank
independence?
 In principle, the answer to the first threat is relatively
straightforward –
 give central banks a charter which includes a strong commitment
to price stability, and the freedom 39 to pursue it.
 This does involve the government in setting the goals,
 but that is the way it should be: central banks cannot expect to
determine the goals they should pursue,
 but they should have adequate scope to pursue the goals that have
been set.
 In the jargon, they should not have goal independence but they
should have instrument independence.
 That is clear enough in principle, but it has been interpreted
differently in practice, resulting in different approaches by central
bank
 having a target other than the ultimate objective might help to
anchor monetary policy, but the authorities have to be sure that the
intermediate target is the correct one.
 The third approach is to require the central bank to give a high priority
to price stability while also having regard to other objectives, such as
growth and employment.
 In this case, the priority attached to fighting inflation at any point in
time will depend a good deal on the make-up of the Board of the bank
and its Governor
Cont’d

 An independent Fed has not always used its freedom successfully

 Its independence may encourage it to pursue a course of narrow

self-interest rather than the public interest.

Cont’d

 Advocates of an independent central bank believe that

macroeconomic performance will be improved by making the

central bank more independent.

 Recent research seems to support this conjecture: When central

banks are ranked from least independent to most independent,

inflation performance is found to be the best for countries with

the most independent central banks

Tools of Monetary Policy
 Three policy tools that the central bank can use to manipulate the
money supply and interest rates:
 Open market operations, which affect the quantity of reserves
and the monetary base;
 Changes in discount lending, which affect the monetary base;
and
 Changes in reserve requirements, which affect the money
multiplier.
 Such use of policy tools has an important impact on interest rates
and economic activity
Monetary Policy
 MP is the process a government or monetary authority of a
country uses to control
(i) the Supply of money, availability of money & interest rate to
attain a set of objectives oriented towards the growth & stability
of the economy
 MP is either being an expansionary policy to increase the total SS
of money in the economy, or contractionary policy, where it
decreases the total money SS
 Expansionary monetary policy- used to combat
unemployment in a recession
 Contractionary monetary policy involves raising interest rates
to combat inflation
Goals of Monetary Policy

1. High Employment
 High employment is a worthy goal for two main reasons:
 The alternative situation—high unemployment—causes much
human misery, with families suffering financial distress, loss
of personal self-respect,
 When unemployment is high, the economy has not only idle
workers but also idle resources (closed factories and unused
equipment), resulting in a loss of output (lower GDP).
Economic Growth

 Economic growth means that more goods and services can be

produced in the economy and a higher national income is

generated.

 The government may promote economic growth using monetary

policy by encouraging the public to save and businesses to invest.

Price Stability

 Inflation-Creates uncertainty and difficulty in planning for future

 Central banks are concerned with price stability because the
alternative is either high inflation or deflation.
 Price instability has negative economic effects by increasing
uncertainty about the future and that may adversely affect
economic growth.
Cont’d

 When the overall level of prices is changing, the information

conveyed by the prices of goods and services is harder to

interpret,

 Which complicates decision making for consumers, businesses,

and government

 A growing body of evidence suggests that inflation leads to lower

economic growth
Cont’d

 Inflation also makes it hard to plan for the future.

 For example, it is more difficult to decide how much funds should
be put aside to provide for a child’s college education in an
inflationary environment.
 Further, inflation can strain a country’s social fabric: Conflict
might result, because each group in the society may compete with
other groups to make sure that its income keeps up with the
rising level of prices.
Interest Rate Stability

 Fluctuations in interest rates make planning and investment

decisions difficult for households and firms.

 Sharp interest rate fluctuations cause problems for banks and

other financial firms.

 So, stabilizing interest rates can help to stabilize the financial

system.
Cont’d

 Interest rate stability is important because consumers decisions to

buy goods (e.g. houses and cars) and firms decisions to invest

both depend on their expectations of interest rates.

 Interest payments represent a significant cost to decision makers.

Stability of Financial Markets

 The existence of a more stable financial markets helps in

avoiding financial crises that affect financial institutions.

 When financial markets and institutions are not efficient in

matching savers and borrowers, the economy loses resources

 For example, fluctuations in interest rates produce large capital

gains and losses to investors and financial intermediaries holding

long term financial instruments

Stability in Foreign Exchange Markets

 In the global economy, foreign-exchange market stability, or

limited fluctuations in the foreign-exchange value of the birr, is an

important monetary policy goal of the central bank of Ethiopia

Cont’d

 Fluctuations in the Birr’s value change the international

competitiveness of Ethiopia industry:
 A rising birr value makes Ethiopian goods more expensive
abroad, reducing exports, and
 A falling birr makes foreign goods more expensive in the
Ethiopian economy.
 Because of the increase in trade between countries, fluctuations in
exchange rates may result in huge losses for domestic consumers
and producers.
Conflict among Goals

 Although many of the goals mentioned are consistent with each

other-high employment with economic growth, interest-rate

stability with financial market stability-this is not always the case.

 The goal of price stability often conflicts with the goals of

interest-rate stability and high employment in the short run (but

prob­ably not in the long run).

Cont’d

 For example, if the central bank tries to prevent a rise in interest

rates, this may cause the economy to overheat and stimulate

inflation.

 But if a central bank raises interest rates to pre­vent inflation, in

the short run unemployment may rise.

 The conflict among goals may thus present central banks with

some hard choices.

Central Bank Strategy: Use of Targets

 The central bank's problem is that it wishes to achieve certain

goals, but it does not directly influence the goals.

 It has a set of tools to employ that can affect the goals indirectly

after a period of time

 If the central bank waits to see what the price level and

employment will be one year later, it will be too late to make any

corrections to its policy-mistakes will be irreversible.

Cont’d

 Monetary tools cannot affect the economic goals directly.

 Thus, the CB uses a number of monetary variables that lie

between them, called targets.

Targets to meet Goals

 Targets are variables that the central bank can influence directly

and that help achieve monetary policy goals.

 The central bank relies on two types of targets- intermediate

targets and operating targets

 Intermediate targets are financial variables - the money
supply(M1,M2,M3) or interest rates- that the central bank
believes will directly help it to achieve its goals.
Cont’d

 w/c have a direct effect on the goals, but not directly affected by

the tools.

Operating Targets:

 In fact, the central bank controls intermediate target variables,

such as interest rates and monetary aggregates, only indirectly

because private-sector decisions also influence these variables.

Cont’d

 The central bank seeks targets that are better links between its

policy tools, intermediate targets, and goals.

 Operating targets, are variables that the central bank controls

directly with monetary policy tools and that are closely related to

intermediate targets.

 Examples of operating targets include Reserve, monetary base

 This targets are responsive to the tools

Cont’d

 Operating Targets -- Variables which are known to have a direct

effect on intermediate targets.

 Variables-- Reserves (R), the Monetary Base (H).

 Intermediate Targets -- Variables which are known to have a

direct effect on final targets

 Variables– interest rate (short-term and long-term), M1, M2,

other money supply measures.

Cont’d

 The central bank pursues this strategy because it is easier to hit a

goal by aiming at target than by aiming at the goal directly.

 Specifically, by using intermedi­ate and operating targets, it can

more quickly judge whether its policies are on the right track,

rather than waiting until it sees the final outcome of its policies on

employment and the price level.

Cont’d

 Suppose that the central bank's employment and price-level goals

are consistent with a nominal GDP growth rate of 5%.

 The central bank chose a 4% growth rate for M2 - its

intermediate tar­get,

 Which will in turn be achieved by a growth rate of 3% for the

mone­tary base - its operating target

Cont’d

 It will carry out open market operations (its tool) to achieve the 3

percent growth in the monetary base.

 After implementing this pol­icy, the central bank may find that the

monetary base is growing too slowly, say, at a 2 percent rate; then

it can correct this too slow growth by increasing the amount of its

open market purchases.

Cont’d

 Somewhat later, the central bank will begin to see how its policy is

affecting the growth rate of the money supply.

 If M2 is growing too fast, say, at a 7 percent rate, the central bank

may decide to reduce its open market purchases or make open

market sales to reduce the M2 growth rate.

Cont’d

 One way of thinking about this strategy (illustrated in Figure 1

below) is that the cen­tral bank is using its operating and

intermediate targets to direct monetary policy toward 'the

achievement of its goals.

 After the initial setting of the policy tools, an operating target

such as the monetary base, which the central bank can control

fairly directly, is used to reset the tools

Cont’d

 So that monetary policy is channeled toward achieving the

intermediate target of a certain rate of money supply growth.

 Midcourse corrections in the policy tools can be made again when

the central bank sees what is happening to its intermediate target,

 Thus directing monetary policy so that it will achieve its goals of

high employment and price stability

Cont’d

1. M d fluctuate between M d' and M

d''

2. With M-target at M*, i

fluctuates between i' and i''

Figure 1 Result of Targeting on the Money

Supply Targeting on the money supply at M*,
will lead to fluctuations in the interest rate
between i' and i" because of fluctuations in
the money demand curve between Md' and
Md"
Choosing the targets

 There are two different types of target variables: interest rates

and aggregates (monetary aggregates and reserve aggregates),

 In our exam­ple, the central bank chose a 4 percent growth rate

for M2 to achieve a 5 percent rate of growth for nominal GDP,

Cont’d

 It could have chosen to lower the interest rate on the three-month

Treasury bills to, say, 3 % to achieve the same goal.

 Can the central bank choose to pursue both of these targets at the

same time? The answer is no.

 Why a central bank must choose one or the other can be shown

using the application of the supply and demand analysis of the

money market.
Cont’d

 Consider why a monetary aggregate target involves losing

control of the interest rate.

 Figure 1 below contains a supply and demand diagram for the

money mar­ket.

 Although the central bank expects the demand curve for money

to be at Md*,
Cont’d

 It fluctuates between Md' and Md" because of unexpected change

in
 Output & price level.
 The public's preferences about holding bonds ver­sus money

 If the central bank's monetary aggregate target of a 4 per­cent

growth rate in M2 results in a money supply of M*, it expects that

the interest rate will be i*.

Cont’d

 However, as the figure indicates, the fluctuations in the money

demand curve between Md' and Md" will result in an interest rate

fluctuating between i’ and i”.

 Pursuing a monetary aggregate target implies that interest rates

will fluctuate.

 The supply and demand diagram in Figure 2 below shows the

consequences of an interest-rate target set at i*.

Cont’d

 Again, the central bank expects the money demand curve to be at

Md*,

 But it fluctuates between Md' and Md" due to unexpected changes

in output, the price level, or the public's preferences toward

holding money.
Cont’d

1. M d
fluctuates between M d'
and

M d''

2. To set i-target at i* Ms fluctuates

between M' and M''

Cont’d

 If the demand curve falls to Md, the interest rate will begin to fall

below i*, and the price of bonds will rise.

 With an interest rate target the central bank will prevent the

interest rate from falling by selling bonds to drive their price

back down and the interest rate back up to its former level.
Cont’d

 The central bank will make open market sales until the money

supply declines to MS', at which point the equi­librium interest

rate is again i*.

 Conversely, if the demand curve rises to Md" and drives up the

interest rate, the central bank would keep interest rates from

rising by buying bonds to keep their prices from falling.

Cont’d

 The central bank will make open market purchases until the

money supply rises to MS” and the equilibrium interest rate is i*.

 The central bank's adherence to the interest-rate target thus leads

to a fluctuating money supply as well as fluctuations in reserve

aggregates such as the monetary base.

Cont’d

 The conclusion from the supply and demand analysis is that

interest-rate and monetary aggregate targets are incompatible:

 A central bank can hit one or the other but not both.

 Because a choice between them has to be made, we need to

examine what criteria should be used to decide on the target

variable.
Criteria for Choosing Intermediate Targets

 The rationale behind a central bank's strategy of using targets

suggests three' criteria for choosing an intermediate target:

 It must be measurable, controllable by the central bank, and

must have a predictable effect on the goal.

Cont’d

1. Measurability: Quick and accurate measurement of a target

variable is necessary because the target will be useful only if it

signals rapidly when the policy diverts from the desired

direction.

 Quick: monetary aggregates data are available after a two-

week delay, while interest rate data are available almost

immediately.
Cont’d

 Accurate: monetary aggregates data are frequently revised

and corrected, while interest rate data are more precise and

rarely revised.

 This makes interest rates more preferable than monetary

aggregates, according to this criterion.

2. Controllability

 CB must be able to exercise effective control over a variable if it is

to function as a useful target

 If the CB cannot control a target, knowing that it is off track is

not useful because the CB has no way of getting it back on track.

3. Predictability

 The most important characteristic a variable must have to be a

good intermediate target, is that it must have a predictable

impact on goals
 Monetary Policy Transmission Mechanism

 Change in monetary policy are triggered by domestic and

external shocks that can imperil the attainment of policy

objectives

 Monetary policy affect the economy through various mechanism

of transmission to the ultimate policy goals

Cont’d

 The process through which monetary policy decisions affect

the economy in general and the price level in particular.

 It is characterized by long, variable and uncertain time lags.

 Difficult to predict the precise effect of monetary policy actions

on the economy and price level.

Lags in Monetary Policy
 The greatest obstacle facing the central bank is the
problem of lags.
 A policy that formulated by a monetary authority
cannot affect the economy immediately; it takes time
to:
– recognize the real problem that the economy face
– formulate and implement the appropriate policy
– observe the impact of the policy
 This time gap between the occurrence of a problem
and the effect of a policy on an economy is called lag.
  Monetary policy lag as a delay between the time at
which a macroeconomic problem arises and the time
at which a policy influences the real economy.
 The lag can be categorized into three.
1. Recognition lag: delay between the time at which
the problem arises and policy makers aware of it
2. Implementation lag: delay between the time the
problem is recognized and a policy is enacted
3. Impact or response lag: delay between the time the
policy is enacted and the policy impacts the
economy
64
Transmission Mechanism of monetary policy

 The transmission mechanisms of monetary policy work through

various channels, affecting different variables and markets, at various
speeds and intensities
 To develop a framework for understanding how to
evaluate empirical evidence we need to recognize that
there are two basic types of empirical evidence in
economics
 Structural model evidence: by Keynesians
 Reduced form evidence: by monetarists
 1. Structural form evidence
 This evidence examines whether one variable affects
another by using data to build a model that explains the
channels through which this variable affects the other
 The model built by Keynesians to exam the effect of
money on economy
 It is:
– specific about the channels through which the money
supply affects economic activity
– description of how the economy operates using a
collection of equations that describe the behavior of firms
and consumers in many sectors of the economy
 Thus, its behavioral equation will be:

 2. Reduced form evidence
 It examines whether one variable has an effect on another by
looking directly at the relationship between the two variables.
 The model was developed by the monetarists
 Monetarists do not describe specific ways in which the money
supply affects aggregate spending
 Instead, they examine the effect of money on economic activity
by looking at whether movements in Y are tightly linked to
(have a high correlation with) movements in M.
 Using reduced-form evidence, monetarists analyze the effect
of M on Y as if the economy were a black box whose workings
cannot be seen.
 The monetarist way of looking at the evidence can be
represented by the following schematic diagram, in
which the economy is drawn as a black box with a
question mark:

 The model illustrates that the linkage between money

supply and the economy is non-structural (there could
be other unobservable variables between the two)
 Conclusions
 No clear-cut case can be made that reduced-form
evidence is preferable to structural model evidence or
vice versa
 If the structure is correct, it predicts the effect of monetary
policy more accurately, allows predictions of the effect of
monetary policy when institutions change, and provides
more confidence in the direction of causation between M
and Y.
 If the structure of the model is not correctly specified
because it leaves out important transmission mechanisms
of monetary policy, it could be very misleading.
 The reduced-form approach, used primarily by
monetarists, does not restrict the way monetary policy
affects the economy and may be more likely to spot the full
effect of M on Y
 However, reduced-form evidence cannot rule out reverse
causation, whereby changes in output cause changes in
money, or the possibility that an outside factor drives
changes in both output and money.
 A high correlation of money and output might then be
misleading because controlling the money supply would
not help control the level of output
 EARLY KEYNESIAN EVIDENCE ON THE
IMPORTANCE OF MONEY

 In 1936 Keynes began to analyze economic activities

 Although Keynesians believe that money has important effects on economic
activity, early Keynesians of 1950s and early 1960s characteristically held the
view that monetary policy does not matter at all to movements in aggregate
output and hence to the business cycle.
 Early Keynesians believe ineffectiveness of monetary policy due
to
1. During the Great Depression, ( Policy couldn’t affect AD)
– low nominal interest rate at that time which in turn affect investment
– Investment could not developed …. Contraction of economy could not
possible…. they concluded that changes in the money supply have no effect on
aggregate output-in other words, money doesn't matter
2. Early empirical studies found no linkage between
movements in nominal interest rate and investment
spending.
– Because early Keynesians saw this link as the channel through
which changes in the money supply affect aggregate demand,
finding that the link was weak also led them to the conclusion that
changes in the money supply have no effect on aggregate output
3. Surveys of businesspeople revealed that their decisions on
how much to invest in new physical capital were not
influenced by market interest rates.
– There was a weak link b/n investment and Interest rate
– Strengthening the conclusion that money doesn't matter
Objections to Early Keynesian
Evidence

 Objected by small group of economists at the University

of Chicago, led by Milton Friedman. Their view on that
money does matter to aggregate demand.
 For them the structural model used by the early
Keynesians was severely flawed,
 In 1963, Friedman and Anna Schwartz published their
classic monetary history of the United States, which
showed that contrary to the early Keynesian beliefs,
monetary policy during the Great Depression was not
easy; indeed, it had never been more contractionary.
 According to monetarists, there were banks failure which
resulted in great depression
 Monetarists objected to this interpretation of the evidence on
the grounds that
(a) the focus on nominal rather than real interest rates may have
obscured any link between interest rates and investment,
(b) interest-rate effects on investment might be only one of
many channels through which monetary policy affects
aggregate demand, and
(c) by the standards of real interest rates and interest rates on
lower-grade bonds, monetary policy was extremely
contractionary during the Great Depression
Cont’d

 The transmission mechanisms of monetary policy work through

various channels, affecting different variables and markets, at

various speeds and intensities.

 Policy actions taken are directly transmitted to money & asset

market

 This in turn affect goods and labor markets, & ultimately

aggregate outputs and prices

Interest rate channel

 The most conventional mechanism

 An expansionary policy leads to a reduction in real interest rate,

which in turn affect business investment, investment in residential

housing & consumer expenditure on durable goods

 As such change alters the marginal cost of lending and

borrowing,
Cont’d

 Affecting economic agents’ cash flow and time preferences for

consumption

 The corresponding shift in AD is eventually reflected in output &

prices
The Asset Price Channel

 Influences the prices of bonds, shares, real estate, and other

domestic assets

 Asset prices affect demand through private consumption &

business investment - impact balance sheets of banks &

businesses

 It operates through changes in firms’ market value and in

household wealth.
Cont’d

 The former alters the relative price of new equipment,

affecting investment spending,

 While the latter affects household consumption and the

availability of collateral for borrowing.

 Equity prices affect corporate investment via Tobin’s q

Cont’d

 An expansionary MP leads to higher equity prices, which make

investment more attractive (via Tobin’s q)
 Higher equity prices also entail increased wealth – raises
consumption & thus raise AD
 Monetarists → An increase MS raises consumer wealth & asset
prices, & hence, spending on hh & enterprise assets
 Keynesian → An increase MS reduces interest rate – make equity
market more attractive
The exchange rate channel

 Works through both aggregate demand (net exports) and supply

(domestic value of imports) - output.

 This channel also involves interest-rate effects because when i fall,

domestic dollar deposit become less attractive relative to other

deposits denominated in foreign currencies.

Cont’d

 As a result, the value of dollar deposits relative to

other currency deposits falls and the dollar depreciate
(a fall in exchange rate).
 The lower the value of domestic currency makes
domestic goods cheaper than foreign good - causing a
rise in net export and hence in aggregate output.
M → I → E → NX → Y
Cont’d

 On the demand side,

– Monetary expansion lower the domestic real interest rate, which
bring about a real depreciation of domestic currency
– This in turn leads to higher net export & stronger AD

 On the supply side,

– The real depreciation raises the domestic prices of imported goods –
rising inflation directly
– Moreover, the higher prices of imported inputs contracts AS,
reducing output & increasing inflation
The credit channel

 Bank lending depends on interest rates & economic conditions

 MP affects economic conditions which amplifies its direct effect

on bank lending via interest rates

 Two mechanisms amplify the direct interest rate effect on

banking lending

 Policy tightening tend to reduce the net-worth of businesses &

individuals
Cont’d

 making them harder for them to qualify for loan at any interest

rate –reducing spending & price pressures

 It also operates through non-price credit rationing stemming

from asymmetric information and/or directed credit.

 This channel is prominent when government intervention in the

loan market is strong, interest rates are strictly regulated, or

credit markets are shallow

Cont’d

 In such contexts, economic activity does not closely depend

on changes in the price of credit,

 So monetary policy tends to resort to directly controlling

the availability of credit to influence aggregate demand.

Cont’d

 An expansionary monetary policy increases the availability

of banks’ loanable resources and hence bank lending,

 Thereby increases output (primarily through increasing

investment).
Thank you