1. Monetary policy and
its management
Chapter 6
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2. Monetary policy and its
management
“There have been three great inventions since
the beginning of time: fire, the wheel, and
central banking.” Will Rogers
2

3. The concept of money supply
 Money supply ("monetary aggregates", "money stock"),
a macroeconomic concept, is the quantity of money
available within the economy to purchase goods,
services, and securities. Thus, the quantity of money
available in an economy is money supply.
 In other words, money supply means total stock of
money held by the public in spendable form.
 The term public refers to the individuals and the
business firms in the economy, excluding the central
government, the central bank, and the commercial
banks.
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4. The concept of money supply
 Constitutnets of money supply:
 Different views. Broadly there are two views:
1. Traditional view: According to this view, money
supply is composed of (a) currency money and
legal tender i.e. coins and currency notes, (b)
bank money i.e. chequable demand deposits
with the commercial banks.
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5. The concept of money supply
2. Modern view: The phenomenon of money
supply refers to the whole spectrum of liquidity in
the asset portfolio of the individual. Thus, this
approach includes (a) coins (b) currency notes
(c) demand deposits with the banks (d) time
deposits with the banks (e) financial assets such
as deposits with the non-banking financial
intermediaries like the post office saving banks,
building societies etc.
(f) treasury and exchange bills, (g) bonds and
equities.
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6. The concept of money supply
 There are two concepts of money supply:
Narrow money supply and broad money
supply. In Nepal, we have narrow money
(M1) and broad money (M2).
 Narrow money supply (M1)=Currency in
circulation +Demand deposits
 Broad money supply (M2)= M1+time deposits
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7. The concept of money supply
In the US, money supply is calculated as below:
 The most common measures are named M0
(narrowest), M1, M2, and M3. In the United States they
are defined by the Federal Reserve as follows:
 M0: The total of all physical currency, plus accounts at
the central bank that can be exchanged for physical
currency.
 M1: M0 + the amount in demand accounts ("checking" or
"current" accounts).
 M2: M1 + most savings accounts, money market
accounts, small denomination time deposits and
certificate of deposit accounts (CDs) of under $100,000.
 M3: M2 + all other CDs, deposits of eurodollars and
repurchase agreements.
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8. The concept of money supply
There are just two official UK measures. M0 is referred
to as the "wide monetary base" or "narrow money"
and M4 is referred to as "broad money" or simply
"the money supply".
 M0: Cash outside Bank of England + Banks'
operational deposits with Bank of England.
 M4: Cash outside banks (ie. in circulation with the
public and non-bank firms) + private-sector retail
bank and building society deposits + Private-sector
wholesale bank and building society deposits and
CDs.v
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9. Factors affecting money
supply
 There are two approaches generally used to
identify the factors affecting money supply in
the economy: the accounting approach, and
the money multiplier or high powered theory
of money.
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10. Factors affecting money
supply
 The accounting approach, which is also
known as the balance sheet approach seeks
to review monetary accounts: balance sheet
of central bank and commercial banks. This
approach takes the consolidated balance
sheet items into account to identify the
sources of money supply. There are two
major sources of money supply: Net Foreign
Assets (NFA), and Net Domestic Assets
(NDA).
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11. Factors affecting money
supply
 In accounting approach, identical relationship is
established. For example, M2 can be written as:
Sources M2 Uses
NFA+NDA M1+Time deposit
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12. Factors affecting money
supply
 In the above table ,
NFA=net foreign assets of the monetary sector
(foreign assets less foreign liabilities)
NDA=net domestic assets of the money sector
M1=Narrow money
TD= Time deposits (saving plus fixed deposits
plus call deposits plus margin deposits)
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13. Factors affecting money
supply
 Foreign assets include gold, SDR holdings,
reserve position in the IMF, foreign
exchange holding of central bank and
commercial bank.
 Foreign liabilities include foreign deposits
held by the banking system and foreign loan
of the banking system.
 NFA increases when foreign assets increase
or when foreign liabilities go down.
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14. Factors affecting money
supply
 NDA increases if claims on government,
claims on government enterprises, and
claims on private sector increase.
 While increase in net non-monetary liabilities
lower NDA. Net non-monetary liability refers
other liability less other assets. Other
liabilities include paid-up capital, general
reserve etc of the banking system. And the
other assets include fixed assets such as
vehicle, furniture, sundry etc.
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15. Factors affecting money
supply
 The money multiplier or high powered theory of
money: The money multiplier theory establishes a
link between reserve money (also called high
powered money or monetary base) and the money
supply. This theory states that money stock is the
product of joint interaction of demand for and supply
of reserve money. According to this theory, there
are two proximate determinants of money supply:
money multiplier and reserve money.
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16. Factors affecting money
supply
 According to the money multiplier theory, money
supply is :
M= m RM
Where,
M=Money supply
m=value of money multiplier, which is m=M/RM
RM= Reserve money or monetary base. This is the
liability of the central bank. This is equal to currency
in circulation+ Deposits of deposit money banks and
others with central bank.
 The idea is that there is a positive relation between
base money (RM) and money supply (M).
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17. Monetary policy
 Monetary policy is the term used to describe
the central banks use of tools to influence the
economy by shrinking or expanding the money
supply.
 The money supply affects the interest rates. The
two are related inversely, such that, as money
supply increases interest rates will fall. When the
interest rate equates the quantity of money
demanded with the quantity of money supply,
the economy is working at the money market
equilibrium. 17

18. Objective of Monetary policy
Objectives of monetary policy:
1. Price stability
2. Full employment
3. Economic growth
4. Favorable balance of payments
However, these objectives are conflicting.
For example, price stability and high
economic growth are very difficult to attain
simultaneously.
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19. Objective of Monetary policy
 Following are the objectives of monetary policy
as stipulated in NRB Act 2002:
 Ensuring the domestic price stability
 Maintaining BOP stability
 Managing adequate level of liquidity to facilitate
economic growth
 Ensuring financial sector stability
 Developing a secure, healthy, and efficient
domestic payments
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20. Instruments of monetary
policy
The main three, which are also called quantitative
instruments of credit control are:
 Bank rate/Discount rate: The discount rate is the
interest rate at which the central bank stands ready to
lend reserves to depository institutions
 Cash Reserve Ratio: The central bank sets required
reserve ratios, which are the minimum percentages of
deposits that depository institutions must hold as
reserves.
 Open market operations (purchase, sale, repo, and
reverse repo): An open market operation is the
purchase or sale of government securities—
government bills and bonds—by the central bank in the
open market. 20

21. Instruments of monetary
policy
The qualitative instruments of credit control
exercised by monetary authority may
include:
 Credit limit or credit ceilings
 Differential interest rates
 Directed credit (for example, it is between
0.25 percent and 3.0 percent of bank’s loans
in deprived sector in Nepal these days)
 Moral suasion (includes persuasion and
pressure) 21

22. Monetary policy
TighterMonetaryPolicy LooserMonetaryPolicy
Openmarketsaleofsecurities Openmarketpurchaseofsecurities
Increaseindiscountrate Decreaseindiscountrate
Increaseinreserverequirement Decreaseinreserverequirement
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23. Monetary policy
 If central adopts contractionary monetary
policy, it tightens instruments and mops up
liquidity from the economy.
 If adopts expansionary monetary policy,
looses its instruments and injects liquidity into
the economy.
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24. Monetary policy framework
Following table is an outline of the possible and
suggestive list of monetary policy instruments,
operating targets (indictors), intermediate targets, and
ultimate goals.
Instruments Operating
Targets
Intermediate
Targets
Goals
CRR
DR/BR
OMOs
Moral
Suasion
Depository
reserves
Discount
rate/interest
rate
Monetary
base
Monetary
aggregates
DR/BR
Domestic
credit
Price
Stability
BoP
Surplus
High
growth and
employment24

25. Nepalese monetary policy
framework
Right now, in Nepal following is the MP framework. It is
not possible to attain goals directly through
instruments. Therefore, operating targets and
intermediate targets are set in between to attain goals.
Instruments Operating
Target
Intermediate
Target
Goals
CRR
BR
OMOs
Moral
Suasion
Excess
Reserve of
Commercial
banks
Monetary
aggregates
(Broad
money)
Price
Stability
BoP
Surplus
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26. Who conducts monetary policy
?
 The answer is central bank. A central bank is the public
authority that regulates a nation’s depository institutions
and controls the quantity of money.
The central bank mainly performs the following functions:
 Conduct of monetary policy
 Banker to the commercial banking system
 Banker to the government
 Supervisor of the banking system
 Manager of the national debt
 Manager of the foreign exchange reserve
 Issuer of the national currency
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27. The monetary transmission
mechanism
 How does money supply work in an economy?
Through money transmission mechanism.
 Money transmission mechanism, the route through
which changes in the supply of money are
translated into changes in output, employment,
prices and inflation.
 Take a few notes:
1. To start the process, the central bank takes steps
to reduce bank reserves by selling government
securities
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28. The monetary transmission
mechanism
2. Each dollar reduction in bank reserves produces a
multiple contraction in checking deposits, thereby
reducing the money supply.
3. The reduction in the money supply will tend to
increase interest rates and tighten credit
conditions.
4. With higher interest rates and lower wealth, interest
sensitive spending-especially investment-will tend
to fall.
5. Finally the pressure of tight money, by reducing AD,
will reduce income, output, jobs, an inflation.
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29. The monetary transmission
mechanism
 The above mentioned steps can be
summarized as below:
 R down M down i up I, C, X down AD down
Real GDP down and inflation down
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30. Monetary Policy in the AS-AD
Model
The following figure illustrates the attempt to
avoid inflation.
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31. Monetary Policy, Real GDP,
and the Price Level
A decrease in the money supply in part (a)
raises the interest rate.
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32. Monetary Policy, Real GDP,
and the Price Level
The rise in the interest rate decreases
investment in part (b).
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33. Monetary Policy, Real GDP,
and the Price Level
The decrease in investment shifts the AD
curve leftward with a multiplier effect in part (c).
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34. Monetary Policy, Real GDP,
and the Price Level
Real GDP decreases and the price level falls.
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35. Monetary Policy, Real GDP,
and the Price Level
The following figure illustrates the attempt to
avoid recession.
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36. Monetary Policy, Real GDP,
and the Price Level
An increase in the money supply in part (a)
lowers the interest rate.
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37. Monetary Policy, Real GDP,
and the Price Level
The fall in the interest rate increases
investment in part (b).
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38. Monetary Policy, Real GDP,
and the Price Level
The increase in investment shifts the AD curve
rightward with a multiplier effect in part (c).
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39. Monetary Policy, Real GDP,
and the Price Level
Real GDP increases and the price level rises.
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40. The money demand
 Money demand in an economy is: MD= P. L (I, Y)
 The equation suggests that there are three main
determinants of the nominal demand for money:
1. Interest rates. An increase in the interest rate will
lead to a reduction in the demand for money
because higher interest rates will lead investors to
put less of their portfolio in money (that has a zero
interest rate return) and more of their portfolio in
interest rate bearing assets (Treasury bills).
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41. The money demand
2. Real income. An increase in the income of
the investor will lead to an increase in the
demand for money. In fact, if income is
higher consumer will need to hold more
cash balances to make transactions (buy
goods and services).
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42. The money demand
3. The price level. An increase in the price level P will
lead to a proportional increase in the nominal
demand for money: in fact, if prices of all goods
double, we need twice as much money to make the
same amount of real transactions. Since the
nominal money demand is proportional to the price
level, we can write the real demand for money as
the ratio between MD and the price level P. Then,
the real demand for money depends only on the
level of transactions Y and the opportunity cost of
money (the nominal interest rate):
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43. The money supply targeting
 Under monetary targeting (MT), central bank fixes
the money supply, and keeps it constant.
 MT is easily observable. People will know if the
central bank hides information. And central bank
controls inflation through MT.
 Two types of shocks: inflationary shock and output
shock will shift the money demand curve.
 Under monetary targeting, central bank changes
interest rate to offset the effect of increased
demand for money.
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44. The money supply targeting
O
M
S
R1
R
R2
E1
E
E2
MD1
MD
MD2
Money Supply and Demand
Rate of Interest
44

45. Interest rate targeting (IRT)
 Under IRT, central bank alters MS.
O
R
E1E
E2
MD1
MD
MD2
Money Supply and Demand
Rate of Interest
S2 S S1
M2 M M1
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46. A few questions for you
 Think and build your answer on your own.
 What is the stance of Nepalese monetary
policy this year: tight or loose?
 What is targeted in Nepal?
 What is the inflation rate in Nepal in Mid-
March 2007?
 Is Nepal’s central bank independent?
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