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Monetary Policy


Identify the range of macro-economic issues currently impacting on the economy of Papua New Guinea and link appropriate macro-economic management strategies to those issues.

Course Overview

Identify the range of macro-economic issues currently impacting on the economy of Papua New Guinea and link appropriate macro-economic management strategies to those issues.

Unit 12 Topic 2 Goals

  • Define monetary policy
  • Identify the instruments or tools of monetary policy
  • Explain how each instrument can be used to contract/expand the economy
  • Describe the aims of monetary policy and state its overall effects on the economy
  • Describe problems encountered in implementing monetary policies in developing countries
  • Distinguish types of monetary policies and their effect on the economy
  • How monetary policy instruments are used to control the money supply

Course Content

6 Lessons 6h 40m

    Macroeconomic policy conducted by a country’s reserve/central bank, to smooth out fluctuations in the economic cycle and counter their economic effects, with the goal of promoting the government’s economic objectives.

    The instruments (tools) BPNG uses are:

    • Interest Rate Policy
    • Liquid Asset Ratio (LGS)
    • Special Deposit (SRD)
    • Open Market Operation (OMO)
    • Control over lending
    • Moral suasion

      Key Points

    • Cash Rate (Kina Facility Rate): the interest rate that commercial banks pay to borrow funds from the central bank
    • Interest rates are determined by the supply/demand for loanable/lending funds
    • Interest rate: the cost of borrowing or reward for lending money, expressed as a % of the total amount borrowed or loaned
    • The central bank increases/decreases the interest rate charged by commercial banks on lending to influence the money supply in the economy
    • So, how do interest rates affect borrowing? Interest rates have an inverse relationship with lending (borrowing).

    • Higher cash rate leads to a higher interest rate. This should lead to decreased spending and investment by businesses and households. Thereby, decreased aggregate demand and inflation.
    • Lower cash rate leads to a lower interest rate. This should lead to increased spending and investment by businesses and households. Thereby, increasing aggregate demand and inflation.
    • These effects are referred to as the transmission mechanism: how changes to monetary policy affect the interest rates that households and businesses face and flow through to economic activity, employment, and inflation.

    • Changes to the cash rate affect other interest rates in the economy
    • Changes in these interest rates affect economic activity and inflation

    Liquid Asset Ratio (LAR): the proportion of total bank deposits (liabilities) put aside to meet customer demands for withdrawal.

    • Increased LAR reduces the ability of the banks to credit loans and deflates the economy
    • Decreased LAR increases the ability of the banks to credit loans and inflates the economy

    Commercial banks are required to hold a certain % of their deposits as “special deposits” with BPNG. This special deposit is not available for lending (required as a buffer).

  • • Imposing/increasing special deposit requirements can decreases lending and be used to deflate (contract) the economy.
  • • Abolition/decreasing special deposit requirements can increase lending and be used inflate (expand) the economy.
  • Moral suasion: mutual co-operation between BPNG and commercial banks in implementing the monetary policies set by the central bank.

    Open Market Operation (OMO):

    OMO: the buying/selling of government securities (Treasury Bills, Central Bank Bills, and Government Inscribed Stock) as an instrument of monetary policy.

    • Government securities: official document (paper) sold by the government. Enables government to borrow money from the private sector
    • To borrow private money the government agrees to buy back the government securities on a certain date and pay a rate of interest

    The effectiveness of monetary policy as an instrument of macroeconomic management is enhanced by the short inside time lags involved with its implementation, but significantly reduced by the long- and variable-time lag before policy changes are fully transmitted and change the level of economic activity.

    Inside Lag: the time it takes to recognise that the state of the economy indicates the need to use counter-cyclical macroeconomic policy, decide on the appropriate policy response and implement it

    Outside Lag: the time it takes for the policy measure to have its effect on the targeted economic variables and the level of economic activity

    Developing countries are yet to reach the stage of industrialisation. Monetary policy is less effective in developing countries because:

    Lack of expertise

    Lack of advanced technology and systems in place for quick, accurate data collection/analysis

    Large existence of informal sector which contributes a large %/amount to overall GDP and is not (properly) accounted for

    How does this affect BPNG?

    • BPNG does not have full control over lending by non-bank financial institutions (Savings and Loans Societies etc.) who lend to the informal sector
    • The informal sector (which contributes a greater % to GDP) is less likely to borrow (or be able to borrow)
    • As a result, the use of the interest rate mechanism (transmission mechanism) is less effective.
    • Therefore, there is an increased time lag – time it takes for monetary policy to have the desired effect on the economy

    So, what are the types of monetary policy?

    1. Restrictive/Tightening Monetary Policy: aims to restrict credit and limit the growth of money supply (Contract the Economy).

      This is achieved by:
    • Increasing the required LGS ratio
    • Increasing interest rates
    • Reducing lending by commercial banks
    • Selling government securities
    • Introducing/increasing special deposits with the central bank

    2. Expansionary/Stimulative Monetary Policy: aims to credit and increase the growth of money supply (Expand the Economy)

    • • Reducing the required LGS ratio
    • • Reducing interest rates
    • • Increased lending by commercial banks
    • • Buying government securities
    • • Abolishing/decreasing special deposits with the central bank

    What are the two types of control in lending:

    • Quantitative control: controlling the volumes of loans to be given
    • Qualitative control: controlling the types of loans to be given and not be given
    • Money: a generally accepted form for exchanging goods/services and settling debt
    • Characteristics of money: scarcity, recognisable, portable, divisible, acceptance, durable, and uniform
    • Functions of money: medium of exchange, measure of value, standard of deferred payments, and store of value
    • Money supply is the total amount of money circulating in the economy
    • The three ways of measuring money supply in PNG are: Narrow, Broad, and Total money supply
    • Factors affecting the size of the money supply are balance of payments, government expenditure (budget), open market operations, lending by commercial banks
    • The Quantity Theory of Money explains the relationship between money supply and price level
    • Multiplier effect calculator: Multiplier Effect = New Deposit x Credit Multiplier
    • Credit creation: a process of providing multiple amounts of credits using the customers’ deposits received by the banking system
    • Credit multiplier shows the number of times, total deposits can be turned into credits
    • The functions of the Central Bank (BPNG) are:

    • o Issuer of currency
    • o Banker to the government and commercial banks
    • o Management of international (foreign) reserves
    • o Control over foreign capital inflow/outflow
    • o Provide forward exchange facilities to importers and exporters
    • o Management of exchange rate
    • o Supervision of financial system
    • o Registration of savings and loans societies
    • o Economic reporting
    • o Implementation of monetary policies via control over commercial banks
      The functions of the Commercial banks are:
    • Accepting deposits
    • Honouring cheques and effecting payments by other means
    • Making loans available
    • Exchange of foreign currency to and from customers
    • Exchange of foreign currency to and from customers and giving financial advice
    • Providing safe custody for valuables, acting as executors and trustees