FM 305: Monetary Policy and Central Banking – Central Monetary Policy

Central Monetary Policy

Central Banks of Other Countries

People’s Bank of China (PBOC)

  • The central bank of the People’s Republic of China.
  • Responsible for overseeing and implementing the country’s monetary policy and financial stability.
  • Functions:
    • Creating and enforcing laws, rules, and regulations.
    • Creating and implementing monetary policy.
    • Managing the State treasury.
    • Regulating the country’s financial markets.
    • Administering the credit reporting industry.
    • Performing any other functions the State Council dictates.

Central Bank of Iran

  • Established under the Iranian Banking and Monetary Act in 1960.
  • Serves as the banker to the Iranian government.
  • Has the exclusive right of issuing banknote and coinage.
  • Tasked with maintaining the value of Iranian rial and supervision of banks and credit institutions.
  • Functions:
    • Issuance of notes and coins.
    • Supervision of banks and credit institutions.
    • Formulation and regulation of foreign exchange policies and transactions.
    • Regulation on gold transactions.
    • Formulation and regulation on transactions and inflow/outflow of Domestic currency.

The Central Bank of Canada

  • Also known as the CBC, is known officially as the Bank of Canada.
  • Its role is defined in the Bank of Canada Act as codified in 1985.
  • The Bank of Canada’s biggest role is to manage Canada’s economy and finances.
  • Functions:
    • Monetary Policy
    • Current Management
    • Managing Government Funds
    • Financial System Monitoring

The Reserve Bank of India

  • Established on April 1, 1935, under the Reserve Bank of India Act 1934.
  • Functions:
    • Issue of note
    • Banker to the Government
    • Controller of the Credit
    • Custodian of Foreign Reserves

The Bank of Thailand

  • Established in 1942.
  • Issues the baht.
  • Acts as central banker to the government and to the commercial banks.
  • Serves as the country's financial agent in dealing with international financial markets, international monetary organizations, and other central banks.
  • Powers of Monetary Board / Functions:
    • Print and issue banknotes and other security documents
    • Promote monetary stability and formulate monetary policies
    • Manage the BOT’s assets
    • Provide banking facilities to the government and act as the registrar for the government bonds
    • Provide banking facilities for the financial institutions
    • Establish or support the establishment of payment system
    • Supervise and examine the financial institutions
    • Manage the country’s foreign exchange rate and manage assets in the currency reserve
    • Control the foreign exchange

The State Bank of Pakistan (SBP)

  • Incorporated under the State Bank of Pakistan Act, 1956.
  • Gives the Bank the authority to function as the central bank of the country.
  • The SBP Act mandates the Bank to regulate the monetary and credit system of Pakistan and to foster its growth in the best national interest with a view to securing monetary stability and fuller utilization of the country’s productive resources.
  • Functions:
    • The primary functions including issue of notes, regulation and supervision of the financial system, bankers’ bank, lender of the last resort, banker to Government, and conduct of monetary policy.
    • The secondary functions including the agency functions like management of public debt, management of foreign exchange, etc., and other functions like advising the government on policy matters and maintaining close relationships with international financial institutions.

The Central Bank of Cuba (Banco Central de Cuba, BCC)

  • Created in 1997 to take over many of the functions of the National Bank of Cuba (Banco Nacional de Cuba), which was established on 23 December 1948 and began operations on 27 April 1950.
  • Functions:
    • Monetary Policy Formulation
    • Currency Issuance and Management
    • Banking Supervision and Regulation
    • Foreign Exchange Management
    • Economic Research and Analysis

The Bank of Korea

  • The central bank of the Republic of Korea and issuer of Korean Republic won.
  • It was established on 12 June 1950 in Seoul, South Korea.
  • It was originally established with a capital of 1.5 billion won, all of which was subscribed by the Government, but the amendment of the Bank of Korea Act in 1962 made the Bank a special juridical person having no capital.
  • Functions:
    • Issuing Banknotes and Coins.
    • Formulating and Implementing Monetary Policy
    • Maintaining Financial System Stability
    • Serving as the Banker to Banks
    • Providing Economic Education

Central Bank of Myanmar

  • The Union Bank of Burma was established on 3rd April 1948 by the Act of Union Bank of Burma 1947. In 1st July 1952, the Union Bank of Burma Act was enacted.
  • The aim of the Central Bank is to control the price stabilities in the domestic market and to preserve the internal and external value of the Myanmar Currency, the kyat.
  • Functions:
    • Monetary Policy
    • Currency Issuance
    • Banker to the Government
    • Supervision and Regulation
    • Foreign Exchange Management
    • Financial Stability.

Bank Indonesia

  • Bank Indonesia is the Central Bank of Indonesia (BI) and operates under the Central Bank Act (No. 23, 1999) as amended with the Act No.6 of 2009, and the Banking Act (No.7, 1992 and No. 10, 1998).
  • The law sets out the objectives of Bank Indonesia and specifies its powers and duties for the collection, processing, and dissemination of the statistics.
  • Functions:
    • Creating and maintaining rupiah stability. Committed to providing rupiah currency.
    • Cooperates with the National Police and Armed Forces
    • Organizes work plan, budget, and performance management system annually.
    • Bank Indonesia’s Communication Department actively provides seminars on the usefulness of monetary statistics for the journalist/press.

Bank of Israel

  • Bank of Israel was established in 1954 as a central bank under Bank of Israel Law 1954.
  • Its headquarters is located in Kiryat HaMemshala in Jerusalem with a branch office in Tel Aviv.
  • Its current Governor is Prof. Amir Yaron.
  • Bank of Israel is an independent institution, separate from the government’s day-to-day operations.
  • Roles and functions as central bank of Israel:
    • Responsible for formulating and implementing monetary policy.
    • Has significant role in regulating and overseeing Israel’s financial institutions, including banks.
    • The Bank of Israel is the sole authority responsible for issuing and managing the Israeli currency, the New Israeli Shekel (ILS).
    • Manages the country’s foreign exchange reserves and plays a role in stabilizing the exchange rate of the Israeli Shekel.
    • Conducts research on various aspects of the Israeli economy.
    • Cooperates closely with the government, particularly the Ministry of Finance.
    • Involved in aspects of public finance and may offer data, advice, or expertise to the government on various economic matters.

The Central Bank of Malaysia (Bank Negara Malaysia, BNM)

  • As with central banks globally, serves as a key institution in shaping and safeguarding the monetary and financial landscape of the country.
  • Plays several crucial roles in the country's financial system and economy:
    • Monetary Policy Formulation
    • Currency Issuance and Management
    • Financial System Stability
    • Financial Regulation and Supervision
    • Foreign Exchange Management
    • Payment Systems Oversight
    • Economic Research and Data Compilation
    • Financial Inclusion and Consumer Protection
    • Crisis Management and Resolution

Inflation and Monetary Policy

Inflation

  • In normal conversation, when people use the word inflation, they are referring to price increases.
  • To economists, inflation means a continually rising price level, a sustained rise that continues for a substantial period.
  • Refers to a broad rise in the prices of goods and services across the economy over time, eroding purchasing power for both consumers and businesses.
  • Two distinct changes in inflation:
    • Temporary changes – one-time adjustment in the price level.
    • Permanent changes – a rise or fall in the long-run course of inflation.
  • Temporary changes in inflation lead to adjustments in the price level and can have many causes aside from monetary policy.
  • Only changes in monetary policy can cause permanent increases or decreases in inflation.

Monetary Policy

  • Generally, it is the process by which the central bank, or government controls the supply and availability of money, the cost of money, and the rate of interest.
  • This is used by the government to be able to control inflation, and stabilize currency.

General Types of Monetary Policy

  1. Inflation Targeting

    • Revolves around meeting publicly announced, preset rates of inflation.
    • The standard used is typically a price index of a basket of consumer goods, such as the Consumer Price Index.
    • It intends to bring actual inflation to their desired numbers by bringing about changes in interest rates, open market operations and other monetary tools.

  2. Price Level Targeting

    • It involves keeping overall levels stable, or meeting a predetermined price level.
    • Similar to inflation targeting, the central bank alters interest rates to be able to keep the index level constant throughout the years.
    • Flourishing and advanced economics opt not to use this method as it is generally perceived to be risky and uncertain.

  3. Monetary Aggregates

    • This approach focuses on controlling monetary quantities.
    • Once monetary aggregates grow too rapidly, central banks might be triggered to increase interest rates, because of the fear of inflation.

  4. Fixed Exchange Rate

    • Also called “Pegged Exchange Rate”, the currency’s value is pegged to the value of a single currency, or to a basket of other currencies or measure of value, such as gold.
    • The focus of this monetary system is to maintain a nation’s currency within a narrow band.

  5. Gold Standard

    • The government allows its currency to be converted into fixed amounts of gold, and vice versa.
    • This may be regarded as a special kind of Fixed Rate Exchange policy, or of Price Level Targeting.
    • This monetary policy is considered flawed because of the need for large gold reserves of countries to keep up with the demand and supply for money.
    • It is no longer used in any country, thought it was widely used in the mid-18th century through 1917.

BSP Monetary Policy Framework

  • Monetary Aggregate Targeting
  • Modified Monetary Aggregate Targeting
  • Inflation Targeting
Monetary Aggregate Targeting – 1985 - Q2 1995
  • This approach is based on the assumption that there is a stable and predictable relationship between money, output and inflation.
  • Changes in money supply (on the assumption that velocity is stable over time) are directly related to price changes or to inflation.
  • BSP is able to determine the level of money supply that is needed given the desired level of inflation that is consistent with the economy’s growth objective.
  • Under the monetary targeting framework, the BSP controls inflation indirectly by targeting money supply.
Modified Monetary Aggregate Targeting - Q2 1995-2001
  • The BSP employed a modified framework beginning the second semester of 1995 in attempt to enhance the effectiveness of the monetary policy by complementing monetary aggregate targeting with some form of inflation targeting placing greater emphasis on price stability.
  • Certain key modifications include:
    1. Allows base money levels to go beyond target as long as the inflation rates are met.
    2. An excess of one or more percentage points of inflation over the program induces mopping up operations by the BSP to bring down base money to the previous month level.
Inflation Targeting - 2002-present
  • This requires a public announcement of an inflation rate that a country will target for the coming years, or in a given period of time.
  • The Philippines formally adopted Inflation Targeting as the framework of Monetary Policy in January 2002.
  • The Philippines’ inflation target is measured through the Consumer Price Index (CPI).
Inflation Targeting: The BSP's Approach to Monetary Policy
  • Inflation targeting is an approach to monetary policy that involves the use of a publicly announced inflation target set by the Government, which the BSP commits to achieve over a two-year horizon.
  • Promoting price stability is the BSP’s main priority, and the target serves as a guide for the public’s expectation about future inflation, allowing them to plan ahead with greater certainty.
  • The Inflation Target
    • The government’s inflation target is defined in terms of the average year-on-year change in the consumer price index (CPI) over the calendar year.
    • According to the BSP, the Inflation Target for 2022 to 2024 remains unchanged at 3.0 percent ± 1.0 percentage point
Policy Rate Setting of BSP
  • Adopted inflation targeting in January 2002
  • Two intrinsic features of the approach - transparency and accountability in monetary policy – expected to enhance the credibility of the BSP in helping create a stable macroeconomic environment in which vital economic reforms to raise the growth potentials of the economy can continue.
  • This approach involves the announcement of the explicit inflation target that the BSP promises to achieve over a given time period.
  • The BSP created an Advisory Committee which deliberates, discusses and recommends to the Monetary Board the appropriate monetary policy stance that will enable the BSP to achieve the desired inflation target.
Policy Instruments - Monetary Tools
  • The BSP implements monetary policy using various instruments to influence the level of liquidity in the market and thereby steer inflation towards the target level.
  • These instruments can be classified into two types:
    1. Direct Instruments
    2. Indirect Instruments
1. Direct Instruments
  • Enable the BSP to control directly certain items in bank’s balance sheets which may be in the form of financial prices of quantities.
  • Direct instruments have a strong coercive element as in the case of reserve requirements and direct lending requirements.
2. Indirect Instruments
  • Work through the market to influence the behavior of financial institutions, usually through the pricing of central bank facilities.
  • Indirect instruments include adjustments in short-term policy interest rates and the conduct of open market operations. (OMO)
Monetary Instruments used by the BSP
  1. Open Market Operations
  2. Acceptance of Fixed-Term Deposit
  3. Standing Facilities
  4. Reserve Requirement
1. Open Market Operations
  • These involve the buy and sale of government securities.
  • The buy and sale of government securities by the BSP is one of the major monetary instruments in regulating money supply.
  • Open Market Operations consist of:
    • Repurchased and reverse repurchase transactions
    • Outright transactions
    • Foreign exchange swaps
a) Repurchased and reverse repurchase transactions
  • In a repurchase or repo transaction, the BSP buys government securities from a bank with a commitment to sell it back at a specified future date at a predetermined rate.
  • The BSP’s payment to the bank increases the latter’s reserve balances and has an expansionary effect on liquidity.
  • In a reverse repo, the BSP acts as the seller of government securities and the bank’s payment has a contractionary effect on liquidity.
b) Outright transactions
  • Refer to the direct purchase/sale by the BSP of its holding of government securities from/to banking institutions.
  • In an outright transaction, the parties do not commit to reverse the transaction in the future, creating a more permanent effect on money supply.
c) Foreign exchange swaps
  • Refer to transactions involving the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed on the deal rate (the first leg), and a reverser exchange of the same two currencies at a date further in the future (the second leg) at a rate (different from the rate applied to the first leg) agreed on deal date.
2. Acceptance of Fixed-Term Deposit
  • The Special Deposit Accounts (SDA) facility consists of fixed-term deposits by banks and by trust entities of banks consists of fixed-term deposits by banks and by trust entities of banks and nonbank financial institutions with the BSP.
  • It was introduced in November 1998 to enable the BSP to expand its toolkit in liquidity management.
  • In April 2007, the BSP expanded access to the SDA facility by allowing trust entities to deposit in the SDA facility in order to better manage liquidity in the face of strong foreign exchange inflows.
3. Standing Facilities
  • To increase the volume of credit in the financial system, the BSP extends discounts, loans and advances to banking institutions.
  • Rediscounting is a standing credit facility provided by the BSP to help banks meet temporary liquidity needs by refinancing the loans they extend to their clients.
  • There are two types of rediscounting facilities available to qualified banks:
    1. the peso rediscounting facility and
    2. the Exporter’s Dollar and Yen Rediscount Facility (EDYRF) which was introduced in 1995.
4. Reserve Requirement
  • Reserve requirements refer to the percentage of bank deposits and deposit substitute liabilities that must keep on hand or in deposits with the BSP and therefore might not lend.
  • Changes in reserve requirements have a significant effect on money supply in the banking system, making them a powerful means of liquidity management.
  • Reserve requirements apply to peso demand, savings, time deposit and deposit substitutes (including long-term non-negotiable tax-exempt certificates of time deposit or LTNCTDs) of universal banks, (UBs) and commercial banks (KBs) and may kept in the form of cash in vault, deposits with the BSP and government securities.
  • Required reserves consist of two forms:
    • Regular or statutory reserves
    • Liquidity reserves
a) Regular or statutory reserves
  • Deposits maintained by banks with BSP up to 40 percent of the regular reserve requirement are paid interest at 4 percent per annum.
b) Liquidity reserves
  • Liquidity reserves are paid the rate on comparable government securities less half a percentage point.
  • The use of liquidity reserves help to reduce bank intermediation costs since they are paid market-based interest rates

Activities of Central Bank

  • The BSP implements monetary policy using various instruments to influence the level of liquidity in the market and thereby steer inflation towards the target level.
  1. Bank Supervision/Pawnshop Regulation
  2. External Debt Regulation
  3. Money Market Involved
  4. Foreign exchange regulations
  5. Export Related Measures
  6. Workers' Remittances
  7. Commodity Classification

1. Bank Supervision/Pawnshop Regulation

  • It actively uses its supervisory and regulatory powers over the financial institutions to guide the direction and pace of the growth of the financial system.
  • Bank supervision does not only include the issuance of appropriate rules and regulations but also the overseeing of the banking system to ascertain that regulations are complied with; examining banking institutions to determine whether they are conducting their business on a sound financial basis; and inquiring into the solvency and liquidity of banks.
  • Likewise, the BSP is charged with the supervision and periodic examination of pawnshops. This is to ensure that the credit operations of pawnshop through the lending of funds to the public are consistent with the BSP’s credit policies, and at the same time safeguard the interest of the public, in the same fashion that the interest of depositors in banks is safeguard.

2. External Debt Regulation

  • The foreign debts of the country is strictly monitored by the BSP to ensure that payments of the principal and interest do not exceed the statutory service ratio of 20% of gross foreign exchange receipts of the preceding year, and that foreign obligations are promptly paid.
  • As a general rule foreign borrowings are approved by the BSP only if they conform to a set of priorities, which favor preferred areas of activities, such as loans with repayment schedules, and loans with liberal financing terms.
  • The BSP establishes yearly ceilings on the amount of foreign borrowing approvals to ensure that the international debt is maintained at manageable levels.

3. Money Market Involved

  • In coordination with the SEC, money market reforms were initiated by the old Central Bank in 1981.
  • Under this reform program, the commercial paper market in the country has been limited to prime paper and to the issues of prime companies.
  • To protect further investor, corporate entities which intend to borrow from the money market are generally required to observe 3:1 debt-to-equity ratio and to secure credit line information bureau has been created through the support of the BSP to provide vital information on the activities and track record of borrowers.

4. Foreign exchange regulations

  • Foreign exchange regulations are designed mainly to achieve the objectives of the BSP of maintaining external stability and ensuring that foreign exchange resources are available at all time for the foreign exchange requirements of the country.
  • The BSP carries out the administrative function with the assistance of specially authorized commercial banks.
  • Capital transfers abroad by residents and capital transactions between residents and non-residents are subject to approval by the BSP.
  • At present, the exchange rate policy is a floating rate system. This means the exchange rate of the peso is determined by the supply of and demand for foreign currencies, like the U.S. dollar.

5. Export Related Measures

  • The BSP extends financial assistance to exporters through its rediscount window in support of the export promotion program of the government.
  • The development of manufactured export products is designed to reduce the vulnerability of the country’s exports to price and demand fluctuations in the international markets

6. Workers' Remittances

  • In coordination with the Secretary of DOLE, the remittance of salaries of said workers to the country has been streamlined.
  • Off-shore banking units, many of which have links with Middle East banks, local universal banks with branches abroad and other remittances company are permitted to act as conduits in the remittance process.
  • The BSP has also put up a rediscount window for manpower exporting firms and for loans extended to overseas contract workers.

7. Commodity Classification

  • In coordination with other government agencies, the BSP periodically reviews and revises the Philippine Standard Commodity Classification Manual which serves as the standard reference in classifying commodities affected under all modes of exchange.
  • This scheme of classification of commodities is basically patterned after the Standard International Trade Classification of the United Nations and synchromesh with the Brussels Trade Nomenclature of the Customs Cooperation Council.