AM04 MMT15

Monetary Policy in a Sovereign Nation

Chapter 15 of Modern Monetary Theory Textbook by Mitchell, Wray, Watts

Questions:

1. Explain why the Conventional Multiplier Theory, which says that Central Bank creates High Powered Money, and Total Money equals a multiplier time HPM, is WRONG?

The central bank determines how much amount should be loaned out and how much amount should be deposited in the banks by controlling the money supply (that is fixed by central bank). The central bank decides reserve requirements (Reserve requirement ratio) for banks. This reserve ratio is the percentage of amount that a bank must has to hold from a given deposit and remaining amount will be lend out in the economy. The total creation of money in the economy by given deposits will be multiplier times deposits (1/Rrr*deposits). The standard theory suggests that the reserve requirement is the constraint for banks but in reality central bank can not control money supply and banks have no contraints on lending and reserves. What central bank can control is the discount rate. The reserves requirement and lending constraints are no more constraints for banks rather its upto them. The banks lending depends on how much they can earn profit by lending opportunities. These opportunities are dependent on the interest rate regulated by central bank. The bank deposits affect the reserves of banks hold by central bank which are then supplied to the banks by central bank to meet daily cash holding by depositors. The banks try to hold very small fraction of the deposits in their vaults and they lend almost all the deposited money to earn interest rate. If the depositors wish to withdraw much money then banks borrow from other banks on interbank rate. The banks credit creation is done by opening account on the name of the borrower where firstly, entry of the deposit is made on the credit side then entry of the same amount is made on the debit side. So by creating an electronic entry, banks create credits. These lendings are done on the basis of issuing cheques. When these cheques approach to central bank, then central bank makes calculations of net reserves of each bank. For example 40 cheques of one million were deposited from HBL to UBL and 50 cheques of 1.5 million were deposited from UBL to HBL, then 1 million from HBL reserves hold by central bank will be transfer to UBL reserves and vice versa but as UBL had to owe .5 million extra to HBL so .5 million again will be transfer from UBL reserves to HBL reserves hold by central bank. Finally each bank has to maintain the specific percentage of reserves at central bank otherwise below this percentage the surplus reserves(after plus minus of cheques among banks) of a bank will be lended to the bank with shortage reserves on the overnight rate. So, the money created by multiplier is much different from the real credit creation process of banks that is not directly controlled by central bank as suggested by conventional theory

2. According to Standard Macro, if deficit is financed by printing money (HPM), this will lead to inflation. If it is financed by borrowing (sales of Government Bonds) this will lead to crowding out. Explain why both theories are wrong?

According to the standard macroeconomics, Govt. faces fiscal constraints and if it faces deficit then this deficit can be filled by two sources one is borrowing and other is by printing money. Quantity theory of money states that if the money supply increases the price level will also increase proportionally but this does not happens in reality. The central bank horizontally supplies the reserves or high powered money at the prevailing discount rate. As banks or private sectors demand the reserves, the central bank creates high powered money. For example if the banks make loans of 10 millions and they want to hold reserves worth of 1 million of this loaned amount for liquidity purpose then central bank lends on overnight rate by printing this 1 million. The central bank can also provide reserves or money to the banks on the basis of t bill purchases. If govt faces deficit budget and finances deficit by printing money, then this will not lead to inflation because horizontal supply of reserves still works here. When govt makes deficit spendings, central bank injects money and provide excess liquidity within market. The direct control of central bank over discount rate results in declining liquidity by maintaining that discount rate. Because when banks have excess reserves, the interbank rate will be pushed down and central bank can sell bonds to mop up the excessive reserves so net effect of the printed money will be cancelled out and no inflation will occur.The conventional theory states that whenever govt. faces deficit and this deficit is filled by domestic borrowing then it has significant impact on the private investment. The govt. needs much supply for loanable funds to finance the deficit as compared to a private household deficit. So the demand for loanable funds by the govt. is too much as compared to private sector and higher demand for loanable funds by govt. results in shortage of supply for loanable funds in the funds market and interest rate becomes very high. This higher interest rate is no approached by private sector because return on investment becomes less than cost of investment hence the private investment declines and crowding out occurs. This is incorrect view of the conventional theory because whenever govt. faces deficit, there is exactly equal surplus of private sector. Actually private surplus are the financial and real wealth of the people that people accomulated when govt. faced deficit. So it is flawed view that govt. competes with private investors on limited supply for loanable funds because when govt. sells bonds to the public there is not limited supply of funds due to growing govt. deficit and private surplus as well as wealth portfolios. The growing private surplus does not lead to limited supply of loanable funds.

3. Explain the conventional view of the TRANSMISSION mechanism of monetary policy. What changes occur as a result of increasing the overnite discount rate, which could eventually lead to decrease in inflation? Explain some reasons why this mechanism may not work ?

The traditional channel of transmission is the interest rate channel. As the interest rate increases, the yield curve will shift upward and it will also raise the long run yields. To control inflation, increase in discount rate saves the economy from overheating because increase in interest rate will result in decline of bond prices. The govt. increases the supply of bonds in the market to reduce the prices of bonds with higher interest rate. The liquidity is contracted by lower bond prices and higher interest rate to reduce inflation rate. The increase in discount rate will negatively affect physical investment because the rate of return becomes lower and cost of the investment is higher. The smaller change in interest rate will have very marginal impact on long run investment but it could have significant impact on short run invesment. The long run investment is less influenced due to smaller change in interest rate because people take more than a year to construct a firm or project and loan is given after few months contract The decline in investment affects employment negatively and income of the people declines so, the aggregate demand decreases. The effect of increase in discount rate also affect the durable consumer spendings because durable spendings are made by borrowing so if the cost of borrowing is higher then people will not prefer to do durable spendings. The increase in discount rate will discourage domestic invester but as discount rate differential is higher for foreigner like discount rate of pakistan is higher than the discount rate of England then the investors from England will be attract to sell the financial assets of England and will purchase the financial assets in Pakistan for them, the currency of Pakistan is appreciated because the demand for currency increases. So increase in discount rate will cause to decline in net exports and capital inflows will occur in pakistan because currency appreciation will boost imports and depress exports. This mechanism may fail to control the inflation if the there is shock which is out of control like cost push inflation by oil crises. The discount rate is the only instrument of monetary policy to control macroeconomic variables so a single instrument may not work to achieve multiple macroeconomic goals. The discount rate affects the liquidity and bank lendings, but sometime lower interest rate even does not result in more lendings like liquidity trap so, slack in aggregate effective demand resulted by money holding may break the transmission mechanism. Sometime, the external shocks like oil prices etc results in higher inflation and central bank hikes the discount rate which results in higher unemployment as well. Sometime, it happens that some sectors of the economy needs higher discount rate to control inflation while at the same time some of the sectors may need cut in the discount rate to achieve macroeconomic goals so this mechanism may also fail in this situation.