Understanding Monetary Policy

"The increase in the interest rate will hurt new businesses and hinder business expansion due to decreased borrowing." Fair enough, but there's more to it.

Governance, be it of any kind, requires a plan of action with underlying clear objectives and strategies to achieve the former in the face of economic uncertainty (in most cases, especially true for developing nations). A landscape as complex and nuanced as an economy requires several action plans (policies) for its governance. One of them is the monetary policy.

A nation's central bank issues a monetary policy quarterly to regulate the money supply in a nation's economy. In Pakistan, State Bank possesses the sole authority to issue such policies. The State Bank fulfills many roles and responsibilities, and one of them is acting as an economic adviser and agent to the government.

Why Show Concern for the Monetary Policy?

Monetary policies are made available for the public eye on the State Bank's official website, and one should read them to get a better grasp of the economic situation in the next three months. The monetary policy helps base purchase decisions, savings, or investment decisions. Moreover, it can influence buying behavior and provide an inflation outlook.

Monetary Policy Types

The questions that arise are:

• What does it mean to 'regulate' the money supply?

• How is the money supply regulated?

Monetary policy is an act of balancing. 'Regulation' refers to a binary choice: either INCREASE or DECREASE the money supply. Both undersupply and oversupply of money hurt the economy. When the goal is to increase the money supply, it is an expansionary (loose) monetary policy. Meanwhile, a contractionary (tight) monetary policy decreases the overall money supply.

Monetary Policy Instruments

As for the second question, the State Bank employs several instruments (or tools) for regulating the money supply. We will discuss the three primary instruments and two additional instruments. 

The three primary tools are:

1. Interest Rate

2. Open-Market Operations (OMO)

3. Cash Reserve Ratio (CRR).

While the other two are:

1. Selective Credit Control

2. Statutory Liquidity Requirement (SLR).

Interest Rate

Also known as the discount rate, coupon rate, or policy rate, the interest rate determines whether to save money or invest it.

A low-interest rate discourages savings. It results in more money floating into the market instead of sitting idly in a savings bank account. Hence, the increase or expansion in the money supply. Moreover, lending can see a downward trend due to low returns while borrowers will be keener to borrow.

Suppose an investment opportunity offers you a 12.5 percent return while putting your savings in a bank account will only yield 7.25 percent? What would you choose, keeping the risk factor aside?

Contrarily, a high-interest rate encourages savings. This way, large quantities of money seldom float into the market, thus reducing or contracting the money supply. Moreover, borrowing can see a downward trend due to high returns while lenders will be keener to lend. 

The State Bank defines the interest rate as:

"Simply, it is the rate charged by the lender to the borrower for the use of money for a specified period, usually expressed on annual terms."

Moreover, in the case of high-interest rates, foreign direct investment (FDI) sees an upward trend since the money owned by local investors does not float in the market during the period. Hence, the market serves as a playground for foreign investors.

The ongoing interest rate in Pakistan is 9.75 percent.

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Open-Market Operations (OMO)

Open-market operations generally refer to the sale and purchase of government securities, such as Treasury Bills (T-Bills), that usually get sold in auctions. A more general example of government securities would be the prize bonds that interest the general public. 

According to the State Bank, "OMOs are the most frequently used instruments for implementing monetary policy in Pakistan." When the government needs financing, it floats securities in the market. Such securities get conveniently sold since they possess a risk-free rate. A risk-free rate implies that the purchaser of the government-issued financial instrument bears no loss since the government is obliged to return at least the principal amount (or the 'face value' in financial terminology). When securities float, a reduction in the money supply occurs.

When the need for financing vanishes and the government has maintained enough money in its reserves, the government buys back (or repurchases) these securities. It results in an increased money supply.

Cash Reserve Ratio (CRR)

Cash reserve ratio, or simply reserve ratio, is the percentage value of minimum cash reserves to be maintained by the scheduled banks as governed and prescribed by the State Bank's prudential regulations. It directly affects the bank's lending activities.

For instance, a CRR of 4 percent signifies that the scheduled bank is obliged to keep at least 4 percent of cash in its possession while the remaining maximum of 96 percent can float (excess cash reserve).

Hence, a low CRR will result in increased lending. On the other hand, a high CRR will cause less lending.

The current CRR in Pakistan is 6 percent. 

Selective Credit Control

Instead of focusing widely on every single economic sector out there, selective credit control, as the name suggests, narrows down its focus on a select bank or several banks catering to a business sector desirable for economic growth or stability, for instance, agriculture or housing.

Statutory Liquidity Requirement (SLR)

SLR is similar to CRR but goes beyond cash and includes gold reserves and government securities, such as T-Bills.

The current SLR in Pakistan is 19 percent for conventional banks and 14 percent for Islamic banks.

Monetary Policy Objectives

The monetary policy aims to achieve several objectives, such as:

1. Achieving stable output levels

2. Reducing inflation.

Achieving Stable Output Levels

Lower interest rates and CRR can benefit entrepreneurs who seek loans to invest in or expand their business, thus producing more goods and services.

Reducing Inflation

A decrease in the money supply through a contractionary monetary policy can reduce inflation - directly linked to the oversupply of money. It also enables the price stability of products and prevents abrupt, frequent changes in product prices.