Lesson 27

Monetary Policy
Basic concepts and definitions
related to monetary policy – I

Lecture No. 116

Basic Concepts and Definitions

Collateral is an asset pledged by a borrower for a loan. The

asset must be acceptable by lender as security against a loan in
case the borrower for any reason cannot pay back the loan.

Cash in vault (or tills) is the currency held by the scheduled

banks in order to meet day-to-day cash requirements of their
customers (SBP)
Basic Concepts and Definitions (SBP)

Nominal anchor is an economic variable that

relatively quickly adjust to changes in
monetary policy instruments and have a
predictable relationship with the ultimate
policy objectives, such as inflation and
economic growth.
Basic Concepts and Definitions (SBP)

Interbank market is the market where financial institutions

trade financial assets or cash amongst themselves.

Money market is the segment of financial markets where

banks and non-bank financial institutions lend or borrow
funds in local currency amongst themselves for short period.
Basic Concepts and Definitions (SBP)

Repo transaction is the simultaneous sale of securities

(such as T-bills and PIBs) with an agreement to purchase
it back in future at a predetermined date and price.

Repo rate is the interest rate at which scheduled banks

lend/borrow among themselves against approved
government securities (T-bills and PIBs).
Basic Concepts and Definitions (SBP)

Reverse repo transaction is the reverse of the repo transaction. It

is defined as the simultaneous purchase of securities with an
agreement to sell it back in future at a predetermined date and
price.

Secondary market is the market that deals with trading of bonds

and securities already issued through primary auctions or initial
public offering (IPO).
Basic Concepts and Definitions (SBP)

Call rate is the rate on short-term loans among

scheduled banks (ranging from overnight up to
fourteen days) that do not require collateral (SBP)

Clean rate is the rate on short-term loans at which

financial institutions lend/borrow among
themselves without any underlying collateral
Basic concepts and definitions
related to monetary policy – II

Lecture 117
Basic Concepts and Definitions (SBP)

Karachi inter-bank offered rate (KIBOR) are interbank

clean (without collateral) lending/borrowing rates
quoted by the banks on Reuters.

The banks under this arrangement quote these rates

at specified time i.e. 11:30 am at Reuters.
Basic Concepts and Definitions (SBP)

Karachi inter-bank offered rate (KIBOR)

Currently 20 banks are members of KIBOR club and, by excluding 4

upper and 4 lower extreme, rates are averaged out and quoted for
both ends viz: offer as well as bid.

The tenors available in KIBOR are one week to 3 years. KIBOR is used
as a benchmark for corporate lending rates.
Basic Concepts and Definitions (SBP)
Market treasury bills (MTBs) are the short term debt instruments of
the Government of Pakistan with tenors available in 3, 6 and 12
months.

They are sold through Primary Dealers in auctions held on fortnightly

basis.

They are zero-coupon securities and are sold at discount.

Basic Concepts and Definitions (SBP)

Primary dealers: the list of financial institutions that are eligible

to participate in the primary market for auction of government
securities.

Primary market – the market that deals with the issuance of new
securities and bonds, such as the auctions of T-Bills, PIBs and
Ijara Sukuk, to a select group of banks and non-banks, known as
primary dealers.
Basic Concepts and Definitions (SBP)

Cash reserve requirement (CRR) is the proportion of total demand

liabilities (including time deposits with tenor of less than 1 year)
that scheduled banks are required to maintain with SBP in the form
of cash on both daily basis and 14-day average basis

Excess (cash) reserve is the amount of cash held by banks, with

SBP, over and above the cash reserve requirements. In general,
increase in excess reserve indicates easy market liquidity
conditions, and vice versa.
Basic Concepts and Definitions (SBP)

Coupon rate is the interest rate payable on bond’s par value at

specific regular periods. For instance, in case of Pakistan
Investment Bonds returns on coupon rate are paid on biannual
basis
Credit is a financial agreement in which a borrower receives a sum
of money (or asset) that is agreed to be paid back in a future date,
generally with an added interest amount
Basic Concepts and Definitions (SBP)
Foreign exchange reserves are the claims of the banking system on
nonresidents, including central bank’s holding of gold, SDRs, foreign
currencies, deposits in foreign exchange abroad, investments in debt
instruments of other countries, and the country's reserve position in
the IMF.

Foreign exchange (forex) swap is a contract between two parties to

exchange two currencies at an agreed exchange rate and reverse the
transaction at a certain point in time in future at an agreed exchange
rate.
 Tools of Monetary Policy: The
Market for Reserves and The Money
Market Rate – Demand for Reserves

Lecture No. 118

Introduction

Monetary policy tools are used to control interest rate

and money supply

Money market rate as the primary instrument of

monetary policy

Monetary Policy Committee announces policy rate -

target for money market rate
Introduction

Four tools of monetary policy to affect interbank market

rate and money supply

Open Market Operations; Discount Policy; Reserve

Requirements; Interest paid on Reserves

Some unconventional measures can be taken in extreme

situations
Market for Reserves
Demand for and supply of reserves (currency equivalent for
transactions between central bank and commercial banks and
between commercial banks)

Determines price of reserves – money market rate

Overnight money market repo rate targeted in Pakistan

Demand for Reserves
What happens to the quantity of reserves demanded by banks in
response to changes in money market rate, holding all other
factors constant.

Reserves = required reserves + excess reserves

Required reserves = required reserve ratio x deposits

Demand for Reserves

Excess reserves; choice of banks

Insurance against deposit outflow but carries cost, opportunity cost

Opportunity cost: interest rate that could have been earned on lending
these reserves minus interest rate paid on excess reserves by central
bank (floor
Floor rate israte)
fixed by central bank below money market overnight repo
rate (or simply money market rate) and changes when the (target)
policy rate changes
Demand curve for Reserves

If money market repo rate is below floor rate (which is paid

on excess reserves) then banks will not lend in the overnight
money market and will hold access reserves instead

Thus, their holding of excess reserves, demand for reserves,

is infinitely elastic at the floor rate; demand curve becomes
horizontal
Demand curve for Reserves

If money market overnight repo rate is above this floor rate,

then opportunity cost of holding excess reserves is positive

Demand for excess reserves is inversely related to

opportunity cost

Above floor rate, demand curve for reserves is negatively

slopped
Demand curve for reserves

Money
Market rate

𝑖𝑑

𝑖𝑚 𝑟 2

𝑖𝑚 𝑟 ∗ 1
f
2
𝑖𝑚 𝑟 1

𝑖𝑜𝑟 𝑅𝑑

Quantity of
Reserves, R
Tools of Monetary Policy: The
Market for Reserves and The
Money Market Rate – Supply of
Reserves
Lecture No. 119
Supply of Reserves

Supplied (though partially controlled) by central bank

Reserves = Non-borrowed reserves + Borrowed reserves

Supply of Non-borrowed reserves is changed through

OMO
Supply of Reserves

Supply of borrowed reserves is dependent on discount

window loans taken by commercial banks from central bank

Interest rate charged on discount loans is called discount rate

or ceiling of money market rate

Ceiling is fixed by central bank above money market rate and

changes only when policy rate changes
Supply curve for reserves
If overnight money market rate is below discount rate (ceiling rate)
then banks will not borrow from central bank

Reserves = Non-borrowed reserves (as borrowed reserves = 0)

If money market rate approaches ceiling rate or tends to increase

above that, then banks will borrow only from central bank

In this case, borrowed reserves are positive, not zero

Supply curve for reserves

When money market rate is below discount rate (ceiling rate), then reserves
are fixed at non-borrowed reserves

Supply curve for reserves is vertical at constant value of non-borrowed reserves

In case money market rate tends to be above discount rate then all desired
reserves are borrowed from central bank

Supply curve for reserves is horizontal at discount rate

Supply curve for reserves
Money
Market rate
𝑖𝑑 𝑅𝑆

𝑖𝑚 𝑟 2

1
∗
𝑖𝑚 𝑟 f
2
𝑖𝑚 𝑟 1

𝑖𝑜𝑟

NBR Quantity of
Reserves, R
 Tools of Monetary Policy: The
Market for Reserves and The
Money Market Rate – equilibrium
in market for reserves
Lecture No. 120
Equilibrium Condition in Market for
Reserves

Equilibrium takes place when demand

for reserves equals supply of reserves

Occurs at intersection of demand and

supply curves for reserves
Equilibrium in Market for reserves
Money
Market rate

𝑖𝑑 𝑅𝑠

𝑖𝑚 𝑟 2

𝑖𝑚 𝑟 ∗ 1
f
𝑖𝑚 𝑟 1 2

𝑖𝑜𝑟 𝑅𝑑

Quantity of
NBR
Reserves, R
Stability of Equilibrium

Equilibrium outcome is stable

Whenever, market deviates from equilibrium

outcome, then there are changes in money market
rate so that market equilibrium is restored
Equilibrium in Market for reserves
Money
Market rate

𝑖𝑑 𝑅𝑠

𝑖𝑚 𝑟 2

𝑖𝑚 𝑟 ∗ 1
f
𝑖𝑚 𝑟 1 2

𝑖𝑜𝑟 𝑅𝑑

Quantity of
NBR
Reserves, R