Understanding

Monetary Variables
AGENDA
• Functions of Money

• Why Money is Valuable?

• Definitions of Money Supply

• Monetary Policy Transmission Mechanism

• How the Mechanics of Monetary System Work?

• External Account and Money Supply

• Current Pakistan Monetary Conditions

• Conclusion
Functions of Money
 Functions of money

1. Medium of Exchange

Buyer Seller
 Functions of money

2. Measuring Rod for Value

Common denominator into which the

current value of all goods & services
can be expressed

Rs.15,000,000 Rs.1,000,000 Rs.2,000

 Functions of money

3. Store of Value (Wealth)

Perfectly liquid
financial asset
Why is Money Valuable?
 Why is money valuable?

Two factors that make money valuable…

Most global currency
collapses were “crisis
of confidence”.

People accept that money could

Confidence be used to buy goods &
services.

When the supply of money is

Supply vs. Demand limited relative to demand,
money will be valuable.

Importance of
Monetary Policy!
Definitions of Money Supply
 Definitions of money supply

Three Main Definitions of Money Supply

Currency in Circulation
Reserve Money (RM) Currency in Banks‟ Vaults
Banks‟ Deposits with SBP

Currency in Circulation
Narrow Money (M1) Rupee Demand Deposits @ Banks

Currency in Circulation
Rupee Demand Deposits @ Banks
Broad Money (M2) Rupee Time Deposits @ Banks
Resident FCY Deposits @ Banks
Monetary Policy Transmission Mechanism
 Monetary policy transmission mechanism

Basics about Monetary Policy

Deals with the supply of money in

What is it? an economy.

Domain of SBP, which is „indepe-

Who conducts it? ndent‟ of MOF.

• Maintaining Price Stability

What objectives? • Facilitating Economic Growth
• Managing Exchange Rate

• Open Market Operations

What tools? • Discount Rate
• Cash Reserve Ratio
 How monetary policy is conducted?

Tools for conducting monetary policy

Changes money market liquidity

to influence interest rates and
Open Market Ops. liquidity available for credit
expansion

Higher CRR would reduce

banking liquidity available for
Reserve Requirement credit expansion while pushing
up interest rates.

Theoretically, the most explicit

Discount Rate signal for change in monetary
policy.
 Monetary policy transmission mechanism

The two building blocks of monetary system

M2 Breakup

Central Bank (SBP) Currency in Circulation

Demand Deposits
Commercial Banks Time Deposits
Resident FCY Deposits
Monetary equations are like balance sheets

ASSETS
This is the “causative side”
i.e., any change in money
supply is caused by a change
in the asset side.
LIABILITIES
This side shows only the
effects of these changes.
Reserve Money (RM) Equation

NFA of SBP
FX Reserves, etc. SBP Liability

ASSETS LIABILITIES
Net Foreign Assets (NFA) Currency in Circulation

Net Domestic Assets (NDA) Currency in banks‟ vaults

Banks‟ deposits with SBP

NDA of SBP
• Financing to Govt.
• Financing to Banks

RM = NDASBP + NFASBP
Broad Money (M2) Equation

NFA of Banking
System
FX Reserves, etc. SBP Liability

ASSETS LIABILITIES
Net Foreign Assets (NFA) Currency in Circulation

Net Domestic Assets (NDA) Demand Deposits

Time Deposits
Resident FCY Deposits

• Financing to Govt. NDA of Banking

• Financing to Private sector System

Banks‟ Liabilities

M2 = NDABanking + NFABanking
How the mechanics of monetary system work?
 How the mechanics of monetary system work?

Stage 0: Beginning of an economy

• A group of few hundred people stranded in some Island decide to
start an economy based on modern political-economic systems.
• Some individuals with leadership abilities form the government
which in turn appoints an independent central bank.
• Four types of economic agents finally emerge
– Government
– Central Bank
– Banks
– Individuals

Contd…
 How the mechanics of monetary system work?

Stage 0: Beginning of an economy

 How the mechanics of monetary system work?

Stage 1: Individual sells wheat to Govt. for Rs.1,000

wheat T-bill
Governmen Central
Individual
t Bank
Cash Cash

Govt. borrowing (NDA) from SBP increases RM & M2

 How the mechanics of monetary system work?

Stage 2: Individual deposits Rs.1,000 in a bank

Bank deposit increase does not always result in M2 growth

 How the mechanics of monetary system work?

Stage 3: Bank loans out Rs.800

• Borrower draws down Rs.500 and leaves the remaining Rs.300 in
account with the same bank.

Private sector borrowing increases M2.

 How the mechanics of monetary system work?
Money Multiplier
This re-lending process can be depicted as follows, assuming a 20% reserve ratio and a $100 initial deposit :

Individual Bank Amount Deposited Lent Out Reserves

A 100.00 80.00 20.00
B 80.00 64.00 16.00
C 64.00 51.20 12.80
D 51.20 40.96 10.24
E 40.96 32.77 8.19
F 32.77 26.21 6.55
G 26.21 20.97 5.24
H 20.97 16.78 4.19
I 16.78 13.42 3.36
J 13.42 10.74 2.68

K 10.74

Total Reserves:

89.26

Total Amount of Deposits: Total Amount Lent Out: Total Reserves + Last Amount Deposited:

457.05 357.05 100.00

External Account & Money Supply
Impact of $1.0 million “private” FX inflow

Step-1: $1.0 million remittance received through Bank.

Step-2: Bank sells US$ to SBP, which credits Rs.80 million to the Bank‟s
account with SBP  SBP‟s NFA increases by $1.0 million.
Step-3: Bank in turn credits the account of recipient of remittance by
Rs.80 million.
Private FX inflows increase RM & M2
Impact of $1.0 million “Govt.” FX inflow

Step-1: Receipt of $1.0 million ADB loan through SBP  SBP‟s NFA
increases by $1.0 million.
Step-2: Govt. uses the rupee proceeds of Rs.80 million to retire T-bill on
SBP‟s balance sheet  SBP‟s NDA reduces by Rs.80 million.
Govt.‟s external inflows do not generate
liquidity but reduce borrowing from SBP.
 External Account and Money Supply

Sterilization of FX inflows
• Mopping up of surplus rupee liquidity generated by large private FX
inflows is called ‘sterilization’.
• Tool for sterilization
– OMO and T-bills that result in shifting of T-bills from SBP’s
books to banks’ books

• Cost of sterilization
– Higher earnings rupee asset (T-bill) substituted by low yield
dollar assets for SBP resulting in revenue loss for the central
bank
 Current Macro Economic Scenario

Current Pakistan Monetary Conditions

• The recent catastrophic floods have serious implications for
macroeconomic stability and growth prospects.

• Inflation and fiscal deficit both on high side.

• Government likely to miss economic growth target

• Slowdown in private sector credit demand

• Government borrowing has increased

• Dependence on foreign borrowing has also increased

• Current Account will have some relief on the back of rising exports
and remittances
 Current Macro Economic Scenario

Steps to Revive Economic Growth

• Implementation of tax reforms

• Restriction of government borrowing from the SBP

• Containment of Fiscal Deficit

• Relief measures for those affected by the floods

• Revival of private sector growth

• SBP should maintain its tight monetary stance during this FY.
Thank you For Your Time