MONETARY POLICY

M onetary policy is the process by which the government, central bank, or

monetary authority manages the money supply to achieve specific goals—
such as constraining inflation or deflation, maintaining an exchange rate,
achieving full employment or economic growth. (Usually the goal of monetary policy is
to accommodate economic growth in an environment of stable prices.) Monetary policy
can involve changing certain interest rates, either directly or indirectly through open
market operations, setting reserve requirements, acting as a last-resort lender (i.e.
discount window lending), or trading in foreign exchange markets.

Monetary policy is generally referred to as either being an expansionary policy, or a

contractionary policy, where an expansionary policy increases the total supply of money
in the economy, and a contractionary policy decreases the total money supply.
Expansionary policy is traditionally used to combat unemployment in a recession by
lowering interest rates, while contractionary policy has the goal of raising interest rates to
combat inflation.

AN OVERVIEW
Monetary policy rests on the relationship between the rates of interest in an economy,
that is the price at which money can be borrowed, and the total supply of money.
Monetary policy uses a variety of tools to control one or both of these, to influence
outcomes like economic growth, inflation, exchange rates with other currencies and
unemployment. Where currency is under a monopoly of issuance, or where there is a
regulated system of issuing currency through banks which are tied to a central bank, the
monetary authority has the ability to alter the money supply and thus influence the
interest rate (in order to achieve policy goals). The beginning of monetary policy as such
comes from the late 19th century, where it was used to maintain the gold standard.

A policy is referred to as contractionary if it reduces the size of the money supply or

raises the interest rate. An expansionary policy increases the size of the money supply, or
decreases the interest rate. Further monetary policies are described as accommodative if
the interest rate set by the central monetary authority is intended to spur economic
growth, neutral if it is intended to neither spur growth or combat inflation, or tight if
intended to reduce inflation.

There are several monetary policy tools available to achieve these ends. Increasing
interest rates, reducing the monetary base or increasing reserve requirements all have the
effect of contracting the money supply, and, if reversed, expand the money supply. Since
the 1970s, monetary policy has generally been formed separately from fiscal policy. And

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even prior to the 1970s, the Bretton Woods system still ensured that most nations would
form the two policies separately.

Within almost all modern nations, special institutions (such as the Bank of England, the
European Central Bank or the Federal Reserve System in the United States) exist which
have the task of executing the monetary policy independently of the executive. In
general, these institutions are called central banks and often have other responsibilities
such as supervising the smooth operation of the financial system.

The primary tool of monetary policy is open market operations. This entails managing the
quantity of money in circulation through the buying and selling of various credit
instruments, foreign currencies or commodities. All of these purchases or sales result in
more or less base currency entering or leaving market circulation.

INSTRUMENTS OF MONETARY POLICY

The techniques or instruments which are available to the authorities to achieve their
targets for monetary policies include:

a. Changing the level/and /or structure of interest rates through open market
operations
b. Government funding policy- i.e. the size of the public sector borrowing
requirement or PSBR ( or the PSDR- public sector debt repayment) and the
method of funding it
c. Reserve requirements
d. Direct controls, which might be either:
- Quantitative
- Qualitative
e. Interventions to influence the exchange rate

CONTROL OVER THE LEVEL AND STRUCTURE OF INTEREST RATES

When the government uses interest rates as an instrument policy, it can try to influence
either the general level of interest rates or the term structure of interest rates. It could do
this by influencing either shot term interest rates or long term interest rates. Long term
rates could possibly be influenced by increasing or reducing the PSBR, and so through
the government’s funding policy and gilts issues.

Influence over interest rates concentrates on short term “(money market) rates, through
open market operations in the discount market. Open market operations can influence
interest rates in the discount market, with an immediate ‘knock-on’ effect into other
money markets, particularly the inter bank market. As we have seen, interest rates in the
inter-bank market influence commercial banks base rates and lending rates.

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It is reasonable to conclude that if influence over short term interest rates is used as a
monetary policy technique, its ultimate aim should be to control inflation or the exchange
rate rather than to control broad money supply growth.

RESERVE REQUIREMENTS ON BANKS AS A MEAN OF CONTROLLING THE

MONEY SUPPLY
As another technique for controlling money supply growth, the government might impose
reserve requirements on banks. A reserve requirement might be a compulsory minimum
cash reserve (i.e. ratio of cash to total assets) or a minimum liquid asset ratio.

Any initial increase in bank deposits or building society deposits will result in a much
greater eventual increase in deposits, because of the credit multiplier:

Ignoring leakages, the formula for the credit multiplier is:

D = C/r

Where C is the initial increase in deposits

r is the liquid assets ratio or reserve assets ratio
D is the eventual total increase in deposits

If the authorities wished to control the rate of interest in bank lending and building
society lending, they could impose minimum reserve requirements- i.e. a minimum value
for r. the bigger the value of r, the lower the size of the credit multiplier would be.

There are drawbacks to reserve requirements as a monetary policy instrument:

a) Unless the same requirements apply to all financial institutions in the

country, some institutions will simply take business from other. For example,
reserve requirements on UK banks but not on building societies would give the
building societies a competitive advantage over the banks, without having any
effect on the control of total credit/money supply growth.

b) Similarly, restrictions on domestic financial institutions which do not

apply to foreign banks would put the domestic financial institutions at a
competitive disadvantage in international markets. This is one reason why
international cooperation on the capital adequacy of banks is an important step
towards better regulation of financial markets.

DIRECT CONTROLS AS A TECHNIQUE OF MONETARY CONTROL

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Another way of controlling the growth of the money supply is to impose direct controls
on bank lending. Direct controls may be either quantitative or qualitative:

a) Quantitative controls might be imposed on either bank lending (assets),

for example a ‘lending ceiling’ limiting growth, or bank deposits (liabilities).
The purpose of quantitative controls might be seen as a means of keeping
bank lending in check without having to resort to higher interest rates.

b) Qualitative controls might be used to alter the type of lending by banks.

For example, the government (via the Central Bank) can ask the banks to limit
their lending to the personal sector, and lend more to industry, or to lend less
to a particular type of firm (such as, for example, property companies) and
more to manufacturing businesses.

Controls might be temporary, in which case, in time, interest rates would still tend to rise
if the money supply growth is to be kept under control. However, the advantage of a
temporary scheme of direct quantitative controls is that it gives the authorities time to
implement longer term policy. Quantitative controls are therefore a way of bridging the
time-lag before these other policies take effect. Quantitative controls might be more
permanents. If they are, they will probably be unsuccessful because there will be
financial institutions that manage to escape the control regulations, and so thrive at the
expense of controlled institutions.

Direct controls in banks, for example, might succeed in reducing bank deposits but they
will not succeed in controlling the level of demand and expenditure in the economy if
lending is redirected into other non-controlled financial instruments of non-controlled
financial institutions. For example, large companies might use their own bank deposits to
set up a scheme of lending themselves.

Direct controls are therefore rarely effective in dealing with the source rather than the
symptom of the problem. Direct controls tend to divert financial flows into other, often
less efficient, channels, rather than to stop the financial flows altogether, i.e. ‘leakages’
are inevitable.

QUALITATIVE CONTROLS AND PRUDENTIAL CONTROLS

Qualitative controls might be mandatory or they might be applied through ‘moral
suasion’. Mandatory directives of a qualitative nature are unlikely in practice, because
they are difficult to enforce without the co-operation of banks and other financial
institution. Moral suasion, on the other hand, might be used frequently. This is a process
whereby the authorities (Central Bank) appeal to the banks:

a) To restrain lending

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 b) To give priority to certain types of lending such as finance for exports or
for investment

c) To say ‘no’ to other types of lending such as loans to private individuals

Moral suasion might therefore be a temporary form of control.

Prudential control refers to the oversight of banks and other financial institutions by the
authorities to ensure that they have an adequate capital structure, liquidity (asset
portfolio) and/or foreign exchange exposure.

A distinction can be made between:

d) Enforceable qualitative controls such as the Central Bank might exert in

its role as supervisor of the banking system. However, it is easier to enforce
quantitative controls than qualitative ones since adherence to the rules can be
measured

e) Suggestions by the Central Bank about what other banks might wish to do

f) Requests by the Banks, giving an indication of what it would like other

banks to do

EXCHANGE RATE CONTROL AS AN INSTRUMENT OF MONETARY POLICY

The exchange rate and changes in the exchange rate have implications for the balance of
payments, inflation and economic growth. The government might therefore seek to
achieve a target exchange rate for its currency.

TYPES OF MONETARY POLICY

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In practice all types of monetary policy involve modifying the amount of base currency
(M0) in circulation. This process of changing the liquidity of base currency through the
open sales and purchases of (government-issued) debt and credit instruments is called
operations. Constant market transactions by the monetary authority modify the supply of
currency and this impacts other market variables such as short term interest rates and the
exchange rate. The distinction between the various types of monetary policy lies
primarily with the set of instruments and target variables that are used by the monetary
authority to achieve their goals.

Monetary Policy: Target Market Variable: Long Term Objective:

Interest rate on overnight
Inflation Targeting A given rate of change in the CPI
debt
Interest rate on overnight
Price Level Targeting A specific CPI number
debt
The growth in money
Monetary Aggregates A given rate of change in the CPI
supply
The spot price of the
Fixed Exchange Rate The spot price of the currency
currency
Low inflation as measured by the
Gold Standard The spot price of gold
gold price
Mixed Policy Usually interest rates Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange
rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard
results in a relatively fixed regime towards the currency of other countries on the gold
standard and a floating regime towards those that are not. Targeting inflation, the price
level or other monetary aggregates implies floating exchange rate unless the management
of the relevant foreign currencies is tracking the exact same variables (such as a
harmonized consumer price index).

a. INFLATION TARGETING

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B. PRICE LEVEL TARGETING

c. MONETARY AGGREGATES

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In the 1980s several countries used an approach based on a constant growth in the money
supply. This approach was refined to include different classes of money and credit (M0,
M1 etc). In the USA this approach to monetary policy was discontinued with the
selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

Whilst most monetary policy focuses on a price signal of one form or another this
approach is focused on monetary quantities.

D. FIXED EXCHANGE RATE

Under a system of fiat fixed rates, the local government or monetary authority declares a
fixed exchange rate but does not actively buy or sell currency to maintain the rate.
Instead, the rate is enforced by non-convertibility measures (e.g. capital controls,
import/export licenses, etc.). In this case there is a black market exchange rate where the
currency trades at its market/unofficial rate.

Under a system of fixed exchange rates maintained by a currency board every unit of
local currency must be backed by a unit of foreign currency (correcting for the exchange
rate). This ensures that the local monetary base does not inflate without being backed by
hard currency and eliminates any worries about a run on the local currency by those
wishing to convert the local currency to the hard (anchor) currency.

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MIXED POLICY

In practice a mixed policy approach is most like "inflation targeting". However some
consideration is also given to other goals such as economic growth, unemployment and
asset bubbles.

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 CHANNELS OF MONETARY TRANSMISSION
• Bank Lending Channel
• Exchange Rate Channel
• Asset Price Channel
• Direct Interest Rate Channel

Bank Lending Channel

We first examine the role of bank credit. Under a contractionary monetary policy shock
‘bank lending channel’ operates through the fall in bank reserves, implying a reduction in
the supply of loanable funds by the banks. In other words, monetary policy may have
amplified effects on aggregate demand by modifying the availability or the terms of new
loans. The lending channel presumes that small and medium-sized firms, facing
informational frictions in financial markets, rely primarily on bank loans for external
finance because it is not possible for these borrowers to issue securities in the open
market.

The importance of this channel thus depends on three factors:

(i) the degree to which the central bank has allowed banks to extend loans;
(ii) monetary policy stance; and
(iii) The dependence of borrowers on bank loans.

These factors are clearly influenced by the structure of the financial system and its
regulation.

The bank lending channel is an enhancement mechanism to the interest rate channel. The
key point here is that the real effects of higher interest rates may be amplified through
the lending channel, beyond what would be predicted were policy transmitted only
through the traditional interest rate channel (cost of capital). As market interest rates rise
subsequent to monetary tightening, business investment falls not only because cost of
capital is high but also due to supply of bank loans mostly to small and medium sized
firms is reduced.

Looking forward, the importance of credit channel will further improve mainly because
of financial sector reforms and continued expansion of private sector credit. On the
contrary, reliance on bank finance should decline as capital markets become more
developed. Nevertheless, given the fact that capital market development tends to take
place gradually and the increased emphasis on small and medium scale enterprises in
Pakistan, the overall effect in the medium term should be an increase in the significance
of the bank-lending channel.

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Exchange Rate Channel

The strength of the exchange rate channel depends on the responsiveness of the
exchange rate to monetary shocks, the degree of openness of the economy, and the
sensitivity of net exports to exchange rate variations. In a small open economy, a
nominal depreciation brought on by monetary easing, combined with sticky prices,
results in a depreciation of the real exchange rate in the short-run and thus higher net
exports.

Asset Price Channel

The role asset prices may play in the transmission mechanism of monetary policy is well
known theoretically, although quite difficult to characterize empirically. Monetary policy
shocks results into fluctuations in assets prices. A monetary policy easing can boost
equity prices in two ways:

(i) By making equity relatively more attractive to bonds (since interest rate fall) and
(ii) By improvement in the earnings outlook for firms as a result of more spending by
households.

Higher equity prices have dual impact of monetary impulses. First, higher equity prices
increase the market value of firms relative to the replacement cost of capital, spurring
investment; secondly, increase in stock prices translate into higher financial wealth of
household and therefore higher consumption. In addition, to the extent that higher equity
prices raises the net worth of firms and households which improves their access to funds,
the effects captured would partly reflect the ‘broad credit channel’ of monetary policy as
well.

A broader range of assets, for example real estate – commercial and residential – may be
included to cover the wealth effects; however, due to data limitations, we use stock
market equity, keeping in mind that these may serve as a proxy to broader range of
assets. Typically, peaks in equity prices tend to lead those in real estate prices. However,
the relationship is somewhat less clear around troughs.

These results need to be accepted with a caution as the share ownership is not yet very
common in Pakistan, and firms mostly rely on bank credit for their financing needs as
against equity financing. We anticipate the role of asset prices in the transmission
mechanism to increase in the future as the capital market develops.

Direct Interest Rate Channel

The interest rate channel, also referred to as the traditional channel, is the primary
mechanism at work in conventional macroeconomic models. Assuming some degree of

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price stickiness, an increase in nominal interest rates, for example, translates into an
increase in the real rate of interest and the higher cost of capital. These changes in interest
rates may lead to a postponement in consumption or a reduction in investment spending.
In the absence of any good indicator for cost of capital, we have measure its impact
indirectly.

MONETARY POLICY APPLIED BY STATE BANK

FY-08 has been troublesome for the Pakistani economy as it faced various challenges,
whose repercussions continue to impact the FY-09.These include:

a. Drain of liquidity from the financial system

b. Rising global commodity, oil and staple food prices
c. Depleting foreign reserves due to disinvestment by foreign investors
d. Surge in import bill
e. Devaluation of the Rupee

The unfolding events on both international and domestic front have enhanced the
economic stress in Pakistan. Pakistan is likely to register a slowdown, and has witnessed
exceptional rise in inflation, which is now emerging as the biggest challenge facing the
economy. The Central bank is expected to play a key role in the current scenario to strike
a balance between growth and price stability. On the balance it is being acknowledged
that managing domestic demand pressures is critical in avoiding further and steeper rise
of inflation; current rate of inflation has already started to impact economic growth and
has induced fresh threats to economic stability.

The excessive drain of rupee liquidity from the system is attributable to the net falling
assets, strong credit demand and strong government borrowing from the SBP. Strong
actions have been taken in order to infuse liquidity into the market:

i. Liquidity injections through Open Market Operations (OMOs)

ii. Increased allowance of commercial banks in T-Bill auctions

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Another growing concern for the economy was the growing external account deficit and
the spiraling of the fiscal deficit out of sustainable levels. The external current account
deficit for Pakistan has reached to $5.9 Billion. The export revenues were nominal
compared to our import bills. The import of oil and food constitutes the major part of our
import bill approximately 40% of the total bill. The oil import bill was $4.9 Billion alone.

Also, the exchange rate remained under pressure and the foreign exchange reserves
depleted as investors due to rising political uncertainty and weakened economy.

Keeping this in mind the SBP took the following corrective actions during the course of
H1-FY09.

A. INCREASED THE DISCOUNT RATE

Discount rate is the rate at which commercial banks obtain money from the central bank.
Loans given to private businesses and individuals are priced on the basis of this rate. It
has been increased from 13%
in H2-FY08 by a 200 bps to
15% in H1-FY09. It is evident
that the SBP has introduced a
very tight monetary policy.
This increase has been
necessitated by the persistent
and excessive government
borrowing from SBP to meet the
financing requirement of the
budget deficit, the precarious
and unsustainable balance of
payment position, global
financial crises and the high
commodity prices. In order to
offload this huge debt to the

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scheduled banks, this increase will act as a critical measure to induce scheduled banks to
participate actively in T-bill auctions, which have been mostly unsuccessful in mobilizing
receipts for the government in recent past. This will also help in pushing up the low and
decline real lending rates necessary to curb the demand pressures and decelerate the current
rapid rise in inflation. An increase in interest rates is necessary to encourage savings in the
economy, importance of which cannot be over emphasized given the state of fiscal and
external current account deficits.

b. REDUCED THE CRR

To ease the liquidity conditions, SBP reduced the Cash Reserve Requirement, in a
staggered manner, by 400 bps to 5%. The SBP also exempted time deposits from the
Statutory Liquidity Requirement and took a host of other measures. In the same vein, to
meet the credit requirements of the exporters, the SBP decided to provide 100 percent
refinancing to banks under the Export Finance Scheme (EFS). These measures allowed
the SBP to address the liquidity situation while remaining vigilant in draining excessive
liquidity build-ups.

The decrease in the CRR is supposed to have an immediate impact on inter-bank interest
rates by providing excess liquidity.

The SBP in its policy has given utmost importance to

a. Demand management – controlling aggregate demand to release demand oriented

pressures from the economy.
b. Controlling the rising external current account deficit
c. Increasing the depleting foreign reserves.
d. Controlling the escalating CPI inflation which results in decreased economin
activity
e. Curbing the liquidity shortages in the money market

These measures are necessary for price stability and long term sustainable growth.
Although it is estimated that demand pressures will recede during the current year if the
supply side issues are not addressed these pressures would remain unchanged.

EFFECTS OF THE MONETARY POLICY

1. Investment will be reduced and saving will be encouraged.

2. Deposit mobilization.

3. Inflationary pressures on the economy are most likely to recede as demand growth
will be substantially curtailed.

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 4. Government borrowing is most likely to be reduced as per policy, to further
tighten monetary conditions. Furthermore, as the SBP is less likely to allow the
government to borrow excessively the government would have to look for
alternative sources of funding and perhaps reduce their expenditures.

5. Investment in certain sectors is most likely to increase (e.g. Textile, other

Exports) as SBP has extended incentives to them.

6. Reduction in the overall import bill and non- developmental expenditure due to no
longer extending of subsidies on commodities.

ASSOCIATED RISKS

1. Inflationary pressures on the economy though expected to recede, if increased

may grow out of control.

2. The current account deficit is due to high import bills. If local production does
not increase this trend would continue and widen the fiscal deficit.

3. Foreign inflows in Pakistan are likely to be low as the local currency has been
rated very low by international agencies.

4. Demand management is addressed by this monetary policy however if it

continues to increase disproportionately it would put pressure on the economy
and increase macro economic policies.

CONCLUSION

• The H1-FY09 Monetary policy goals are:

- Controlling inflation
- Stabilizing the exchange rate
- Reduce government borrowing
- Macroeconomic stability
- Controlling the external current account deficit and fiscal deficit
- Liquidating the money market
- Increase tax revenue

• A Contractionary Policy has been implemented by the Central Bank to increase

the total money supply.

• Some of the factors involved in failure of market-based monetary policy are:

- SBP has failed to regulate commodity financing operations.

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 - Net foreign reserves - decline
- Net long term foreign capital inflows- declined.
- Worsening external debt situation
- SBP’s ineffectiveness to recover banks debts.
- Concentration of financial sector assets.

• Key challenges to monetary policy, faced by SBP are:

- Growing external current account deficit.

- Inflation
- Excessive government borrowings
- Pressures on Forex reserve

CRITICISM ON THE MONETARY POLICY

The H1-FY09 monetary policy has met great criticism from economists, bankers and
business men.

According to the Federation of Pakistan Chambers of Commerce and Industry President

Sultan Ahmed Chawla, the high interest rate would further push up the cost of
production, which would definitely be transferred to consumers, adding to inflationary
pressures rather than curbing inflation. This inflation is not demand-push, which can be
controlled through a tight monetary policy. Instead, the major causes of rising inflation in
the country are the hike in prices of oil, wheat and other food items. All these are
inelastic products and the monetary policy cannot control their prices. Measures must be
taken to improve the supply of these goods and improve our supply management.

Economists have been arguing for an expansionary policy in this state of recession to
control over the damaging effects on employment and investment.

Businessmen and Industrialists have been extremely critical and opposed to the new
monetary policy and have expressed concerns over the closure of industry owing to high
mark up and the continued negligence of the business community. They argue that this
step would further increase the cost of production and destroy the industries.

President of the Karachi Chamber of Commerce and Industry, Anjum Nisar was of the
opinion that Pakistan was fast on its way of becoming one of the most expensive
countires of the world.

Furthermore, the Central Bank maintained the discount rate to induce commercial banks
to participate in T-Bill auctions. However, the hike in State Bank’s discount rate failed to
induce banks into investment in treasury bills as banks chose to invest only in three-
month papers taking no interest in six-month bills and showing little inclination to invest
in one-year papers.

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UNITED STATES MONETARY POLICY
The object of monetary policy is to influence the performance of the economy as reflected in
such factors as inflation, economic output, and employment. It works by affecting demand
across the economy—that is, people's and firms' willingness to spend on goods and services.

MONETARY POLICY TOOLS

MONETARY BASE

Monetary policy can be implemented by changing the size of the monetary base. This
directly changes the total amount of money circulating in the economy. A central bank
can use open market operations to change the monetary base. The central bank would
buy/sell bonds in exchange for hard currency. When the central bank disburses/collects
this hard currency payment, it alters the amount of currency in the economy, thus altering
the monetary base.

Open market operations play an important role in:

• Steering interest rates

• Managing the liquidity situation in the market
• Signalling the stance of monetary policy

Key figures for outstanding open market operations

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Related to monetary policy implementation issued by the ECB in 2009 :

RESERVE REQUIREMENT

The monetary authority exerts regulatory control over banks. Monetary policy can be
implemented by changing the proportion of total assets that banks must hold in reserve
with the central bank. Banks only maintain a small portion of their assets as cash
available for immediate withdrawal; the rest is invested in illiquid assets like mortgages
and loans. By changing the proportion of total assets to be held as liquid cash, the Federal
Reserve changes the availability of loanable funds. This acts as a change in the money
supply.

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The low-reserve tranche amount and exemption amount effective on January 1, 2009 are
44.4 and 10.3 (in millions on U.S dollars) .

DISCOUNT WINDOW LENDING

Many central banks or finance ministries have the authority to lend funds to financial
institutions within their country. By calling in existing loans or extending new loans, the
monetary authority can directly change the size of the money supply.

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Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the
nominal interest rates. Monetary authorities in different nations have differing levels of
control of economy-wide interest rates. In the United States, the Federal Reserve can set
the discount rate, as well as achieve the desired Federal funds rate by open market
operations. This rate has significant effect on other market interest rates, but there is no
perfect relationship. In the United States open market operations are a relatively small
part of the total volume in the bond market. One cannot set independent targets for both
the monetary base and the interest rate because they are both modified by a single tool —
open market operations; one must choose which one to control.

In other nations, the monetary authority may be able to mandate specific interest rates on
loans, savings accounts or other financial assets. By raising the interest rate(s) under its
control, a monetary authority can contract the money supply, because higher interest rates
encourage savings and discourage borrowing. Both of these effects reduce the size of the
money supply.

Fed Funds Interest Rate

Past Trend Present Value & Future Projection

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THE BAILOUT PLAN
In September 2008, the Bush administration proposed and negotiated a $700 Billion
Bailout Plan with the Congressional politicians. The US Treasury Secretary, Henry M.
Paulson proposed for a sweeping bailout of financial institutions. He asked Congress for
$700 billion to use to buy up mortage-backed securities whose value had dropped sharply
or had become impossible to sell, in what he called the Troubled Asset Rescue Plan As
originally outlined, the government would have bought up toxic mortgage-backed
securities at a premium over their current deflated values. By paying "hold to maturity''
prices, the government would provide troubled firms with an infusion of capital, reducing
doubts about their viability and thereby restoring investor confidence.

The plan in its original form was quickly rejected by both Democrats and Republicans in
Congress and was criticized by many economists across the political spectrum. Congress
insisted on adding provisions for oversight, limits on executive pay for participating
companies and an ownership stake for the government in return for its investments.

Even so, the plan proved to be strikingly unpopular with an outraged public, and on Sept.
29 it failed in the House of Representatives. But as the markets continued to plunge, a
slightly altered version won the support first of the Senate, on Oct. 1, and of the House,
on Oct. 3. President Bush quickly signed the bill.

Shortly afterward the Plan’s course was reversed, and the $350 billion in the first round
of funds allocated by Congress not to buy toxic assets, but to inject cash directly into
banks by purchasing shares, an approach that many Congressional Democrats had pushed
for earlier. In an initial round of financing, nine of the largest banks were given $25
billion apiece.

The Treasury also used the bailout to steer funds to stronger banks to purchase weaker
ones. Unfortunately, no strings were attached to the Treasury infusions, and many of the
banks appeared to be using the funds to bolster their balance sheets rather than to make
new loans.

On Nov 12, The Treasury of State abandoned the idea of asset purchases, and said the
bailout money would be used instead for a broader campaign to bolster the financial
markets and help consumers seeking loans for cars or tuition and other kinds of
borrowing.

To the anger of many Democratic members, none of the first round was used to prevent
further increases in foreclosures. An oversight panel created by the original bailout bill
also delivered a round of stinging criticisms in its first report, delivered Dec. 10. The
report said that the Treasury had failed to create a system to track how bailout funds were
being used or to require that banks use them to increase lending and unfreeze credit
markets.

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The last big chunk of the first round funds ended up going to Detroit, in $17.4 billion in
emergency loans to keep General Motors and Chrysler afloat. President Bush had initially
rebuffed Democratic efforts to use the financial bailout for that purpose, preferring to
redirect loan guarantees meant to help factories switch to building more fuel-efficient
cars. But after Senate Republicans blocked a bill that would have done that, Mr. Bush
agreed to use TARP funds, while adding tough condtions for the car makers, their
creditors and unions that mirrored much of what Senate Republicans had sought.

On Jan. 12, 2009, the White House said that President Bush, at President-elect Barack
Obama’s urging, would ask Congress to release the $350 billion remaining in the bailout
fund.

Troubles continued in the financial sector - both Citigroup and the Bank of America
needed second rounds of capital infusions, and federal guarantees against losses totalling
tens of billions more -- while Ben S. Bernanke, the Federal Reserve chairman, warned
that more capital injections might be needed to further stabilize the financial system.

Another centerpiece of the plan would stretch the last $350 billion that the Treasury has
for the bailout by relying on the Federal Reserve's ability to create money, in effect, out
of thin air. The Fed's money will enable the government to become involved in the
management of markets and banks in ways not seen since the Great Depression. In the
credit markets, for instance, the administration and the Fed are proposing to expand a
lending program that would spend as much as $1 trillion to make up for the $1.2 trillion
decline between 2006 and last year in the issuance of securities backed primarily by
consumer loans. The plan's third major component would give banks new helpings of
capital with which to lend. Banks that receive new government assistance will have to cut
the salaries and perks of their executives and sharply limit dividends and corporate
acquisitions. They will also have to make public more information about their lending
practices. A Treasury fact sheet said that banks would have to state monthly how many
new loans they make, but stopped short of ordering banks to issue new loans or requiring
them to account in detail for the federal money.

In addition, Obama officials were preparing a $50 billion initiative to enable millions of
homeowners facing imminent foreclosure to renegotiate the terms of their mortgages.

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A COMPARISON OF US AND PAKISTAN’S MONETARY POLICY

Diagnostics of Pakistan economic situation is different from global and regional

developments; therefore, policy responses have to be different. With the world in grip of
the worst financial crisis, some sections of the society have argued for fiscal stimulus and
monetary easing in Pakistan drawing parallels between the global and the Pakistan
economy. It is critical to recognize that the magnitude, depth, and impact of this global
crisis vary across regions and countries and that the domestic macroeconomic situation
differs in each country. While a number of advanced countries are facing severe liquidity
crisis, which transformed into an insolvency crisis, the macroeconomic fundamentals of
these countries, to start with, Interim Monetary Policy Measures, November 2008, were
in order. At the same time other large Asian countries, while being impacted by the
global events, have been able to weather the storm given their strong reserve positions.

In contrast, Pakistan, hit by the global commodity price shock and given the delays in
pass through of this price effect, witnessed a growth in its fiscal and external current
account deficits that reached unsustainable levels and alarmingly high inflation. With
stagnating tax to GDP ratio, this not only enhanced recourse to borrowings from the SBP
but also resulted in a fall in foreign exchange reserves, triggering depreciation in the
exchange rate. Since there are significant differences in ‘diagnostics’ among Pakistan and
other countries it must be recognized that the policy solutions will also be different.

Considering the size of macroeconomic imbalances, the SBP remains committed to

achieve price stability over the medium term and thus have to launch steeper monetary
tightening to tame the demand pressures and restore macroeconomic stability in FY09.

The road ahead for Pakistan, both politically and economically, will remain tortuous in
2009 with a confluence of new challenges having emerged. A more effective tackling of
the militant threat, beyond the present military broadside, will remain of paramount
importance, as will defuse brewing tensions with India. Although the new US President
Barack Obama’s strategy towards Pakistanis not entirely clear yet, with the controversial
use of unmanned drones to strike militant hide outs along Pakistan’s border with
Afghanistan having continued at the start of his tenure, we believe that he will adopt a
more finely calibrated approach than his predecessors. As for the economy, there are
incipient signs of stabilization, but much work left to be done, particularly as far as
reforming Pakistan’s rickety fiscal regime is concerned.

The challenges facing the administration of President Asif Ali Zardari will not diminish
in 2009, and could grow even more daunting. Tensions with arch-rival India remain
heightened following the November 2008 terrorist attacks in Mumbai. Domestically, the
battle against militants in the north western tribal areas is ongoing. On the economic
front, although a balance of payments crisis has been averted on the back of a US$7.6bn
IMF loan, the urgent need to ameliorate macro economic imbalances means that the
government will be forced to tighten its belt further. While the IMF has acknowledged
that this process of consolidation should not come at the cost of social stability, it is hard

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to see how the government could maintain any form of cushion for Pakistanis given its
depleted resources and need to raise tax revenues.

Thanks to a US$7.6bn IMF rescue package Pakistan has, for the time being at least,
averted a balance of payments crisis and possible sovereign default. A process of
stabilization, under pinned by tighter fiscal and monetary policy, is underway and will be
helped by the steep fall in international commodity prices. Pakistan’s yawning twin
deficits, in the fiscal and current accounts, should comedown tin 2009 as should inflation.
Nonetheless, ongoing electricity and security problems, coupled with restrictive credit
conditions and a weakening global economy - which will keep a definite capon foreign
investment inflows - is likely to drag growth lower in 2009, and we accordingly forecast
real GDP growth to slow to 2.5% in FY2008/09 (July-June), less than half the rate in
FY2007/08and significantly below the near 7% average rate of expansion seen over the
past five years.

The business environment will remain highly challenging throughout 2009, largely due to
the stifling energy shortage, which has brought many industries to their knees, and the
parlous security situation. The government has said that it wants to attract some US$10bn
in foreign investment over 2009 - much of which it believes will come from the Gulf
region - but BMI is not convinced that this will be possible, given the current bleak
outlook for the global economy and climate of risk aversion. A large part of this
investment would be solicited for infrastructural projects and the energy sector in
particular, where a 3,000-3,500MW capacity shortfall needs to be plugged before year-
end.

However if we are trying to compare the monetary policies of the two countries, it may
be a difficult task as both the countries have other macro and micro influences working at
the same time simultaneously. But we can still see how well the monetary policy is
implemented in the two countries using the instruments of the monetary policy.

Comparing the monetary policy of the two we can conclude the following:

UNITED STATES
a. Crisis response
b. Risk management
c. Longer-term issues
d. Open market operations
e. Central bank liquidity swaps
f. Lending to primary dealers
g. Other lending facilities
h. Support for specific institutions

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PAKISTAN

a. Devaluation of the Rupee

b. Lending to depository institutions
c. Surge in import bill
d. Disinvestment by foreign investors
e. Depleting foreign reserves
f. rising to Global commodity and food prices
g. Drain of the liquidity from the financial system

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