Monetary Policy and Inflation Targeting - YouTube

Promoting price stability is a usual goal among central banks.

There is price stability when the general price level of goods and services in the country

moves at a low and predictable rate, thus preserving the value of your money.

Conversely, when prices rise substantially and unpredictably, your money buys fewer goods

and services.

Here in the Philippines, the Bangko Sentral ng Pilipinas or BSP, the country’s monetary

authority, is tasked “to promote price stability conducive to a balanced and sustainable growth

of the economy.”

The BSP keeps inflation low and stable through the conduct of monetary policy, which consists

of decisions about the money supply and the cost of borrowing money to influence demand

for goods and services.

In 2002, the BSP adopted inflation targeting as the framework for monetary policy, where

the National Government sets the inflation target and the BSP announces and commits to

achieve it.

The BSP has monetary policy tools that are used to influence the money supply and the

cost of borrowing money.

The primary tool is the BSP’s policy rate, the key interest rate of the BSP, which signals

its monetary policy stance.

The decision on the monetary policy stance considers the inflation outlook for the target

period.

Specifically, the BSP regularly assesses price and other developments to ensure that monetary

policy settings remain appropriate:

> It generates inflation forecasts and compares these with the inflation target.

> If forecast is significantly different from the target, the BSP may then change its monetary

policy stance using tools to manage inflation to meet the target.

> Any change in the BSP’s monetary policy stance — which affects the decisions of

households and businesses as to their consumption, investment, saving and production — will

impact overall demand and, ultimately, inflation.

For example, if the BSP believes that there is an excess demand relative to the supply

of goods and services which may result in high inflation, it will tighten its monetary

policy stance.

Now, what happens when the BSP tightens its monetary policy stance by increasing its policy

rate?

> Money supply will be reduced because banks will be encouraged to put their excess money

at the BSP.

> Since bank credit will be lower as a result, banks will likely increase their interest

rates.

> Higher interest rates will encourage the public to borrow less from banks.

People would also be using a portion of their income for higher interest payments instead

of using the money to buy stuff they want.

> A rise in interest rates would also make it more expensive for firms to finance their

investments.

> When people have less money to buy goods and services, they will demand less of them.

> If total demand goes down, pressures for price increases ease.

The end effect of the BSP’s tighter monetary policy is lower inflation.

This is how monetary policy works through the interest rate channel.

With generally similar results, monetary policy also works through the expectations, credit,

exchange rate, and wealth channels.

Transparency is essential to inflation targeting; that’s why all monetary policy decisions

are relayed to the public.

Communication and credibility are crucial in anchoring inflation expectations, or the

public’s expectations of price movements of goods and services in the future.

If the BSP is credible, its monetary policy decisions will boost public confidence that

inflation will be kept within target or will be brought in line with the target, ultimately

guiding the public in making well-informed economic and financial decisions.