Monetary Policy
Topic Twenty-Four

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Monetary Policy

Monetary Policy refers to those actions and decisions undertaken by the Central Bank to create appropriate monetary conditions in line with the economic objectives of the country. Monetary policy is used to make changes to the money supply in the economy to correct for recessionary and inflationary problems. This means that the authorities will make decisions to alter the money supply based on the state of the economy. If the economy is in recession, the government can implement expansionary monetary policy in order to increase money supply to create economy activity in order to bring the economy out of the recession. On the other hand, if the economy is in an inflationary mode which is beyond full employment, the Central Bank can carry out contractionary monetary policy in order to reduce the money supply in order to bring the economy back at the full employment level. In many countries, monetary policy is undertaken by the Central Bank. There are three main instruments of monetary policy which are the reserve requirements ratio, open market operations and the discount rate.

Reserve Requirement Ratio

The reserve requirement ratio is the percentage of the annual deposits that financial institutions are required to hold with the Central Bank (or local financial regulator). By varying this percentage, the Central Bank influences the ability of the commercial banks to create money. When the economy is growing or when there is inflationary pressure, the Central Bank will increase the reserve requirement ratio so that more of the banks’ deposits will be held with the Central Bank and less will be available for lending by the commercial banks to their customers. This will have the effect of reducing the money supply in the economy and reducing the inflationary position.

On the other hand, when there is a downturn in economic activity or a recession, the Central Bank reduces the reserve requirement ratio thereby allowing the banks to hold less deposits with the Central Bank and have more money to lend and invest. This will have the effect of increasing the money supply and the level of economic activity which can bring the economy out of the recession.

Open Market Operations

Operations market operations is the buying and selling of government bonds in order to manipulate the money supply. The government sells bonds to the public when there is too much money in circulation or an inflationary situation in the financial system as in the case of full employment and economic boom. When the Central Bank sells bonds to the public on behalf of the government, this will have the effect of taking money away from the public. This will mean that the public will have less money in their possession to spend and so the money supply available to the public will be reduced.

On the other hand, when there is too little money in the financial system as in the case of a recession, the government tries to stimulate economy activity by buying back bonds from the local investors. The government will be exchanging the money back for the bonds (or taking back the bonds and giving back money to the public) from the public. Therefore, the public will now have more money in their possession to spend and so the money supply in the economy will increase and so too will be the level of economic activity.

Discount Rate

The discount rate is the rate at which financial institutions can borrow from the Central Bank. When there is too much economic activity, the Central Bank increases the discount rate thereby making borrowing difficult by the commercial banks. Therefore the banks will have less money to lend. This will have the effect of reducing the money supply and reducing some of the economic activity in the economy. On the other hand, when there is too little economic activity or too little money supply in the economy, the Central Bank can reduce the discount rate thereby making borrowing by commercial banks from the Central Bank easier. These commercial banks will now have more money available to lend to their customers. This will have the effect of increasing economic activity.

Expansionary Monetary Policy

Expansionary monetary policy is adopted when the government through the central bank wants to solve for a recessionary or deflationary position. The government will want to increase the money supply and the level of economic activity. Expansionary monetary policy is where the Central Bank reduces the reserve requirement ratio, buys bonds and securities from the public or reduces the repo rate. These will have the effect of increasing the money supply. The changes in the money supply are depicted in what is known as the LM Curve (the LM Curve gives the combinations of income and the interest rate for which the demand for money or desired liquidity equals the money supply) as shown in the following graph. The LM curve will shift to the right from LM1 to LM2. This will have the effect of increasing income from Y1 to Y2 and reducing the rate of interest from i1 to i2.

Figure 1

Contractionary Monetary Policy

Contractionary monetary policy is when the government through the central bank wants to solve for an inflationary situation. This means that there is too much money and economic activity in the system. The government will want to reduce the money supply. Contractionary monetary policy is where the central bank increases the reserve requirement ratio, sell bonds and securities to the public and increases the discount rate. These will have the effect of decreasing the money supply. Assuming that the money supply was at LM2, the changes in the money supply will be shown as a leftward shift of the LM curve from LM2 to LM1. This will have the effect of decreasing income from Y2 to Y1 and increasing the rate of interest from i2 to i1 as seen in the graph above.

Effects of Expansionary Monetary Policy

The following are some of the effects of expansionary monetary policy.

  • Expansionary monetary policy causes an increase in bond prices and a reduction in interest rates;
  • Lower interest rates lead to higher levels of capital investment;
  • The lower interest rates make domestic bonds less attractive, so the demand for domestic bonds falls and the demand for foreign bonds rises;
  • The demand for domestic currency falls and the demand for foreign currency rises, causing a decrease in the exchange rate. (The value of the domestic currency is now lower relative to foreign currencies);
  • A lower exchange rate causes exports to increase, imports to decrease and the balance of trade to increase.

Limitations of Monetary Policy

Even though monetary policy is a useful tool for solutions of economic problems, it also has limitations such as follows:

Deflation - deflation is a decrease in the general price levels of goods and services. If there is deflation, the value of money will increase. Deflation is good for lenders and bad for borrowers: when loans are paid back, the cash is worth more. Thus, deflation discourages borrowing, and by extension, consumption and investment today. If monetary policy is too contractionary for too long, deflation could set in

Fiscal policy – monetary policy can be limited if not implemented together with fiscal policy. An increase in the money supply through monetary policy can result in a fall in the interest rate. This can have the effect of affording investors a reduced return on the investments. This can result in investors switching to foreign investments where they can get a higher return on their investments. This will result in an outflow of foreign reserves and lead to a devaluation or depreciation of the local currency. In order to prevent this adverse effect of monetary policy, fiscal policy will have to be simultaneously implemented which will have the effect of stabilizing the local interest rate.

Liquidity trap - the liquidity trap is an aspect of Keynesian economics that states that in a situation of low interest rates, monetary policy will be ineffective. This is so because the rate of interest is so low that consumers and investors will not get large returns on their investments and will choose not to invest in interest bearing investment instruments but keep their money in savings accounts at the bank. In addition, due to the inverse relationship between price of a bond and the interest rate, many consumers and investors will not want to buy bonds because they expect that its price will rise to high beyond their affordability.

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