MONETARY POLICY

Written by:

 AGBOOLA OLUBUSOLA

 MR ESEIWI WOROBOSA

 GIWA AZEEZ ADEMOLA

 SANNI YUSUF OLATUNJI

 OGUNDARE AKINTOLA MARIAM

 IBRAHIM MUSA ABIODUN

 

INTRODUCTION

Monetary policy is the art of managing money. Money must be managed because it is very use introduces a potential threat to the stability of the economic system. For the use of money enables economic subjects to create a time lag between their acts of supplying goods and services to the market and their acts of purchasing goods and services from the market. Consequently, in a given time period, total spontaneous supply and total spontaneous demand may not be equivalent, as they would necessarily be in a barter economy. The fact that money, received for services rendered, may indefinitely be hoarded, or at a later moment again dishoarded, and the fact that newly created money may be injected into the flow of spending, thus reflecting a demand for goods and services not matched by a commensurate supply, means that the use of money creates the possibility of disturbances in the regular circuit flow of demand and supply. The ultimate aim of monetary policy should be to cancel out such disturbances if and when they occur, thus assuring a steady flow of total demand that will continually absorb the steady flow of total supply. Under conditions of perfect competition, this is bound to be accompanied by the full utilization of available productive resources (Mankiw, 2010).

 

The monetary policy plays an act role in a country’s economic growth if it is implemented effectively to maintain price stability and to keep inflation rate at minimum level. Such goals are achieved through a process by which monetary authority of a country controls the supply of money, availability of money, and cost of money or interest rate. Monetary policy depends on the relationship between interest rate in an economy (i.e. the price of money at which money can be borrowed) and the total money supply. Monetary authority uses variety of tools to control one or both of these variables to influence outcomes, such as economic growth, inflation, exchange rate with other countries and unemployment (Hameed& Amen, 2011).

 

 

 

Definition of monetary policy

Monetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment (Hameed, 2011).

 

These policies are implemented through different tools, including the adjustment of the interest rates, purchase or sale of government securities, and changing the amount of cash circulating in the economy. The central bank or a similar regulatory organization is responsible for formulating these policies.

 

A monetary policy is a process undertaken by the government, central bank or currency board to control the availability and supply of money, as well as the amount of bank reserves and loan interest rates. Its other goals are said to include maintaining balance in exchange rates, addressing unemployment problems and most importantly stabilizing the economy. In the US, the Federal Reserve System is the agency executing monetary policy, which can either be contractionary or expansionary, with the former aiming to slow down the supply and even limit it to prevent the devaluation of assets and slow down inflation and the latter increasing the supply of money by lowering loan interest rates to encourage businesses to expand and cut down unemployment rates during recession. Basically, the agency decides how much interest rates would be imposed on banks in terms of borrowing, where banks would also be the ones to determine how high these rates will they be asking from the borrowers (Ahmed &Suliman, 2011).

 

During elections, the controversial issue of monetary policy is ironically avoided by hopeful candidates, who would talk about other matters except for this subject. Why, it would seem that this topic has its own set of complicated and vague perks and setbacks, with the importance for people to understand what it really is and what its implications in our daily lives. To have a well-informed opinion on this subject, let us take a look at its advantages and disadvantages.

Objectives of Monetary Policy

The primary objectives of monetary policies are the management of inflation or unemployment, and maintenance of currency exchange rates (Ahmed &Suliman, 2011).

  1. Inflation:Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.
  2. Unemployment: Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market.
  3. Currency exchange rates: Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.
  4. Exchange Stability: The traditional objective of monetary policy has been the achievement of stable exchange rates. This objective was primary, while stability of prices and output was secondary owing to the paramount importance of international trade in the leading economies of England, Denmark, Japan etc. For them, maintenance and proper conduct of the gold standard was considered to be the primary function of the monetary authorities. This way, minor changes in exchange rates were easily noticed. These led to a lot of speculation and consequent dislocation of economies. This imposed on them problems of inflation and deflation. This objective is now considered to be of secondary importance except in case of countries like Japan and England, whose prosperity still depends upon foreign trade. However, in under-developed countries the relationship between economic growth and exchange stability is of special importance because an under-developed country has to import materials and equipment for planned industrial development besides making heavy borrowings from abroad. Therefore, the exchange rate has to be so adjusted that the balance of payments position does not worsen.
  5. Price Stability: In the thirties, during and after the great depression (1929-33), price stability and control of business cycles became important objectives of monetary policy. Fluctuations in prices in the upward direction and more so in the downward direction create difficult problems of production and distribution, besides great economic unrest and political upheavals. Stability of the price level, thus, became the chief aim of monetary policy. But this objective of monetary policy proved to be short lived on the ground that it was difficult to determine a satisfactory price level at which the general price level should be stabilized.

Price stabilisation policy is beset with many difficulties: one, it may remove indirect business incentives which come through a rise in prices. Moreover, the prices of different sectors and groups in the economy vary considerably and show different trends. Again, stability of prices does not lead to stability of business conditions. Keeping in view the great stress laid by transactions and cash balance theorists upon the evil consequences of inflation and deflation, some tried to enquire into the relationship of the full employment objective with that of the objectives of price stability.

  1. Objectives of Full Employment and Economic Growth: The objective of price stabilisation is good but it is not always desirable. We happen to live in an age of welfare states and full employment policies. There was a time, when exchange and price stabilities were considered important objectives of monetary policy, but in recent years both price and exchange stabilities have been relegated to the background and full employment its attainment and maintenance—has assumed greater importance as the goal of monetary policy. It is argued now that achievement of full employment also results in price and exchange stabilities.

 

Advantages of Monetary Policy

  1. Monetary policy can bring out the possibility of more investments coming in and consumers spending more. In an expansionary monetary policy, where banks are lowering interest rates on loans and mortgages, more business owners would be encouraged to expand their ventures, as they would have more available funds to borrow with affordable interest rates. Plus, prices of commodities would also be lowered, so consumers will have more reasons to purchase more goods. As a result, businesses would gain more profit while consumers can afford basic commodities, services and even property.
  2. Monetary policy allows for the imposition of quantitative easing by the Central Bank. The Federal Reserve can make use of a monetary policy to create or print more money, allowing them to purchase government bonds from banks and resulting to increased monetary base and cash reserves in banks. This also means lower interest rates and, eventually, more money for financial institutions to lend its borrowers.
  3. Monetary policy can lead to lower rates of mortgage payments.As monetary policy would lower interest rates, it would also mean lower payments home owners would be required for the mortgage of their houses, leaving homeowners more money to spend on other important things. It would also mean that consumers will be able to settle their monthly payments regularly—a win-win situation for creditors, merchandisers and property investors as well!
  4. Monetary policy can promote low inflation rates.One of the biggest perks of monetary policy is that it can help promote stable prices, which are very helpful in ensuring inflation rates will stay low throughout the country and even the world. As inflation essentially makes an impact on the way we spend money and how much money is worth, a low inflation rate would allow us to make the best financial decisions in life without worrying about prices to drastically rise unexpectedly.
  5. Monetary policy promotes transparency and predictability.A monetary policy would oblige policymakers to make announcements that are believable to consumers and business owners in terms of the type of policy to be expected in the future.
  6. Monetary policy promotes political freedom.Since the central bank can operate separately from the government, this will allow them to make the best decisions based upon how the economy is performing doing at a certain point in time. Also, the banks would operate based on hard facts and data, rather than the wants and needs of certain individuals. Even the Federal Reserve can operate without being exposed to political influences.

 

Disadvantages of Monetary Policy

  1. Monetary policy does not guarantee economy recovery. Economists who criticize the Federal Reserve on imposing monetary policy argue that, during recessions, not all consumers would have the confidence to spend and take advantage of low interest rates, making it a disadvantage.
  2. Monetary policy is not that useful during global recessions.Proponents of expansionary monetary policy state that even if banks lower interest rates for consumers to spend more money during a global recession, the export sector would suffer. If this is the case, export losses would be more than what commercial organizations could earn from their sales.
  3. Monetary policy ability to cut interest rates is not a guarantee.Though a monetary policy is said to allow banks to enjoy lower interest rates from the Central Bank when they borrow money, some of them might have the funds, which means that there would be insufficient funds that people can borrow from them.
  4. Monetary policy can take time to be implemented.With things expected to be done immediately in these modern times, implementing a monetary can certainly take time, unlike other types of policies, such as a fiscal policy, that can help push more money into the economy faster. According to experts, changes that are made for a monetary policy might take years before they begin to take place and make changes felt, especially when it comes to inflation.
  5. Monetary policy could discourage businesses to expand.With this policy, interest rates can still increase, making businesses not willing to expand their operations, resulting to less production and eventually higher prices. While consumers would not be able to afford goods and services, it would take a long time for businesses to recover and even cause them to close up shop. Workers would then lose their jobs.

 

Monetary Policy during Depression

Depression is characterised by falling prices, incomes, output and employment. It is a period of low interest rates and unusually high liquidity preference. The objectives of monetary policy during depression are to offset the decline in velocity of money, to satisfy through additional money supply demands for precautionary and speculative motives; to strengthen the cash position of banks and non-bank groups (Ahmed &Suliman, 2011).

 

Monetary policy is oriented to stimulating lending for investment and consumption purposes bringing down the structure of interest rates with a view to encouraging investments. The cheap money policy is followed with a view to increasing aggregate demand, using excessive saving for development, stimulating the prices of securities to increase confidence in tire security market. Lowering of interest rate is easier than wage reduction: it also stimulates consumption by encouraging hire-purchase or installment buying.

 

It has been argued that monetary policy during depression has little scope, for it encounters practical difficulties. Policy makers find that rates of interest are already very low during depression and cannot be depressed further. Injections of cash and other liquid securities into the economy are absorbed by firms, banks and individuals in strengthening their liquidity position. They frustrate monetary policy by changing from risky and liquid assets to less risky and more liquid ones under the general wave of pessimism and business uncertainty.

 

In these circumstances, businessmen are scared away by the rapidly depleting profit margins. Even if the central bank is able to lower the rate of interest, the effect on investment may be negligible because the marginal efficiency of capital continues to be low. Businessmen borrow only when business is expanding. Merely low rates of interest cannot make unwilling and nervous borrowers to borrow. One can take a horse to water but cannot make it drink. Even if a lowering of interest rate encourages investment, there is a limit beyond which rate of interest cannot be lowered by increased money supply. Thus, monetary policy, if pursued during depression, is rendered ineffective (Ahmed &Suliman, 2011).

 

However, it would be a mistake to dispense with monetary policy as irrelevant for curing depression, for cheap credit policy does affect private investment and household demand for durable consumer goods. Monetary policy is a necessary adjunct to other measures for maintaining full employment.

 

INSTRUMENTS OF MONETARY POLICY

Fiduciary or paper money is issued by the Central Bank on the basis of computation of estimated demand for cash. Monetary policy guides the Central Bank’s supply of money in order to achieve the objectives of price stability (or low inflation rate), full employment, and growth in aggregate income. This is necessary because money is a medium of exchange and changes in its demand relative to supply, necessitate spending adjustments. To conduct monetary policy, some monetary variables which the Central Bank controls are adjusted-a monetary aggregate, an interest rate or the exchange rate-in order to affect the goals which it does not control. The instruments of monetary policy used by the Central Bank depend on the level of development of the economy, especially its financial sector. The commonly used instruments are discussed below (Central Bank of Nigeria, 2015).

  1. Reserve Requirement: The Central Bank may require Deposit Money Banks to hold a fraction (or a combination) of their deposit liabilities (reserves) as vault cash and or deposits with it. Fractional reserve limits the amount of loans banks can make to the domestic economy and thus limit the supply of money. The assumption is that Deposit Money Banks generally maintain a stable relationship between their reserve holdings and the amount of credit they extend to the public.
  2. Open Market Operations: The Central Bank buys or sells (on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and non-banking public (that is in the open market). One such security is Treasury Bills. When the Central Bank sells securities, it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of money.
  3. Lending by the Central Bank: The Central Bank sometimes provide credit to Deposit Money Banks, thus affecting the level of reserves and hence the monetary base.
  4. Interest Rate: The Central Bank lends to financially sound Deposit Money Banks at a most favourable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for the interest rate regime in the money market (the nominal anchor rate) and thereby affects the supply of credit, the supply of savings (which affects the supply of reserves and monetary aggregate) and the supply of investment (which affects full employment and GDP).
  5. Direct Credit Control: The Central Bank can direct Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available savings is allocated and investment directed in particular directions.
  6. Moral Suasion: The Central Bank issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system. It can, from this advantage, persuade banks to follow certain paths such as credit restraint or expansion, increased savings mobilization and promotion of exports through financial support, which otherwise they may not do, on the basis of their risk/return assessment.
  7. Prudential Guidelines: The Central Bank may in writing require the Deposit Money Banks to exercise particular care in their operations in order that specified outcomes are realized. Key elements of prudential guidelines remove some discretion from bank management and replace it with rules in decision making.
  8. Exchange Rate: The balance of payments can be in deficit or in surplus and each of these affect the monetary base, and hence the money supply in one direction or the other. By selling or buying foreign exchange, the Central Bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction, through the balance of payments and the real exchange rate. The real exchange rate when misaligned affects the current account balance because of its impact on external competitiveness. Moral suasion and prudential guidelines are direct supervision or qualitative instruments. The others are quantitative instruments because they have numerical benchmarks.

 

Conclusion

Based on reviews of literature and empirical studies, monetary policy is a very important policy that can be used to influence economic activity of a nation. Two policy instruments that central bank can use are money supply and interest rate. Since money is an important in all economic transactions; and interest rate is a tool that can be used to motivate investors, having control over them makes central bank, to some extent, have influence over economic decisions, which in turn affect economic output of a country.

 

This study is conducted in an attempt to examine if there is a significant effect of money supply and interest rate on economic growth of the nation covering period from 2000 to 2012. As a result, money supply is found to have a significantly positive relationship with GDP, while an increase or decrease in interest rate over the period have no effect on GDP of Cambodia.

 

 

REFERENCES

Ahmed, A., Elsheikh M., &Suliman Z.S. (2011). The Long-Run Relationship Between Money Supply, Real GDP, and Price Level: Empirical Evidence from Sudan. Journal of Business Studies Quarterly, (e-journal) 2(2).

CBN (2019) Statistical Bulletin Financial Sector Final eCopy

Hameed, I., & UME-Amen.(2011). Impact of Monetary Policy on Gross Domestic Product (GDP).Interdisciplinary Journal of Contemporary Research in Business [e-journal] 3(1).

Mankiw, N.G. (2010). Macroeconomics, 7th Ed. Worth Publishers.

MEF.(2008). Macroeconomic Management in Respond to the Global Financial. Ministry of Economy and Finance (MEF). [online] Pages 3-4. Available at: ttp://cdc-crdb.gov.kh/cdc/second_cdcf/download/mef_global_financial_crisis.zip%3e