From Raj Nallari and Breda Griffith's lecture notes on Economic Growth and Poverty Reduction.
As discussed in previous postings, poverty can be reduced by increasing economic growth and by increasing the share of this growth going to the poor. Economic growth can be fostered by a set of policies aimed at macroeconomic stability. By this we mean low budget deficits, a low and stable rate of inflation and sustainable external debt. Fiscal and monetary policies are of central importance to the rate of inflation in the economy. As we saw, one of the ways of financing a government deficit is to print money. Excessive money creation results in inflation and can lead in turn to macroeconomic instability. A second way of financing the deficit is to borrow from abroad, which adds to external debt, a third way is to run down foreign exchange reserves increasing the likelihood of an exchange rate crisis. This week we provide an introduction to monetary policy and the main instruments of monetary policy. In upcoming weeks we will continue with a description of inflation, its causes and its impact on economic growth and on poverty. Finally, we will focus on exchange rate policies and on fixed versus flexible exchange rates.
Monetary policy may be loosely defined as the Central Bank’s decisions on money supply and inflation and exchange rate objectives.
Demand for Money Curve
Monetary policy works through changes in the money supply and interest rates. For example, in the face of a recession and high unemployment, the central bank may choose to use expansionary monetary policy to stimulate demand. In such a case, the central bank would expand the money supply (M), and bring down interest rates. We can think of the interest rate as the price of money. If the supply of money increases relative to the demand, the price (interest rate) falls. The lower interest rates mean that it is cheaper to borrow money which stimulates business investment. As businesses invest more, they hire more workers, increasing employment. There are now more workers with a paycheck and their spending creates an increase in aggregate demand for goods and services. Lower interest rates also stimulate additional consumer spending directly. Businesses respond to the increased AD for their products by increasing investment and employment. This creates more AD and so on.
Two types of monetary instruments exist:
Direct instruments of control include (1) credit ceilings on individual banks, (2) control of interest rates, and (3) use of discriminatory capital/asset ratios. While these instruments have fallen out of favor in industrialized countries, most developing countries use these instruments.
Once the overall credit ceiling is in place, individual ceilings are then established for each major financial institution based on past market shares. Direct controls are reasonably effective in preventing excessive credit expansion in the short term but lose their effectiveness over time. They tend to reduce competition among banks – once a bank reaches its credit ceiling, it has no incentive to continue to attract additional deposits. Banks may concentrate on their established clients and be unwilling to finance new projects that may turn out to be more profitable. Thus the flow of capital in the economy is restricted. Furthermore, when credit is disbursed based on administrative criteria rather than profitability, corruption tends to increase. Disaffected depositors and borrowers create incentives for financial intermediation outside the control of the Central Bank. Thus there is a loss of monetary control as credit operations are conducted outside of the banking system.
Interest rate controls are often introduced along with credit ceilings. Over time, these may be ineffective as it is generally not possible to control both the cost and quantity of credit. Fees may be imposed thus raising the cost of credit and defeating the original purpose. Moreover, imposing excessive fees and/or imposing other restrictions on loans reduce the transparency of the price system in providing the correct signals for the allocation of resources.
A minimum capital/asset ratio is often used by the central bank to force branches of foreign-owned banks to increase their capital.
Indirect instruments include (1) reserve requirements, (2) Central Bank lending facilities, (3) open market operations and (4) deposit management.
Reserve requirements, which are held in the form of cash in banks’ vaults and deposits with the central bank, affect the demand for reserve or base money and, working through the money multiplier, assist in controlling the broader money supply and credit conditions. An increase in reserve requirements typically raises banking system costs (as interest rates paid to banks for reserve holdings are typically less than rates banks pay to depositors), which tend to be passed on in the form of higher interest rates on loans. However, frequent changes in reserve requirements can confuse market participants and lead to excess holdings of reserves. This can in turn hamper the effectiveness of monetary policy.
The Central Bank’s lending facilities should only provide short term or emergency financing to the banking system. By expanding or restricting access to the central bank credit and refinancing/rediscounting facilities, credit expansion in the economy is influenced. But in some of the developing countries, political pressures have led to the use of this instrument to extend credit to commercial banks with inadequate reserves (such as state-owned banks) or to provide support to troubled financial firms. Reduction in access to central bank rediscount facilities and credit is very effective as it curtails credit to the private sector through the banking system. The discount rate – the interest rate that a bank must pay the central bank when it borrows money from it - is generally high to discourage borrowing by the commercial banks which could offset the impact of open market operations. The central bank also operates as lender of last resort in emergency circumstances. In doing so, it will generally provide credit at high interest rates and only when borrowing banks are in a position to supply high-quality collateral. This encourages banks to first seek to raise funds from the public or the interbank market.
- Open market operations refer to the Central Bank’s buying and selling (or borrowing and lending) of securities to inject or withdraw liquidity respectively into the system. There are a number of advantages to developing open market operations, including the development of a money market, and the flexibility it lends to the central bank in conducting its monetary policies.
- The Central Bank is generally the government’s bank, managing government deposits. Transferring government deposits between the banks and the central bank affects the level of reserves. While performing an essential ‘fiscal agent’ role for the government, viewed from a narrower monetary policy angle, it is not the most transparent instrument of monetary control and a key disadvantage is that it does nothing to encourage market development and competition.
Next week: Inflation