Monetary policy

Monetary policy refers to the manipulation of money supply, liquidity and interest rates in the economy in order to achieve increased employment, economic growth, reduced inflation and improved balance of payments. Monetary policy works through the intermediary of monetary policy instruments such as the bank rate, open market operations (OMO), variable reserve requirements (cash and liquidity ratios), funding, marginal requirement, selective credit control and moral persuasion. It means the management of money supply in furtherance of the economic policies of the state. It also implies those measures which are adopted by the central bank to control money supply. When it relates to objectives, monetary policy means defining the objectives of a sound money management and the measures adopted in its pursuance. Money plays a dynamic role through its influence on the price level e.g. a lot of money in the economy coupled with less commodities triggers inflation. Inflation is known to impoverish those with fixed money income. On the other hand deflation is known to enrich the poor at the expense of investors. A change in price level means an opposite change in the purchasing power of money. It causes unmerited transfer of real wealth from one section to another. It also affects production as well as the distribution pattern.

The following are the major objectives of monetary policy:

  • Exchange rate stability
  • Price stability
  • Full employment
  • Ensure B.O.P. equilibrium
  • Economic growth.

5.1 Exchange Rate Stability

Monetary policy is aimed at curbing foreign exchange fluctuation. Fluctuation in forex are easily noticed and given wider publicity than fluctuation in the domestic price level. A major reason is that it encourages speculation in forex which adversely affect foreign trade. Small countries depending too much on foreign trade cannot afford erratic movements in exchange rates, which introduces lack of confidence and encourage capital flight (capital and other investment leaving the economy). On the other hand speculators thrive on to making a „fast back_ (quick gain) which distorts foreign exchange. Foreign exchange stability is particularly important for countries depending on foreign capital. A stable exchange stabilizes international relationships. It also smoothens international trade and international lending though at the expense of domestic price stability.

5.1.1 Price Stability
A gentle rising price level acts as a stimulus for productive enterprises. It increases profit margins, induces new investments and takes the economy nearer to full employment. It gradually reduces the debt burden but it is difficult to prevent it turning into a galloping or run away inflation_ (super inflation). On the other hand falling prices favour consumers compared producers and may lead to unemployment. This has a fiscal implication in the way that it will affect tax yield. A stable price level should steer off both inflation and deflation. A stable price level is required to maintain the equity of long term contracts and hold the balance between creditors and debtors and between employees and workers. It is worthy to note that the price level is a composite of different prices and can only be inferred from the index number. The price changes are only a symptom of mal-adjustment between money supply and supply of goods. But it is difficult to tell which requires adjustment i.e. money supply or the supply of goods. Thus stabilizing the price
level is not easy.

5.1.2 Balance of Payment Equilibrium
Balance of payment is one component that tends to affect any economic performance. The traditional objective of monetary policy has been to establish a balance in the foreign payment position and this is done through manipulating bank rates. In the short run, a country facing an adverse balance of payments may raise bank rates. This will raise all other short run interest rates in the money market. This will arrest an outflow of foreign exchange reserves. It will also induce an inflow of funds from abroad as investor will be
induced to invest in high interest earning assets. It will introduce more money supply. The raise in the interest rate would also encourage saving reduce spending and cause prices to fall. This would encourage export and restrict imports hence restoring the balance of payment equilibrium.

5.1.3 Economic Growth and Stability
Monetary policy should also induce economic growth and price stability. This can be done through authorization of banks to issue short-term credit to certain areas of the economy. Example includes agriculture, informal commercial/service industry. Thus short term credit sometimes make-up for the shortage of funds hence ensuring that the affected sector grow with stability. Commercial banks which are controlled by the Central Bank expand credit when economic activity is contracting. In this case the Central Bank has to set up policies that ensure commercial banks lends to the needy sectors of the economy. Again the monetary policy must ensure that money supply that comes through credit does not affect production through increase in prices. In this case monetary policy must tame money supply to ensure all sectors of the economy grow with stability.

5.2 Instruments of Monetary Policy

Monetary policy instruments mean those measures that are adapted to achieve the objectives of monetary policy. The objective of monetary policy instrument is credit control. The instrument used to control credit by the

Central Bank includes:-
1. Bank rate policy.
2. Open market operation
3. Reserve requirement
4. Credit rationing
5. Margin requirement
6. Consumer selective credit control.
7. Direct action, moral persuasion and publicity qualitative.
8. Funding

5.2.1 Bank Rate Policy
This is the rate at which Central bank advances loans to commercial banks. During inflation the bank rate is raised and in view of this commercial banks also raise their rate of interest. This discourages borrowing as the cost of borrowing is raised. It also decreases the supply of money which was to be in circulation. During deflation, bank rate is reduced since commercial banks also lower the rate at which it advances loans to the borrowers. This in turn increases the supply of money in circulation.

5.2.2 Open Market Operations
Addition to setting the terms on which it is prepared to lend, the Central Bank can act directly on the supply of financial assets in the banking system by means of its activities in the market for securities. If banks have a surplus of liquid assets a reduction of their deposit at the Central Bank might still leave them with adequate total supply of liquid assets. And they will not be obliged to reduce their total deposits. When the Central Bank wishes to see an expansion of bank lending, it will enter the market and buy securities
(Treasury bills and bonds) making payment for them with cheques drawn on itself. The seller of these securities pays the Central Bank cheques into account at the commercial bank. The bank now holds claims on the Central Bank which will settle its indebtedness by crediting the outstanding amount to the bankers_ deposits. An increase in the banker deposit at the CB amounts to an increase in the liquid asset ratio. The bank will be able to expand there total lending by a multiple of the increase in their liquid assets.

5.2.3 Reserve Requirement
All commercial banks are required to keep a specific part of their money as part of a reserve with the Central Bank. During inflation reserve requirements is increased and due to that money at the disposal of commercial bank decreases. During deflation reserve requirement is reduced thus money at the disposal of commercial banks increases.

5.2.4 Rationing Credit
All commercial banks can loan from Central Bank up to a specific limit. During inflation this limit is decreased so as to reduce the amount of money in circulation. During deflation this limit is increased so as to increase the amount of the circulation.

5.2.5 Margin Requirement
When loan is obtained from a commercial bank a specific security is offered to the commercial bank. The difference between the value of the security and the amount advanced is known as the margin requirement. During inflation margin requirement is raised by the Central Bank to deter borrowers from getting big loans hence reducing demand for money. During deflation the margin requirement is reduced to attract borrowers to demand for more money.

5.2.6 Consumer Selective Credit Control
According to this method the Central Bank encourages/discourages the purchase of commodities on instalment basis. This is to ensure that during inflation less purchase on credit is done so as to discourage demand for money. During inflation the minimum cash payment is increased and the number of instalments reduced.

5.2.7 Direct Action, Moral Persuasion and Publicity
The Central Bank can also issue orders to commercial banks to advance more or less loans and this is known as direct action. Sometimes it can request the commercial banks to behave in a specific way in the interest of the country; this is known as moral persuasion. Through publication of some reports by the Central Bank on monthly or quarterly basis, commercial bank can change
their policies according to these reports. This is known as publicity.

5.2.8 Funding
This is the conversion of short term debt agreements into long term. The government could be having budget deficits which it wants to control at manageable levels, and feels that it cannot afford to honor its short term repayment obligation. As they fall due. Moreover, this decision also has an effect of reducing the present money supply level although it is expensive servicing such long term debts in future, in terms of high interest rates.

5.3 Factors Influencing the Effects of Monetary Policy in

Developing Countries
The bank rate assumes the existence of a well knit and closely integrated money market. Such a market does not exist in the developing countries. Most commercial banks are foreign owned and they are virtually independent of the Central Bank. They have liquid resources of their owner and do not have to rely on rediscounting (get assistance from Central Bank). The bank rate
assumes an indirect relationship between interest and investment. However reality has shown that businessmen will borrow even at high interest rates.

Interest is only a minor element in the composition of the cost structure. Investment is thus insensitively related to the rate of interest.
There is no direct relationship between the Central Bank and the other components of the money market hence the market interest rate rarely respond to the bank rate. The Central Bank has no control on the money lenders (black market) and other financial intermediaries such as merry- goround, cooperatives etc. Sometimes owing to the risk involved there may be either a lack of borrowers or lack borrowers who are creditworthy applicants and require credit for purposes which are acceptable to the bank under the
prevailing circumstances. Most developing countries Central Banks are directly influenced by politicians and sometimes the monetary policy can be dictated by these very politicians

5.4 Fiscal policy

Fiscal policy is the management of public finance by the government so as to influence the economy in the desired direction. It is the conduct by the government of its financial operations in the pursuit of economic stabilization. The government must frame its taxation, expenditure and public debt policy so as to secure economic stability with growth.

5.4.1 Comparison between Fiscal Policy and Monetary Policy
Both aim at regulating the level of aggregate demand for domestic goods and services or the output of the economy. Fiscal policy is formulated and enforced by the government directly. While monetary policy is formulated and enforced by the Central Bank. However, there is nowhere in the world where the Central Bank is thoroughly independent of the government. It functions under the governor, in Kenya under the Ministry of Finance.

Fiscal policy is government revenue, expenditure and debt management with a view to have a direct impact on the economy i.e. so as to manage the allocation of resources and the flow of funds in order to affect the level of income, prices, employment and output. Monetary policy on the other hand is government policy in relation to money supply to achieve the same policies as
those of taxation.

5.4.2 Origin of Fiscal Policy
Until the great depression of 1930, monetary policy had been the main instrument of economic stabilization. The great depression saw the failure of free enterprise economy. During this period, under monetary policy economies failed completely. The prices went down men and machines were thrown out of work. Demand contracted and workers had no purchasing power to buy goods and services.

Investment failed to peak up even a 1% rate of interest failed to attract the demand for investment. Capital and the capitalist system collapsed suggesting monetary policy could no longer click. It was against this background of universal despair that Keynes in his general theory (1936) gave an insight into the determinants of national income and the role of government in making capitalist economies to work. Keynes key assumptions are:

1. A mature economy does not necessary attain equilibrium at a level of full employment.

2. A reduction in wage rate is no cure to depression. It will only further depress the demand for goods and services.

3. The state must accept responsibility through public expenditure on autonomous investment, a public work program to maintain a high stable level of effective demand. Keynes emphasized the role of government in the economy. According to him capitalism could work only with government help, government guidance and government control. This is the origin of fiscal policy i.e. collecting revenue, spending money and managing its debt as an instrument of economic stabilization.

5.4.3 Objectives of Fiscal Policy
The objectives of fiscal policy are the same as monetary policy objectives these are

  1. Stabilization of the economy
  2. Price stability
  3. Economic growth
  4. Full employment
  5. Redistribution of income and wealth
  6. Equilibrium in balance of payments

1. Stabilization of the Economy
Fiscal policy aims at stabilizing the economy during period of disturbances. In a boom, a period characterized with rising prices it seeks to siphon off the excess liquidity in the economy through increased taxation, borrowing and reducing public expenditure. In a depression when private investment is low and people have no money to spend on goods and services, the government undertakes public investment to make-up for the shortfall in consumption expenditure and private investment expenditure. This sustains aggregate demand. Fiscal policy irons out these fluctuations and put the economy back on track through tax holidays, subsidies and the provision of infrastructural facilities. Through these actions the government seeks to increase production.

2. Price Stability
The government seeks to maintain a reasonably stable general price levels. Prices must be such as to be within the interest of the consumer and at the same cover cost and yield a reasonable margin of profit.

3. Economic Growth
Prices act as resource allocating mechanism. They allocate resources among different lines of production. The economy must grow through price changes.
The price must cater for the growing needs of a growing population. It must ensure that Gross National Product (GNP) is growing faster than population.

4. Full Employment
This is a primary goal of any economic policy. But how full is full employment? And what is the trade off between fall employment and
inflation? At 3% unemployment is considered consistence with full employment. While any figure above 5% is deemed adverse and calls for corrective measures. Keynes gives high priority for full employment. He advocates for substantial public expenditure and private investment expenditure. According to him only the state can undertake autonomous investment on large scale even if it entails deficit spending where government prints more money. State expenditure on public works generates more

5. Redistribution of Income and Wealth
Progressive taxation tends to reduce wealth inequalities and it is used to finance transfer payment and social security benefits.

6. Equilibrium in Balance of Payments
An adverse balance of payments comes about through excess of import over exports i.e. where a country’s international debts exceed its credits. Imports can be reduced through import tariff and export increased through various export promotion schemes including subsidies, value addition etc.

5.4.4 Fiscal Policy Instruments
The fundamental objects of the fiscal policy are to find revenue for the government to finance its growing expenditure. Fiscal policy seeks to achieve its objectives through 3 major ways.

  • Taxation
  • Public expenditure
  • Public debt management.

Taxation implies the charges or levies imposed on the agents of production, (labour, capital, entrepreneur, land). Taxation is normally tuned to the state of the economy. Taxation affects consumption and production. During times of depression the taxable capacity is low and in such a period there should be a reduction in taxes so as to sustain at least minimum levels of consumption and investment.

Indirect taxes should be cut to stimulate consumption demand. During times of inflation, taxes should be raised to siphon of the increased liquidity in the economy. Given that taxes reduce, the disposable income in the hands of the public, it then implies that demand will be decelerated. The manipulation of tax rate is an effective and cyclical device.

Implying tax rates can be manipulated either to give incentive to production or give des-incentive to consumption. A deflation requires an expansionary tax policy. The deficient aggregate demand and recession calls for a cut in tax rates in order to stimulate consumption spending. This in itself will increase investment and employment. Investment spending may also be stimulated by reduction in corporate income tax, tax holiday, depreciation allowance, tax credits in purchases of capital good etc. tax changes are therefore stabilization device.

Public Expenditure
Public expenditure is the opposite of taxation. It implies government spending tax revenues to achieve fiscal policy objectives. Both consumption expenditure and private investment tends to go down during periods of deflation. A time like this, public expenditure is necessary for it has a stabilizing effect. One major effect is through government multiplier, which affects income and employment positively. During inflation government expenditure should be reduced and the government should budget for a surplus and set in motion the reverse multiplier. Taxation should be increased to mop up the surplus liquidity in the economy and at the same time government should go slow on its public work programs and spent less non urgent items.

Debt Management
It implies the ways in which the government tries to ensure that indebtedness is either cleared or prudently managed. When government spending cannot be covered by taxation and other sources like income from public property and public undertakings government has to borrow. Borrowing if productivity invested increases output, income and employment and it has an expansionary effect on the economy. The economy can achieve more credit feedback effect on all the sectors of the economy. Borrowing takes many forms but it depends on the cost and the convenience of borrowing by the government. For instance borrowing through bonds has several advantages:

  • It is absolutely safe.
  • Its one form of public participation in economic development.
  • There is ready market for bonds and they are easily marketable.
  • They can be held as transition income pending disposal at an opportune time (moment)
    The demand for government bonds depends on the credit standing of the government and on an attractive rate of interest.

4. External Borrowing
A wise public debt management with proper timing and choice of the most appropriate type of debt and mode of repayment can reduce the budgetary cost of servicing the debt and promote economic growth. Without a public policy, there is likely to be a deep deflation with falling prices, falling profits and liquidation of firms and mass unemployment. Public debt management enables the Central Bank to undertake open market operations in pursuance of its credit control policy.

5. Deficit Financing
Means government expenditure in excess of taxation and non bank borrowing i.e. borrowing from the public. Public expenditure is financed by taxation, non bank borrowing and deficit financing. Taxation and non bank borrowing are financed out of genuine saving and they do not add to money supply or community purchasing power. Budget deficit is covered either by drawing down the cash balance or borrowing from the Central Bank which creates new money. This new money is inflationary because it is not matched by increased production. Deficit financing or deficit spending is different from a deficit without spending. Government may reduce taxation without any increase in expenditure thus creating a budget deficit. The reduction of taxation increases the disposable income of the public and raises the level of consumption and employment. Deficit is financed also by new money which is matched by
increased productivity and does not therefore raise the price level. This is a situation where Central Bank prints more to finance a deficit on condition that the economy is stable.

5.4.5 Limitations of Fiscal Policy

  1. Even with correct forecasting of the course of the business cycle, the fiscal policy is rendered difficult by the uncertain incident of different taxes and government spending.
  2. Timing lags pose a real problem. The time lag may not only reduce the effectiveness of fiscal policy but even create distortion not desired. Uncertainty surrounding the time lag between the initiation of fiscal measure and their full impact on output, income and employment may have an adverse effect on fiscal policy.
  3. Other things may rarely be equal. Public investment may compete with private investments for resources which may possibly lead to decline in private investment which may cancel or modify the impact of the public investment. It is difficult to define accurately the size of fiscal action that will not affect private investment.
  4. Fiscal policy cannot overcome business psychology. It is particularly ineffective in the face of hyper inflation when speculation takes over. Even a high rate of taxation can not restrain the temptation to make a fast buck (abnormal profits) e.g. among the monopolists.
  5. The theory of fiscal policy assumes that public expenditure has a multiplier effect. All expenditures do not have the same multiplier effect. Public investment expenditure has a large multiplier effect than transfer payment which give right only to consumption expenditure whereas public investment expenditure creates additional demand for capital goods as well as additional demand for labour employed in the capital good industry.

5.4.6 Coordination of Monetary and Fiscal Policies

These are two interrelated policies. Monetary policy has fiscal implication and fiscal policy has monetary implications. Monetary policy provides stability in the long run leaving the fiscal policy to provide the built-in stabilizers to iron– out short run fluctuations. Monetary policy provides the financial infrastructure while fiscal policy through its instrument of taxation borrowing and deficit spending has an impact on money supply and liquidity in the economy. Monetary and fiscal policies are interdependent and mutually
reinforce each other. Fiscal policy owes, much of its success its coordination with monetary policy e.g. a large public borrowing program depends for its success the Central Bank rate and open market operations (OMO) designed to stabilize the price of the securities in the money market. A cheap money supply will reduce the rate of interests and facilitate government borrowing.

Each must reinforce the other in the interest of growth with stability. Monetary and fiscal policies have to be integrated. Monetary policy is more flexible and can be adjusted to changing needs. Monetary policy is a weapon against inflation while fiscal policy is a weapon against deflation. Each has its point of strength and points of weaknesses. They have to be suitably combined to meet economic needs as they are complimentary.

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