Topic 5

Monetary Policy:
Purpose: To introduce the learner to monetary policy and the instruments of monetary
policy
Specific Objectives;
By the end of the lesson the learner should be able to:
(i) Define monetary policy
(ii) Explain the objectives of monetary policy
(iii) Describe instruments of monetary policy
(iv) Describe factors influencing the effectiveness of monetary policy

Introduction;
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 a n d improved balance of p a y m e n t s . Monetary policy works t h r o u g h t h e
intermediary of monetary policy instruments such as t h e bank rate, open m a r k e t
operations (OMO), variable reserve requirements (cash and liquidity ratios), funding,
marginal requirement, selective c r e d i t 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 trigger’s 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.
These effects of money plus others that relates to savings and expenditure demands good
management of money. Hence prudent monetary policies must be adopted. The aims of
monetary policy are the same as those of economic policy. These aims or objectives

1
depend on economic environment i.e., what role does country want money to serve and
what economic problem needs to be addressed.
Objectives of Monetary Policy:
1) Exchange rate stability
2) Price stability
3) Ensure the mopping out of excess liquidity
4) Ensure neutrality of money.
5) Ensure control of business cycles
6) Full employment
7) Ensure B.O.P. equilibrium
E c o n o m i c growth.

Exchange Rate
Stability
Monetary policy is aimed at curbing foreign exchange fluctuations. Fluctuations in forex
is easily noticed and given wider publicity than fluctuation 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 fluctuating
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.
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’s difficult to prevent it turning into a galloping
or run-away inflation (super inflation). On the other hand, falling prices favors 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

2
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 employers and workers. It’s
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.
Mopping up excess Liquidity
The overall liquidity position includes not only cash and stock in trade but also potential
credit from banks and other sources of money. Monetary policy should aim not so much
at the regulation of the supply of money but at the control of the general liquidity position
of business in the economy. Both bank and non-banks financial institutions create
financial claims and engage in multiple creation of credit and multiple increases in the
respective demand liabilities. There is need to control this creation of credit especially by
non-financial institutions.
Ensure Neutrality of Money
Money is only a medium of exchange and its role is purely passive i.e., to facilitate
exchange. In its absence barter trade should establish the ratio of exchange or value. The
relative values as established under barter should not be distorted by money. Money
should reflect these relative values and not distort them. Money supply should be so
managed as to make sure the same ratio of exchange is involved as it would be under
barter. In this case money supply should be inelastic in case of a full employment but in
case of underemployment, money supply should be flexible or elastic. Money supply
should be stabilized to ensure that prices are not distorting economic activities. Prices
should therefore reflect the real ratio of exchange. Under normal circumstances if money
was to become neutral then it must be isolated from the price level. Fluctuations in the
relative prices will register only in changes in demand and supply of good and services
and the resulting allocation of resources would then truly confirm to the communities
wants. It is the non- neutral monetary policy that distorts the price levels. Non-neutral
monetary policy has been criticized on the ground that it assumes a static economy. But
again, neutrality of money has been utilized on their liability to correct economic

3
fluctuations.

Ensure control of Business Cycles:

One important objective of monetary policy is to moderate the periodical cynical in the
economic activities. In most cases, monetary policy control is effective in controlling a
boom but not a depression which call for a fiscal policy. Monetary control has to be
wisely used so as not to hurt the production.
Full Employment

Full employment, job for all those willing to work at the current rate of wages. It does not
mean job for all, all the time for the entirely labor force. Every state strives to achieve
full employment. Keynes emphasized the role of monetary policy in raising national
income and employment and equilibrium in the job market is reached at the level of full
employment where job seekers get jobs at the current rate of wages. Hence monetary
policy should aim at achieving the equilibrium between saving and investment at a
level of full employment. If interest rates are pushed beyond the full employment output
and real income does not increase, then inflationary pressures will develop.
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.
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
4
 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.

Monetary Policy Instruments:

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
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
Open Market Operations:

Addition to setting the terms on which it’s 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 their total lending by a multiple of the increase in
their liquid assets.

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.
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.
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.

6
Consumer Selective Credit Control:

According to this method the Central Bank encourages/discourages the purchase of

commodities on installment basis. This is to ensure that during inflation less purchase on credit
is done so as to discourage demand for money. During deflation the minimum cash
payment is increased and the number of installments reduced.

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.
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 honour 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 going to be
expensive servicing such long term debts in future, in terms of high interest rates.

Factors Influencing the Effective 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.

7
 There is no direct relationship between the Central Bank and the other components of the
money market hence the market interest rate rarely responds to the bank rate.

The Central Bank has no control on the money lenders (black market) and other financial
intermediaries such as merry go round, co-operatives 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

Review Questions;

1. Discuss some of the consequential economic impacts of high and rising rate if interests
2. Discuss the main limitations of applying credit control instruments in developing
economy
3. Briefly explain the likely effects of an expansionary monetary policy in an economy
4. Inflation is harmful to any economy. However, a little of it could be beneficial. Discuss
5. Explain three monetary policy instruments used to control and regulate money supply in an
economy
6. Explain the factors that limit the effective use of monetary policy in developing
countries

References:

Frederic s. Mishkin (2001), the economics of money, banking, financial markets, sixth edition.

Keynes, J. M. 1936, The General Theory of Employment, Interest, and Money, Macmillan

Friedman, M. ed.1956. Studies in the Quantity Theory of Money, The University of Chicago
Press.