Monetary policy and its effectiveness

tools of Monetary policy and its effectiveness. The central bank

1. Money & Banking Professor Mahmoud Touny Chapter 6 Monetary Policy and its Effectiveness

2. Introduction: Monetary policy can be defined as “the set of actions taken by the monetary authorities (the central bank) to adjust the money supply in proportion to the desired level of economic activity in order to achieve a set of economic objectives.” The central bank uses a set of tools to implement the monetary policy, some of which are quantitative, and some are qualitative, in addition to the direct tools.

3. Goals of the monetary policy: Monetary policy aims to achieve several goals: - Stabilization in the general level of prices. - Achieving full employment. - Achieving high growth rates. - Strengthening stability in financial markets. - Stabilization of the interest rate. - Achieving exchange rate stability .

4. Tools of Monetary Policy: First: Quantitative Tools The quantitative tools of monetary policy are those that seek to influence the volume and cost of credit. These tools are called the traditional tools, which include the required reserve ratio, the rediscount rate in addition to the open market operations.

5. a ) The Required Reserve Ratio: The required reserve ratio is the percentage that the central bank imposes on the commercial bank to keep from its deposits with the central bank as an interest-free deposit. This ratio is determined according to the prevailing conditions in the economy. The objective of the required reserve ratio is to use it as a tool to control the amount of credit granted by commercial banks and thus control the money supply.

6. In times of recession and economic depression, the central bank reduces the required reserve ratio, which leads to an increase in the excess reserves available with commercial banks. This in return increases the ability of commercial banks to grant credit through the work of the money multiplier. This will lead to an increase in the purchasing power in the national economy. This policy is called expansionary monetary policy.

7. In the case of inflationary waves, the central bank increases the required reserve ratio. This will result in a decrease in the amount of money that can be directed to credit. Consequently, a decrease in the money supply and a decrease in the purchasing power. Also, a decrease in the volume of investment, and thus a decrease in the aggregate demand. This policy is called contractionary monetary policy.

8. b) The rediscount rate: The rediscount rate is the interest rate that the central bank receives from rediscount of commercial paper offered by commercial banks or the cost of borrowing from the central bank. Commercial banks usually re-discount the commercial papers they have with the central bank or borrow from the central bank in order to enhance their cash reserves.

9. If the economy suffers from inflationary waves, the central bank can raise the re-discount rate. This discourages the commercial banks from re-discount their commercial papers and then reducing the volume of funds allocated for lending by commercial banks. As a result and due to the money multiplier, this leads to a decrease in the money supply. Also, raising the re-discount rate leads to the commercial banks, in turn, raising their discount rate for commercial papers, as well as raising the interest rate on their granted loans which will reduce their demand for loans, and the money supply decreases.

10. However, if the objective of monetary policy is to expand the money supply in order to address a recession, the central bank resorts to reducing the re-discount rate. This encourages commercial banks to re-discount their commercial papers or increase the demand for commercial banks to borrow from the central bank. This results in an increase in the excess reserves of the commercial bank and thus increases the ability of banks to grant credit and thus increase the money supply. Also, the reduction of the rediscount rate results in a decrease in the interest rate on loans, which leads to an increase in the volume of investment, thus increasing aggregate demand.

11. c) Open Market Operations: Open market operations mean that the central bank sells or buys securities, especially government securities, to influence the money supply. In cases of recession, the central bank buys government securities and bonds from the market. This results in an increase in the volume of liquidity in the market and thus an increase in the purchasing power of individuals and an increase in the volume of excess reserves at commercial banks that leads to an increase in the money supply.

12. An increase in the money supply leads to an increase in the purchasing power in the market, which leads to an increase in aggregate demand. On the other hand, an increase in the money supply leads to a decrease in the interest rate, which leads to an increase in investment, employment, and income. In the case of inflation, the central bank adopts a contractionary monetary policy by entering the financial market as a seller of government securities and bonds to absorb excess liquidity in the market.

13. This results in a decrease in the purchasing power of the national economy and a decrease in the excess reserves of commercial banks, and then a decrease in their ability to grant credit, which in turn leads to a decrease in the money supply through the monetary multiplier. A decrease in the money supply will also affect the interest rate in the market, so the interest rate will rise, which will negatively affect investment, employment, and income. As a result, the aggregate demand will decrease, which will result in a decrease in the inflation rate.

14. The effectiveness of the quantitative tools: For the rediscount rate: The effectiveness of the rediscount rate depends on several factors which are: The extent of the expansion of the discount market which requires large transactions in commercial bills. Modern commercial transactions have become less dependent on the use of commercial bills. This resulted in a decrease in the effectiveness of this policy.

15. During a recession, commercial banks usually have excess reserves. Therefore, reducing the rediscount rate, in this case, will not lead to an increase in commercial banks' demand for rediscounting their commercial papers. In boom periods, the central bank resorts to raising the re-discount rate. However, this policy may be ineffective due to the investors' desire to finance their investments through borrowing. Therefore, they accept borrowing despite the high-interest rates on loans, which encourages commercial banks to re-discount their commercial papers due to their need to increase the volume of their reserves.

16. For open market operations: The success of open market operations depends on the existence of sufficient securities in the market to the extent that the entry of the central bank into the market as a seller or buyer of securities effectively affects the money supply. Using this tool requires the availability of a wide, organized, and active financial market, which is not available in many developing countries which suffer from the lack of widespread use of securities and treasury bills.

17. For the required reserve ratio: Changing the required reserve ratio is considered the most effective and least expensive tool of the monetary policy, especially in developing countries. However, the effectiveness of the required reserve ratio differs in cases of boom and inflation from cases of recession and depression. In times of inflation, this tool is considered one of the successful policies as the commercial banks do not find a way to respond to the central bank’s instructions to raise the required reserve except by reducing loans and investments and thus reducing the volume of deposits.

18. In times of recession, lowering the required reserve ratio is not very effective in encouraging loan demand due to the low demand for loans during the recession period. Therefore, this policy must be accompanied by other measures to increase the demand for loans. Also, the effectiveness of the required reserve ratio depends on the size of the excess reserves held by commercial banks. Keeping large excess reserves by commercial banks limits the effectiveness of changing the required reserve ratio in affecting the money supply.

19. Increasing the effectiveness of quantitative tools may require the use of a combination of these tools together to achieve the desired goal. For example, when the central bank resorts to entering the financial market as a seller of government securities in order to absorb excess liquidity, this may require the central bank to raise the rediscount rate so that commercial banks do not finance the purchase of government securities by rediscounting the commercial papers it has. Also, the success of monetary policy requires coordination with fiscal policymakers in order to stimulate growth and increase the level of employment without leading to higher inflation rates.

20. Second: Qualitative tools Qualitative monetary policy tools are those tools that the central bank uses to influence the direction of credit and not its total volume. These tools are widely used in developing countries due to the poor effectiveness of the quantitative tools. These tools are many, but we can summarize them in two groups: the loan framing policy and the loan selective policy .

21. a) Loan Framing Policy: The loan framing policy means that the central bank imposes a higher credit ceiling that no bank can exceed, in order to limit the ability of banks to grant credit. The central bank uses this policy in times of inflation to determine the maximum amount of loans that the commercial bank can grant. This of course contributes to a decrease in the money supply. This policy can also direct credit so that priority is given to the sectors that were not the cause of inflation, and credit is restricted to the sectors that were the cause of inflation.

22. In general, the loan framing policy did not achieve the target goal in the countries that implemented it due to several factors: The desire of monetary authorities in many cases not to impose a significant restriction on the finance of the economy. This policy represents a selective treatment, and its use may lead to sectoral distortions. Some institutions may resort to borrowing among themselves or issuing debt bonds to overcome these restrictions.

23. b) Selective Loan Policy: These selective measures are intended to facilitate access to special types of loans or sometimes to control their distribution. These loans usually aim to influence the direction of the loans towards the areas to be stimulated. This policy takes several practices such as: bears part of the cost (interest rate) of loans directed to some activities such as activities related to export or agriculture. Re-discounting the commercial papers of some loans, such as export loans with the normal rediscount rate in order to encourage these activities.

24. Using differential interest rates to influence the volume of loans directed to the targeted sectors. Placing restrictions on consumer credit in order to restrict aggregate demand to curb inflation. In general, the central bank resorts to using these qualitative tools to avoid the systemic and undesirable effects that result from the use of quantitative tools that do not distinguish between sectors.

25. Third: Other tools of monetary policy (Direct tools): The success of quantitative and qualitative tools in achieving their goals depends on the response of individuals and banking institutions to these procedures. These tools may also not be sufficient or ineffective in many cases in achieving the desired effect. As a result, the central bank resorts to other direct means and procedures, and this is called direct supervision.

26. Moral persuasion: Moral persuasion is the case where the central bank resorts to the method of dialogue with the management of commercial banks in order to convince them of the objectives of monetary policy and the measures that commercial banks must take in order to achieve these goals. However, experience indicates the limitations of this method in achieving its objective, especially in the case of developing countries.

27. Direct instructions: The central bank resorts to using other means such as compulsory instructions and orders that commercial banks must follow. Commercial banks must submit periodic reports on the loans granted according to the directions of the central bank. Based on these reports, the central bank can issue warnings to banks that do not implement these instructions, and it may reach the point of taking penalties against them. In general, the method of direct control of credit is more useful for treating inflation than cases of recession, because forcing banks to limit the expansion of loans is more possible than compelling them to increase loans.

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