WHAT IS MONETARY POLICY?

Monetary policy refers to the deliberate actions of the monetary authorities of a country to manipulate monetary
instruments to achieve macroeconomic objectives. The Government uses it to indirectly influence the level of
aggregate demand in the economy. The main target variables of monetary policy are the rate of interest (price of
money) and the supply of money.

MONETARY POLICY INSTRUMENTS

These options are accessible to the Central Bank to implement monetary policy and include:

Open market operations These operations are the sale and purchase of securities on the money market by
the government. Government, through the Central Bank, uses open market operations to influence the money
supply of an economy.
o If the government thinks the money supply is too low, Central Bank purchases securities from the
public; money enters the circular flow of income and then the commercial banking system. The
money supply is therefore expanded and causes interest rates to fall and aggregate demand to rise.
o If the government wants to decrease the money supply, Central Bank sells securities to the public;
money leaves the circular flow of income and then the commercial banking system. The money

supply contracts and causes interest rates to rise and aggregate demand to fall.
Maintaining a legal reserve requirement The reserve requirement is that proportion of deposits that
commercial banks must keep on hand in the form of cash to facilitate the daily transactions of their
customers. These deposits must not be used for lending or investing. The money multiplier (1/reserve
requirement) changes when the reserve requirement changes. As such he legal reserve requirement may be
changed to influence the money supply.
o When the government wants to increase money supply, the Central Bank can decrease the legal
reserve requirement, thereby increasing the money multiplier. A larger proportion of the deposits of
the commercial banks are now available for lending and the credit creation process is more easily
facilitated. As such the money supply increases.
o When the government wants to decrease the money supply, the Central Bank can increase the legal
reserve requirement, thereby decreasing the money multiplier. The commercial banks now have fewer
deposits available for lending and the credit creation process is stifled. As such, the money supply
increases. In addition, the Central Bank can institute the use of special reserve deposits onto
commercial banks and other financial institutions. This may be done in addition to the increasing of

the legal reserve requirement to further stifle credit creation.

The discount rate and repo rate The discount rate is the interest rate at which commercial banks can
borrow from the Central Bank for short-term loans. The repo rate is that rate at which commercial banks
borrow from the Central Bank for overnight financing. These are basically the costs of borrowing from the
Central Bank.
o When the government wants to increase the money supply, the Central Bank can decrease the
discount rate and repo rate, thereby making it cheaper for commercial banks to borrow funds for
lending. Commercial banks will borrow more and the money supply will increase. Commercial banks
will lower their interest rates, facilitating more borrowing by the public.
o When the government wants to decrease the money supply, the Central Bank can increase the
discount rate and the repo rate, thereby making it more expensive for commercial banks to borrow
funds for lending. Commercial banks will borrow less and the money supply will decrease.

Commercial banks will increase interest rates, stifling credit creation.

Financing fiscal deficits Tools of monetary financing may be used to cover fiscal deficits. To do this, the
Government may increase the money supply or actually print more money (seigniorage).

Moral suasion The Central Bank may attempt to persuade institutions of the financial sector to take a
particular line of action by simply communicating its wishes to them. The Central Bank may use letters and
verbal statements in its encouragement. However, the commercial banks are not obligated to follow the

wishes of the Central Bank.

Selective credit control This refers to a non-traditional technique that the Central Bank may use to
discourage particular types of investment. The Central Bank may offer some preferential treatment (e.g.
favourable discount rates) to those commercial banks that adhere to its objective.

IMPLEMENTATION OF MONETARY POLICY

Monetary policy is implemented to actions taken to achieve macroeconomic objectives. These include full
employment, stable prices, a satisfactory level of economic growth and equilibrium in the balance of payments
account. There are two types of monetary policy:

Tight or contractionary monetary policy This course of action is taken to restrict the amount of spending
in an economy. To achieve this, the money supply is decreased and/or interest rates are increased.
Deflationary monetary policy is used to counter inflation, by reducing the attractiveness of borrowing, and

therefore reducing aggregate expenditure.

Easy or expansionary monetary policy This course of action is designed to stimulate economic activity,
that is, increase the amount of spending in the economy. It is used to increase the level of employment and
economic growth. It makes borrowing more attractive, thereby increasing aggregate expenditure by
individuals and firms.

EFFECTIVENESS OF MONETARY POLICY

Monetary policy is indirect in its approach to achieving macroeconomic goals and has been criticised as being
permissive and not compelling. Some factors which affect the effectiveness of the monetary policy implemented are:

Elasticity of the demand for investment This refers to the responsiveness of demand for investment as a
result of a change in interest rates. If this demand is inelastic, a change in the interest rates would have little
effect on the level of investment, and therefore aggregate expenditure. This occurs in the case of interestinsensitive investments investments undertaken for reasons such as business expectations and government

incentives. Monetary policy employed, therefore, would be weak.

Excess reserves by commercial banks If the reserve requirement ratio is lowered, commercial banks
should lend more, thus expanding the money supply and facilitating the credit creation process. If the
commercial banks are in possession of excess reserves (maybe because they are unwilling to lend or there is
no demand for borrowed funds), monetary policy would be inefficient. This is because the lowering of the
reserve requirement ratio would not facilitate the expansion of the money supply as the commercial banks

still hold the excess (which theoretically should have been lent out).
Liquidity trap When the demand for money is perfectly interest, the interest rate remains unchanged even
when the money supply increases. This tends to occur at very low rates of interest. No capital gain is
expected from holding financial assets at such low interest rates and all wealth is held in terms of money. If,
then, the Central Bank increases the money supply, the whole increase would be added to speculative

balances and the interest rate would remain unchanged.

Difficult to control the money supply of foreign-owned banks Monetary policy is implemented to
expand the money supply through commercial banks. The effectiveness of the monetary policy is dependent
on the commercial bank lending this money to the public, thereby increasing the money supply. Foreignowned banks, however, may channel their funds to foreign bank accounts and foreign investment funds,

thereby having no impact on the domestic money supply.

Time lags Monetary policy does not have immediate effect on an economy. Deposits take time to be
created and money supply therefore takes time to expand. It also takes time to expand the capital stock as

investments take time; a fall in the rate of interest works with a time lag.
Fiscal indiscipline If the governments fiscal policy strategies do not have the same objective as monetary
policy, the monetary policy will not be effective. For example, monetary policy could be implemented to curb
inflation by increasing interest rates. However, its effects are negated if the government increases spending,
thereby promoting economic activity.

BIBLIOGRAPHY

Bahaw, E. (2011). CAPE Economics: Comprehensive Economics For Caribbean Students Unit II. Caribbean
Educational Publishers.

Caribbean Examinations Council. (2012). CAPE Economics for self-study and distance learning. Nelson
Thornes Ltd.

Monetary Policy. (n.d.). Retrieved January 28, 2015, from Encyclonomic Webpedia:
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=monetary+policy