Monetary policy
Monetary policy involves changes in interest rates, the supply of money and exchange rates to influence aggregate demand
in the economy.
Instruments of monetary policy:
Interest rate also known as minimum lending rate
It refers to the discount rate at which the Central bank lends to commercial banks. An increase in the discount rate reduces
the amount of lending made by commercial banks. In most countries a change in the discount rate will typically be followed
by a similar change in the interest rates charged by commercial banks to their customers (cost of borrowing/return on
savings).
Money supply
Money supply consists of all the money in an economy at any one time. It is the quantity of money in circulation in the
economy.
The Central Bank can increase the money supply in an economy through Quantitative easing (QE) policies which include
central-bank purchases of assets such as government bonds and other securities, direct lending programs, and programs
designed to improve credit conditions of financial institutions.
Foreign exchange rates
Deliberately altering exchange rates to influence the macro-economic environment may be regarded as a type of monetary
policy. Changes in exchanges rates initially work their way into an economy via their effect on prices.
Exchange rates can be manipulated by buying or selling currencies on the foreign exchange market. To raise the value of
the rupees the Bank of Mauritius buys rupees (revaluation), and to lower the value, it sells rupees on the international market
(devaluation).
Credit regulations
Credit regulations are rules affecting bank lending. Central banks may impose credit regulations on commercial banks to
help maintain financial stability and to influence bank lending. Many central banks may require the commercial banks to
hold a proportion of their asset in forms that can be converted quickly into cash to meet customer’s demand for cash.
Expansionary monetary policy
Expansionary monetary policies involve policies designed to increase AD, resulting in economic growth, more employment,
but also higher inflation and possibly a deficit in the BOP. An expansionary monetary policy can be achieved by:
decreasing the interest rate
o Lower interest rates make it cheaper to borrow; this encourages firms to invest and consumers to spend.
o Lower interest rates reduce the cost of interest repayments. This gives household greater disposable income and
encourages spending.
o Lower interest rates reduce the incentive to save and encourage spending.
increasing the growth of money supply
In addition to cutting interest rates, the Central Bank could pursue a policy of quantitative easing to increase the money
supply and reduce long-term interest rates. Under quantitative easing, the Central bank creates money. It then uses this
created money to buy government bonds from commercial banks. In theory, this should increase the monetary base and
cash reserves of banks, which should enable higher lending
reducing the exchange rate (devaluation)
A devaluation will help to reduce the price of exports and increase the price of imports. This will increase the quantity of
money in circulation and increase AD in the following ways:
o Higher volume of exports and export revenue into the country
o Domestic consumers prefer to buy relatively cheaper home-produced goods than higher priced imports.
o Encourage foreign MNCs to set up in the country.
Contractionary monetary policy
Contractionary monetary policies involve policies designed to reduce AD. A contractionary monetary policy can be
achieved by increasing the interest rate, reducing the growth of money supply or raising the exchange rate (revaluation).
A tight monetary policy involves:
Raising the interest rate
Higher interest rates tend to reduce aggregate demand (AD) because:
o Borrowing becomes more expensive. Therefore, firms and consumers are discouraged from investing and spending.
o Saving becomes more attractive. Therefore, firms and consumers are more likely to keep saving money in the bank
rather than spend.
o Reduced disposable income. Consumers with a variable mortgage will see a rise in monthly mortgage interest
payments. Therefore, they will have less income to spend.
Reducing money supply
The Central bank can also tighten monetary policy by restricting the supply of money by:
o printing less money or sell long-dated government bonds to the banking sector. By selling bonds, banks see a
reduction in liquidity and therefore reduce lending.
o A central bank could also raise the minimum reserve ratio (proportion of customers’ deposits that a bank holds as
reserves in the form of cash). This forces banks to keep more liquidity in banks and give out less in terms of loan.
raising the exchange rate (revaluation)
A revaluation will increase the price of exports and decrease the price of imports. Thus, exports will fall and lead to a decline
in aggregate demand. This will reduce the quantity of money in circulation and decrease AD.
Effects of monetary policy measure on the government macroeconomic aims
Expansionary policy in the form of lower interest rates, higher money supply or devaluation of currency will help to increase
investment, production and consumer spending. As results, unemployment will be lower and higher economic growth.
However, higher aggregate demand will be inflationary and people may increase their spending on imported goods. Thus,
this may worsen the current account position in the BOP.
The effect of expansionary monetary policy:
On the other hand, during a period of high inflation, government may wish to adopt contractionary policy in the form of
higher interest rates, lower money supply or revaluation of currency. These policies will reduce investment, production and
consumer spending which ultimately leads to a lower aggregate demand and lower pressure on price level. However, a
contractionary policy will increase unemployment and reduce economic growth.
Expansionary monetary policy may help to reduce the inequality between the rich and the poor. Government increases
money supply to increase aggregate demand and production. There would be more job opportunities for the poor and allow
them to get higher income. This will lead to higher economic growth and lower unemployment.
However, evidence has shown that higher economic and rising income does not necessarily reduce the gap between the rich
and poor. The benefits of higher economic growth are not equally spread across every individual or household. Expansionary
monetary policies must be backed by other policies like progressive tax system, welfare benefits, education and law
protecting workers.
