Monetary policy is one of the public interventionist measures aimed at influencing the level and pattern of economic activity so as to achieve desired goals. It covers all the actions by the Central Bank which influence the quantity, cost and availability of money and credit in the economy
Specifically, monetary policy works on the principle economic variables of aggregate supply in the economy and the level of interest rates s
John Maynard Keynes holds that in the short-run fiscal policy is critical and that monetary policy matters only in as far as it affects fiscal variables whereas monetarism holds that monetary policy is the determinant of aggregate demand
Instruments of monetary policy
- Open market operations (OMO)
This is the sale or purchases of marketable securities conducted in the open market by the central bank. this is an instrument of control over the monetary system.
It normally targets the cash balances of commercial banks and non-bank financial institutions in their tills
It also mops excess commercial bank reserves at the central bank
OMO is sometimes adopted to make bank rate policy more effective if the member bank refuses to raise the lending rate following the rise of the bank rate. the central bank can withdraw excess liquidity in the economy by selling securities thus compelling member banks to raise their rate
Disadvantages of open market operation
- Open market operations may not be effective if the sales of securities are offset by cash on hoards
- The purchase of securities on the other hand may be accompanied by a withdrawal of notes and coins from circulation. in such cases, cash reserves remain unaffected
- Owing to political and economic uncertainty money may not attract borrowers and thus when trade is good and prospects for-profits are high, entrepreneurs borrow even at high-interest rates
- The circulation of money should have a constant velocity but the velocity of bank deposits is never constant. it increases in times of high production and decreases in times of depression thus the policy of contracting credit is neutralized by increased velocity of circulation
- Selective credit control
This is a qualitative measure of credit control used to encourage those sectors of economic activity considered essential and to discourage those which are of lower priority.
This policy has been affected by the central bank through issuing special directives regarding loans, advances or investments made by commercial banks
Measures to achieve selective credit control include;
- Fixing a minimum margin for lending by banks against stocks of specific goods/services against other types of securities
- In developed countries selective credit control is used to prevent speculation in share market
- Direct control e.g. the central bank may advice commercial bank and other financial institutions to approve loans for industrialization and limit lending for other purposes
- Fixing a minimum discriminatory rate of interest on credit for particular commodities
- By controlling underwriting activities of investment bank where they dictate on the availability of credit to investors during an initial public offer (IPO). High credit control will mean less subscription for the initial public offer
- Interest rate policy
Kenya offers a low interest policy for the purpose of encouraging investment and protecting the small borrower
Moreover, stability of interest rate has also been emphasized since it is regarded as an important factor for promoting development
- Bank rate policy
It is also called the discount rates.
The bank rate is the maximum rate at which the central bank of a country provides loans to commercial banks in an economy.
When the central bank raises the bank rate the cost of borrowing by commercial banks from the central bank increases discouraging borrowing. banks also raise their lending rate hence discouraging individuals from borrowing thus contracting bank credit resulting in reduction in aggregate money supply
Disadvantages of the Bank rate policy
- All other rates should flow in the direction of the bank rate if it is changed. This will not be the case if commercial banks-maintained reserves of their own. For the changes in the bank rate to cause changes in all other rates, a well-organized money market is needed. This is not so in developing countries like Kenya.
- For the successful contracting of credit, businessmen must be responsive to changes in the rising rate of interest. However empirical studies have shown that the rate of interest does not exercise a strong influence on borrowing for investment and other purposes. It is true that where there is need to achieve desired goals, demand for credit by businessmen depends on the economic situation, the prospects of high returns and not necessarily on the rate of interest. In the case of a severe depression and the prospects of making profits are bleak entrepreneurs will not invest even though the lending rates may have been reduced.
- The Minimum Liquidity Assets Ratio
The liquidity assets ratio can be defined as the proportion of the total assets of a bank which are held in form of cash and liquid assets.
This instrument affects banks lending and has the advantage that it affects all banks equally and has a powerful effect in controlling credit creation since it is a direct method and its effects are immediate.
A related instrument has been the cash ratio whereby the central bank may instruct commercial banks to keep a higher or lower percentage of deposits received by them in cash form.
The central bank may also require commercial banks to maintain minimum cash balances against their total deposit liabilities.
The main purpose of this instrument is to reduce the bank’s free cash base and hence their capacity to give loans and advances.
- The exchange rate
This can also be used as an instrument of monetary policy.
An exchange rate refers to the price of one currency in terms of another. It has been argued that frequent changes in the shilling’s exchange rate would adversely affect investment because of the associated uncertainty.
The Exchange rate policy seeks to ensure a balance of payments equilibrium.