It is important to understand the distinction between objectives or goals, targets and instruments of monetary policy
Goals of monetary policy refer to the objectives (price stability, economic growth or full employment) while targets refer to variables such as the supply of money, bank credit and interest rates which are sought to be changed so as to attain the objectives
The following are some of the goals or objectives that monetary policy may be expected to attain
- Achievement of price stability
This is the problem of avoiding inflation. Inflation reduces the ability of money to effectively perform its function, especially as a store of value and as a standard of deferred payments.
Price stability can be maintained by regulating the money supply through the monetary policy tools such as discount rates, minimum reserve requirements and Open Market Operations.
Price stability however does not mean absolutely no change in price i.e. a certain rate of inflation is inevitable. A high degree of inflation has adverse effects on several accounts. First, inflation raises the cost of living of the people and hurts the poor most. It sends many people below the poverty line
It makes also makes exports costlier and therefore discourages them. on the other hand, due to higher prices at home people are induced to import goods to a large extent thus inflation has adverse effects on the balance of payments
A higher rate of inflation leads to a rapid fall in the value of money hence people don’t have the incentive to save equally a high inflation encourages businessmen to invest in assets such as gold, jewelry, real estate among others
- To attain Economic Growth
This can be defined as a process where the real Gross National Product per capita increases over a period of time.
Monetary policy can contribute to this end by providing investment funds through cheaper credit and by mobilizing savings that can be used for investment. Investment funds can be allocated to those sectors with the highest rates of return.
This better allocation of resources brings about increased output. Monetary policy can promote economic growth by ensuring adequate availability of credit and lowering the cost of credit.
There are two types of credit requirements for businessmen; working capital for importing needed raw materials and machines from abroad and; capital to finance investment in projects for building fixed capital. Easy availability of credit at low-interest rates stimulates investment and thereby quickens economic growth.
To ensure higher economic growth, adequate expansion of the money supply and greater availability of credit at a lower rate of interest is needed. But the large expansion of money supply and bank credit leads to an increase in aggregate demand which tends to cause a higher rate of inflation. This raises the question of what is the acceptable tradeoff between growth and inflation. Whereas prevention of depreciation of the Kenyan shilling requires tightening of monetary policy that is; rising of interest rates, reducing the liquidity of the banking system so that banks restrict their credit supply, the promotion of economic growth requires low lending rates of interest and greater availability of credit for encouraging private investment
- To maintain equilibrium in the balance of payments (BOP)
Until the early 1990s, Kenya followed a fixed exchange rate system and only occasionally devalued the shilling with the permission of the International monetary fund.
The policies of a floating exchange rate and increasing openness and globalization of the Kenyan economy have made the exchange rate of the shilling quite volatile. The changes in capital inflows and capital outflows and changes in demand for and supply of foreign currency, particularly the US dollars arising from the imports and exports cause great fluctuations in the foreign exchange rate of the shilling.
In order to prevent large depreciations and appreciations of foreign exchange, the Central Bank of Kenya has to take suitable monetary measures to ensure foreign exchange stability. When there is a mismatch between demand for and supply of foreign exchange, the external value of the shilling changes.
For instance, in July 2008, the depreciation of the Kenya shilling was caused by the increase in demand for dollars for financing the country’s imports, the surging inflationary pressures and excess liquidity in the market.
Through the rise in the cost of credit and reduction in the availability of credit, borrowing from the banks can be discouraged and hence a reduction in demand for dollars. Higher interest rates in Kenya would also discourage foreign institutional investors and the Kenyan corporates to invest abroad which will work to reduce the demand for dollars. This will prevent the fall in the shilling’s value.
Alternatively, to prevent the shilling from depreciating the central bank of Kenya can release more dollars from its foreign exchange reserves.
This will increase the supply of dollars in the foreign exchange market which will correct the mismatch between demand for and supply of US dollars. Hence the shilling’s exchange rate will stabilize. Alternatively, monetary policy can be used in such a way that credit is selectively directed to the export sector and away from the import sector.
- To attain full employment
At the same time, capital inflows can be encouraged and outflows discouraged through exchange controls. Another related goal is that of exchange rate stability which often requires the intervention of policymakers in the foreign exchange market.
Full employment can be said to be consistent with some little unemployment as potential workers search for employment
It is argued that a certain amount of structural unemployment is acceptable since individuals without jobs may not have the skills needed by employers at least in the short run. monetary policy can encourage employment by encouraging credit to labour-intensive sectors like rural agriculture.
in addition, a policy that lowers the rate of interest constitutes expansionary monetary policy and its likely to lead to increased investments and hence more employment opportunities
interest rate stability
interest rate stability is desirable because fluctuation in the interest rate can create uncertainty on the economy and make it harder to plan for the future
fluctuations in interest rate affect consumer willingness to buy houses for example it makes it more difficult to decide when purchasing a house and for construction firms to plan how many houses to build . interest rate can be stabilized when there is stability in the money supply.