Unit 3
Money and Banking
Monetary policy consists of the process of drafting, announcing, and implementing the plan of actions taken by the central bank, currency board, or other competent monetary authority of a country that controls the quantity of money in an economy and the channels by which new money is supplied. Monetary policy consists of management of money supply and interest rates, aimed at achieving macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity. These are achieved by actions such as modifying the interest rate, buying or selling government bonds, regulating foreign exchange rates, and changing the amount of money banks are required to maintain as reserves. Some view the role of the International Monetary Fund as this.
Monetary Policy
Meaning:
Monetary policy is concerned with the changes in the supply of money and credit. It refers to the policy measures undertaken by the central bank to influence the availability, cost and use of money and credit with the help of monetary techniques to achieve specific objectives. Monetary policy aims at influencing economic activity in the economy mainly through two major variables, i.e, (a) money or credit supply and (b) the rate of interest.
Definition:
RBI: Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control to achieve the goals specified in the Act (1934).
A.J. Shapiro: “Monetary policy is the exercise of the central bank’s control over the money supply as an instrument for achieving the objectives of economic policy.”
N.G. Mankiw: “Monetary policy refers to the setting of the money supply in the economy by the central bank.”
G.F. Stanlake: “It is any deliberate action by the monetary authorities which is designed to change the availability (money supply) or the cost of money (rate of interest).”
Monetary policy is how a central bank or other agency governs the supply of money and interest rates in an economy in order to influence output, employment, and prices.
Monetary policy can be broadly classified as either expansionary or contractionary.
Monetary policy tools include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations (subject to the central bank's credibility).
Understanding Monetary Policy
Economists, analysts, investors, and financial experts across the globe eagerly await the monetary policy reports and outcome of the meetings involving monetary policy decision-making. Such developments have a long lasting impact on the overall economy, as well as on specific industry sector or market.
Monetary policy is formulated based on inputs gathered from a variety of sources. For instance, the monetary authority may look at macroeconomic numbers like GDP and inflation, industry/sector-specific growth rates and associated figures, geopolitical developments in the international markets (like oil embargo or trade tariffs), concerns raised by groups representing industries and businesses, survey results from organizations of repute, and inputs from the government and other credible sources.
Monetary authorities are typically given policy mandates, to achieve stable rise in gross domestic product (GDP), maintain low rates of unemployment, and maintain foreign exchange and inflation rates in a predictable range. Monetary policy can be used in combination with or as an alternative to fiscal policy, which uses to taxes, government borrowing, and spending to manage the economy.
The Federal Reserve Bank is in charge of monetary policy in the United States. The Federal Reserve has what is commonly referred to as a "dual mandate": to achieve maximum employment (with around 5 percent unemployment) and stable prices (with 2 to 3 percent inflation). It is the Fed's responsibility to balance economic growth and inflation. In addition, it aims to keep long-term interest rates relatively low. Its core role is to be the lender of last resort, providing banks with liquidity and serve as a bank regulator, in order to prevent the bank failures and panics in the financial services sector.
At a broad level, monetary policies are categorized as expansionary or contractionary.
If a country is facing a high unemployment rate during a slowdown or a recession, the monetary authority can opt for an expansionary policy aimed at increasing economic growth and expanding economic activity. As a part of expansionary monetary policy, the monetary authority often lowers the interest rates through various measures that make money saving relatively unfavorable and promotes spending. It leads to an increased money supply in the market, with the hope of boosting investment and consumer spending. Lower interest rates mean that businesses and individuals can take loans on convenient terms to expand productive activities and spend more on big ticket consumer goods. An example of this expansionary approach is the low to zero interest rates maintained by many leading economies across the globe since the 2008 financial crisis.
The primary objectives of monetary policies are the management of inflation or unemployment, and maintenance of currency exchange rates.
Inflation
Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the economy. If inflation is high, a contractionary policy can address this issue.
Unemployment
Monetary policies can influence the level of unemployment in the economy. For example, an expansionary monetary policy generally decreases unemployment because the higher money supply stimulates business activities that lead to the expansion of the job market.
Currency exchange rates
Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign currencies. For example, the central bank may increase the money supply by issuing more currency. In such a case, the domestic currency becomes cheaper relative to its foreign counterparts.
Tools of Monetary Policy
Central banks use various tools to implement monetary policies. The widely utilized policy tools include:
Interest rate adjustment
A central bank can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a central bank increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease.
Change reserve requirements
Central banks usually set up the minimum amount of reserves that must be held by a commercial bank. By changing the required amount, the central bank can influence the money supply in the economy. If monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases.
Commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).
Open market operations
The central bank can either purchase or sell securities issued by the government to affect the money supply. For example, central banks can purchase government bonds. As a result, banks will obtain more money to increase the lending and money supply in the economy.
Depending on its objectives, monetary policies can be expansionary or contractionary.
Expansionary Monetary Policy
This is a monetary policy that aims to increase the money supply in the economy by decreasing interest rates, purchasing government securities by central banks, and lowering the reserve requirements for banks. An expansionary policy lowers unemployment and stimulates business activities and consumer spending. The overall goal of the expansionary monetary policy is to fuel economic growth. However, it can also possibly lead to higher inflation.
Contractionary Monetary Policy
The goal of a contractionary monetary policy is to decrease the money supply in the economy. It can be achieved by raising interest rates, selling government bonds, and increasing the reserve requirements for banks. The contractionary policy is utilized when the government wants to control inflation levels.
Devaluation is the deliberate downward adjustment of the value of a country's money relative to another currency, group of currencies, or currency standard. Countries that have a fixed exchange rate or semi-fixed exchange rate use this monetary policy tool. It is often confused with depreciation and is the opposite of revaluation, which refers to the readjustment of a currency's exchange rate.
Devaluation is the deliberate downward adjustment of a country's currency value.
The government issuing the currency decides to devalue a currency.Devaluing a currency reduces the cost of a country's exports and can help shrink trade deficits.
Reasons behind Devaluation
The government issuing the currency decides to devalue the currency and, unlike depreciation, it is not the result of nongovernmental activities. One reason a country may devalue its currency is to combat a trade imbalance. Devaluation reduces the cost of a country's exports, rendering them more competitive in the global market, which in turn, increases the cost of imports, so domestic consumers are less likely to purchase them, further strengthening domestic businesses. Because exports increase and imports decrease, it favors a better balance of payments by shrinking trade deficits. That means a country that devalues its currency can reduce its deficit because of the strong demand for cheaper exports.
Devaluation and Depreciation
Depreciation and devaluation both affect the value of a country's currency. Both of them cause a fall within the value of a country’s currency in terms of other currency. However, the way during which this happens is very different. The causes and long-term impacts on the country's economy are different in both these cases.
Devaluation of a currency
Devaluation of a currency is related to countries having a fixed exchange rate regime. Under the fixed rate regime, the central bank or the govt decides the value of the currency with reference to other foreign currencies. The central bank or the govt purchases or sells its currencies to take care of the exchange rate. When the govt or the central bank reduces the value of its currency, then it's referred to as the devaluation of the currency. Under this, the worth of the domestic currency is deliberately reduced in terms of other foreign currencies.
For example, in 1966 when the India was following the fixed exchange rate regime, the Indian rupee was devalued by 36 %.
Reasons and objectives of currency devaluation
• To increase Exports: countries choose currency devaluation to boost their exports within the international market. Devaluation of currency makes its goods cheaper compared to its International competitors. For instance , recently China devalued its currency to form its goods less expensive within the international market. This was aimed to form its goods more competitive in the global market and to increase its overall exports. This can also increase the economic process rate of the country due to higher exports and a rise within the aggregate demand and the economy.
• Competitive devaluation (race to the bottom): if one country devalues its currency other countries also are incentivized to devalue their own currency to maintain their competitiveness and the international export market. This example can result in tit for tat currency wars which is also called the “race to the bottom”. Competitive devaluation can cause rise in unchecked inflation.
• To reduce trade deficits: currency devaluation makes a countries exports cheaper, while imports become costlier . This results in a rise in exports and reduce in imports. This situation favors the improved balance of payment and reduces trade deficits. Countries facing consistent trade deficits choose currency devaluation to correct their balance of payment and reduced their deficits. However, devaluation of currency also increases the debt burden of foreign denominated external loans.
• To reduce the sovereign debt burden: countries may choose currency devaluation and weak currency policy to reduce the govt issued sovereign debt burden. If the debt payments are fixed, devaluation of currency will make the domestic currency weaker and can ultimately make the payments less expensive over time. For instance , if a country's domestic currency is devalued to 80% of its initial value, $10 million debt payment are going to be reduced to figure only $8 million now. However, this policy fails if the country holds a large amount of foreign external loans as they're going to become relatively more costly.
Disadvantages of currency devaluation
• Inflation: it can cause increase within the inflation rate as essential imports like oil etc will become costlier . It also can lead to inflation .
• It reduces the purchasing power of the country’s citizens and foreign goods and foreign tours become expensive for them.
• Large and quick devaluation of currency may reduce the faith of international investors within the domestic economy. Foreign investors would be less interested in holding the govt debt as devaluation reduces the value of their holdings.
• Devaluation of currency negatively impacts the corporates and individuals who hold debt within the foreign currency.
Depreciation of a currency may be a phenomenon related to countries with floating rate of exchange regime. Within the floating rate of exchange regimes, the value of a country's currency is decided by the market forces of demand and provide . The rate of exchange of the currency changes on day to day as per the demand and supply of that currency with reference to foreign currencies. A currency depreciates with respect to foreign currency when the availability of currency within the market increases while its demand falls.
Reasons liable for currency devaluation
• Decline in exports: the decline during a country's overall exports results in a decline in export revenues. This reduces the demand for the country's currency and leads to its depreciation.
• Large increase in imports: a large increase within the demand for imported goods and services can cause a deficit . Increase within the current account deficit can cause a net outflow of the currency which may weaken the exchange rate resulting in currency depreciation.
• Monetary policy of Central Bank: if the central bank reduces its policy interest rates it can cause the outflow of hot money like foreign portfolio investment etc. this will cause the depreciation of domestic currency.
• Open market operations of the central bank: if the central bank undertakes open market operations to buy foreign currency and gold etc it can cause the depreciation of domestic currency. RBI undertakes open market operations just in case of rapid appreciation or depreciation of the rupee and to scale back volatility within the foreign exchange market.
Devaluation vs depreciation
Both devaluation and depreciation cause the decline within the value of domestic currency. However, there are certain differences between them.
• Devaluation is that the official reduction within the value of a currency, while depreciation refers to an unofficial decline within the currency’s value.
• Devaluation is that the phenomena associated with fixed exchange rate regime. Whereas, depreciation of a currency is related to the floating or managed floating exchange rate regime.
• Devaluation of the currency is done purposely by the central bank or the govt . Whereas the economic process of demand and provide are liable for the depreciation of a currency.
• The impact of currency devaluation is for short term, while the depreciation of currency can affect the economy for a extended time.
• Devaluation of currency is completed occasionally by the central bank, whereas depreciation and appreciation of currency occur on a day to day .
Impact of currency devaluation and depreciation
• Impact on the property: the impact of devaluation and depreciation on the worth of a property is similar. The worth of the domestic property for the country’s citizens doesn't change much. However, the prevailing foreign investors may lose money as the value of existing property therein country would be now lesser in foreign currency.
• Impact on foreign investment: The foreign investors may get interested in invest in domestic assets like housing market etc because depreciation and devaluation make it cheaper for foreigners to buy the local land . However, too frequent devaluations of currency within the fixed exchange rate regimes can negatively impact foreign investment due to speculations about the economic instability of the domestic economy.
• Impact on exports and imports: in both devaluation and depreciation, the impact on exports and imports is analogous . Exports become cheaper in the international market which increases its demands. Imports become expensive and therefore the overall imports reduce.
• Aggregate demand: devaluation and depreciation would increase the consumption of domestic goods at the value of imported goods leading to a rise in economic growth rate.
• Inflation: depreciation and devaluation of currency can have a similar impact on the inflation rate. Increase within the cost of imports can cause cost-push inflation, whereas an increase within the domestic demand can cause demand-pull inflation.
• Fall within the real wages: depreciation and devaluation induced inflation can cause fall in the real wages if the nominal wages aren't increased in response to the rise in the inflation rate.
• Impact on the exchange rate and therefore the current account balance of payments: depreciation and devaluation improve within the current account balance of payments due to a relative increase in exports with reference to imports.
• Long term impacts: the long-term impacts of devaluation and depreciation differ. The depreciation of the domestic currency during a floating exchange rate regime, can increase its exports, boost spending and may make the economy look better for the foreign investors. This will increase the flow of foreign investment which can cancel out a number of the effects of depreciation. However, this is often impossible during a fixed rate economy as only the govt or central bank change the exchange rates.
Monetary policy is not an end in itself, but a means to an end. It involves the management of money and credit for the betterment of the general economic policy of the government to achieve predetermined objectives. The objectives of monetary policy vary in different countries at different times and under different economic conditions.
Various objectives or goals of monetary policy are:
Price stability (low and stable rate of inflation) – Stable prices improve public confidence, promote business activity, and ensure equal distribution of income and wealth. It is a pre-requisite for development. The stability objective includes maintaining the domestic as well as the external value of the currency.
Economic growth – One of the most important OBJECTIVE OF MONETARY POLICY has been the rapid economic growth and development of a country. A suitable monetary policy would help with the proper utilisation of natural and human resources, more capital formation, more employment, increase in national and per capita income along with an increase in the standard of living.
Balance of payments (BOP) Equlibrium: Many developing countries suffer from disequilibrium in BOP can be ‘BOP surplus’ or ‘BOP deficit’. The former reflects an excess money supply in domestic economy, while the later stands for stringency of money. If the monetary policy succeeds in maintaining monetary equilibrium can be attained.
Exchange stability (orderly foreign exchange market and an adequate level of foreign exchange reserves): Exchange rate is the price of a home currency expressed in terms of any foreign currency. The traditional objective of monetary policy has been the achievement of stable exchange rates. If the exchange rates is very volatile (frequent ups and down), it leads to the international community losing confidence in the economy. Monetary policy aims at maintaining relative stability in the exchange rate.
Full employment: Full employment has been ranked among the foremost objectives of monetary policy. It is an important goal not only because unemployment leads to wastage of potential output, but also because of the loss of social standing and self-respect.
Reduction in Equality and Wealth: Inequality in income and wealth due to right of private property and law of inheritance is a common feature of capitalist and mixed economies. As a result, society is divided into two classes, rich and poor The objective of monetary policy is to reduce the inequalities of income and wealth.
Creation and Expansion of Financial Institutions: A major objective of monetary policy in a developing country is to speed up the process of economic development by providing credit facilities and mobilising savings for productive purposes. The monetary authority can help in establishment and expansion of banks and institutions in urban and rural areas.
