MONETARY POLICY
The monetary policy has either positive or negative influence on the money multiplier and ultimately money supply. This will depend on whether reserve requirements are raised or lowered. If the reserve requirements are raised, the value of reserve ratio will rise thereby reducing the money multiplier and thus the money supply. And vice versa.
Tools of monetary policy
- The bank rate (Central Bank lending rate). This is the rate of interest charged by the central bank on commercial bank borrowing from it. This will ensure or discourage borrowers because commercial banks will increase their lending rates. When this rate is increased, commercial banks increase the rate of interest charged on loans. This will discourage demand for loans and this in turn reduces money in circulation – and checks on inflation. When this rate is reduced, commercial banks reduce the rate of interest charged on loans. This will encourage demand for loans and this in turn increase money in circulation. The Central Bank, as it tries to control inflation, has to be careful not to discourage production.
- Central Bank sells securities (‘open market operations’): Central Bank sells securities to the public through commercial banks. The Central Bank can also sell government treasury bills and bonds which will mature after 90 days to the public. This is called open market operations. The central will buy these securities later when the amount of money in circulation has been reduces – and inflationary pressures stemmed.
- Variable reserve ratio of commercial banks: Central Bank may increase the variable reserve requirements (the cash ratio, and reserve requirements at the central bank) of commercial banks (as a legal requirement) during a period of inflation. This takes away money from the commercial banks which would otherwise have been given out to borrowers as loans.
- Selective credit control: The central bank, usually following advice from government, can require commercial banks give credit to specific sectors (e.g. commercial agriculture, aquaculture, value addition firms, mining, etc.). This reduces the number of enterprises obtaining loans and hence reduces the amount of money in circulation.
- Special deposits: The central bank can require commercial banks to make certain deposits above the minimum legal requirement as way
of curbing inflationary pressures in the economy. This has the effect of reducing commercial bank’s pool of money available lending and thus reduces money in circulation.
- Moral Suasion (a form of persuasion): central bank does not give directives but instead gives informal advice and appeals to commercial banks not to hike interest rates and affect the economy. Again, the central bank can appeal to and persuade commercial banks to restrict credit during an inflationary period. Commercial banks may follow the advice given by their supervisor and lender of last resort to avoid falling into disfavour.
