Essay on Monetary Policy

Monetary policy refers to the use of interest rates and the level of money supply to manage the economy. Monetary policy may be used to increase the level of economic activity (reflationary policies) or to decrease the level of economic activity (deflationary policies). A relationship therefore exists between monetary supply and the rate of interest. Economic theories have been suggested as to the extent of this relationship. Nevertheless, the monetary authorities may use various monetary policy measures to stimulate economic activity in the country.

The Monetary authorities can establish either the level of money supply or the rate of interest, not both. If the demand for money (liquidity preference) does not change, any change in the supply for money will alter the interest rate. (Refer to monetary policy 1)The diagram supplied shows that an increase in the money supply from MS to MS1 will cause a fall in the interest rate from R to R1. Assuming the monetary authorities fixed the supply of money. A change (increase or decrease) in the demand for money (liquidity preference) will effect a change in the interest rate. The diagram supplied shows that a decrease in the demand for money (L to L1) will reduce the interest rate from R to R1.

Varying views exits as to whether manipulating the interest rate or money supply will easier stimulate economic activity. The Monetarists maintain that a change in the supply of money will have a direct and proportionate effect on interest rates. They believe due to the shape of the Long Run Aggregate Supply curve (LRAS), the price level can be altered but output will remain unchanged in the long run. Keynesians disagree, saying that there are relatively close substitutes to money. If there is a change in the money supply, it will be because of a change in the demand for these substitutes hence a change in the interest rates.

Governments implement monetary policy measures in order to fulfil four main macroeconomic objectives. These are increased economic activity (increased GNP), high employment, price (inflation) stability and a satisfactory balance of payments position. This essay will discuss those monetary measures used to stimulate economic growth. Economic growth refers to an increase in consumption and aggregate demand for goods and services. Therefore, stimulating economic growth would involve using some means to encourage an increase in aggregate consumption and aggregate demand for goods and services.

One measure that can be applied is decreasing the interest rates causing a reduction in the price paid for the services of capital. People and firms are encouraged to borrow money since it is now cheaper to do so. The increased finance available allows for increased spending. It also lowers a firm’s costs since their borrowing is cheaper they are able to gather more finance increase production. Firms benefit from economies of scale and households in terms of cheaper prices, which will boost demand. The monetary authorities have to be careful with this measure. If demand rises too much, firms may not be able to increase output in the short run causing prices instead of output to rise (inflation). In Malta the rate of interest was decreased in January 2001. In February 2001 there was an increase in the general price levels noted by the Retail Price Index, by 27%.

A second measure is reducing the Reserve Requirement ratio (RRR). The Reserve Requirement Ratio refers to a specified percentage of assets that a firm must have in cash. This percentage directly influences the ability of banks to lend money. If the monetary authorities want to increase spending or demand they can lower the amount of money a commercial bank is required to hold. This will enlarge the amount of money available to consumers because the bank is required to hold back less of it. The Maltese monetary Policy Council in 2001 wanted to boost sluggish economic activity and lowered their reserve requirement ratio from 5% to 4%. It proved successful in stimulating economic growth as citizens increased borrowing and as a result, spending. Lowering the reserve requirement ratio can also have its shortcomings. The increased access to money can lead to inflation.

A third measure is using easing the special deposit policy. The special deposit policy is where the monetary authorities instruct commercial banks to place some of their liquid assets with them. If the monetary authorities release the special deposits they hold it will mean that commercial banks can increase their lending since their liquid assets have increased. Also, using Moral Suasion the monetary authorities can persuade banks to lend more. Although it is a rarely used measure in the UK, the Reserve Bank of Australia frequently employs it. The Reserve Bank of Australia influences by promoting it as a moral responsibility by commercial banks to operate in a way that will further national good. Moral suasion and special deposits can appear simple and effective but for many reasons it is often not the best way to regulate economic activity. One of those reasons is the ingenuity of humans to find a way around regulations in order to gain a profit.

Exchange rates refer to the price of one currency in terms of another currency or currencies. If a government uses a fixed exchange rate, it can increase economic activity by establishing a relatively low exchange rate or (under a floating rate system). This will allow domestic goods and services (g+s) to be price competitive in terms of foreign currency. This will stimulate demand for those g+s domestically and internationally. Increased demand will encourage increased output and lower prices will boost spending.

A means of stimulating aggregate demand is by increasing the money supply. By adjusting their Open Market Operations (OMO’s) monetary authorities manipulate the money supply. If the monetary authorities want to increase money supply (hence demand) it will enter the market purchase securities and pay for it with cheques drawn on itself. It will be supplying money to the market via these market operations. This will increase the commercial bank’s liquid assets thus expanding the amount of money the bank is able to lend.

Monetary policy provides a means of achieving macroeconomic goals. The monetary authorities will try to boost demand or encourage spending in order to stimulate economic activity. Monetary authorities however have to be careful in its use of reflationary monetary policy measures since they may end up causing more problems (e.g. inflation). However, appropriate and accurate implementation of monetary policy measures will promote steady economic growth.

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