1.0. INTRODUCTION
One of the functions of the Central Bank of Nigeria (CBN) is to
formulate and execute
monetary policy to promote monetary stability and sound financial
system in Nigeria. The
authority to formulate and implement monetary policy is vested in
the CBN as outlined in the
Central Bank Act of 1958 (and subsequent amendments), the CBN
Decree No. 24 of 1991 and
the Banks and other Financial Institutions Decree No. 25 of 1991.
These laws, enjoin the CBN to
promote monetary stability and sound financial system in Nigeria
under the overall guidance of
the Federal Government. In this note, you shall learn about the
concept of monetary policy and its
objectives, Instruments and role in economic development.
You
shall also learn about the
limitations of monetary policy in developing economies in this note.
2.0. OBJECTIVES
At the end of this note, you should be able to;
· Define and explain the concept of monetary
policy
· Identify and discuss the objectives of monetary
policy
· Identify and explain the Instruments of monetary
policy
· Describe the role of monetary policy in
developing economies
· Discuss the limitations of monetary policy in
developing economies.
3.0. MONETARY POLICY
3.1. The Concept of Monetary Policy
Monetary policy is a major economic stabilization weapon which
involves measures designed
to regulate and control the volume, cost, availability and direction
of money and credit in any
economy to achieve some specified macroeconomic policy objectives.
It is a deliberate effort by
the monetary authorities (The CBN) to control the money supply and
credit condition for the
purpose of achieving certain broad economic objectives.
The monetary policy in the Nigerian context encompasses actions by
the CBN that affect
the availability and cost of commercial and merchant banks reserve
balances and thereby, the
overall monetary and credit conditions in the economy. The main
objective of such action is to
ensure that overtime, expansion of money and credit will be
adequate for the long-run needs of
the economy.
3.2. Objectives of Monetary Policy
Monetary authorities charged with the responsibility to administer
monetary policy are
normally concerned with the selection of some economic objectives.
Such economic objectives
must be such that are in the general interest of the society. The
objectives of monetary policy in
any economy may include the following:
Attainment of a high rate or 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 and more so, it breeds poverty.
Full employment according to
Keynes means the absence of involuntary unemployment. In
otherwords, full employment is a
situation in which everybody who wants to work, get work. This
does not mean zero
unemployment since there is always a certain amount of frictional,
voluntary or seasonal
unemployment. Thus, what most policy makers aim at is actually
minimum unemployment and
the percentage varies among countries.
Maintenance of relative stability in
domestic prices: One of the objectives of monetary
policy is to stabilize domestic price levels in an economy. This
policy is favored by many
economies because fluctuations in prices bring uncertainty and
instability to the economy.
Besides, rising and falling prices are both bad because they bring
unnecessary loss to some and
undue advantage to others. So a policy of price stability keeps
the value of money stable,
eliminates cyclical fluctuations, brings economic stability, helps
in reducing inequalities of
income and wealth, secures social justice and promotes economic
welfare.
Achievement of a high and sustainable
economic growth: One of the most
important objectives of monetary policy is to achieve rapid
economic growth of an
economy. Economic growth refers to the process whereby the real
per capita income of a country
increases over a long period of time. Economic growth is measured
by the increase in the amount
of goods and services produced in a country. A growing economy
produces more goods and
services in each successive time period. Thus, growth occurs when
an economy’s productive
capacity increases which, in turn, is used to produce more goods
and services. The attainment of
high economic growth refers to maximum sustainable high output,
that is, the most possible
output with all resources employed to the greatest possible
extent, given the general social and
organizational structure of the society at any given time. In its
wider perspective, economic
growth implies raising the standard of living of the people, and
reducing inequalities of income
distribution.
Maintenance of Balance of payments
equilibrium: The achievement of this goal has been
necessitated by the phenomenal growth in the world trade as
against the growth of international
liquidity. It is also recognized that deficit in the balance of
payments will retard the attainment of
other objectives, especially the objective of rapid economic
growth. This is because a deficit in
the balance of payments leads to sizeable out flow of gold. The
maintenance of balance of
payments equilibrium therefore involves keeping international
payments and receipts in
equilibrium. That is, avoiding fundamental or persistent
disequilibrium in the balance of
payments position.
Exchange Rate Stability: This objective involves avoiding excessive,
undue and
unnecessary fluctuations in the currency exchange rate. This is
meant to help in
protecting and promoting foreign trade which ultimately enhances
economic growth and
development.
3.3. Instruments of Monetary Policy
The instruments or tools of monetary policy are broadly classified
into two, first, the
quantitative or indirect instruments; and second, the qualitative,
selective or direct instruments.
The instruments affect the level of aggregate demand through the
supply of money, cost of
money and availability of credit. The instruments of monetary
policy are discussed below:
3.3.1. Quantitative instruments
These are instruments or tools of monetary policy which operate
primarily by influencing the
cost, volume and availability of bank reserves. They lead to the
regulation of the supply or credit
and cannot be used effectively to regulate the use of credit in
particular areas or sectors of the
credit market. These instruments include bank rate variation, open
market operations and
changing reserve requirements and liquidity ratio. They are meant
to regulate the overall level of
credit in the economy through commercial banks.
Bank rate or rediscount rate policy: Bank rate is the minimum lending rate of the
Central Bank at
which it rediscounts first class bills of exchange and government
securities held by the commercial
banks. This discount rate is the rate of interest rate the
monetary authorities (as lenders of last
resort) charge the commercial banks on loans extended to them.
When the Central Bank finds that
inflationary pressures have started emerging within the economy,
it raises the bank rate. Borrowing
from the Central Bank then becomes costly and commercial banks
borrow less from it. The
commercial banks, in turn, raise their lending rates to the
business commnotey and borrowers
borrow less from the commercial banks. This therefore, contracts
credit and prices are checked
from rising further. On the contrary, when prices are depressed,
the central bank lowers the bank
rate. It becomes cheaper now to borrow from the Central Bank by
the commercial banks. The latter
also lower their lending rates which encourage the business commnotey
to borrow more and
investment is encouraged. By this, output, employment, income and
demand will start rising and
down ward movement of prices are checked.
Open Market Operations (OMO): Open Market Operations refers to the sale and
purchase of
government securities in the money market by the central bank
depending on whether the
economy is inflationary or deflationary respectively. When prices
are rising and there is need to
control them, the Central Bank sells securities. This will lead to
the reduction of the reserves of
commercial banks and therefore, they will not be in a position to
lend more to the business
commnotey, hence investment is discouraged and the rise in prices
is checked. On the other hand,
when recessionary forces start in the economy, the Central Bank
buys securities from the
commercial banks and the reserve of the commercial banks are
raised and they lend more. This
will lead to increase in investment, output, employment, income in
the economy and
subsequently fall in price is checked.
Liquidity Ratio: Every commercial bank is required by law to keep
a certain percentage of
its total deposits in the form of a reserve fund in its vaults.
This is in order to control their
liquidity and influence their credit operations. This ratio is
usually expressed as a percentage of
customers’ deposits and it can be manipulated by the central bank
to vary the ability of
commercial banks to make loans to the public by simply increasing
or decreasing the ratio. The
central bank imposes upon the banks a minimum liquidity ratio,
being varied according to the
needs of the situation. It is designed to enhance the ability of
the banks to meet cash withdrawals
on them by their customers. When prices are rising, the central
bank raises the liquidity ratio.
Banks are by this, required to keep more with themselves in from
of this ratio without lending it
out to the public and therefore lending is reduced. The volume of
investment, output and
employment are adversely affected. On the other hand, when the
ratio is lowered, the reserves of
the commercial banks are raised and they lend more and the
economic activities are favourably
affected.
Cash reserve requirements: This refers to the cash reserves or balances
held by banks with Central
Bank and which the Central Bank has authority to vary according to
the exigencies of the credit
control. These are usually certain percentage of the total
deposits of commercial banks kept in
form of reserve fund with the central bank by law. This is in
order to control their liquidity and
influence their credit operations. Such deposits with the central
bank must not be less than a
prescribed portion of the banks’ deposit liabilities. It is more
effective than OMO, since it acts
directly and has no effect on the prices of government securities
or on interest rates. The central
bank increases or decreases the rate during inflationary periods
and depression periods in the
economy respectively depending on the prevailing situation in the
economy.
3.3.2. Qualitative or selective instruments
Selective credit controls are used to influence specific types of
credit for particular purposes.
They confer on the monetary authorities the power to regulate the
terms on which credit is
granted in specific sectors. These powers or controls involve the
official interference within the
volume and directions of credit into those sectors of the economy
which planners believe are of
crucial importance to economic development. These instruments
include moral suasion and
selective credit controls or guidelines.
Moral Suasion: At times, the monetary authorities attempt to
affect both the total and the mix of
credit by appeal and voluntary response rather than by regulation
and authority. Moral suasion is
a process by which the monetary authorities through informal
discussion make known to
commercial banks the direction in which monetary policy and the
contribution which are
expected on the part of the commercial banks. This instrument
tends to be effective in the short
term and in periods in which the basis for the appeal are both
visible and meaningful to the
institutions involved. There is no legal basis for forcing
commercial banks to meet their
commitments. However, monetary authorities have frequently found
it necessary either to
replace voluntary compliance with enforced compliance or to
introduce threats of retaliation for
failure to comply.
Selective credit control or
guidelines: This is an instrument of
monetary policy used specifically
to direct credit to sectors that are favoured at certain periods.
This tool involve administrative
orders whereby the central bank, using guidelines, instructs banks
on the cost and volume of
credit to specified sectors depending on the degree of priority of
each sector. Thus, selective
credit controls are examples of the use of monetary policy to
influence directly the allocation of
resources, indicating a lack of faith in the working of the free
market. Here, the Central Bank
may resort to “Credit Rationing” by prescribing absolute limits up
to which specified sectors of
the economy may be authorized to get credit from the banking
system or from particular types of
banks.
3.4. The Role of monetary policy in Developing
Economies
Monetary policy in a developing country like Nigeria plays an
important role in increasing the
growth rate of the economy by influencing the cost and
availability of credit, by controlling
inflation and maintaining equilibrium in the balance of payments.
Some of the roles that
monetary policy plays in the development of the Nigerian economy
and other developing
economies of the world are discussed below:
Control of inflation: Inflation is a serious economic problem that
causes excessive and undue
fluctuations in the price levels in an economy which are highly
upsetting to the economy. Not
only do such wide price gyrations produce windfall profits and
losses, but they also introduce
uncertainties into the market that make it difficult for
businesses to plan a head. However,
monetary policy is an important economic policy in the control of
inflationary pressures in
developing economies including Nigeria. In controlling
inflationary pressures arising from the
process of development in the developing countries, monetary
authorities have been using both
quantitative and qualitative instruments of credit control. In the
use of both quantitative and
qualitative instruments of monetary policy in the control of
inflation, the qualitative credit
control measures are however been said to be more effective in
developing countries than the
quantitative measures in influencing the allocation of credit, and
thereby the pattern of
investment. They prove more useful in controlling “sectoral
inflation” in an economy. The
selective credit controls are more appropriate for controlling and
limiting credit facilities to the
productive sectors like agricultural, mining, industrial sectors,
etc.
Achievement of price stability: Monetary policy is an important instrument for
achieving price
stability. It brings a proper adjustment between demand for and
supply of money. An imbalance
between the two will be reflected in the price level. A shortage
of money supply will retard
growth while an excess of it will lead to inflation. As the
economy develops the demand for
money increases due to the gradual monetization of the
non-monetized sector, and the increase in
agricultural and industrial production. These will lead to increase
in the demand for the
transactions and speculative motives. So the monetary authorities
will have to raise the money
supply more than proportionate to the demand for money in order to
avoid inflation.
Bridging of balance of payments
deficit: Monetary policy in the form
of interest rate policy
plays an important role in bridging the balance of payments
deficit. Developing countries
develop serious balance of payments difficulties to fulfill
planned targets of development. It is a
fact that developing countries depends on the industrially
developed countries for capital goods
such as capital equipments, machines, iron and steel, spare parts
and components, etc for
infrastructural development thereby raising their imports. On the
other hand, exports are almost
stagnant and are high-priced due to inflation. As a result, an
imbalance is created between
imports and exports which lead to disequilibrium in the balance of
payments. Monetary policy
can help in narrowing the balance of payments deficit through high
rate of interest. A high rate
attracts the inflow of foreign investments and helps in bridging
the balance of payments gap.
Incentives to higher savings in the
economy: A policy of high interest
rate in developing
countries also acts as an incentive to higher savings, develops
banking habits, and speed up the
monetization of the economy which are essential for capital
formation and economic growth. A
high interest rate policy is also anti-inflationary in nature, for
it discourages borrowing and
investment for speculative purposes in foreign countries. Further,
it promotes the allocation of
scarce capital resources in more productive channels. However, it
is advisable for the monetary
authorities in developing countries to follow a policy of
discriminatory interest rate, charging
high interest rates for non-essential and unproductive uses and
low interest rates for productive
uses.
3.5. Limitations of Monetary policy in
Developing Economies
The experience of developing countries reveals that monetary
policy plays a limited role in such
countries. Some of the limitations of monetary policy in
developing countries are explained
below.
Underdeveloped money and capital
markets: The money and capital
markets of these countries
are underdeveloped so much so that these markets lack in Bills,
Stocks and Shares which limits
the success of monetary policy
.
Large amount of money outside banking
system: Most rural dwellers in the
developing
countries have little or no habit of depositing money in the
banks. They prefer to keep huge sums
of money in their houses as their wealth. Besides, some well-
to-do people in the urban areas do
not deposit money in the bank but use it for buying jewelleries,
gold, real estate etc in
speculation. Monetary policy is also not successful in such
countries because bank money
comprises a small proportion of the total money supply in the
country. As a result, the central
bank is not in position to control credit effectively.
Large non-monetized sector: There is a large non-monetized sector which
hinders the success of
monetary policy in developing countries. People mostly live in
rural areas where there are no
banks and also, money is not always use for exchange. As a result
of the absence of banks and
inadequate use of money for transaction in the economy, monetary
policy fails to influence this
large segment of the economy.
High liquidity: Most commercial banks possess high liquidity so
that they are not influenced by
the credit policy of the central bank. This also makes monetary
policy less effective.
10.0. CONCLUSION
This note discusses monetary policy, its objectives, instruments
and limitations especially
in developing countries.
11.0. SUMMARY
In this note, we have learned about;
· The concept of monetary policy
· The objectives of monetary policy
· The instruments of monetary policy
· The role of monetary policy in developing
economies
· The limitations of monetary policy in developing
economies.
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