The role of National Bank of Rwanda from 1995 to 2010

2.18. Monetary policy

It is first responsibility of central bank, Means by which central bank uses to control amount of balancing money available in the economy for demand and supply. (O.C. Ferrell et al, 2006)

2.18.1 Theory on monetary policy

Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment.

Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals).

If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the  marginal benefit of increasing economic output outweighs the  marginal cost of inflation); however, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior); so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.

While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation).

Reputation plays a crucial role in determining how much markets would believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc.

In fact it has been argued that to prevent some pathologies related to the  time inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations.

Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks.

The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another. ( B.M. Friedman, 2001)

According to Ferrell, there are four basic tools of monetary policy:

Open market operations: refers to decisions to buy or sell the T-bills and investments in the open market. This monetary tool is the most commonly employed of all central banks operations, is performed almost daily in an effort to control the money supply

Reserve requirement: is the percentage of deposits that banking institutions must hold in reserve. Funds so held are not available for businesses and consumers. Because the reserve requirement has such a powerful effect on the money supply, the central bank does not change it very often, relying instead on open market operations most of the time.

Discount rate: is the rate of interest the central bank charges to loan money to any banking institution to meet reserve requirements.

Credit control: the authority to establish and enforce credit rules for financial institutions and some private investors.

Regulatory function: second responsibility of central bank is to regulate banking institutions that are members of central bank.

Accordingly, the National Bank of Rwanda establishes and enforces banking rules that affect monetary policy and the overall level of the competition between different banks. It determines which non-banking activities, such as brokerage services, leasing and insurance, are appropriate for banks and which should be prohibited.

The National Bank of Rwanda is also responsible for supervising the central insurance funds that protects the deposits of member institution. (O.C. Ferrell et al, 2006)