2.2 THE INSTRUMENTS OF MONETARY POLICY
After selecting monetary policy objectives, Central Banks make
use of various monetary policy instruments at their disposal. Fundamentally
these instruments allow the Central Bank to stimulate or slow down the economy
by influencing the quantity of money and credit the banks can provide to their
customers through loans. Two types of monetary instruments are generally
classified, namely indirect and direct policy.
According Gidlow (1998), the indirect policies are considered
to be actions taken by the Central Bank whereby it achieves its monetary policy
aims by encouraging market participants to take particular actions in terms of
their lending and borrowing behavior. These actions may be the result of price
and interest rate incentives or disincentives brought about in the financial
market. The direct policy instruments on the other hand refer to the measures
taken by Central Bank that seek to attain the aims of monetary policy by means
of certain rules prescribing the behavior pattern of banks and possibly other
financial institutions. The indirect instrument is also considered as
market-oriented whereas the direct instrument is a non-market-oriented. Meyer
(1980) agreed that monetary policy instruments are generally classified as
either general or selective controls. General controls have their primary
effect on either the net monetary base or the size of the money multiplier.
These include open market operations, changes in reserve requirements, and
changes in the discount rate. Selective controls on the other hand, have their
primary influence on the allocation of credit among alternative uses. The
examples of selective controls include margin (or down payment) requirements
for loans to acquire securities and interest rate ceilings on rates paid by
banks on savings accounts or charged by banks on loans. Gidlow (1998) provided
as an example of direct policy instruments, the case of instructions sent to
banks under which the latter are requested not to exceed a certain amount of
lending to domestic private sector borrowers as specified period, and
instructions that banks must not quote interest rates above or below a certain
maximum or minimum level on their various credit and deposit facilities made
available to customers. Alexander et al (1995:14) also provided an interesting
explanation about direct and indirect policy instruments. They showed that the
term «direct» refers to the one- to one correspondence between the
instrument (such as credit ceiling) and the policy objective (such as a
specific amount of domestic credit outstanding). Direct instruments operate by
setting or limiting either prices (interest rates) or quantities (amounts of
credit outstanding) through regulations, while indirect instruments act on the
market by, in the first instance, adjusting the underlying demand for, and
supply of bank reserves. Based on these descriptions, it can be noted that both
types of policy instruments play an important role in economic activities.
However, direct and indirect instruments do not have the same effectiveness in
improving market efficiency in the same economic environment. As has been
specified previously, the most common direct instruments are interest rate
controls, credit ceilings and directed lending. Alexander et al (1995: 15)
argued that «direct instruments are perceived to be reliable, at least
initially in controlling credit aggregates or both the distribution and the
cost of credit. They are relatively easy to implement and explain and their
direct fiscal costs are relatively low. They are attractive to governments that
want to channel credit to meet specific objectives». In countries with
very rudimentary and noncompetive financial systems, direct controls may be the
only option until the institutional framework for indirect instruments has been
developed. The same authors also showed the disadvantages of direct
instruments. These consist of the fact that credit ceilings are based on
amounts extended by particular institutions and therefore they tend to ossify
the distribution of credit and limit competition, including the entry of new
banks. All those advantages lead to the conclusion that direct instruments
often lose their effectiveness because economic agents find means to circumvent
them.
Three main types of indirect instrument are mentioned:
-Open market operations
-Reserve requirements,
-Central Bank lending facilities
The open market operations are often seen as the most
important monetary policy tool because they are the primary determinants of
changes in interest rates and the monetary base and are the main source of
fluctuations in the money supply (Mishkin, 1997).
The way this instrument influences the economy can be seen
from purchase or sale of financial instruments by the Central Bank. Open market
purchases expand the monetary base, thereby raising the money supply and
lowering the short-term interest rates. Conversely, open market sales reduce
the reserves of the banking system, reducing the ability of banks to lend and
invest, and limiting the amount of funds available for the economy to use
(Federal Reserve System and Monetary Policy, 1979).
Open market operations are also based upon dynamic defensive
operations; dynamic operations are those taken to increase or decrease the
volume of reserves in order to ease or tighten credit. Defensive operations, on
the other hand, are those taken to offset the effects of other factors
influencing reserves and the monetary base.
Another interesting indirect monetary policy tool concerns the
changes in the reserve requirements. This consists of obliging banks to hold a
specified part of their portfolios in reserves at the Central Bank (Alexander
et al, 1995). This instrument affects the money supply by causing the money
multiplier to change.
Lastly, the Central Bank's lending facilities it is an
indirect instrument, which is often well known as discount policy. The discount
policy involves changes in the discount rate which affects the money supply by
affecting the volume of discount loans and the monetary base. A rise in
discount loans adds to the monetary base and expands the money supply whereas a
fall in discount loans reduces the monetary base and shrinks the money supply
(Mishkin, 1997).
Once all the instruments mentioned above are well applied, the
results easily seen in the level of economic activity since those instruments
influence the growth of the money supply as well as other financial
variables.
However, it is also worth noting that by using indirect
instruments, the Central Bank can determine the supply of reserve money in the
long term only under a fully flexible exchange rate regime. Even under a pegged
or managed exchange rate regime, however, Central Bank transactions affect
reserve money, at least in the short term. These transactions affect bank's
liquidity position, which results in adjustments to interbank, money market,
and bank loan and deposit interest rates to re-equilibrate the demand for, and
the supply of, reserve balances (Alexander et al, 1995).
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