Quoins of monetary policy

The essence of monetary policy will now be clear to you. It is a policy on money creation and specifically on the growth rate in money creation. No CB would like to engineer negative money growth because this could lead to deflation, and deflation means a decline in asset values, which means a decline in wealth. And a decline in wealth means a fall in consumption and investment expenditure (GDE), the principal driver of economic growth (GDP). So the policy is aimed at sustainable economic growth which requires a stable and low inflation environment. Therefore, in terms of the identity AM x AV = DP x Areal GDP (assuming V to be stable), AM3 should not exceed the economy's capacity to expand at a rate, Areal GDP, that will deliver a AP of not more than the inflation target (which in most cases is 2% pa). Thus, monetary policy implementation must include a position on the economy's elasticity of supply.

You know that money is created by bank loans to the government and the NBPS and that bank purchases of forex also create money. So the drivers of money growth are the demand for loans by government and the NBPS and decisions by banks to purchase forex (= a minor factor usually). You know that central banks have tools at their disposal to control the creation of money and these are the reserve requirement (the r can also be changed but is rarely used), the KIR and OMO.

Under the firm-RR model the reserve requirement is used to curb M3 growth in a quantitative manner via creating, through OMO purchases, a desired volume of reserves (ER). Interest rates are free to find their own levels (or should be because a CB cannot control both without creating unsustainable distortions).

Under the firm-BR model the main operational tool is the central bank's lending rate (KIR-L) to the banks which is made effective by ensuring through OMO a liquidity shortage (BR) at all times (i.e. the CB keeps the loans-to-banks window open at all times). The "effective-making" of the KIR filters through to the banks' prime rate (and to all other rates and the exchange rate), thus influencing the demand for loans (the main driver of money creation).

The IBR model is similar to the firm-BR model but focuses on the banks' interbank rate and influences it in conditions of both bank liquidity surpluses (ER) and bank liquidity shortages (BR). As in the former case this model also aims to ultimately bring to bear a major impact on the banks' lending rates (and the exchange rate and other rates), and so influence demand. It will be evident that under the latter two models the reserve requirement (if it exists; as we have seen, it does not in all cases) is an unimportant element in money creation; it is merely one of many factors that influence bank liquidity, as detailed earlier.

A final word before we get to the more substantial (than the previous) monetary policy transmission mechanism (MPTM): the monetary authorities (CB and Treasury) do not always get it right. Banks are supposed to provide loans to creditworthy customers and for projects that are viable. Central banks have all the tools to curb excessive money growth. The system is an elegant one because money is always available, liberating economies from the stifling lack of money (gold coins and bullion) in earlier times, but there is much evidence that the authorities are not being responsible enough. The consequences are painful. Is a new implementation model required, one that takes due account of the elasticity of the economy? A model in terms of which bank borrowing by the governments of poor countries for developmental projects can take place to the extent that the borrowings create revenue to cover the borrowing interest rate, assuming that the domestic economy can produce the goods (for development) demanded?

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