Effectiveness of Monetory Policy

Various studies have reflected the existence of a positive relationship between the increase of money supply and the level of inflation. Generally, this is reflected by the continued rise of prices of the various products. A situation ensues where excess amounts of money tend to be chasing too few goods. In this perspective, this study tested on whether monetary policy is an effective tool in the combating of inflation and ensuring price stability. The first and foremost objective of the central bank is to formulation and implementation of the monetary policy for maintaining the values of local currency.Otherwise the living standard of the general people may go down. This study finds out the money supply has a direct impact on the level of inflation. Statistically, money supply has a statistical significance on the level of inflation in the country. Thus, monetary policies aimed at controlling the amount of money supply in the economy, have a tremendous impact on controlling the leve l of inflation 2. Objectives of the Study The objectives of the study revolved around exploring the significance and the suitability of the monetary policy in realizing macroeconomic goals.Some of these macroeconomic objectives included price stability, economic growth, full employment, and a favorable balance of payment. 3. Specific Objective Find out the effectiveness of monetary policy in ensuring price Stability & preserving the value of local currency by combating of inflation. 4. Introduction Since time immemorial, inflation has always been an issue of extreme sensitivity. This accrues to the fact that a case of inflation has overall effect on the prices of commodities. An instance of spiraling, uncontrollable inflation is usually a sign of impending catastrophic doom.Thus, the control of monetary policy has turned out to be an essential function of all governments in the world. Inflation does not necessarily have to be reflected a continued increase in the prices of commoditi es (hyperinflation), the vice versa can also be a reflection of inflation (deflation). However, both situations are more than unhealthy for the economy. In most economic situations, the major reasons for the inception of inflation are a culmination of excessive demand for products. The necessary economic policy would thus be entrenched on looking at the causes of an unnecessary rise.This way, they can thus be able to come up with the right measures that can aid in controlling the existing verbal demand in an economy. To this end, various researchers have established the ability of monetary policy as a tool for controlling inflation. All over the world, in diverse economies, monetary policy has been seen as an approach to effectively control inflation. This is reflected by the ability of monetary policy in controlling the rise in demand by an increase in the available rates of interest.In addition, monetary policy reduces the existing real money in the economy. A rise in the interest manages to bring an overall reduction in collective demand in an economy. To this end, this Essay aims at looking at how effective monetary policy as a tool for ensuring price stability. 5. Background Analysis Monetary policy is defined as a public interventionist action that aims at manipulating the level and array of economic activity so as to accomplish specific, desired goals.Specifically, monetary policies are aimed to work fewer than two economic variables that affect the level of inflation in an economy. The two aggregate variables are supply of money in circulation and the respective interest rate in an economy. Monetary policy is among the few tools that a national government can utilize to control the economy using the given monetary authority in the control of the supply and availability of money. Controlling the availability, leading to a control of access, ultimately influences the demand of products.The law of demand ultimately reflects that an increase in demand for products of products leads to an increase in prices. Demand is in turn influenced by the availability of money in the economy. Thus, direct or indirect control of money leads to an ultimate control of inflation. In most instances, governments try to influence an overall level of economic activities to be in line with individual objectives. Some of these objectives include socio cultural, political, economic, and technological objectives.Generally, the main aim of governments is the existence of a macroeconomic stability. Usually, macroeconomic stability encompasses stable prices, economic growth, full employment, balance of external payment, and development in a country. Generally, it is the Job of the central bank of any nation to come up with, and implement, monetary policies that aim at achieving stability in the expected price level of products in a country. However, the major aim is to attain stability in prices so as to be able to sustain the existing value of the currency in a particular country.All economies of the world endeavored to create a central bank as a means of safeguarding the value of individual currency. In the case of integrated economies, there exist geographical banks and one major bank for the respective organization. For example, various American states have federal banks to check on their currency. In addition, an overall control is exhibited by the Central Bank of America. In addition, monetary policy is a major tool exploited in a battle of preserving a runners in an economy. 6.Literature Review Theory has proposed several ways in which inflation can be combated; this essay is concerned with the literature that led to the use of such instruments and policies. To enable us understand the prepositions made the study analyzed several theories: 7. The Classical Quantity Theory of Money This theory was developed by Irving Fisher. Fisher took the view that money was only used as a medium of exchange to settle transaction involving the dem and and supply for goods and services. The quantity theory of money can be developed to a theory of price levels.Since NV=APT Where V – Velocity of circulation M -Money supply p _ price T -Quantity of transactions Assuming that V and T are roughly constant, P will vary directly with increase or decrease in the amount of M and it changes in money supply (M) that causes the prices (P) to change, not changes in price that cause the changes in supply is assumed to be constant as the economy in question is assumed to be operating at full employment. If the velocity of circulation is more or less constant than any growth in money supply (M) over and above the potential of the economy to increase, T will cause inflation.This is then consistent with the monetary policy to curb inflation by controlling the money supply in the economy as it leads to inflation. A further notable feature in this theory is that the government monetary policy should allow some growth in money supply if the economy is growing but not let the growth in money supply to get out of hand as if output in the economy (T) is growing and the velocity of circulation (V) is constant then a matching growth in the money supply of money is needed to avoid deflation. . The Monetarist Policy Theory Monetarists argue that since money is a direct substitute for all other assets, an increase in the supply of money supply, given a fairly stable velocity of circulation, will have a direct effect on the demand for other assets since there will be more money to spend on those assets. If the total output of the economy is fixed, then an increase in the money supply will lead directly to higher prices.Monetarists therefore reach the same conclusion as the old quantity theory of money that a rise in money supply will lead directly to a rise in prices and probably also too rise in money incomes, an increase in real output and so an increase in employment. In the long run however, they argue that all increases i n the money supply will be reflected in higher prices unless there is a long term growth in the economy. Monetarist school of economic thought contended that money supply is a key determinant of the level of production the short run and the rate of inflation in the long run.In order to minimize uncertainty monetarist advocated for the maintenance of a constant rate of growth of money supply. Developing countries have depended on monetary policy in order to achieve price stability, economic growth and development, positive balance of payments and full employment. To contain any reduction in GAP the Central Bank adopted a selective credit control and special attention was given to the interests of marginal traders and productive agents in Agriculture. 9. Tools of Monetary Policy : There are three tools of monetary policy for which the value of money changes.For ensuring price stability monetary policy has to focus on these three tools. Monetary Policy of Bangladesh Bank The aim is to achieve the twin goals of containing inflation and promoting sustained and stable economic growth; provide policy advice to the Government on deficit managing and public debt management; manage the balance of payments and foreign exchange reserves; provide payment services and ensure the stability of the financial system; conduct treasury and government securities related operations; and efficiently perform other international financial activities.Financial Sector Developments Critical activities cover the development of the financial systems; provide effective prudential supervision; ensure information access, market intelligence, and contingency planning to avoid systematic risks; assist banking and financial entities o become efficient and competitive; discover new modalities for delivering agricultural and industrial term credit; enhance the access of small and medium enterprises to investment funds; further develop the market in public and private debt and risk capital; and pro mote measures for inclusion of people hitherto bypassed in formal financial systems.In addition, the Bangladesh Bank will continuously adopt necessary measures for taking a proactive stance in decision making; compiling relevant statistics and conducting high quality and timely economic research to review the country financial and economic conditions to purport decision making; ensuring efficient and professional management of Bib's human and financial resources; and establishing Bib's distinct identity based on its values and strategic roles.In order to uphold the mission, Bangladesh Banks aim would be to provide the required leadership by discharging its duties in a manner that shows a clear vision, is watchful, far-sighted, intelligent and responsive based on an effective and efficient communication strategy. At all times, Bib's aim would be to remain committed, efficient, capable, logistically supported, speedy, focused, and aggressive where necessary in order to ensure that the Bangladesh Bank always remains a credible and prestigious institution with an efficient organizational structure committed to achieving its goals. 9. Interest rate policy This arises where the central bank increases the rate of interest rates for borrowing funds. This instrument is most applicable in cases where banks turn to the central banks as an avenue of securing funds. The rates that can be increased include the overnight borrowing rate. This tends to discourage borrowing which then end up reducing the rate of inflation in an economy. So interest rate is a crucial important to sustain the price stability. Comparison of Interest Rate in Bangladesh Source: 1 . Statistics Department, Bangladesh Bank for Scheduled Banks Weighted Average Interest Rate. . Debt Management Department, Bangladesh Bank for Weighted Average Call Money Market Rates. 9. 2 Inflation Targeting This is an economic monetary inflation policy aimed at achieving a specific level of inflation in the country. This involves the setting of a certain level of inflation by the central bank, and then working towards achieving the given level of inflation. This is usually done through the utilization of interest rate changes and other monetary tools. Despite the embracing of the above monetary policies, many countries still find themselves being faced by extreme inflation rates.The rates end up eroding the value of the specific currency. A devaluation of currency ends up creating an unfavorable balance of payment and hence accumulation of debts and deficit budgets. In this perspective, third world countries continue to remain poor despite their rigorous endeavors aimed at escaping the unfavorable economic situation. In mimes of political tumult, monetary policy also tends to be ineffective in cases of political turmoil. The matter is further aggravated when political instability combines with economic shocks.This leads to a culmination of extreme inflation being witnessed in a country. An epitome of this was witnessed in Bangladesh during the period of Care taker Government of 2007-2008. The prices of basic commodities soared to the extent that they were virtually impossible to the average man. In addition, the monetary policies set out to correct out the situation ended up being ineffective in the control of the ensuing inflation. Economic shocks such as depressions, recessions, and booms also render monetary policies ineffective. This was witnessed during the 2008/09 economic recession all over the world.During the recession, major world economies faced harsh circumstances despite having well formulated monetary policies in place. The available strategies failed to stir the economy back to stability. 9. 3 Foreign Exchange Valuation Figure of Inflation Rate in Bangladesh A method for providing an interface for Foreign Exchange trading centered on a Foreign Exchange rate and this rate is an important factor of value changing of money. So the foreign exchange rate is an impor tant factor for monetary policy. Comparative Figure of exchange Rate in Bangladesh 10.Monetary Policy Instruments: There exist a variety of monetary policy instruments through which the central bank controls/ maintains general price level. Some of these tools include the following: 10. 1 Open Market Operations: Open market operations refer to the sale or purchase of securities. The transactions usually take place in the open market of the central bank. This instrument usually targets the available cash balances of commercial banks and other non bank institutions. The available balances are checked in relation to excess reserves available at the central bank.The major aim of this tool is the attainment of a predetermined level of reserve money. A situation of influenced commercial bank lending ensues hence an overall control of money supply in the economy. 10. Ii. Setting the bank rate: Central bank sets a bank rate for its borrowers. To maintain the general price level, central bank changes the rate time to time. If it wants to take the additional money from the market, it rises the interest rate on the other hand if there is shortage of money in the market it reduces the rate to make balance and control the price level. 0. Iii. Adjusting Reserve Ratio Reserve Ratio is also known as liquidity asset ratio is defined as the proportion of total assets being held by a bank. Every commercial bank has to maintain a reserve of liquid money to the central bank which is called SSL (Statutory Liquidity Ratio). This is usually in the form of liquid assets and cash. This instrument is effective since it manages to indiscriminately affect all banks. Also, the method tends to be directly established and the effects of its implementation are felt soon after its inception.The intended purpose of the tool is usually to create a situation where a banks free cash base is reduced. This reduces a banks ability to give out loans and advances and creates an overall reduction of avai lability of money. The reduction of excess money supply ends up curbing prices and inflation. 10. Lb. Moral Suasion It is one of the qualitative instruments of controlling general price level through persuasion at a moral sight not to disburse more loans to the particular bank. Persuasion not to give out loan to the any particular sector to control money supply . 10. V. Certain Margin RequirementsEvery importer has to keep a certain margin at the time of opening any LLC to the commercial banks to import goods from foreign countries. This marginal money becomes locked up to the bank until the goods are imported and the transaction is settled. This margin level is determined by the central bank and trough setting up new margin requirements central bank can maintain the general price level. 10. V'. Selective Credit Control These instruments prevail on the quantitative measure of credit control that strives at encouraging selective essential sectors of the economy while at the same time discouraging others.In one such instance, the Central Bank of Bangladesh, Bangladesh Bank can ensue to restrict government borrowing up to a given extent. Normally, the given legal limit is 5 percent of the most recent audited government ordinary revenues. Usually, this aims at reducing a case of excess government expenditure. A case of excess government spending leads to a situation of inflationary crisis. 1 1 . Failure of Monetary Policy in Developing Countries Despite the widespread success of monetary policies, there exists a tendency of failure of the policy in developing economies.The failure can be attributed to a yard of reasons. Some of the reasons include the following: I) In developing economies, markets and financial institutions tend to be highly disorganized. The lack of well developed capital and money markets and a limited quantity and range of financial assets creates and atmosphere that leads to the failure of monetary policy. It) In some instances, monetary polic ies end up being misused by the authorities. This leads to a situation where the monetary policies fail to address the situation at hand. Ii) In third world countries, commercial banks tend to have excess funds due to lack of viable projects and borrowers. This reduces the sensitivity of their cash base. In this case, the effectiveness of open market operations ends up being severely limited. Iv) The existence of high levels of corruption ends up rendering some instruments like selective credit control to be ineffective. V) Illiteracy in the developing countries ensures that individuals have little or no knowledge on the working of monetary policy. This reduces the effectiveness of monetary policy. Ii) Most individuals in developing countries prefer personal storage of money as opposed to bank deposits. This ends up reducing the effectiveness of Central Bank's endeavors 12. Conclusion To establish the effectiveness of monetary policy as a tool for combating inflation, The variables investigated were the level of inflation, commercial banks interest rates, money supply and the foreign exchange rate (measurable in dollars) and money supply was found out to be most significant factor affecting the rate of inflation.When money supply increases by one hundred billion the rate of inflation increases by 5. 478 . This being so, then it means that any increase in money supply should be managed to a level that allows the economy to grow and also high enough to avoid fellatio (a situation where the prices are falling) This is due to the fact that, if money supply is zero and the other factors are also zero, there will be a deflation of 18. 042. This means that the economy is not growing hence adversely affects the other objectives of macroeconomics.Also, it is evident that there exist a positive relationship between increase in foreign exchange rate and the rate of inflation; when the currency depreciates at a rate of one, inflation increases at a rate of 0. 233. Therefo re efforts should be made to avoid any rise in foreign exchange or any appreciation in the domestic currency. Also, this research showed that there exist a negative relationship between the rate of inflation and the commercial banks interest rates.When the commercial banks interest rates increase by one percent, the rate of inflation reduces by 0. 84. Thus, increase in interest rates is one way of controlling the rate of inflation. However, the rates of interest should be managed at a level that does not hurt investments as high interest rates hinders investments and this leads to poor economic growth hence it adversely affects the other macroeconomic objectives. Apart from the macroeconomic variables discussed above it is also evident other factors influence the rate of inflation.Some of these factors include political instability, tribal clashes, international financial crisis (recession and depression ) amongst others. Inflation targeting (where the monetary authorities set a cer tain target and manages the macroeconomic variables towards achieving that inflation rate) as policy should also be used as this has shown positive results in some parts of the world such as South Africa. Thus, monetary policy, as a tool for controlling inflation, is effective