No Nonsense
Money, credit and monetary policy
MONETARY policy involves changing the money supply (MS) to influence the economy through changing interest rates. Any perception that MS is increased by printing money by central banks (CB) is mistaken. Money (or currency) is printed to:
- Meet people's demand for currency (when income and/or prices increase), and
- Replace damaged or worn out currencies.
An increase or a decrease in the money supply by CB is a process -- a mechanism implemented through buying and selling Treasury Securities (TS) called Open Market Operations (OMO). In BB terminology, an OMO purchase of TS from banks is called Repos (Repurchase). This adds reserves (liquidity) to banks -- an expansionary monetary policy stance. An OMO sale of TS to banks by BB is called Reverse Repos (mops up reserves from banks) -- a contractionary policy stance.
As banks reserves are increased, new loans are made and money supply is increased; when loans are paid off, money supply is decreased.
Increased reserves received by banks through Repos tend to lower lending rates, which encourage borrowing and, thus, MS increases. Borrowers use this money to buy goods and services, including capital goods.
The data in the table shows that changes in MS (M1= currency in circulation outside banks + checking account deposits) had no significant or systematic effects on interest rates (compare M1 growth with changes in lending and deposit rates). The trivial fluctuations in interest rates may be regarded as random noises -- not policy induced systematic changes, indicating that over the sample period changes in the MS had no effect on interest rates.
One plausible interpretation is that banks were able to lend out all their available reserves at the prevailing lending rates and, hence, there was no idle reserves pressure for banks to lower that rate to entice borrowers (demand for credit is nearly perfectly elastic -- a horizontal credit demand curve). For example, during the Sept. FY 06:Q1, M1 grew at 22.2% and the corresponding average lending rate was 12.41%. During the following quarter (Dec. FY06:Q2) M1 grew at 32.5% (a 10.3% jump up), and the lending rate, instead of falling, moved up to 12.60%.
Private sector credit growth (PSC) also reveals no systematic or predictable pattern of movements with lending rates. Although higher M1 growth appeared to be associated with higher PSC growth during the FY07, the pattern became unpredictable over FY08 quarters, showing no predictable relationship with lending rates.
In addition to inflation fear, political uncertainty, and fear of being incarcerated for politically pushed loan extraction may also account for a lackluster growth in PSC.
As is well known, the major effects of monetary policy on output can take anywhere from three months to two years. And the effects on inflation tend to involve even longer lags, believed to be one to three years, or more.
So, how did BB's monetary policy affect the economy over the last two years? From the Table one can only see a predictable relationship between money growth and inflation rate: higher M1 growth (currency + checking account deposit) in FY07 transformed into higher inflation rate in FY08 (with lags).
Real interest rate (real rate = lending rate inflation rate) kept falling as inflation surged up, resulting in both lenders and depositors losing the purchasing power of their funds -- a real blow to both lenders and savers -- discouraging both lending and saving.
For the most part, the demand for goods and services is not related to the market interest rates, also called nominal interest rate (example, lending rates), quoted in the financial pages of newspapers; instead it is related to real interest rates (nominal rates the expected inflation rates).
Changes in real interest rates affect firms' and consumers' demand for goods and services mainly by altering the costs of borrowings, the availability of bank loans, the wealth of households, and foreign exchange rates.
For example, a decrease in real interest rates lowers the cost of borrowing; that leads businesses to increase investment spending, and it leads households to buy durable goods, such as autos and new homes and so on.
These would be accompanied by higher production and consumption, raising real GDP -- which constitute the short-run effects of monetary policy.
Note that the CB cannot set the real interest rate directly because the public's inflation expectations are not precisely predictable. Since the CB is the sole supplier of bank reserves it can only set nominal "bank rate" (rate at which banks borrow reserves from the CB).
To raise hopes that monetary policy can increase real output growth and hence alleviate poverty reduction is a deception, if you will.
The real business cycle theory and its empirical proof was the subject of intense research in the decades of the 80s and 90s. Professor Christopher Sims of the University of Minnesota, using his newly innovated econometric methodology of vector auto-regression (VAR), showed that money growth accounted for only 4% of the variations of output growth while interest rate accounted for 40% (1980, American Economic Review). That finding could not be refuted in subsequent research.
In one of my 1988 papers, "Money and the Business Cycle -- Another Look" (Review of Economics and Statistics, Harvard University), I found that neither money nor interest rates directly affect real output -- the channel of monetary and interest rate effects are transmitted to real output through changes in investment spending.
During the same periods, numerous studies have shown that only monetary policy surprises (unanticipated OMOs in the bonds market) have effects on real economic variables. If the CB's policy actions are perfectly predicted by the private sector then monetary policy has no statistically significant effect on interest rates and real economic variables.
That is precisely the reason monetary authorities all over the world do not indulge in policy deliberations in press conferences and press briefings. For example, the minutes of the US Federal Reserve policy meetings are not publicly available until about two months later.
The BB's recent publicly talked about pressure on banks to narrow the interest rate spread went unheeded, making the BB looked ineffective and powerless.
My August 13 piece, "Monetary policy and inflation targeting," emphasised targeted credit expansion and at the same time pursued an activist monetary policy for inflation targeting. I also emphasised that success of such a policy is contingent upon data gathering and monitoring if the targeted credit is being properly utilised.
World Bank funded BB's Policy Analysis Unit (PAU), that started about four years ago, has been doing some policy analysis with real life data. Not much has changed in the PAU activities since my last seminar presentation in BB's research department in December 2005. Strengthening the PAU with proper accountability would immensely benefit the understanding, transmission and future directions of monetary policy.
Additionally, each of the nine divisional branch offices of BB should have their own Policy Analysis Unit to gather primary economic data covering the entire division, and carry on some basic data analysis and then feed them back to the BB headquarter for further review and analysis.
A nation of 150 million people deserves a central bank equipped with the state of the art econometric techniques of data analysis and highly skilled economists in all areas of research and policy analysis.
(Thanks to Professor Ahsan Habib of Adrian College, Michigan, formerly economics lecturer of Dhaka University, for his review.)
Dr. Abdullah A. Dewan is Professor of Economics at Eastern Michigan University, USA.
For all latest news, follow The Daily Star's Google News channel.
Comments