The goals and effects of monetary policy on economic growth

¶ … Goals of a Monetary Policy

Finance.

Monetary policy is a complex framework of money demand and money supply. It cannot be framed easily as the formulating of the monetary policy for the state is a massive responsibility for the central bank of that state because the composers of the monetary policy are very well aware of the fact that there little mistake can cost the state and its economic development a lot. (Labonte, 2006)

Monetary policy can be defined as a set of policies that are related to the supply of money. As the sole agency which is responsible for the money supply in a state is the central bank of that state, therefore, monetary policy can also be defined as the rules, policies or statements of the central bank of a state, especially of its board of directors, that have an impact on the aggregate demand and national spending. (Labonte, 2006)

Specific attention is being paid to the announcements, of the Chairman of the central bank and the board of directors, that relate to the monetary policy by the financial press and markets. This is because the monetary policy has a direct impact on the aggregate demand and through aggregate demand; it can influence the Gross Domestic Product (GDP) of a state.the monetary policy of a state can have an influential impact on other variables such as real foreign exchange rates, unemployment, interest rates, and output etcetera. (Labonte, 2006)

Though all the above mentioned variables are the important ones, but the impact of monetary policy on these variables usually occurs in the short run. The monetary policy, however, has a long-term impact on the rate of inflation. An increase in the money supply can lead towards a decrease in interest rates which will lead towards an increase in investment. This increase in investment will lead towards an increase in Gross Domestic Product (GDP) and this will consequently increase employment and economic stability but all this will happen in the short run. (Labonte, 2006)

In the long run, however, an increase in the money supply would lead towards a rapid increase in the rate of inflation. So the positive effects of the rapid growth of money are evident only in the short run and in the long run the economy is left to handle with extreme rates of inflation. In the economies where high rates of inflation are common, the rapid growth of money does not stimulate any positive effect instead it causes the rates of inflation to go higher. (Labonte, 2006)

2. Goals of a Monetary Policy

According to the Federal Reserve Act, 'the Board of Governors and the Federal Open Market Committee should seek to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.' It can be said that stable prices in the long run can trigger sustainable economic growth and employment and they can also lead towards moderate interest rates. (The Federal Reserve System: Purposes and Functions, 2005)

When the prices of goods, services and labor are stable then this indicates that the prices are not distorted by the changes in the rates of inflation. Such stable prices provide a clear way for the allocation of resources and thus the resource allocation can be made more efficient. This in return can lead towards a higher standard of living. (The Federal Reserve System: Purposes and Functions, 2005)

In addition to that, stable prices also lead towards an increase in the rate of savings and generation of capital. This because the risk of loss in the value of assets, due to inflation, is decreased and the households are encouraged to save more, and businesses and investors are also encouraged to invest in different projects. (The Federal Reserve System: Purposes and Functions, 2005)

In addition to that, employees of the Federal Reserve and other central banks also include economic growth, stability of financial markets and the stability of foreign exchange markets in the key goals of a monetary policy. (Conduct of Monetary Policy: Goals and Targets, 2003)

2.2. Employment

Monetary policy is a wide term and it has a broad meaning. Generation of employment and maximization of output is also one of the main objectives of the monetary policy. The number of jobs that a monetary policy generates (employment) and the rate of increase in output because of a monetary policy depends on the price stability, technology, people's priorty to save money and trends of working and risk taking over the period of time. (Cambazo-lu & Karaalp, 2012)

In the long run price stability lleads toward efficient allocation of resources. Which in return lead towards maximization of output. And this maximization of output lead towards high rates of employment. The high rates of employment in return elevate the living standards to a higher rate. (Cambazo-lu & Karaalp, 2012)

In the short run, countries may face various phases of boom and recessions. The central bank can control the rate of inflation and can elevate the rates of employment by controlling the money supply. This control over the rates of inflation and the rates of employment is maintained in a short run and does not remain in effect in the long run. (Cambazo-lu & Karaalp, 2012)

2.3. Economic Stability and Growth

The monetary policy plays an important role in stabilizing and triggering economic growth. The monetary policy's goal to achieve economic stability can be distorted by the pressure of accomplishing other goals of the policy. The first step taken by the monetary policy to attain sustainable economic growth is to maintain stable prices throughout the economy. As these stable prices can prevent the value of money from decreasing and contribute towards maintaining the purchasing power of the money. (How Does Monetary Policy Affect Economic Growth?, 2001)

The second step that the policy takes is to cut down the interest rates to a lower level. As the rate of interest is the cost of borrowing, lower rates of interest encourage the businesses to borrow from sufficient fud units (SFUs). The businesses then invest these borrowed funds in productive operations. These investments lead towards higher Gross Domestic Product (GDP) and ultimately higher standards of living and a stable economic growth. (How Does Monetary Policy Affect Economic Growth?, 2001)

Stable economic growth makes a country sound and powerful. It enhances its trade and commerce activities and directs an attractive amount of Foreign Direct Investment (FDI) towards it. It elevates the living standards of the citizens of that country and lead towards maximized investment, output and employment in that country. (How Does Monetary Policy Affect Economic Growth?, 2001)

2.4. Moderated Interest Rates

The supply of money has a direct impact on the interest rates. The increase in money supply would always lead towards a decrease in the rates of interest, whereas, a decrease in the money supply would always lead towards an increase in the rates of interest. The supply of money has the above discussed impact on the interest rates at least in the short run and the medium run. (Mishkin, 1983)

Interest rates can have a direct impact on the investment and consumer expenditure. In addition to that, rates of interest can also have an influential impact on the valuation of capital. Decline in the interest rates can have an expansionary effect on all the three variables, whereas, an increase in the rates of interest can have a contractionary impact on all the three variables. (Mishkin, 1983)

But both high increase and decrease in the rates of interest can be harmful for the economy as a constant increase in the rates of interest can lead towards elevated rates of inflation. Whereas, a constant decline in the rates of interest can lead towards elevated rates of deflation. It is, thus, a critical element of the mechanism of a monetary policy to maintain moderate or stable rates of interest in order to stabilize the economic growth and prices as well so that the individuals and the businesses can enjoy maximum economic welfare. (Mishkin, 1983)

2.5. Stable Financial Markets

The stability of financial markets is another key goal of the monetary policies. Healthy and stable financial markets lead towards a healthy economy. Financial markets consist of financial intermediaries that play an important role in channeling the funds from Sufficient Fund Units (SFUs) to Deficit Fund Units (DFUs). (Driffill, J. et al., 2005)

If the financial markets are not stable then there is a flaw in the proper channeling of funds. Those with productive ideas do not get the appropriate amount of funds and hence there is an evident decrease in the investments. In addition to that, if the funds are channeled through financial intermediaries then there is a decline in the chances of frauds and there is also a decrease in the transaction costs, that is the time and money required to channel funds. So the instability and inefficiency of financial markets can lead towards high rates of frauds and high transaction costs. (Driffill, J. et al., 2005)

Apart from that, financial markets also facilitate the individuals to invest their money in sound portfolios of assets. They decrease the risk associated with investments as they convert the high risk assets into low risk assets by constituting a variety of pools of assets that have both high and low risk assets. If the financial markets are stable then they can perform all these functions efficiently and can have an expansionary impact on investments, savings, Gross Domestic Product (GDP), employment and overall economic growth. (Driffill, J. et al., 2005)

Central banks usually try to stabilize financial markets by smoothing the rates of interest. That is, by decreasing the fluctuations in the rates of interest in the short run. As the unnecessary fluctuations in the interests can have a negative impact on the functioning of financial institutions, specially on the functioning and operations of different commercial banks. (Driffill, J. et al., 2005)

As banks usually borrow on short terms and lend on long terms. In addition to that, if due to unnecessary fluctuations in the rates of interest a bank fails to pay off its borrowed amount then this failure can have a negative impact on the functioning of all the other financial institutions and on the stability of financial market as well. The central banks, therefore, try to maintain stability in the financial markets by maintaining stability in the interest rates. (Driffill, J. et al., 2005)

2.6. Stable Foreign Exchange Markets

The foreign exchange market provides a platform through which the currency of one country is exchanged for the currency of any other country. The exchange rate for the countries is determined and the foreign exchange transactions are then completed at a physical level. (Bordo, M. et al., 2012)

The central banks aim to maintain stability in the foreign exchange markets through appropriate policies. This is because the decline in the exchange rate of a country leads towards the decline in the value of money and consequently towards an increase in the rates of inflation. (Bordo, M. et al., 2012)

Whereas, an increase in the foreign exchange rate lead towards a decreased in the demand of local goods as the consumers find imported goods less expensive. This lead towards the decline in the exports of the country and an increase in the imports of the country. The decline in exports and an increase in imports has a negative impact on the balance of payments and the country thus has to suffer a trade deficit. (Bordo, M. et al., 2012)

The central banks try to maintain stability in the foreign exchange markets as the stable foreign exchange markets lead towards lower rates of inflation and better trade performance. Both these variables can have a positive impact on the overall economic growth of the country which is the broad goal of almost every monetary policy. (Bordo, M. et al., 2012)

While designing a monetary policy the central banks and the responisible officials shall ensure that the policy works well in the long run and the medium run. As the short run impacts of the policies are not everlasting but the changes in the monetary policy can have a prominent impact on an economy in the long run. So the targets for a monetary policy should be designed in a way that they have a positive impact on the prices, interest rates, economic growth, financial markets, foreign exchange markets and employment in the long run. And they may contribute towards overall economic growth of the country in the long run. (Macfarlane, 2012)

3. Policies to Achieve Macroeconomic Goals in Developing Countries

Economic growth is not a naturally occurring phenomena. Over a period of time, the world has seen some countries witnessed real growth in economic terms. Whereas, the poverty and economic conditions in some countries kept on deteriorating. During the past years some countries have achieved great economic stability and have decreased the rates of poverty and inflation to a great extent. All these conditions prevail in different countries due to their policy frameworks and structures. (Macroeconomic stability, inclusive growth and employment, 2012)

Developing countries face a number of problems in achieving the key goals of the monetary policy. The major problem prevailing in the low income or developing countries is that the central banks of such countries are not independent and therefore, they cannot take corrective measures to target economic growth without justifying their actions to other parties. In addition to that, the political pressure in developing countries is greater than that in developed countries so the central banks have to align their actions very carefully with the demands and pressures of the political conditions. (Monetary Policy in Developing Countries, 2011)

There are four main strategies, namely inflation targeting, exchange rate fixing, currency board and dollarization, that the developing countries can use to achieve the macroeconomic or monetary policy goals. (Huang, & Wei, 2005)

3.1. Inflation Targetting

It is a policy or a framework in which the central bank of the country announces the target inflation rate for that country. Either the central bank announces this target rate at its discretion or it is ordered to announce it. The developing countries either go for mechanical inflation target or they opt for optimally chosen target. (Huang, & Wei, 2005)

The mechanical inflation target can be defined as a framework that guides the developing countries to follow the footsteps of the developed countries. That is, to set a low target inflation rate of about four percent. The optimally chosen target is a framework that enables the country to choose a target rate of inflation which is in alignment with the optimal rate of inflation of that country. The optimal rate of inflation is higher in those countries where the institutional quality is very low. The mechanical inflation rate usually ranges between one to four percent as it is similar to the targeted rate of developed countries. (Huang, & Wei, 2005)

3.2. Fixed Exchange Rate or Currency Board

While following the framework of the fixed exchange rate or currency board the developing countries implement the inflation rate of the anchor country as their target inflation rate. This is because the anchor country has better quality institutions than those of the developing countries. Because of the low quality institutions the developing countries usually have an inflation rate which is lower than the optimal inflation rate and a tax rate which is higher than the optimal tax rate. (Huang, & Wei, 2005)

While using the fixed exchange rate or currency board framework, the developing countries are said to be 'importing credibility' from the anchor country. If there are no stochastic shocks in the Philip's curve then the fixed exchange rate, currency board and mechanical target framework have the same effect on the economy. Whereas, when such shocks are prevalent then the mechanical target framework is preferred because it has the flexibility to adjust to such shocks. (Huang, & Wei, 2005)

3.3. Dollarization

There are three forms of dollarization: 1) Official Dollarization; it means that the country has no legal currency and the dollar is the legal tender. 2) Official Semi-Dollarization; it means that the dollar is used as a legal tender along with the local currency. 3) Unofficial Dollarization: it means that the dollar is not a legal tender but it is widely used in private transactions as a store of value and a medium of exchange. (Meyer, 2013)

Unofficial dollarization protects the citizens of the country from the high rates of inflation and it also elevates in the rates of borrowing and investments in the country. As the people are not willing to borrow and invest in the local currency due to its deteriorating value and purchasing power. On the other hand, official dollarization reduces the rates of inflation as they are close to the rates prevalent in the United States of America. It also reduces the nominal interest rates as there is no risk of currency devaluation, therefore, the devaluation risk premium is not being paid. It also has a positive impact on the financial markets of the country and it elevates the international trade to a higher level. (Meyer, 2013)

4. Conclusion

The key goals of the monetary policy are interrelated to each other and achieving one would automatically lead towards the achievement of the other. The broader goal of almost all the monetary policies is the economic development and well being of the country.

The policy structures in the developing countries are different than those of the developed countries. Developing countries usually use dollarization, fixed exchange rates, currency board or inflation targeting frameworks to achieve the key goals of the monetary policy.