tools of Monetary policy and its effectiveness. The central bank

2. Introduction:
• Monetary policy can be defined as “the set of actions
taken by the monetary authorities (the central bank) to
adjust the money supply in proportion to the desired level
of economic activity in order to achieve a set of economic
objectives.”
• The central bank uses a set of tools to implement the
monetary policy, some of which are quantitative, and
some are qualitative, in addition to the direct tools.

3. Goals of the monetary policy:
 Monetary policy aims to achieve several goals:
- Stabilization in the general level of prices.
- Achieving full employment.
- Achieving high growth rates.
- Strengthening stability in financial markets.
- Stabilization of the interest rate.
- Achieving exchange rate stability.

4. Tools of Monetary Policy:
 First: Quantitative Tools
 The quantitative tools of monetary policy are those that seek
to influence the volume and cost of credit.
 These tools are called the traditional tools, which include the
required reserve ratio, the rediscount rate in addition to the
open market operations.

5. a) The Required Reserve Ratio:
 The required reserve ratio is the percentage that the central
bank imposes on the commercial bank to keep from its
deposits with the central bank as an interest-free deposit.
 This ratio is determined according to the prevailing
conditions in the economy.
 The objective of the required reserve ratio is to use it as a
tool to control the amount of credit granted by commercial
banks and thus control the money supply.

6.  In times of recession and economic depression, the central
bank reduces the required reserve ratio, which leads to an
increase in the excess reserves available with commercial
banks.
 This in return increases the ability of commercial banks to
grant credit through the work of the money multiplier.
 This will lead to an increase in the purchasing power in the
national economy.
 This policy is called expansionary monetary policy.

7.  In the case of inflationary waves, the central bank increases the
required reserve ratio.
 This will result in a decrease in the amount of money that can
be directed to credit.
 Consequently, a decrease in the money supply and a decrease in
the purchasing power.
 Also, a decrease in the volume of investment, and thus a
decrease in the aggregate demand.
 This policy is called contractionary monetary policy.

8. b) The rediscount rate:
 The rediscount rate is the interest rate that the central bank
receives from rediscount of commercial paper offered by
commercial banks or the cost of borrowing from the
central bank.
 Commercial banks usually re-discount the commercial
papers they have with the central bank or borrow from the
central bank in order to enhance their cash reserves.

9.  If the economy suffers from inflationary waves, the central bank
can raise the re-discount rate.
 This discourages the commercial banks from re-discount their
commercial papers and then reducing the volume of funds
allocated for lending by commercial banks.
 As a result and due to the money multiplier, this leads to a
decrease in the money supply.
 Also, raising the re-discount rate leads to the commercial banks,
in turn, raising their discount rate for commercial papers, as well
as raising the interest rate on their granted loans which will
reduce their demand for loans, and the money supply decreases.

10.  However, if the objective of monetary policy is to expand the money
supply in order to address a recession, the central bank resorts to
reducing the re-discount rate.
 This encourages commercial banks to re-discount their commercial
papers or increase the demand for commercial banks to borrow from
the central bank.
 This results in an increase in the excess reserves of the commercial
bank and thus increases the ability of banks to grant credit and thus
increase the money supply.
 Also, the reduction of the rediscount rate results in a decrease in the
interest rate on loans, which leads to an increase in the volume of
investment, thus increasing aggregate demand.

11. c) Open Market Operations:
 Open market operations mean that the central bank sells or buys
securities, especially government securities, to influence the
money supply.
 In cases of recession, the central bank buys government
securities and bonds from the market.
 This results in an increase in the volume of liquidity in the
market and thus an increase in the purchasing power of
individuals and an increase in the volume of excess reserves at
commercial banks that leads to an increase in the money supply.

12.  An increase in the money supply leads to an increase in the
purchasing power in the market, which leads to an increase in
aggregate demand.
 On the other hand, an increase in the money supply leads to a
decrease in the interest rate, which leads to an increase in
investment, employment, and income.
 In the case of inflation, the central bank adopts a contractionary
monetary policy by entering the financial market as a seller of
government securities and bonds to absorb excess liquidity in
the market.

13.  This results in a decrease in the purchasing power of the
national economy and a decrease in the excess reserves of
commercial banks, and then a decrease in their ability to grant
credit, which in turn leads to a decrease in the money supply
through the monetary multiplier.
 A decrease in the money supply will also affect the interest rate
in the market, so the interest rate will rise, which will negatively
affect investment, employment, and income.
 As a result, the aggregate demand will decrease, which will
result in a decrease in the inflation rate.

14. The effectiveness of the quantitative tools:
 For the rediscount rate:
 The effectiveness of the rediscount rate depends on several
factors which are:
- The extent of the expansion of the discount market which
requires large transactions in commercial bills.
- Modern commercial transactions have become less dependent
on the use of commercial bills.
- This resulted in a decrease in the effectiveness of this policy.

15. - During a recession, commercial banks usually have excess reserves.
Therefore, reducing the rediscount rate, in this case, will not lead to an
increase in commercial banks' demand for rediscounting their
commercial papers.
- In boom periods, the central bank resorts to raising the re-discount
rate. However, this policy may be ineffective due to the investors'
desire to finance their investments through borrowing.
- Therefore, they accept borrowing despite the high-interest rates on
loans, which encourages commercial banks to re-discount their
commercial papers due to their need to increase the volume of their
reserves.

16.  For open market operations:
- The success of open market operations depends on the existence of
sufficient securities in the market to the extent that the entry of the
central bank into the market as a seller or buyer of securities
effectively affects the money supply.
- Using this tool requires the availability of a wide, organized, and
active financial market, which is not available in many developing
countries which suffer from the lack of widespread use of securities
and treasury bills.

17.  For the required reserve ratio:
- Changing the required reserve ratio is considered the most effective
and least expensive tool of the monetary policy, especially in
developing countries.
- However, the effectiveness of the required reserve ratio differs in
cases of boom and inflation from cases of recession and depression.
- In times of inflation, this tool is considered one of the successful
policies as the commercial banks do not find a way to respond to the
central bank’s instructions to raise the required reserve except by
reducing loans and investments and thus reducing the volume of
deposits.

18. - In times of recession, lowering the required reserve ratio is not very
effective in encouraging loan demand due to the low demand for loans
during the recession period.
- Therefore, this policy must be accompanied by other measures to
increase the demand for loans.
- Also, the effectiveness of the required reserve ratio depends on the
size of the excess reserves held by commercial banks.
- Keeping large excess reserves by commercial banks limits the
effectiveness of changing the required reserve ratio in affecting the
money supply.

19. - Increasing the effectiveness of quantitative tools may require the use
of a combination of these tools together to achieve the desired goal.
- For example, when the central bank resorts to entering the financial
market as a seller of government securities in order to absorb excess
liquidity, this may require the central bank to raise the rediscount rate
so that commercial banks do not finance the purchase of government
securities by rediscounting the commercial papers it has.
- Also, the success of monetary policy requires coordination with fiscal
policymakers in order to stimulate growth and increase the level of
employment without leading to higher inflation rates.

20. Second: Qualitative tools
 Qualitative monetary policy tools are those tools that the central
bank uses to influence the direction of credit and not its total
volume.
 These tools are widely used in developing countries due to the
poor effectiveness of the quantitative tools.
 These tools are many, but we can summarize them in two
groups: the loan framing policy and the loan selective policy.

21. a) Loan Framing Policy:
 The loan framing policy means that the central bank imposes a
higher credit ceiling that no bank can exceed, in order to limit the
ability of banks to grant credit.
 The central bank uses this policy in times of inflation to determine the
maximum amount of loans that the commercial bank can grant. This
of course contributes to a decrease in the money supply.
 This policy can also direct credit so that priority is given to the sectors
that were not the cause of inflation, and credit is restricted to the
sectors that were the cause of inflation.

22.  In general, the loan framing policy did not achieve the target
goal in the countries that implemented it due to several factors:
- The desire of monetary authorities in many cases not to
impose a significant restriction on the finance of the
economy.
- This policy represents a selective treatment, and its use may
lead to sectoral distortions.
- Some institutions may resort to borrowing among themselves
or issuing debt bonds to overcome these restrictions.

23. b) Selective Loan Policy:
 These selective measures are intended to facilitate access to
special types of loans or sometimes to control their distribution.
 These loans usually aim to influence the direction of the loans
towards the areas to be stimulated.
 This policy takes several practices such as:
- bears part of the cost (interest rate) of loans directed to some
activities such as activities related to export or agriculture.
- Re-discounting the commercial papers of some loans, such as
export loans with the normal rediscount rate in order to encourage
these activities.

24. - Using differential interest rates to influence the volume of
loans directed to the targeted sectors.
- Placing restrictions on consumer credit in order to restrict
aggregate demand to curb inflation.
 In general, the central bank resorts to using these
qualitative tools to avoid the systemic and undesirable
effects that result from the use of quantitative tools that do
not distinguish between sectors.

25. Third: Other tools of monetary policy (Direct tools):
 The success of quantitative and qualitative tools in achieving
their goals depends on the response of individuals and banking
institutions to these procedures.
 These tools may also not be sufficient or ineffective in many
cases in achieving the desired effect.
 As a result, the central bank resorts to other direct means and
procedures, and this is called direct supervision.

26.  Moral persuasion:
 Moral persuasion is the case where the central bank resorts to
the method of dialogue with the management of commercial
banks in order to convince them of the objectives of monetary
policy and the measures that commercial banks must take in
order to achieve these goals.
 However, experience indicates the limitations of this method in
achieving its objective, especially in the case of developing
countries.

27.  Direct instructions:
 The central bank resorts to using other means such as compulsory
instructions and orders that commercial banks must follow.
 Commercial banks must submit periodic reports on the loans granted
according to the directions of the central bank.
 Based on these reports, the central bank can issue warnings to banks that do
not implement these instructions, and it may reach the point of taking
penalties against them.
 In general, the method of direct control of credit is more useful for treating
inflation than cases of recession, because forcing banks to limit the expansion
of loans is more possible than compelling them to increase loans.