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UNIT TWO: EXPANSIONARY MONETARY POLICY VS RESTRICTIVE MONETARY POLICY
CONTENTS 1.0. Introduction 2.0. Objectives 3.0. Main content
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and in business demand for investment goods, a deflationary gap emerges. The central bank start an expansionary monetary policy that eases the credit market conditions and leads to an upward shift in aggregate demand. For this purpose, the central bank purchases government securities in the open market, lowers the reserve requirements of member banks, lower the discount rate and encourages consumer and business credit through selective credit in the money market, and improves the economy.
In Nigeria, when the CBN‘s monetary policy Committee wishes to increase the money supply, it can do a combination of three things:
1. Purchase securities on the open market, known as Open Market Operations 2. Lower the CBN Monetary Policy Rate (MPR)
3. Lower Reserve Requirements
These all directly impact the interest rate. When the CBN buys securities on the open market, it causes the price of those securities to rise. The MPR is an interest rate, so lowering it is essentially lowering interest rates. If the CBN instead decides to lower reserve requirements, this will cause banks to have an increase in the amount of money they can invest. This causes the price of investments such as bonds to rise, so interest rates must fall. No matter what tool the CBN uses to expand the money supply interest rates will decline and bond prices will rise.
Increases in bond prices will have an effect on the exchange market. Rising bond prices will cause investors to sell those bonds in exchange for other bonds. When interest rates are lower, the cost of financing capital projects is less. So all else being equal, lower interest rates lead to higher rates of investment. When the policy-making group at the Federal level gathers, they take a detailed look at current and expected economic conditions. The members of the monetary policy committee will be given forecasts of the likely direction of the economy in the upcoming year or so. To be effective, the committee desires to anticipate economic problems rather than reacting to current conditions.
Let us look at the scenario facing the Nigeria in early 2016. The Nigerian economy had been growing at a rapidly increasing clip during the preceding years. As 2016 began, several key indicators of the economy were entering the danger area. For example, crude oil exports were dwindling and industrial capacity utilization was reaching a level that could cause an increase in the inflation rate by the later part of 2016 if low economic growth rates continued. Rather than wait for the anticipated inflation to materialize, the Federal Government through the CBN initiated an expansionary monetary policy to speed the growth rate of GDP. Figure 2 is money market equilibrium, which shows the demand and supply of money in the money market.
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Figure 2: Money Market Equilibrium
Money Supply Mos Interest Rate
Money Demand ro Md
Qom
Quantity of Money
Figure 2 shows the demand and supply of money in the money market. We show the money supply as a vertical line at a level controlled by the CBN. The equilibrium interest rate, r0, is determined by the intersection of the demand for money and the supply of money, labeled money supply.
3.1.1. Scope and Limitations
During the 1930s and 1940s, it was believed that the success of monetary policy in stimulating recovery from a depression was severely limited than in controlling a boom and inflation. This view emerged from the experiences of the Great Depression and the appearance of Keynes‘s General Theory.
The monetarists hold that during a depression the central bank can increase the reserves of commercial banks through a cheap money policy. They can do so by buying securities and reducing the interest rate. As a result, their ability to extend credit facilities to borrowers increases. But the experience of the Great Depression tells us that in a serious depression when there is pessimism among businessmen, the success of such a policy is practically nil. In such a situation, banks are helpless in bringing about a revival. Since business activity is almost at a standstill, businessmen do not have any inclination to borrow to build up inventories even when the rate of interest is very low. Rather, they want to reduce their inventories by repaying loans already drawn from the banks.
Moreover, the question of borrowing for long-term capital needs does not arise in a depression when the business activity is already at a very low level. The same is the case
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with consumers who faced with unemployment and reduced incomes do not like to purchase any durable goods through bank loans. Thus all that the banks can do is to make credit available but they cannot force business men and consumers to accept it. In the 1930s, very low interest rates and the piling up of unused reserves with the banks did not have any significant impact on the depressed economies of the world.
This is not to say that an easy monetary policy in times of severe contraction will be without beneficial effect, its effect will be largely that of preventing a bad situation from getting worse. But a restrictive monetary policy combined with a business downturn would surely aggravate the downturn-the classical example of this was the monetary policy in 1931 that contributed to the deepening of the Great Depression. However, if credit is readily available on favourable terms, it clearly has a stabilizing effect. By meeting the liquidity requirements of business, it can slow and perhaps reduce the extent of the downturn.
But what led to the decline of monetary policy in the 1930s and 1940s? In addition to the sad and disillusioning experiences during and after the Great Depression, it was Keynes‘s General Theory that led to a decline in monetary policy as an instrument of economic stabilization. Keynes pointed out that a highly elastic liquidity preference schedule (liquidity trap) renders monetary policy impotent in time of severe depression.