Gift Kasika

There are a number of accommodative monetary policies and procedures that can be used by central banks and government to stabilise the economy in periods of distress.

The objectives of central banks are to stabilise the financial system in the economy in order to facilitate the achievement of macroeconomic equilibrium, and to lessen the effect of disturbances on the economy. The achievement of these objectives relies on a choice of monetary policy or a combination at the central bank’s disposal. Central banks’ policies work through influencing the capacity of commercial banks to extend credit to the general public. Monetary policy objectives that central banks strive to achieve are basically a specific inflation rate, a particular growth in aggregate money stock, or a particular exchange rate. These policy targets are referred to as intermediate targets of monetary policy.

The central bank policy instruments towards achieving these targets work indirectly by affecting agents with a time lag. Central banks do not possess the capacity to directly and immediately control the behaviour of the public towards the attainment of the monetary policy targets. They, however, have two policy instruments over which they have direct and total control. These instruments are commonly known as Operational Targets (OT). Operational Targets are the variables over which the central bank has direct and immediate control. These are the instruments that influence the behaviour of various agents and banks in particular in order to facilitate the achievement of their intermediate policy objectives.

Central banks have two instruments which meet the above definition of OT: the quantity of cash reserves and the interest rest. The quantity of cash reserves is the level of cash which the central bank makes available to commercial banks, on which banks can extend credit to the public. By expanding or contracting the level of cash reserves, the central bank can influence the level of aggregate spending in the economy towards the achievement of monetary policy targets. On the same token, by manipulating the cost of borrowing funds, which is the interest rate, the central bank can influence the level of aggregate spending towards the achievement of their policy targets. The interest rate at which central banks provide cash to the banking sector are called the repurchase rate (repo rate), and is basically short-term, which has to be repaid overnight. 

A policy instrument choice between the quantity of cash reserves and the interest rate can be applied in different economic conditions. Under a normal and non-crisis state, the interest rate is the most appropriate policy tool, while in crisis conditions, the quantity of cash is the most ideal.

Deposit extensions to the public require commercial banks to keep more cash reserves in their accounts held at the central banks because most of the payments are between deposit holders from different banks. Banks need to keep enough cash on their central bank accounts for the purpose of interbank settlements.

The central bank is the most reliable source of additional cash reserves for commercial banks. Because of this, central banks have the mandate to pursue monetary policy targets through the OT. Without this relationship, the central bank will lose its capacity to conduct monetary policies. 

QUANTITATIVE EASING (QE)

Quantitative easing involve methods of stabilising the macroeconomic state following a disturbance. When economic activities are contracting, people will be unwilling and/or unable to take more loans from the banks, and business activities of commercial banks will contract as well. In the time of economic contraction, the focus of the public shifts from taking more loans, which constitutes money-creation to the repayment of their loans, which is a money-destruction component. When the credit extension facilities of commercial banks are not utilised in this way, the economy will be contracting. Therefore, government interventions are then required to counter the further contracting as its self-reinforcement.

The government can intervene with a mechanism known as Quantitative Easing (QE). In times of economic contracting, government will have to step up by borrowing money from commercial banks in order to restore the credit extension of commercial banks ,and therefore facilitate money growth within the economy. By borrowing from the banks, the government will stimulate the money stock and the total spending. As the spending in the economy picks up and the confidence in the private sector is restored, the government can gradually reduce its indebtedness so as to build on the capacity of the private sector’s borrowing needs.

In a situation where the government is unable to take more loans in the way explained above, the central bank has the capacity to conduct QE. The central bank will have to buy large stock of government debt paper from the banks and/or from the public in order to extend cash reserves in the economy, and therefore raising total spending. The objective of QE is to stimulate total spending on goods and services. Through QE, total spending can increase through three channels.

First, by directly increasing the money stoke: money in the hands of the general public leads to an increase in total spending on goods and services, provided the injections are more than the money that leaks out of the spending stream.

Secondly, by indirectly raising the money stock through a rise in the bank’s cash reserves. Increases in the bank’s reserves will prompt the banks to increase their credit extension to the public, and therefore more money in the economy will increase total spending in the economy, provided the leakages on the spending stream are less than the injections.

Thirdly, by indirectly increasing total spending through lowering the interest rate on borrowing for long-term investment. When the interest rate is low, people are inclined to take more loans, and will therefore increase their investment spending. The increases in investment spending will increase total spending via the multiplier effect throughout the economy.