The framework of Monetary Policy

In the context of the memorial lectures at the Bank of Mauritius (BOM) this week and the launching of monetary policy challenge and financial literacy program, I thought fit to try my hand at something slightly more academic and also to clear out some of the inconsistencies that have appeared in the analysis and comments of the few, that just because they are constantly in the spotlight, who believe that they can get away with their outdated simplistic Monetarist/Keynesian dichotomy. I will try to keep it as simple as possible without leaving out the interplay of the variables (money, bank credit and interest rates) that govern monetary policy and have a significant influence on the economy.

Monetary policy is related to a number of fundamental economic indicators such as exchange rate, inflation, asset prices, etc. It is also important to assess the stance and impact of monetary policy to understand the state of the economy in a given period. Assessing the stance of monetary policy is not that straightforward and the behavior of monetary policy indicators are not always easily to reconcile; domestic credit can be declining simultaneously with interest rates and interest rates may be falling at the same time as the exchange rate is rising.

 

The monetary policy stance is assessed through various indicators: monetary aggregates, interest rates (real interest rate relative to the neutral level) and yield spreads, the yield curve, exchange rate, (real exchange rate relative to its neutral level) and the monetary condition index (a weighted average of the interest rate and the exchange rate). Monetary policy is said to be expansionary or contractionary if it tends to push output over or  below its potential. It is said to be neutral if it does not induce the economy to deviate from the steady state.

 

The monetary transmission mechanism is the term used to denote the different channels through which often after long, variable and not fully predictable lags, monetary policy affects outputs and prices. A good understanding of the transmission mechanism is an important prerequisite for implementing a sound policy. It allows a judgment to be formed as to the extent and the timing of monetary policy decisions which are appropriate in order to meet its final objectives (maintain price stability). The stages in the transmission mechanism:
(a) Changes in money market conditions affect financial markets as reflected in market interest rates, asset prices, the exchange rate and the general liquidity and credit condition in the economy;
(b) Changes in financial markets conditions affect spending and prices;
(c) The timing and strength of the various channels in each of the stages depend on the economic and financial structure of the economy, and
(d) the important role of inflation expectations in determining the timing and size of monetary policy effects -- a more direct channel of transmission.

 

The exchange rate channel: For an open economy that is dependent on foreign trade the exchange rate provides another important channel through which monetary policy affects the economy. The exchange rate channel is linked to the effect of monetary policy on aggregate demand -- the indirect effect. A tightening of monetary policy will increase domestic real interest rates, make domestic currency deposits comparatively more attractive and lead to an appreciation of the domestic currency. Because prices are slow to change, the appreciation translates into higher prices relative to foreign goods and lower profits from exports. This appreciation will cause a decline in net exports and thus in aggregate output. Lower demand for domestic goods and services eventually puts downward pressure on prices and wages. The more direct effect on inflation is through the immediate impact of the appreciation on prices of imported goods.

The wealth channel: Monetary policy affects demand through the wealth effects on consumption and investment. As a result of a contractionary monetary policy, the public will find that its money balances have been reduced below the level demanded and will try to increase its money holdings by reducing spending. Consequently the decreased demand for equities reduces equity prices and consumers’ wealth, leading to a fall in consumption.

The credit channel: The credit channel emphasizes the role that credit conditions play in monetary transmission mechanism. An expansionary monetary policy will lower interest rates, improve households and firms net worth. But instead of the direct effect this has on the demand for goods, it emphasizes the effect on the terms of credit. Specifically, as a result of their higher net worth, borrowers can provide higher collateral and therefore present less risk to lenders. This entails a lower premium on financing, which further stimulates borrowing, investment and consumption.

The wealth and credit channels can have the opposite effects than those described above if the private or pubic sector held debt are in foreign-denominated currencies. The relative importance of the various channels depends on the particular country. For example, in a country where households do not hold a significant share of long-term assets, the wealth effects are not likely to be significant.

 

Role of Inflationary Expectations

            Inflationary Expectations have a number of significant implications for the money transmission mechanism and the conduct of monetary policy.  Monetary policy with emphasis on price stability will tend to anchor inflationary expectations at a low level. The impact of monetary policy on the economy depends on households’ and firms’ expectations about the future and the influence which they have on the actual behaviour of economic agents. Thus the impact of monetary policy on the economy depends not only on the current stance of monetary policy but also on its expected stance in the future. The latter influenced by how the central bank conducts monetary policy and the credibility it has among the public.

 

 

 

 

Changes in demand to inflation

The speed depends on the degree of nominal price rigidities and economic flexibility. In the long run, the level of output tends to be determined by supply side factors such as technology, the capital stock and the size of the labour force. In the short run, increases in aggregate demand beyond potential output tend to create bottlenecks in the economy which fuel inflation. These inflationary pressures may arise through different channels: demand for labour, wage pressures, unit labour costs, price inflation. Slow adjustments of real wages and other relative prices will in general lead to protracted effects on the real economy.

In Mauritius, the BOM indirectly targets the short-term interest rate through its monetary policy operations and the inflationary expectations of participants in the primary market. Preliminary studies on the institutional framework show that the BOM has relatively weak control over the short-term interest rate. An equally important observation is relative insignificance of real exchange rate and the output gap relative to expectations. These have to be investigated further.  It has also been observed that Mauritius’ experience of inflation targeting lite regime- float the exchange rate managed float and announce an inflation target- has succeeded in the past in achieving low inflation. But, in the new situation of rising global inflation and the gradual elimination of administered prices locally, will the inflation targeting lite regime be as successful ?

 

In its last Article IV consultation staff report on Mauritius, IMF warned that the inflationary risks need to be monitored carefully and that the high headline inflation has to be reduced quickly to medium-term target of 4.5–5 percent by anchoring inflationary expectations. More importantly, they note that there is an urgent need  “to develop the institutional framework (including research on transmission mechanisms of monetary policy and improving communication with the public) in order to establish the repo rate as an effective policy rate.” The Monetary Policy Committee at the BOM is a new body but very soon it will have to set the ball rolling by divulging to the public its operating and intermediate targets and the transmission mechanism to achieve these targets.  But first of all, they will have to be themselves confident of  the transmission mechanism of monetary policy. That will require some deeper analysis.