UNDERSTANDING MONETARY POLICY SERIES NO 24 … MONETARY … · UNDERSTANDING MONETARY POLICY SERIES...

CENTRAL BANK OF NIGERIA

UNDERSTANDING MONETARY POLICY SERIES

NO 24

c 2012 Central Bank of Nigeria

HOW CENTRAL BANKS ACHIEVE

PRICE STABILITY

Stanislaus A. UkejeStanislaus A. UkejeStanislaus A. Ukeje

10TH

ICYL DO EP PY AR RA TT ME EN NO TM

AnniversaryCommemorative

Edition

Central Bank of Nigeria33 Tafawa Balewa WayCentral Business DistrictsP.M.B. 0187Garki, AbujaPhone: +234(0)946236011Fax: +234(0)946236012Website:E-mail:

www.cbn.gov.ng [email protected]

ISBN:

© Central Bank of Nigeria

978-978-52863-0-4

iii

Central Bank of Nigeria

Understanding Monetary Policy

Series 24, December 2012

EDITORIAL TEAM

EDITOR-IN-CHIEF

MANAGING EDITOR

EDITOR

ASSOCIATE EDITORS

Aims and Scope

Subscription and Copyright

Correspondence

Email:[email protected]

Moses K. Tule

Ademola Bamidele

Charles C. Ezema

Victor U. ObohDavid E. Omoregie

Umar B. Ndako Agwu S. Okoro

Adegoke I. AdelekeOluwafemi I. Ajayi Sunday Oladunni

Understanding Monetary Policy Series are designed to improve monetary policy communication as well as economic literacy. The series attempt to bring the technical aspects of monetary policy closer to the critical stakeholders who may not have had formal training in Monetary Management. The contents of the publication are therefore, intended for general information only. While necessary care was taken to ensure the inclusion of information in the publication to aid proper understanding of the monetary policy process and concepts, the Bank would not be liable for the interpretation or application of any piece of information contained herein.

Subscription to Understanding Monetary Policy Series is available to the general public free of charge. The copyright of this publication is vested in the Central Bank of Nigeria. However, contents may be cited, reproduced, stored or transmitted without permission. Nonetheless, due credit must be given to the Central Bank of Nigeria.

Enquiries concerning this publication should be forwarded to: Director, Monetary

Policy Department, Central Bank of Nigeria, P.M.B. 0187, Garki, Abuja, Nigeria,

iv


Mandate

Vision

Mission Statement

Core Values

§Ensure monetary and price stability

§Issue legal tender currency in Nigeria

§Maintain external reserves to safeguard the international

value of the legal tender currency

§Promote a sound financial system in Nigeria

§Act as banker and provide economic and financial

advice to the Federal Government

“By 2015, be the model Central Bank delivering

Price and Financial System Stability and promoting

Sustainable Economic Development”

“To be proactive in providing a stable framework for the

economic development of Nigeria through the

effective, efficient and transparent implementation

of monetary and exchange rate policy and

management of the financial sector”

§Meritocracy

§Leadership

§Learning

§Customer-Focus

v

MONETARY POLICY DEPARTMENT

Mandate

To Facilitate the Conceptualization and Design of

Monetary Policy of the Central Bank of Nigeria

Vision

To be Efficient and Effective in Promoting the

Attainment and Sustenance of Monetary and

Price Stability Objective of the


Mission

To Provide a Dynamic Evidence-based

Analytical Framework for the Formulation and

Implementation of Monetary Policy for

Optimal Economic Growth

The understanding monetary policy series is designed to support the communication of monetary policy by the Central Bank of Nigeria (CBN). The series therefore, provides a platform for explaining the basic concepts/operations, required to effectively understand the monetary policy of the Bank.

Monetary policy remains a very vague subject area to the vast majority of people; in spite of the abundance of literature available on the subject matter, most of which tend to adopt a formal and rigorous professional approach, typical of macroeconomic analysis. However, most public analysts tend to pontificate on what direction monetary policy should be, and are quick to identify when in their opinion, the Central Bank has taken a wrong turn in its monetary policy, often however, wrongly because they do not have the data for such back of the envelope analysis.

In this series, public policy makers, policy analysts, businessmen, politicians, public sector administrators and other professionals, who are keen to learn the basic concepts of monetary policy and some technical aspects of central banking and their applications, would be treated to a menu of key monetary policy subject areas and may also have an opportunity to enrich their knowledge base of the key issues. In order to achieve the primary objective of the series therefore, our target audience include people with little or no knowledge of macroeconomics and the science of central banking and yet are keen to follow the debate on monetary policy issues, and have a vision to extract beneficial information from the process, and the audience for whom decisions of the central bank makes them crucial stakeholders. The series will therefore, be useful not only to policy makers, businessmen, academicians and investors, but to a wide range of people from all walks of life.

As a central bank, we hope that this series will help improve the level of literacy in monetary policy as well as demystify the general idea surrounding monetary policy formulation. We welcome insights from the public as we look forward to delivering content that directly address the requirements of our readers and to ensure that the series are constantly updated as well as being widely and readily available to the stakeholders.

Moses K. TuleDirector, Monetary Policy DepartmentCentral Bank of Nigeria

FOREWORD

CONTENTS

vii

Section One: Introduction

Section Two: Conceptual Issues

Section Three: Monetary Policy Frameworks for Achieving Price Stability

Section Four: Monetary Policy Tools and their Effects on Price Stability

Section Five: Conclusion

Bibliography

.. .. .. .. .. .. .. 1

.. .. .. .. .. .. 32.1 Price Stability .. .. .. .. .. .. .. 32.2 Sources of Instability in Prices .. .. .. .. .. 4

73.1 Monetary Targeting .. .. .. .. .. .. 83.2 Exchange Rate Targeting .. .. .. .. .. .. 93.3 Price Level Targeting.. .. .. .. .. .. .. 93.4 Inflation Targeting.. .. .. .. .. .. .. 93.5 Mixed Policy.. .. .. .. .. .. .. .. 10

114.1 Price-based and Indirect (market) Tools .. .. .. 11

4.1.1 Policy Rate .. .. .. .. .. .. 114.1.2 Reserve Requirements.. .. .. .. .. 124.1.3 Discount Window.. .. .. .. .. .. 134.1.4 Open Market Operations (OMO) .. .. .. 134.1.5 Central Bank Bills.. .. .. .. .. .. 13

4.2 Quantity-based and Direct (non-market) instruments .. 144.2.1 Credit Ceiling .. .. .. .. .. .. 144.2.2 Sectoral Allocation of Credit .. .. .. .. 144.2.3 Interest Rate Control .. .. .. .. .. 144.2.4 Moral Suasion .. .. .. .. .. .. 15

.. .. .. .. .. .. 17

.. .. .. .. .. .. .. .. 19

HOW CENTRAL BANKS ACHIEVE PRICE STABILITY

1

H O W C E N T R A L B A N K S A C H I E V E P R I C E

S T A B I L I T Y 1

Stanislaus A. Ukeje2

SECTION ONE

Introduction

Every modern State has a central bank or monetary authority which has a

monopoly in the issuance of legal tender currency and responsibility for policies

relating to the supply of money and credit. Acceptability of notes and coins

issued by central banks as means of exchange, unit of account, store of value

and standard for deferred payments depends on public confidence. Prior to the

20th Century, confidence in legal tender currency was derived from their gold

value. This monetary regime was called the gold standard but as commerce

expanded, the supply of gold could not match the demand for money. The Bank

of England had to adopt the „responsibility doctrine‟ as proposed by Walter

Bagehot, undertaking to lend to other banks on acceptable collateral, to enable

them meet their needs.

After the World War I, the gold standard weakened, resulting in widespread

macroeconomic instability including; high inflation, reduced economic growth

and high unemployment. Global efforts to restore the gold standard revealed

that each country needed to maintain internal and external stability to

guarantee confidence in the fiat money.

The introduction of the Bretton Woods system of fixed exchange rate, backed by

gold through the United States‟ dollar reduced concern about inflation and the

value of money. When this system failed in 1971, inflation and growth became

once again a public issue. To confront high inflation and low growth (stagflation)

1This publication is not a product of vigorous empirical research. It is designed specifically

as an educational material for enlightenment on the monetary policy of the Bank.

Consequently, the Central Bank of Nigeria (CBN) does not take responsibility for the

accuracy of the contents of this publication as it does not represent the official views or

position of the Bank on the subject matter.

2Stanislaus A. Ukeje is an Assistant Director in the Monetary Policy Department, Central

Bank of Nigeria


2

of the 1970s, Paul Volcker, Chairman of the United States‟ Federal Reserve

(central bank), implemented a policy of reducing the rate of growth of money

supply and increased interest rates to levels that exceeded the rate of inflation.

Price stability was restored and sustained in the advanced economies for many

years until the 2007 global financial crises. This prompted some analyst to aver

that business cycle and inflation had ceased to be a major economic problem in

the advanced economies. Indeed, there were several proposals to remove

banking regulation from central banks to some independent bodies. However,

the collapse of Lehman Brothers and the subsequent global economic turmoil

that started in 2007 brought to the fore once again, the towering responsibility of

central banks for financial sector stability, output growth, and employment.

Following this introduction, section II contains conceptual issues, while Section III

presents monetary policy framework for achieving price stability. Section IV

discusses the tools of monetary policy and their effects on price stability. Section

V conclusions the paper.


3

SECTION TWO

Conceptual Issues

2.1 Price Stability

Price stability is a situation where the average change in prices of goods and

services is just sufficient to support the growth of the economy. Price stability does

not necessarily mean that prices are not changing in the economy, but rather

connote a situation where the average increase in the general price level is

matched with a corresponding growth in the aggregate economy. It is a situation

where there is no deflation or inflation in the economy. It means that prices on

average are relatively stable over time.

The change in the general price level, also termed inflation, can be stable,

variable, and/or unpredictable. The stable form of inflation provides a suitable

environment for economic planning and investments, while the variable and

unpredictable form of inflation create uncertainties and are not conducive for

sound economic decisions.

Inflation in a country, region or globally is measured in terms of changes in an

index of prices over a period of time, mostly over 12-months. The index may be

broad or narrow. A widely used price index is the Consumer Price Index (CPI)

based on the market cost of living on a representative basket of consumer goods

and services purchased by households. Other indexes include: Producer Price

Index (PPI) which is a measure of changes in the price of the final products of

domestic producers; Wholesale Price Index (WPI); the Personal Consumption

Expenditures Price Index or PCEPI; and the Gross Domestic Product Deflator. There

are other indexes based on the price of precious metals such as gold, the

average of nominal wages and the average of asset (securities) prices.

Annual change in the general level of prices within the range of 1 and 3 per cent

is generally regarded as low and stable inflation rate in many countries. Thus price

stability does not mean the stability of the average level of prices and does not

refer to price changes in the short-term such as a day or a week.

As there are different indexes adopted to capture change in the general price

levels, there are also different inflation measures, namely; core, headline and

food. “Core” or underlying inflation refers to inflation measured by changes in

CPI, PCEPI or the GDP Deflator but excluding certain volatile prices, such as food

and energy prices. “Headline” inflation is a measure of the total inflation within an


4

economy, including food and energy, which may experience sudden price

spikes. Households are more concerned about this measure of inflation because

it reflects the true cost of living.

Central banks are usually concerned about the “Core” inflation rate because it

shows the effects of demand and supply on the gross domestic product of a

country. It is the measure of persistent inflation, excluding short-term and

reversible price movements, which the central bank should resist using monetary

policy tools. This is because it is now generally accepted, both in policy and

academic spheres that the primary objective of central banks is to achieve price

stability. In the evaluation of price developments, most central banks use the CPI

because it covers goods and services consumed by most households, the public

at large are accustomed to it and it is available regularly.

2.2 Sources of Instability in Prices

Price instability manifests as price volatility, where volatility refers to the pace at

which prices move higher or lower, and how wildly they swing. It is the frequency

and severity with which the general price level rises and falls. In general, price

instability is caused by factors including money supply, seasonality, and market

sentiment that produce wild swings in demand and supply.

The assertion that inflation is always and everywhere a monetary phenomenon

(Friedman, 1963) has almost been accepted as a truism, because in every

instance that the general price level in a country is high for a sustained period of

time, the rate of money supply growth is also high. This is so because price stability

is closely associated with money and its functions. As the amount of money in

circulation in an economy increases, the pressure for output to increase rises.

When this happens, prices rise and the value of money declines because more

money will have to be spent to buy the same amount of goods and services.

Accommodative monetary policy in the United States by the Federal Reserve

from 2001 (Taylor, 2007), contributed to stimulating the demand for housing and

asset prices. A lot of capital flowed into the United States about the same time

from China and commodity exporters, which supported the credit growth and

financial innovations that eventually resulted in the global financial crisis of 2007.

In Nigeria, the accommodative monetary policy of the Central Bank of Nigeria

from 2004 (fuelled by high oil prices and stable exchange rate regime) caused

banks to grow their loan books rapidly, especially by financing the acquisition of

privatized State enterprises (e.g. Nigerian Telecommunications Ltd) and grant

margin loans to stock market firms. Bank failures and credit freeze followed in


5

2009, and the government enacted the Asset Management Company of Nigeria

Act 2010, to rescue the banking system from total collapse.

The Euro area has been in recession because of unsustainable sovereign debt,

owed mainly to private banks which have had to take enormous losses. All three

examples above, show that price instability follows any time money supply grows

very rapidly for a considerable time.

Another factor that produces price instability is seasonality. During some long

festivals, such as Lent, Easter, Ramadan and Eid el kabir for instance, transport

and many other prices rise sharply and fall also sharply, after the festivals. In this

case, the festive season changes demand. A factor similar to seasonality that

causes price instability is weather. Food prices depend on the supply and the

supply depends on favorable weather for bountiful harvest. Volatility of food

prices is one important source of general price instability, because food is a major

component of the standard consumer basket of goods and services in Nigeria.

Market sentiment is yet another factor that causes price instability. The price

volatility of stocks and commodities, is often aggravated by the anxious

expectation of stock brokers and commodities traders. The movements in stock

and oil prices in recent times have been fuelled by the speculative behavior of

traders, and this is transmitted through the financial channel, resulting in the

volatility of the general price level.

It should be noted that all the factors discussed above are critical in aggravating

price instability, if the money supply responds in support of demand.


6


7

SECTION THREE

Monetary Policy Frameworks for Achieving Price Stability

A central bank as an institution must have a clear mandate under the law

establishing it. It is important, however, to emphasize that experience and

empirical studies have shown that central banks may pursue other auxiliary

objectives to facilitate the attainment of the price stability mandate.

Central banks conduct monetary policy within a given monetary policy regimes

(monetary policy frameworks), which provide structures for making monetary

policy decisions. . A monetary policy framework is the setting, within which a

central bank modifies its key instruments. Mc Nees (1987) defined it as comprising

“the institutional arrangements under which monetary policy decisions are made

and executed”. The defining characteristics of a monetary policy framework are;

(i) target variables set to be achieved and the set of instruments used by the

central bank to achieve its goal and (ii) the central bank‟s long-term objective. In

addition to facilitating making monetary policy decision, a monetary policy

regime or framework enables monetary policy decisions to be communicated

easily to banks, financial markets and the general public.

Below are widely known and used monetary policy frameworks and their

associated instruments, target variables and long-term objectives (Table 1)

Table 1: Typical Monetary Policy Frameworks

Monetary Policy

Framework

Target Market Variable Long-term Objective

Monetary Aggregates Rate of growth of money

supply

Target rate of change in the CPI

Fixed Exchange Rate The nominal exchange rate

of the domestic currency

The nominal exchange rate of the

domestic currency

Price Level Targeting Overnight rate of interest Given level or range of CPI

Inflation Targeting Overnight rate of interest A given rate of change in the CPI

Gold Standard The spot price of gold Low inflation as measured by the price

of gold

Mixed Policy Generally interest rates Generally the rate of unemployment

and change in CPI

Central bank mandate is realised within its monetary policy framework, which is

normally determined by the political authority of the country through legislation.

In Nigeria, two principal Acts guide the monetary policy framework today. These

are the Banks and Other Financial Institutions Act (1991) and the Central Bank of


8

Nigeria Act 2007. In selecting a framework, the monetary authority usually takes

into account the structure and depth of the financial sector, the level of fiscal

discipline, the extent of trade openness of the economy, the structure of the

economy (in particular, the dependence or otherwise of the economy on a

particular sector), the ease of transmission of monetary policy to economic

activities and inflation and other factors. Besides, it is important that there is a

sufficient degree of expertise on monetary policy issues both inside and outside

the central bank, especially in the Ministry of Finance and the Statistical Agency.

Some of the distinguishing features of monetary policy frameworks are discussed

below:

3.1 Monetary Targeting

In this framework, monetary policy aims to control various monetary aggregates

in order to keep inflation down, and requires a level of stability in the velocity of

money, that is, the speed with which money circulates in the economy. The

framework focuses on the growth rate of a chosen monetary aggregate such as

RM (reserve money); M0 or narrow money (consisting of coins and currency

notes, whether in circulation or in the vaults of banks); MB or monetary base

(made up of M0 and mandatory (i.e. minimum) and excess reserves held by

banks); M1, the most liquid measure of money supply (consisting of notes and

coins in circulation and assets that can be readily converted to cash); M2 or

broad money (consisting of M1 and assets that can be converted to cash but not

immediately such as savings and fixed deposits, money market funds and

overnight repos); M3 a broad money aggregate (made up of M2 and large time

deposits and liquid assets, large money market funds and short-term repos usually

held by institutional investors); and an aggregate of the liquidity in an economy,

money with zero maturity (MZM), which is composed of M2 plus all money market

funds less fixed deposits because they are not redeemable at par on demand).

A central bank using this framework must choose the appropriate monetary

aggregate to target. Monetary targeting framework is based on the assumption

that there exist a long-run positive relationship between price growth and money

supply growth. The aggregate target becomes the nominal anchor or

intermediate target of monetary policy. But financial liberalization and innovation

have made it more difficult to monitor aggregate measures of money supply and

have also affected the stability of the velocity of money. The relationship

between monetary aggregates and the price level has weakened because of

the changing nature of financial sector due to financial innovations. It is also the

case that the monetary aggregate selected by a central bank may not be

amenable to precise management and control.


9

3.2 Exchange Rate Targeting

This is a monetary policy regime in which interest rates are set, with a view to

achieving a target exchange rate, between the currency of a country and the

currency of another country or a basket of currencies. The currency against

which the domestic currency is benchmarked is termed the nominal anchor, and

is usually a stable currency. Otherwise, currencies targeting it will experience

volatility, which will negatively affect output and inflation in such countries. In

open economies, international trade is very important and the stability of the

exchange rate determines the performance of the economy. In the period

following the end of the Bretton Woods system of fixed exchange rate, many

developed countries adopted exchange rate targeting as a means of stabilizing

their economies.

A common danger to the integrity of this framework is large international capital

flows and speculation, which could weaken the resolve of the monetary

authorities to maintain the exchange rate target indefinitely. The Monetary

Authority of Singapore (MAS) has successfully used this framework to maintain

price stability as a sound basis for sustainable economic growth. A majority of IMF

member countries, mainly small open economies, use exchange rate targeting

frameworks and adopt the United States dollar as the anchor currency.

3.3 Price Level Targeting

This is a monetary policy regime under which the overall goal is to keep the price

level stable or at a pre-determined level. The Central Bank or Monetary Authority,

alters the policy interest rate in order to keep the consumer price index (CPI) at a

specific level over a period. Thus, if the CPI reads 8 per cent at the end of a given

year, whereas the central bank‟s price target was 4 per cent, interest rate will be

altered to ensure that CPI will be 4 per cent at year-end. Price targeting,

therefore considers previous periods‟ inflation to determine future course of policy

actions. In this case, price level targeting would reduce uncertainty in inflation

outlook. If economic agents accept the price level target set by the central

bank, the potential outcome would be reduced variability of output and

inflation. However, only Sweden in the 1930s ever adopted price level targeting

as a monetary policy regime. The Bank of Canada is currently undertaking

research on the feasibility of adopting it.

3.4 Inflation Targeting

In inflation targeting, unlike price level targeting, a central bank publicly pre-

announces official quantitative targets (or a succession of targets) for the inflation

rate that it is to achieve over one or more time horizons. Inflation targeting is


10

forward-looking, and involves active and direct shaping of inflation expectations.

Central banks that adopt this regime of monetary policy, set the inflation target

on the basis of a vast array of information on the rate of employment, nominal

and real exchange rates, output gap, producer prices, import prices, nominal

and real interest rates, the total fiscal deficits, the primary deficits and other

variables. The data from these various sources helps the central bank to forecast

the likely path of inflation. In an inflation targeting regime, the fiscal authorities

undertake to coordinate policies in ways that would support the achievement of

the target inflation. In practice, inflation targeting has enabled central bank to

control inflation expectation, and in a number of cases successfully lower inflation

outcome. Typically, inflation-targeting central banks assign monetary policy

making to the Monetary Policy Committee (MPC), made up of central bank

officials and external members; the Committee is given policy independence

and required to operate transparently and be accountable.

3.5 Mixed Policy

Whereas price stability is almost universally accepted as the primary goal of

central banks, in many jurisdictions, monetary policy regimes continue to pay

attention to monetary aggregates, exchange rate and interest rate. The Bank of

England has adopted inflation targeting as its monetary policy framework, but it

continues to intervene in the foreign exchange market, conduct open market

operations and engage in asset purchase programmes. In practice, most

countries adopt an admixture of policy regime.


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SECTION FOUR

Monetary Policy Tools and their Effects on Price Stability

Monetary policy tools are used to control interest rates, inflation, exchange rate

and other macroeconomic indicators, in order to achieve price stability. There

are broadly two classes of monetary policy tools used by central banks to

achieve price stability. Meyer (1980) classified the control tools into two, general

or selective. The monetary base and the money multiplier are two variables that

have unrestricted impact on money supply. Thus general control tools impact on

monetary aggregates through either the monetary base or the money multiplier.

The general controls are price-based, and include ratios such as reserve

requirements; instruments with interest rates, (central bank rates); open market

operations (OMOs); and central bank bills. These instruments are indirect and are

market based. The selective controls are quantity-based instruments, which are

almost all non-market based and direct instruments. Selective controls are able to

alter the choice among alternative uses in the allocation of credit. Credit can be

allocated to loans for acquiring securities through margin or down-payment

transactions or to hedge on interest rate (floors and or ceilings) received by bank

depositors on their savings or paid by borrowers to banks on loans.

4.1 Price-Based and Indirect (Market) Tools

Indirect monetary policies are according to Gidlow (1998), monetary policy

decisions of central banks or Monetary Authorities aimed at achieving monetary

policy objectives by influencing financial market behaviour with regard to lending

and borrowing. The behaviour of financial market participants in response to

central bank policy actions are directed at taking advantage of incentives or

avoiding disincentives embedded in price and interest rate changes. Examples of

price-based policy tools are:

4.1.1 Policy Rate

Central banks‟ policy rate is an indicator of the monetary policy stance; raising it

indicates monetary tightening while lowering it indicates monetary easing. It

influences market interest rates towards „targets‟ set by the Bank through lending

to DMBs or purchasing and selling bonds to the banks. Usually, a central bank will

not lend money to a DMB below the policy rate (MPR) nor will it take deposits

from a DMB at a rate above the policy rate. In market economies, bond prices

move in an opposite direction to money market rates; and money market rates

move in response to the policy rate. Thus by changing the monetary policy rate,

central banks are able to influence the demand for money and inflation

expectation and outcome.


12

There are jurisdictions in which the policy rate is the interest rate charged on

repurchase agreements („repos‟ or „RPs‟) with Deposit Money Banks/Discount

Houses and Primary Dealers in the financial market by the central banks. A repo is

an agreement to sell a financial asset (such as a bond, stock or bank deposit

receipt) and repurchase the same asset at a slightly higher rate overnight or such

agreed short period. The repo is terminated in a „reverse repo‟. By adjusting their

official/target repo and reverse repo rates, central banks influence decision of

economic agents to borrow or lend, depending on the attendant costs and

benefits.

4.1.2 Reserve Requirements

Central banks impose reserve requirements on depository institutions for system

liquidity management and for prudential regulation. Reserve requirements limit

the amount of funds that DMBs can give as loans to their customers. There are

two types of reserve requirements: cash and liquidity reserves. The cash reserve

requirement is generally called the Cash Reserve Ratio or CRR while the liquidity

requirement is termed Liquidity Ratio or LR because they are measured relative to

the total deposit liability of a financial market (bank) entity. CRR, also called

primary reserve requirements, is that proportion of the total deposit liabilities (i.e.

the sum of demand, savings and time deposit liabilities) of a DMB that the

Monetary Authority shall drain and hold as reserves for the entity concerned over

a maintenance period. LR on the other hand is the proportion of the liquid assets

which a DMB shall hold relative to its total deposit liabilities. It (LR) is composed of

assets that should be freely and readily convertible to cash without a significant

loss, and free from any charge, lien or encumbrance. The other name for reserve

held under Liquidity Ratio is secondary reserve requirement.

Over and above the CRR, DMBs also hold voluntary reserves with the central

bank to meet clearing balance requirements or as flight to safety. The level of the

reserves affects the interbank rate (i.e. the overnight interest rate in the interbank

market in which banks lends and borrows from one another without collateral).

CRR is a particularly blunt instrument, which impacts on the interbank rate without

a lag. Central banks alter reserve requirements in response to price

developments; a rise in reserve requirements generally will lead to increase in

interbank rates, thereby increasing short-term and long-term interest rates, which

can cause a reduction in credit and growth of money supply. A reduction in

reserve requirements would have the opposite effects.


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4.1.3 Discount Window

This is a monetary policy instrument by which a central bank provides

accommodation (lends short-term) to eligible institutions to enable them meet

liquidity shortage. Repurchase (repos) and reverse repurchase (reverse repos or

RRPs) take place at the Discount Window. The interest rate at the Discount

Window is called discount rate, base rate or repo rate charged on such loans is

called the discount rate, repo rate or base rate. It is an important tool for

maintaining financial and banking system stability. In some jurisdictions, the

discount window mechanism is referred to as Standing Facility. In Nigeria, there is

the Standing Lending Facility (SLF) through which the Central Bank the Central

Bank lends to banks and the Standing Deposit Facility (SDF) through which the

DMBs place funds with the Central Bank. Increase in lending through the Discount

Window increases money supply through enlarging the monetary base while

decrease contracts money supply by contracting the monetary base (Mishkin,

1997).

4.1.4 Open Market Operations (OMO)

This is a tool used by central banks to change the level of money supply. It is

purchase or sale of government securities by a central bank to the banking and

non-banking public for liquidity management purposes. When a central bank

notices there is excess liquidity in the system, it sells securities to reduce DMBs‟

reserves (monetary base). But to increase money supply in the economy, a

central bank buys securities from DMBs and by doing so injects liquidity into the

system. By injecting or withdrawing liquidity from the banking system, central bank

affects money market and other interest rates in its desired direction. Interest rate

is a key macroeconomic price which has impact on asset prices, the exchange

rate and the general price level. Thus OMO can be used to ensure price stability.

4.1.5 Central Bank Bills

These are short-term securities (unlike Treasury bills) issued by the central bank for

periods not exceeding 12 months. Banks holding the bills do not add them in the

determination of liquidity reserve requirements. In that way, the bills affect

liquidity and interest rate in the money market. Also, central bank bills cannot be

discounted for cash at the central bank or accepted by the central bank as

collateral in a repo transaction. Therefore, unlike treasury bills, issue of central

bank bills reduces DMBs‟ reserves by the amount of the issue for the duration of its

tenure. OMO transactions using central bank bills are sterilisation operations in

local currency and can be used to prevent depreciation of the domestic

currency.


14

4.2 Quantity-Based and Direct (Non-Market) Instruments

Direct monetary policy instruments are tools used central banks to achieve

monetary policy objectives by setting aggregate monetary, credit and interest

rate targets for DMBs and other financial institutions. Through regulations, direct

instruments operate by setting or limiting either quantities (e.g. amounts of credit

outstanding) or prices (e.g. interest rates). By the term “direct”, it means that

there is a one-to-one correspondence between the tool and the policy goal

objective (Alexander, Baliño, and Enoch, 1996). Direct instruments are commonly

used in countries where the financial market is not highly developed, even

though it exists to different degrees in all jurisdictions.

4.2.1 Credit Ceiling

A central bank may direct DMBs to limit the amount of credit to the private sector

within a period, issuing the directive well before the beginning of the period.

Accordingly, both credit institutions and credit customers would be aware of the

directive. The goal is to control the expansion of bank credit. Recent experience

with public sector debt sustainability has resulted in some central banks similarly

capping credit to the government from time to time. By directly limiting credit

expansion, the central bank controls the contribution of money supply growth to

inflation.

4.2.2 Sectoral Allocation of Credit

Where a government (the fiscal authority) has preferred economic sectors in her

growth and development agenda, central banks would issue directives to the

DMBs, requiring them to allocate either specified percentages or amount of

credit to the preferred sectors. Considerations about equity and social justice

sometimes make governments and monetary authorities to identify economic

and geographical regions, social groups and gender for priority allocation of

credit. Apart from controlling the expansion of credit and money supply, sectoral

allocation of credit influences the use of credit and its impact on inflationary

development and aggregate demand.

4.2.3 Interest Rate Control

Interest rate represents the price of capital; it influences savings mobilisation and

financial intermediation. Free market interest rate in an uncompetitive market

situation may discourage financial intermediation, and encourage financial

repression. Where this is the case, experience shows that much of the currency

issued by the central bank is outside the banking system, thus limiting the velocity

of money. To counter this, central banks in some jurisdictions set interest rate floors

for savings and ceilings for credit. By controlling interest rate, a key component of

macroeconomic prices that feeds into inflation is controlled


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4.2.4 Moral Suasion

Regulatory powers of central banks over financial institutions, especially deposit

money banks, provide opportunity for persuading them to pursue suggested

strategies and policies such as intensifying savings mobilisation, reducing charges,

increasing or restricting credit and others. The DMBs yield to the persuasion of the

Monetary Authorities in order to maintain harmonious relations. In this way,

strategies and policies that moderate inflation can be implemented by DMBs

contrary to their profit-maximising behaviour.


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SECTION FIVE

Conclusion

Price stability is a situation where the average change in prices of goods and

services is just sufficient to support the growth of the economy. Price stability does

not necessarily mean that prices are not changing in the economy, but rather

connote a situation where the average increase in the general price level is

within a narrow range. Consumer Price Index (CPI) is the most widely used price

index, based on the cost of living on a fixed basket of goods and services. It was

discussed that there are different indices of change in the general level of prices

as there are also different inflation measures, namely headline, core, and food.

In general, price instability is caused by factors (such as money supply,

seasonality, market sentiment, among others) that produce wild swings in

demand and supply. Several monetary policy frameworks such as monetary

aggregates, fixed exchange rate, price level targeting, inflation targeting, and

mixed policy were extensively discussed. Two major categories of monetary tools,

namely; price-based and indirect (market) and quantity-based direct instruments

are deployed in the monetary policy management.


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