At the helm of all economic activities in a country, lies the governance of its central bank. The Federal Reserve System, central banking system of United States of America was established on December 23, 1913, with the formulation of the Federal Reserve Act. The need of a central bank was realized by policy makers in the wake of erratic financial chaos in the days of the yore. (The financial mess in 1907 led the US policy makers to think of better policies to create a stable economy). It was realized quite early, especially by the US government that international participation in economic activities would form the main component of global economy. To manage the economy, that is to create more jobs and increase the national income, it was mandatory for an expert body to oversee the nation's economic policy. The Bank of England in the UK; the Reserve Bank of India (RBI), in India; Central Bank of the Republic of China, in China; Banque de France, in France, et al, are just some of the central banks of top economies in the world.
Central Banks and Monetary Policy
The functioning of central banks in all countries have evolved in the last fifty years, as globalization has forged a new era of economic trade. Most of the central banks have overhauled their systems and have changed policies to face the global competition. In a nutshell, it can be stated that the duties and responsibilities of a central bank of a country are mostly related to price stability, creating employment, strengthening the economy, creating transparency in the financial network of national and private banks, minimizing financial risks and overseeing monetary policies. Since a central bank forms an independent apex banking institution in a country, it forms the monetary policies for bolstering development of the country. So, do you think that monetary policy affect our daily lives in any way? Well, they surely affect our purchasing power and that surely, impacts our lifestyle. Let us get into more details on how the policies chartered by the governors and directors of central banks shape our economy in general, and our lifestyles, in particular.
Effects of Monetary Policy on Economy
Erratic increase or decrease in prices of commodities or other items, if continued unabated for a substantial period, can be a source of imbalance in the economy. While framing monetary policies, the fundamental objective of central banks all over the world is to maintain price stability. Now, price stability is directly related to demand and supply of the products besides the available money supply. By using monetary policy tools, the central banks ensure that money supply is controlled in a manner such that the aim of sustainable economy is achieved (sustainable economy = maximum employment + stable prices + growth).
How does a central bank control money supply in the market? Consider a hypothetical situation in which an economy is doing great and it is growing faster. When an economy grows too fast and there is too much growth, it can lead to inflation (more money in the market→ people consuming more→ higher prices→ inflation). As we know, inflation is not healthy for any economy, so the central bank will try to curb it by using monetary tools. Thus, if inflation is an imminent danger, central bank will hike interest rates so that there is decrease in money supply (if interest rates are hiked, people will save more and spend less so that they can get better returns on their investments). If less money is available in the market, people will consume less and demand will decrease. A decrease in demand will lead to decrease in supply and general pricing of the products, respectively. By doing this, the central banks hope to bring back the economy to stable level.
On the flip side, consider the situation where an economy is in a slump and the central bank wants to promote better employment and higher growth. To do so, it will reduce interest rates which leads to more money supply into the market. When interest rates are decreased, the banks can give loans to consumers at a lower rate. People and businesses borrow more money thereby, boosting their spending and investment capacity. In a low-interest scenario, buying stocks, or for that matter, any type of investment becomes more attractive. Similarly, with low-interest rates, the value of currency decreases and the imports become expensive while the demand in domestic market increases (with more money in pocket, people consume more). Therefore, the overall sentiment in the domestic market becomes positive, and to meet increased demands, companies invest more, and more job opportunities are created.
One noteworthy point here is that interest rates invariably affect the currency exchange value. Suppose the interest rates are increased by the banks in USA, then the yields (profits) of assets in US dollars will be more promising, which will encourage investors in foreign markets to bid higher for these assets. Now, this will increase the value of US dollar which will lead to lower cost of imports for US inhabitants. However, for the people outside USA, prices of the goods exported from the USA will increase.
Well, do you get the drift, how small changes in the monetary policy affects the subtle relationship between financial instruments. Sometimes, even rumors or unexpected situations in a country can cause a drop in the financial market. In such situations investors lose confidence in their investments and to avoid further losses, quickly withdraw it. Most of the spending decisions, be it related to buying stocks of a blue-chip company or purchasing a toothpaste, are impacted by small changes in monetary policies. Lower the interest rates, and market sentiment changes and acquires positive note: people start spending and investing more. Just like lowering of house loan rates encourages housing demands, lower interest rates favor investments.
Some Key Monetary Policy Tools
Monetary policies are significantly affected by the reserve ratio rates. It is decided by the central banks of the respective countries. According to the rules governing the federal reserve system, "Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks."
Let us understand it by the help of an example. Suppose the central bank in USA determines the reserve ratio to be 10%. This would mean that all banks in the country must have 10% of the depositor's money held as cash in the banks. So, if a financial institute has deposits worth $1,000, it should have $100 in reserve. This is also known as CRR or Common Reserve Ratio.
Another reserve ratio, known as liquidity ratio measures the ability of a bank to fulfill its short-term debt obligations. Generally, higher the liquidity ratio, better is the ability of the bank to repay its debts. Similarly, some other parameters that help central banks to formulate policies and manage money supply are lending/deposit rates (base rate, savings bank rate) and policy rates (bank rate, repo rate, reverse repo rate). Though differences may be observed in the basic formulation of these rates in different countries, most of the central banks depends on these rates to control the economy.
Limitations of Monetary Policy in the Current World
Despite the fact that central banks have excellent statistical and data tools to predict accurate results, it is never possible to exactly predict the market nature. Central banks, even though they are powerful, cannot overcome external factors like weather, calamities, political upheavals, etc., to name a few that can cause a significant gap in demand and supply, thereby hurting or boosting market sentiments. Moreover, charting out well-drafted economic plans is not a day's work. It requires data collected over a certain period.
Statistical tools, mathematics and economics can only be effectively applied to data collected over a period of at least 3 to 6 months. Since economics is not an exact science (it is in fact, a blend of human behavior and science), predicting the market with 100 percent accuracy is virtually impossible. Nevertheless, with all the resources at their hands and the expertise of bankers, policy makers and economists, a central bank try to raise the nation's economic power and improve the livelihood of population.
It can be conclusively stated that the monetary policies that are designed and executed by a central bank through the financial institutions operating in the country, do play a role in imparting a stability to the economy. The financial world has faced numerous economic shocks in the last 3-4 years; however, collectively the world economies have been able to recover from it to some extent. It is also important to state here that they still have a long way to go in structuring and mending the global economy.
The Occupy Wall Street campaign reminds us of the striking financial inequality prevalent in all parts of the developed and developing world. Financial inclusion, a long neglected fundamental of a stable economy, must now be at the top of agenda pursued by the monetary policies. Now the question is, "Are central bank behemoths ready with monetary policies to take up the challenge of eliminating the basic flaws in structures of the free-market economies?" Well, only time will tell. Meanwhile, we can keep a close eye on the monetary policies that are in effect, and see how they can force our economic growth.