Monetary policy is the policy actions taken by the monetary authority or the central bank to change the factors or aspects related to the existing financial situation of a country. Defined in another way, monetary policy is the actions taken by a country’s central bank to control the money supply in order to achieve macroeconomic goals that promote sustainable economic growth. Accordingly, policy measures are taken by a central bank of the country regarding the money supply or bank loans or the interest rates and exchange rates which are the prices of money in relation to the amount of money circulating in the country.
Presently Sri Lanka’s financial management is based on a financial target framework. In this framework, the ultimate goal of price stability must be achieved by influencing changes in the broader money supply linked to the money supply through the multiplier. The operational goal of monetary policy is reserve money. The monetary target framework is implemented through a monetary program.
The central bank prepares the monetary program taking into account economic factors such as expected fiscal and balance of payment developments, economic growth, credit growth at expected levels and inflation. Based on these factors, the financial program sets the desired path for cash growth and determines the path of quarterly reserve cash targets required to achieve this cash growth. The bank will then conduct its open market operations (OMO) within an interest rate corridor formed by its policy rates ie the repo rate and the reverse purchase rate to meet the reserve currency target. Policy rates are periodically reviewed and adjusted accordingly to bring reserves on target.
Central banks have a wide range of tools that they can use as instruments of monetary policy. The main monetary policy instruments currently used are (a) policy interest rates and open market operations (OMO) and (b) statutory reserve requirements (SRR) on commercial bank deposit liabilities.
Currently, the central bank conducts its monetary policy under an active open market operating system. The main components of the system are (i) an interest rate corridor set by the bank’s key policy rates i.e. repurchase rate and reverse purchase rate, (ii) a daily auction to absorb or inject liquidity, (iii) a on interest rates at the threshold of the corridor fixed facilities and (iv) direct transactions.
The central bank’s repo rate and reverse repo rate, which are the lower and upper bounds for comparable overnight interest rates in money markets, are key tools for achieving the path of reserve currency targets. These rates, which are the signaling mechanism of the bank’s monetary policy stance, are reviewed regularly, usually once a month, and revised if necessary.
A daily auction is conducted to absorb liquidity through repurchase transactions, if there is excess liquidity, or inject liquidity through repurchase transactions, if there is a shortage of liquidity, thereby keeping overnight interest rates stable. Reserve money target path. An auction is a multiple-bid, multiple-price system. Participants may submit up to three bids in each auction and successful bidders will receive their bids at the prices specified in the respective bid.
Fixed facilities are available for participating institutions that are unable to meet their liquidity requirements during the daily auction. That is, even after the daily auction, if a participant has excess funds, he can enter into a repurchase transaction under the fixed facility. Similarly, if a participant needs liquidity to cover a shortfall, he can borrow funds on a repurchase basis under the fixed facility. Accordingly, these facilities help in controlling the wide fluctuations in interest rates.
Direct transactions are done at the Central Bank’s discretion to address long-term liquidity problems. If a relatively large excess of liquidity exists and can persist for a long period of time, it is absorbed by the outright sale of treasury bills from the goods held by the central bank and, if there is insufficient stock of treasury bills, by issuing central bank bills. own securities. Similarly, buying treasury bills and bonds in the secondary market and buying treasury bills in the primary market will remove a long-term liquidity shortage.
There is also another policy rate known as bank rate. It is the rate at which the Central Bank lends to commercial banks as a last resort. These are secured loans and government securities are accepted as collateral. Bank rate is usually a penalty rate which is higher than other market rates. Therefore, at present this rate is only an indicative rate, so commercial banks can borrow from the central bank at a repurchase rate lower than the bank rate.
Sri Lanka’s statutory reserve ratio as a fiscal policy instrument has not been changed frequently and only on a few occasions has it been modified to suit the discretion of fiscal policy. Accordingly, in a contractionary monetary policy, the interest rate is raised and in an expansionary monetary policy, the reserve ratio is lowered.
According to the monetary policy, various financial securities trading by the central bank to maintain the base money at a target level is called market operations. Generally the Central Bank of Sri Lanka uses treasury bills, treasury bonds and central bank securities for this purpose. In implementing monetary policy, the central bank follows the goals of liquidity or funding and base money to be available in the money market or interbank market. Accordingly, if there is a significant difference between the target liquidity and the existing liquidity, the central bank conducts a securities trade to acquire the desired liquidity level. If the available liquidity is greater than the expected liquidity, the central bank sells securities in the market to reduce it, and if there is a shortage of liquidity, the central bank buys securities in the market.
Since the central bank receives an amount of money equal to that value in case of sale of securities, the amount of base money is reduced by that amount. In case of purchase of securities, the base amount will increase by that amount. Market activities are also used to influence short-term interest rates in financial markets. In this case, especially when the interest rates rise due to shortage of funds in the financial market, the supply of money will be increased by buying securities at a higher price, so the amount of funds will increase and the low interest rate will decrease.
In some cases, the central bank also uses hedge market operations to reduce the impact of transactions in the foreign exchange market on the local currency market. That is, the central bank trades local securities in the open market to neutralize the effect of the base currency in a purchase or sale of foreign exchange in the foreign exchange market.
Unlike the policy interest rate and the statutory reserve ratio, the stock market is a very short-term process and this stock market has an immediate effect on the money supply and base money.
In bank credit controls, a central bank controls the amount of credit provided by the banking system in accordance with the desired financial policy of the country. A fundamental factor that determines money creation and money supply is the volume of bank loans. Therefore, debt control as a fiscal policy instrument is a direct measure. Here, the Central Bank has been empowered to control the amount of credit provided by the banking system, the repayment period of the loans and the security obtained for the loans. Further, to encourage the amount of credit provided to the leading sectors of the economy, the minimum amounts of credit to be given to various productive sectors can be fixed or maximum limits can be set on consumer credit to limit the growth of consumer credit in an inflationary phase.
In order to control it in case of inflation, with the aim of discouraging consumer borrowing, it can be indicated by setting a very short repayment period for consumer loans, obtaining high value collateral securities. Thus, the Financial Control Authority is trying to achieve the objective of price stability and economic stability through debt control measures. Through the instructions and guidelines given by the Central Bank to the existing banks in the country, they are guided to maintain the business activities of the banks in terms of loans and deposits in accordance with the financial policy.
If the economy faces a high unemployment rate during a slowdown in economic growth or a recession, the central bank chooses an expansionary monetary policy aimed at increasing economic growth and expanding economic activity.
Developing economies like Sri Lanka are highly sensitive to inflationary pressures. However, increasing the money supply can lead to higher inflation, which can raise the cost of living and business activities. Contractionary monetary policy aims to lower inflation by raising interest rates and slowing the growth of the money supply. This may slow economic growth and increase unemployment, but is often necessary to reduce inflation.
A central bank uses contractionary monetary policy to reduce inflation. By limiting the amount of money banks can lend, they reduce the money supply. Banks charge higher interest rate. This causes businesses and individuals to borrow, slowing growth. Also, in order to encourage economic activities in cases of high loan interest rates in the economy, the Central Bank takes measures such as reducing the interest rate, increasing the supply of credit to the leading sectors of the economy, and reducing the gap between loan interest and deposit interest.
The Central Bank is given the freedom to conduct monetary policy with the aim of achieving the desired inflation targets, and is also responsible for its performance. This rule-based framework increases the credibility of monetary policy, which can lead to additional welfare gains for the economy as a whole. This is because the financial market and the general public are assured of maintaining inflation at the target level, so only a small change in policy interest rates by the central bank is required to bring inflation back to the target level.
When a central bank wants to limit liquidity, it raises the reserve requirement. This gives banks less money to lend. Reduces the need for reserves when liquidity is needed to expand. This gives member banks more money to lend. Central banks rarely change the reserve requirement, which requires a lot of paperwork for members. To discourage bank borrowing, the central bank raises the discount rate at which members borrow funds through its discount window. That action reduces liquidity. By lowering the discount rate, borrowing is encouraged. It increases liquidity and boosts economic growth.
The central bank intervenes in the domestic foreign exchange market to maintain a target exchange rate and to build up its international reserves and to curb excessive volatility that typically arises from domestic and global speculative activities.
Fiscal policy plays a key role in Sri Lanka’s development by controlling price fluctuations and general economic activity. This is done by making a proper match between money demand and money supply. As the economy grows, the demand for money continues to increase. Therefore, in order to avoid inflation, the central bank takes steps to increase the money supply in proportion to the increase in money demand.
On the contrary, a fall in the price level adversely affects the pace of development. At this time, the central bank takes steps to control the use of money and credit by following an appropriate monetary policy. Also controls speculative activities through direct physical controls. Therefore, the monetary authority is conscious of controlling the fluctuations in prices so that they do not adversely affect investment and production in an economy.
In general, Sri Lanka faces the problem of inflationary pressures due to various structural rigidities and imbalances. Sometimes, inflation leads to constant depreciation of the local currency, causing exchange rate fluctuations and confusion in internal trade. As a result, it affects the economic growth rate.
Therefore, a central bank is alert to price changes and takes steps to control it accordingly. It also tries to maintain exchange stability. In other words, the central bank takes qualitative and quantitative methods of credit control to check the inflationary trend of the economic authority and further the economic growth process.
Large scale investment is essential for the development of an economy. A low interest rate policy is therefore recommended as an incentive for economic development.
Also, if imports exceed exports, the Central Bank will take steps to reduce the money supply. This will drive down prices, thereby encouraging exports and discouraging imports. The central bank also takes steps to reduce the domestic interest rate to control the exchange rate volatility caused by the fall in exports and rise in imports. As a result the price level will fall, exports will increase and imports will decrease. On the other hand, the interest rate on foreign loans should be raised to encourage inflow of foreign capital. Thus, the balance of payments deficit will be covered. When imports are less than exports, the domestic interest rate should be raised and the interest rate on foreign loans should be reduced.
The Central Bank conducts its Open Market Operations (OMO) within the corridor of interest rates formed by its policy rates i.e. the standing deposit facility rate (formerly the repurchase rate) and the standing lending facility rate (formerly the reverse repurchase rate), to achieve the intended inflation path. Policy rates are periodically reviewed and adjusted appropriately, if necessary, to guide the interest rate structure of the economy with a view to achieve the desired path of inflation.
*The writer, Assistant Lecturer,Department of Economics,University of Kelaniya